Warren Buffett is the world's sixth-richest person, according to Forbes. He's the CEO of Berkshire Hathaway (BRK.A 1.18%) (BRK.B 1.30%), a company with a market capitalization of nearly $800 billion. But keep in mind that he's not the founder, and Berkshire isn't precisely how he amassed his fortune. Buffett got rich by being a good investor.
Insurance is perhaps Buffett's favorite sector to invest in. In Berkshire Hathaway's 1974 letter to shareholders, he wrote, "We consider the insurance business to be inherently attractive." And yet I believe he would take a hard pass on insurance newcomer Lemonade (LMND 0.83%).
Here's why he wouldn't buy (and why you might consider it anyway).
Insurance underwriting and inflation
Inflation in the U.S. is at a 40-year high. In response, the Federal Reserve raised interest rates earlier in March. And it could raise rates seven more times in 2022 alone to try to slow the rate of inflation.
Image source: Getty Images.
The 1970s were also years of high inflation, and Buffett lamented the problem this creates for insurance companies. Buffett additionally wrote in the 1974 letter, "With costs moving forward rapidly and prices [of policies] remaining unchanged, it was not hard to predict what would happen to profit margins."
In other words, insurance companies try to write profitable policies. But if the cost to replace the stuff that's being insured goes up, it throws off the policy underwriting equation, and profits consequently decrease.
Lemonade's struggles
Against this backdrop, the problem for Lemonade is its policies are wildly unprofitable to begin with. One way to measure this is with a metric called gross loss ratio, which means the amount of money from its gross premiums that are paid back out to cover claims.
Since the gross loss ratio measures how much money the company pays to cover claims, the lower the ratio, the better. After all, a ratio over 100% means you paid out more than you brought in, making it impossible to turn a profit in the end. This chart shows Lemonade's progress over the years.
| Year | Gross Loss Ratio |
|---|---|
| 2017 | 161% |
| 2018 | 113% |
| 2019 | 79% |
| 2020 | 71% |
| 2021 | 90% |
Data source: Lemonade SEC filings.
Lemonade's special sauce is its artificial intelligence (AI) technology. By automating menial human decisions and replacing them with tech, the company can theoretically have better margins than insurance incumbents in time.
Good AI learns and improves as it goes along. Lemonade's was making good progress until 2021. Unfortunately, the company is still so small that it's exposed to concentration risk. For example, 19% of its 2021 gross written premium came from Texas. Therefore, Lemonade was disproportionately impacted by the catastrophic freeze there.
All this means Lemonade's AI isn't writing profitable policies, and it got worse in 2021. Was this just bad luck for a small company with concentrated risk, or is the tech not living up to the hype? Investors don't really have a way to determine the answer, which is something that concerns me.
In short: Lemonade's already struggling. And struggles could be exacerbated as we enter an intrinsically challenging environment of high inflation.
Here's what Buffett likes
Buffett's Berkshire Hathaway made headlines on March 21 for acquiring Alleghany for $11.6 billion. This is about 10.3 times Alleghany's net profit in 2021 and about 1.3 times its book value -- quite the bargain.
Buffett says, "Rule No. 1: Never lose money." And with a strong history of profitable operating results, it will indeed be hard to lose money by acquiring Alleghany. Given a long enough holding period, the business should produce cash flows in excess of what Berkshire paid.
Here's why Lemonade might be a buy anyway
There's a higher chance of losing money with Lemonade than with Alleghany. Therefore, I bet Buffett wouldn't buy Lemonade stock. But here's why you might consider Lemonade anyway.
Despite its challenges, Lemonade has its merits also. In its short corporate history, it's already amassed over 1.4 million customers, making it the fastest an insurance company has reached that milestone. It's rapidly expanding its insurance options and geographies, providing ongoing opportunity to increase its customer base and average premium per customer. Moreover, while it's generating big losses, it's well capitalized with $1.1 billion in cash, cash equivalents, and short-term investments. The stock, therefore, trades under two times its book value.
Furthermore, it's OK for investors to lose money. I know it sounds ridiculous, but Motley Fool co-founder David Gardner calls it "losing to win." As he frequently points out, you can only lose 100% of your investment. By contrast, your upside isn't limited. By trying to identify great companies early, we'll frequently be wrong. But simply finding and holding one huge winner can offset a pile of bad investments.
Buffett's high-accuracy investment strategy has paid off handsomely. But the losing-to-win strategy can be equally effective -- with some caveats. To start, this isn't throwing money at everything. Striving to beat the market with 50% to 60% of picks should still be a goal. After all, we aren't trying to lose.
Lastly, position sizing is key. I believe investors should simultaneously invest in mature companies like Alleghany and upstarts like Lemonade. But investing less money when the future is less certain is prudent. If Lemonade is ultimately unsuccessful, a small position won't derail my long-term finances. But if it is a big winner, even a small position can have an outsized positive impact on my diversified portfolio.
For this reason, I'm holding a small position in Lemonade even though I don't think my hero Buffett would like it. The future is far from certain for Lemonade. But that goes both ways; it could still be a success as well as failure. If it overcomes today's challenges, I'll be happy I grabbed a small stake at today's price.
