I regularly add new stocks to my portfolio, and insurance-technology company Lemonade (LMND -0.46%) was one of the final companies I added in 2020. And after just a couple of months, my investment had already doubled in value. But that was before the stock crashed back down to earth, cutting my initial investment in half.
My experience with Lemonade demonstrates a stock market truth: Volatility is pervasive in the short term. However, time typically irons out volatility. Good businesses will create shareholder value as time marches on, bad businesses will destroy it, and the stock price will eventually reflect this either way.
Image source: Getty Images.
Will Lemonade ultimately create or destroy shareholder value? Time will tell. But there are great reasons to believe in the stock for the long term. That said, however, there's one thing holding me back from adding to my position right now.
Why buy Lemonade stock?
Lemonade is trying to change the insurance game. New customers are served via artificial-intelligence (AI) software, reducing labor costs. And when customers choose Lemonade, they simultaneously choose a charity. Customers pay their monthly bills, Lemonade pockets roughly 25%, reinsures the policies to mitigate downside risk, and the rest is donated to the customers' elected charities.
In theory, this unique business model aligns Lemonade's financial incentives with those of its customers, which could inspire existing customer loyalty and help it stand out to attract new customers. And there's good reason to believe the last part of this theory is playing out before our eyes. Consider that Lemonade surpassed 1 million customers in 2020 after less than five years in business. For perspective, investing legend Warren Buffett owns GEICO, which didn't reach 1 million customers until it had been in business for 28 years.
As of the third quarter of 2021, Lemonade has over 1.3 million customers, showing the growth trend is ongoing. Therefore, it seems like the business model is resonating.
Furthermore, Lemonade has fantastic optionality and can easily keep growing its customer count. The company started with renters and homeowners insurance in limited areas. But it's since expanded to new regions. And in the past year, it's launched pet insurance, life insurance, and (most recently) car insurance.
This broad expansion can attract more new customers to Lemonade. Moreover, if people sign up for more than one product, the company can efficiently grow its revenue per user. In the third quarter, revenue per user was up 26% year over year, suggesting this is already happening.
Finally, consider Lemonade's financial potential. When it went public in 2020, the company had just one employee per 2,000 customers, thanks to its AI software handling tasks. This compares to an estimated 150 customers to 450 customers per employee at Lemonade's competitors. Because of this, it's an idea that could scale very well.
Image source: Getty Images.
What's holding me back
All of this is predicated on the assumption that Lemonade's software can write profitable policies. The software is supposed to improve with time and data, so patient investors can cut it slack for where it is right now. But the company needs to demonstrate the merits of its AI with fundamental improvements over time.
Insurance companies measure policy profitability with loss ratios. A loss ratio of 100% implies a company paid back all of the money it collected in premiums to cover claims. For Lemonade, its gross loss ratio improved sequentially every quarter from the first quarter of 2019 to the second quarter of 2020, hitting its best at 67%. However, in the most recent quarter, Lemonade's gross loss ratio was at 77%.
There are several possible ways to explain why this key business metric is sliding. First, Lemonade has some geographic concentration risk, meaning a single event can have an outsize negative impact, like the Texas freeze. Second, as already noted, Lemonade has recently launched new insurance products with lower margins. Considering these are growing fast, they're quickly raising the overall loss ratio.
Both of these possible explanations are short-term problems. However, it's also possible that AI software can't write profitable policies and Lemonade's business model will never make sense. That's an extreme, worst-case scenario. But it can't be ruled out entirely.
The problem is that investors can't be sure what the true culprit is here for Lemonade. I'm inclined to think it's the short-term problems mentioned here. If true, I expect its loss ratio will show signs of improvement throughout 2022 as we move further away from the problems.
Given all we've seen about Lemonade's business, I believe it has multibagger potential, and that's why I own a small position. And I'll gladly add to it as the business shows me it's worthy of it. For this reason, if the loss ratio improves in 2022, I'll buy more Lemonade stock in a heartbeat.
