What happened

Shares of insurance company Lemonade (LMND -6.23%) fell 40.8% in August, according to data from S&P Global Market Intelligence. The company relies on machine learning and other types of artificial intelligence (AI) to manage its insurance operations, from sign-up and plan premiums to risk assessment and claim payouts.

Last month's second-quarter earnings report delivered a mixed bag of strong and disappointing results as Lemonade's AI systems misjudged some expensive risks, and investors were quick to focus on the bearish trends.

So what

Most of the headline figures looked good in the second quarter. Revenue more than doubled year over year as the in-force premiums (active insurance-policy fees) rose by 50%. The quarterly premium per customer increased from $290 to $360, and the annual dollar retention rate increased from 83% to 87%. In other words, the average Lemonade customers paid 24% more for their insurance plans -- and told their friends to sign up.

That's all good news, but the story didn't end there.

Due to a rising number of severe storms and growing pains in the more-recent car insurance business, Lemonade's gross loss ratio landed at 94%. That's up from 87% in the first quarter and 86% in the year-ago report. This crucial metric measures the amount of claim payouts and other insurance losses divided by premium fees. It is a meaningful way to monitor the company's risk management, and Lemonade hopes to lower it below 75% in the long run.

But the second quarter moved in the opposite direction, and investors panicked. As a result, Lemonade's stock fell 21.6% on Aug. 3 and continued to slide for the rest of the month.

Now what

Giving Lemonade's stock a haircut makes sense due to a poor loss-ratio performance. After all, getting this metric down to a more profitable level is crucial to the company's long-term success.

However, it should be noted that the problematic loss ratio shows a lot of progress if you back out the unseasonable weather events and the learning-to-walk car insurance operation. The gross loss ratio in Lemonade's renter's insurance dropped below 50% in the second quarter, pet insurance purred at 77%, and home insurance stopped at less than 70% (backing out weather catastrophes).

Chart showing Lemonade's segment-level gross loss ratios falling over time.

Image source: Lemonade. CAT = non-hurricane weather catastrophes.

These trends are a testament to Lemonade's insurance operations improving over time, as its AI systems learn how to manage risks based on a rapidly growing inflow of real-world customer data and policy-related events. Every new customer, every insurance claim, every loss, and every adjustment becomes fodder for the machine-learning process. It's no surprise that the company's newest service line is its worst-performing insurance business.

So I understand why Lemonade's stock fell on a seemingly strong earnings report, but I also expect the loss ratio to continue improving. This stock was an overvalued market darling in 2021. Share prices have fallen more than 90% from those lofty highs.

Nowadays, it looks like a reasonably priced bet on AI-powered disruption in the enormous insurance industry. This stock is not every investor's cup of lemon tea, but I'm sorely tempted to double down on my own Lemonade holdings at this bargain-bin stock price.