Gavin Davis, Gianluca Casapietra and Dan Lukpanov
The company played up its rapid growth with gross earned premium and customers both up around 84%, as well as its continued improvement on its loss ratio to 67% on a gross basis from 82% YoY.
However, as the company moves into a new phase of life as a public company, it is likely to begin to face more scrutiny and, over time, a little less automatic belief in its self-described narrative as an inevitable disruptor if it does not deliver financial results to match its rhetoric.
Ironically perhaps, given early concerns, the company so far has delivered good progress on improving its loss ratio and enough growth on a percentage basis to keep that part of the narrative intact.
However, over time, we expect the key issues to become: (a) how much the company is spending to achieve its growth, (b) how well the company is retaining and graduating its customers and (c) whether the model has competitive advantages relative to existing direct incumbents.
We have five key points following the company’s first quarterly update with its new cohort of investors.
First, the company’s latest spin on its contrast to incumbents boldly takes the company from the cutting edge of insurance innovation circa 1750 to the dizzy heights of the 1930s.
Recall, when the company first launched in 2015 at the absolute peak of hype around crypto-currencies and distributed ledger technologies, it marketed itself as a revolutionary “peer to peer” insurance company.
At that time, this would have made the company as innovative and high-tech as the Philadelphia Contributionship, founded in 1752 by Benjamin Franklin as what is known in tech circles as a “mutual insurance company”.
Of course, this label and model was rapidly dropped. Yet the company’s first conference call was replete with a new spin. Management made at least three references drawing a contrast between its model and “traditional broker-based insurance incumbents”.
There are several things to say about this. The first is to congratulate Lemonade for accelerating its tech curve almost 200 years in its five years of existence. The company has now caught up to the revolutionary direct-to-consumer business model – like Geico, which was founded in 1936.
The second is to say that the first question any InsurTech in personal lines should be asked is: “What are you doing that Progressive or Geico aren’t doing?”
The second is: “And if they’re not doing it already, what is to stop them copying you?”
With this in mind, the company’s framing of its business model as disrupting the “broker-based incumbents” with no mention of the two 500lb gorillas already in the room seems somewhat odd, and one wonders at its motivation for deliberately eschewing traditional insurance investors.
Second, this lack of comparison to Geico and Progressive seems notable given the company’s apparent inefficiency at manufacturing growth.
The longer-term question on growth is whether Lemonade has (a) any fundamental competitive advantages that allow it to either price its products more competitively, (b) whether it is able to manufacture a brand that will allow it to compete with the existing heavyweights in its target markets and (c) whether it can scale its marketing spend to become more efficient at manufacturing growth.
In spite of the high-percentage growth rates, it should be noted what a small base the company is starting from. For context, Progressive grew NWP by $5bn in 2019, or 33x Lemonade’s entire FY 2020 GEP guidance.
Ultimately, over time, Lemonade will need to prove not that it can just outgrow the “broker-based incumbents” but also the existing direct-to-consumer giants. The experience of Esurance suggests there is something of a natural limit to the number of mass-market direct providers (customers might check a couple of quotes online, but not 10 if they are trying to “save time” as well as money).
As things stand, there are legitimate questions here. In its S-1, Lemonade says it spends $1 of marketing to generate “more than $2” of in-force premium. Though it did not update this figure in its release or call, management did refer to the life-time value (LTV) relative to customer acquisition costs (CAC) as “strong and stable”.
On its call, the company went to great lengths to explain the importance differences when comparing acquisition costs of direct insurers versus “broker based” businesses.
This is fair enough – though should be so painfully obvious to any investor in an insurance company that it borders on condescension. But sure, the proper way to think about Lemonade’s acquisition costs is not as a percentage of first-year premium but as a percentage of life-time premium – essentially the CAC-to-LTV metric the company referenced.
But there’s a problem with that too. As we noted back when it first filed its S-1, Lemonade has a retention problem. The firm sheds more than half of its customers in the first two years.
At a 2:1 ratio of in-force premiums to marketing spend, Lemonade would need an average policy life expectancy of around six to nine years to be as efficient at producing growth as Geico or Progressive.
In fact, it would be reasonable to assume an average policy lifetime for Lemonade of around three years – based both on the company’s disclosed retention metrics and a rule of thumb two-to-three-year average tenancy duration for renters. In this instance, Lemonade would need to produce >$7 of premium for every dollar of marketing simply to be as efficient as Geico or Progressive.
Lemonade may have several innovative aspects to its business model that gives it a real competitive advantage in terms of its cost to manufacture products, accumulate data, triage claims etc. But selling direct to consumers is not one of them on its own. In fact, it does not seem particularly efficient relative to existing incumbents in this regard at this point.
Notably, assuming a three-year average policy life and a 2:1 premium-to-marketing spend implies a ~17% lifetime acquisition cost ratio. Assuming it could scale operating expenses to be in line with a top-tier performer like Progressive would put the expense ratio around ~30%. With the firm running at a ~70% loss ratio, this doesn’t leave a lot of room for margin.
Ultimately, Lemonade will either need to get more efficient at manufacturing growth, be more efficient on operating expenses than top-tier incumbents or improve its loss ratio towards the lower end of its 60-70% target. All of these are possible over time, but something must improve.
Third, despite telling investors that its business model is “premised on” converting renters to homeowners, the company seems to want to not provide any information on its success.
