Lemonade (LMND -1.84%) made a splash last summer with its initial public offering (IPO). The company aims to disrupt the multitrillion-dollar insurance industry with its use of big data, artificial intelligence (AI), and a novel business model. And so far, Lemonade has been a sweet investment -- the stock is up over 400% from its IPO price of $29.
Of course, Lemonade's impressive performance means high stakes when the company announces earnings on Mar. 1, and Wall Street will be watching this young tech company to see how it fares against much larger rivals. Here's where investors should focus their attention.
Lemonade's gross loss ratio
Insurance is a highly unpredictable business, affected by things like weather, natural disasters, and freak accidents -- in other words, things insurers can't control. But Lemonade is trying something different. The AI-powered tech company uses a fixed-fee business model that attempts to stabilize gross margin and reduce volatility.
Image source: Getty Images.
To do this, Lemonade depends on reinsurance, which is essentially insurance for insurance companies. For example, when customers make premium payments, Lemonade keeps 25% (the fixed fee) and gives the other 75% to reinsurance partners. In exchange, the reinsurers take responsibility for 75% of losses and they pay Lemonade a 25% commission.
If Lemonade's gross loss ratio -- the percentage of premiums paid out in claims -- is below 75%, the company keeps a minimum of its 25% fixed fee and Lemonade's reinsurance partners profit. If the ratio climbs above 75%, Lemonade's reinsurers lose money. That matters because Lemonade has to periodically renegotiate its reinsurance contracts, and if the company caused its partners to lose money, it would likely receive less favorable terms in the next contract.
Why it matters right now
Investors should always pay attention to gross loss ratio, since it's a key determinant of any insurance company's profitability. But it's especially timely right now, since a portion of Lemonade's reinsurance contracts expire on June 30. That means its reinsurance partners will have to decide if they want to keep doing business with Lemonade, and if they're willing to accept the same terms.
That's a big deal -- it has serious implications for the long-term viability of Lemonade's differentiated business model. Not only does reinsurance make Lemonade's business less volatile (in theory), but it also improves the company's capital efficiency.
Regulatory laws in the U.S. and EU require insurance companies to retain a certain amount of cash to cover losses. Without its current reinsurance strategy, Lemonade would be required to save as much as $1 out of every $2 in earned premiums. However, because Lemonade's reinsurance strategy offloads substantial risk, the company is only required right now to retain $1 out of every $7. That means Lemonade has more cash to invest in growing its business.
So far, so good
So far, Lemonade's gross loss ratio has trended sharply downward, driven by the company's AI-powered underwriting and fraud detection. That bodes well for the company's future and its ability to keep its reinsurance partners.
|
Metric |
2018 |
2019 |
Q3 2020 |
|---|---|---|---|
|
Gross loss ratio |
113% |
79% |
72% |
Data source: Lemonade filings with the Securities and Exchange Commission..
Moreover, Lemonade's gross loss ratio of 72% in the most recent quarter actually compares favorably with its competitors. For instance, the industry average in recent years has been 82% for property and casualty insurers, and 72% for the top 20 companies. In other words, Lemonade is keeping up with industry giants like Berkshire Hathaway and its subsidiary Geico.
If that trend continues, Lemonade could indeed disrupt the multitrillion-dollar insurance industry in a big way.
A final word
Investors should be aware that, as an unprofitable and richly valued company, Lemonade's share price could swing wildly, especially after it announces earnings. It's important to keep a level head and avoid making emotional decisions.
If Lemonade's gross loss ratio drifts above 75% for a quarter or two, that's not the end of the world. What matters is long-term performance, and the overall trend. In other words, is Lemonade's loss ratio typically below 75% and moving downward? If the answer is yes, I'm not selling.
