For the past two years, there was little evidence that Lemonade (LMND 8.23%) Chief Executive Officer Daniel Schreiber was correct in his belief that artificial intelligence (AI) would revolutionize the insurance industry. As a result, investors lost faith in Schreiber and his company, and the stock is down 92% from its Jan. 11, 2021, all-time high of $183.26.
However, investor confidence in the company has risen recently. First-quarter results revealed a positive trend in one crucial metric investors use to evaluate if Lemonade's AI-based insurance revolution can replace conventional insurance business models. As a result of signs of progress, the stock price has gained about 11% this year, more than the S&P 500.
So has Lemonade turned the corner in proving its AI-fueled business model can achieve better results than traditional insurance? If so, the company might prove to be the future of the insurance industry.
Let's take a deeper look.
A declining gross-loss ratio is good news
When assessing an insurance company's performance, it's crucial to consider its loss ratio. This metric is determined by dividing the total claims paid by the premiums received. Generally, a well-run insurance company will produce a gross-loss ratio of between 60% and 70%, giving a company enough margin to pay expenses and build up cash to meet future claims while earning a profit.
A company with a loss ratio of more than 100 pays more in claims than it collects in premiums. This is a sign it must begin pricing in the risk that customers pose, or it will become difficult for the insurer to survive. Yet, if a company prices premiums too high, it may lose business as customers look for cheaper alternatives. A proper balance is needed.
The company's founders started Lemonade with the idea that AI could set premiums more efficiently and accurately than humans. They established a long-term goal for its AI to maintain a gross-loss ratio of less than 75% to produce profitable growth. Among the most significant reasons the stock price of this company collapsed over the past two years is that the company's consistent gross-loss ratio was far above that magic 75% number. In other words, it was fundamentally unprofitable, leading many investors to conclude that its AI wasn't up to the task of pricing premiums correctly.
The good news, however, is that management has internal projections showing that the loss ratio is on track to drop to 75% and below during the next several quarters. And among the reasons that the stock has risen after the latest earnings is that the company's results show its loss ratio trending in the right direction, convincing more investors that AI might work in insurance.
The chart below shows gross-loss trends during the past three quarters. It's important to note that if it weren't for the unusually high number of disastrous weather incidents, which the company calls CAT events, the gross-loss ratio would have been 72% (shown on the ex-CAT trend line).
Image source: Lemonade.
The cherry on top is that Lemonade's AI is learning how to price premiums during the worst bout of inflation in 40 years. Inflation makes insurance-premium pricing particularly difficult. If the AI can decrease the loss ratio under the current high-inflation conditions, it bodes well for its future performance under less stressful conditions.
The company plans to use generative AI
During the company's latest shareholder letter, management discussed its plans to use generative AI, the same technology behind ChatGPT, for as many as 100 of the company's business processes.
Management believes it can achieve substantial cost reductions within 18 months and, according to the letter, "be somewhat impactful on our financials late this year." For example, management stated that it factored in generative AI's expected cost reductions when it revised its full-year 2023 outlook for adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) to a loss of $205 million to $200 million. This is down from a previous forecast of an adjusted EBITDA loss of $245 million to $240 million.
Suppose Lemonade's management is correct in saying that it can produce substantial cost savings through generative AI in 2024 and beyond; the company may become profitable far more rapidly than its current price-to-sales ratio of 3.7 suggests.
Why you still might want to remain cautious
Investing in this company may involve some uncertainty as management has yet to provide detailed information on how it plans to use generative AI. Additionally, the company also acknowledges the technology still has issues. Those issues include bias, wrong answers, data privacy, and copyright concerns. So, the company says that it will be "thoughtful" in implementing generative AI. Still, there is a risk it could fumble the ball and cause severe reputational harm to the company.
Consumers already don't trust AI and want it regulated. So investors in the company must also accept the risk that government regulation could eventually stifle Lemonade's AI-based business down the road.
Why you should consider buying the stock
Lemonade began monetizing chat interfaces, AI, and bots eight years ago, well before OpenAI made chatbots cool with ChatGPT. So it has a head start over many other companies.
If you are looking for a simple way to invest in AI, Lemonade will likely be among the first companies to monetize AI effectively. As a result, aggressive growth investors should consider buying the stock at its relatively low valuation.
