Growth investors were initially enamored with Lemonade (LMND 5.36%) when it first came public at the end of June 2020. However, six months later, Lemonade ran into the after-effects of the pandemic, which put its business model under stress. Despite quarterly reports showing high customer and premium growth, investors have recently become more concerned about the company's lack of profitability. Here's why Lemonade deserves a vigorous inspection before you decide to invest your hard-earned dollars.

Profitability worries

Many growth investors initially believed Lemonade's lofty promises that it could use artificial intelligence (AI) to lower fraudulent claims and exceed older insurers' underwriting performance. 

However, some critics think Lemonade's AI has fewer advantages than the company promotes. For example, AI can suggest poor solutions when encountering circumstances that it has never seen before -- like the high inflation we're currently enduring.

A hand squeezes the juice from a lemon into a large glass.

Image source: Getty Images.

Rising labor costs and COVID-related supply disruptions of crucial materials and parts are the leading cause of the present surge in inflation, which increases costs for vehicle replacement, vehicle repair, rental cars, and home construction. Ultimately, these rising costs drive higher housing and auto insurance claims. As a result, Lemonade's accuracy in predicting how much money to set aside to pay future claims could suffer. In addition, since home and auto insurance are areas of Lemonade's most aggressive expansion, Lemonade may experience significant difficulty maintaining underwriting profitability.

Additionally, the rise of more frequent and damaging storms stemming from climate change could make predicting future insurance claims challenging for Lemonade's AI.

Lemonade's pursuit of profits turns sour

You can measure the effectiveness of Lemonade's business model and its AI through its underwriting profitability. The company must keep its gross loss ratio, a measure of underwriting profitability, under 75% for Lemonade's business model to work. In the second quarter of 2020, when investors were more optimistic about the company, Lemonade had achieved its lowest gross loss ratio of 67%, within its target range of 60% to 70%. 

Unfortunately, the overall trend of loss ratios has been up since the fourth quarter of 2020. Winter storm Uri caused a loss ratio of 121% in the first quarter of 2021. The loss ratio dipped to 74% in the second quarter before rising in the third quarter to 77%. Lemonade ended 2021 with a loss ratio of 96% -- a far cry from Morgan Stanley analysts' optimistic 2020 loss ratio projections of 65% by 2021-2022. Moreover, the fourth-quarter results have some investors openly questioning Lemonade's ability to improve its underwriting results.

Between investors' wariness toward unprofitable growth investments and Lemonade's lackluster profitability, as of March 30 2022, Lemonade's stock has fallen 37% year to date versus a roughly 14% gain for the property and casualty insurance industry.

Should investors remain optimistic?

McKinsey, a management consulting firm, published a report arguing that older, legacy insurers are in danger of long-term disruption if they fail to change swiftly to many insurance innovations written about in Lemonade's blogs. So while some industry experts openly dismiss Lemonade's advantages, many of its innovations could eventually become the industry norm.

Lemonade CEO Daniel Schreiber also continues to express optimism that the company can achieve both underwriting profitability and EBITDA profitability -- EBITDA is a profitability measure that stands for earnings before interest, taxes, depreciation and amortization. In the company's Q4 2021 earnings call, Schrieber remarked that 2022 will be a year of peak losses, with EBITDA improving in 2023. 

However, investors might want to take Lemonade's sweet promises with a grain of salt. Back in 2019, Lemonade's Chief Insurance Underwriting Officer wrote a blog post expressing optimism about Lemonade's underwriting profitability, asserting that "we're closing in on where we need to be to make everything work." More than two years later, underwriting profitability continues to miss the target. 

Lemonade says there's a good reason behind its recent rising loss ratios. Its newer insurance products often start at a high loss ratio, and new products are a growing share of its total underwriting pie. As a result, those new insurance products take longer before they start to help lower Lemonade's overall loss ratio.

But in its most recent earnings call, co-CEO Shai Winiger also mentioned that the large rise in the loss ratio in the fourth quarter was due to "older, large losses to which the company under reserved." 

In plain English, Lemonade failed to predict how much money it would need to pay off claims. As a result, it could take longer than Lemonade's management says for the company to achieve profitability, or Lemonade might never achieve profitability -- bad news for its investors in both cases.

Lemonade is a high-risk investment

If Lemonade survives this current period, It should become a much stronger company by showing resiliency through unfavorable scenarios, while gaining valuable data to improve its AI models. 

However, Lemonade investors should still exercise great caution. Lemonade has an unproven business model that could take several more years to demonstrate success. As a result, the short term could prove very rocky, and only investors with high risk tolerance and patience should invest in Lemonade.