Recall, in its S-1, Lemonade said: “Our business model is premised on the expectation that a significant number of our users that are renters will continue to retain coverage with us as they move from being renters to homeowners.” [Emphasis added]
To this end, it was a little surprising the company chose not to "give a deep breakdown of those metrics” relating to how many of its renters were graduating (read: no metrics at all).
Recall, in the S-1, the company said just 10% of its condo insurance customers “graduated” from renters. If the goal of the business model is to manufacture homeowner PIF, the business has so far organically produced 1,245 of them (as of end Q1) – or probably around $2mn of annualized premium.
On the call, management did concede that the “majority” of its growth in homeowners remains new customers and not graduation.
But it seems notable that (a) the company’s business model is by its own definition "premised on” the success of converting renters’ policies to homeowners’ policies and (b) the company is not providing investors with any way to track this progress.
For a company that seems so keen to accentuate the positive, its decision not to share this metric seems like a highly important data point on its own.
Fourth, the company seems to be confused about the nature of its retention problem.
As noted above, we have previously flagged retention as a key issue for Lemonade. In fact, we expect this will become the key determinant of success for all the InsurTech “disruptors” over time who have strong incentives to show “proof of concept” growth early in their life cycle.
That said, Lemonade’s comments on retention seemed somewhat all over the map – on the one hand acknowledging that renters is by nature a high-churn market, but on the other insisting it will improve over time as the mix of vintages shifts.
At one point on the call, CEO Dan Schreiber specifically called out what he described as an industry orthodoxy that loss-ratio improvement could not occur concurrently with rapid growth. For us, the comments strike to the heart of the growth controversy around Lemonade and other comparable start-ups. Here’s how he put it.
This is all well and good as a straw man to draw contrast for your tech-driven business model, but this is not what industry orthodoxy is. The real orthodoxy is that growth carries a higher risk, a higher loss ratio and higher volatility because of adverse selection risk.
In fact, elsewhere Lemonade itself tacitly acknowledges that this assumption is embedded in its own business, as it expects its first-year loss ratio to be worse than mature years.
This is because, all else equal, in insurance, the population of shopping customers is worse than the population of non-shopping insurance customers. (This is what makes incumbents with big books valuable in spite of low growth.)
This is important because it governs the rules of the road for disruption in insurance. The fundamental reality is that even the world’s best disruptor with significant competitive advantages, a lower cost to produce, and unlimited capital supply will have the pace of their growth limited by the pace of annual shopping.
You can have the best insurance product the world has ever seen and an NPS of 100, but insurance is not and never will be an inherently “delightful” thing that drives people to take the effort to switch carriers simply for the better experience.
It’s something you buy when and because you have to, not because you want to. Having a Lemonade renters’ policy instead of a Travelers will not win you “street cred” in the way having an iPhone over a Nokia 3210 in 2008 would, nor virtue signal in a way many other millennial-oriented products do.
There is no “killer app”, no “must have” product that could lead to a mass-adoption event. Any incremental effort – even 90 seconds – outweighs any potential gain in “delight”.
This is why the universe of shoppers is typically mixed heavily with (a) new customers and (b) customers who have left their last insurance company for reasons that make them more likely to be a bad insurance customer (e.g. a claim issue).
This is why incentives to grow rapidly to “prove the concept” and “get to scale” can be so value-destructive over time.
And this is why high-quality insurance companies have the characteristics of quality compounders and not hockey-stick growth, as competitive advantages compound over time and lead to both better growth, with higher-quality segments of shoppers, and higher retention of good customers.
What seems strange is the company sort of acknowledged the nature of the business it is in when it described its target market of renters as “transient”, subject to multiple life events that lead them to cancel coverage.
The irony is, Lemonade may well have created a lower-touch, more cost-efficient (at scale) model that could conceivably address the renters’ market in a lower-cost way and significantly outperform incumbents – and could possibly migrate that to other lines over time. However, if it overpays to acquire customers with a low retention simply to maintain its growth narrative with investors, it will destroy value, even if every other part of the model really is better than incumbents.
Finally, we can’t help but point out the bizarre nature of the firm’s update on its “giveback”.
Recall, we have previously highlighted the latent risk of the company’s marketing through virtue-signaling approach of its “giveback” as a key risk given that (a) the company has given next to nothing to charity over the course of its existence and (b) it has manufactured several multi-millionaires. This is a poor look in general for a “public benefit corporation” and is typically the sort of corporate hypocrisy that does not sit well with the exact consumers Lemonade is explicitly targeting with these marketing gimmicks dressed up as “behavioral economics” for Wall Street.
On the call, co-founded Shai Wininger appeared to try to get ahead of this, pointing out that the firm’s annual donation this year was “20x” its first giveback in 2017 and “higher than our three previous years combined”. Seeing that the giveback was $1mn, and stock-based compensation this year alone is $11mn, this is an odd framing that does more to highlight how little it was in previous years.
But even more bizarre was the following statement:
These numbers seem… strange? 50,000 Covid-19 patients alone would get $20 each out of $1mn, leaving no room for feeding 980 families or covering rent for more than 100 struggling households. It’s unlikely that $20 a patient would buy a Tylenol or a cotton swab in any American hospital, so unless Lemonade is doing a deal on off-market hydroxychloroquine, it’s not entirely clear how this adds up.
Perhaps the executive misspoke, or perhaps the numbers includes its “community” including the Lemonade foundation and/or founder contributions – the company did not respond to our questions.
But even granting that, that would only seek to highlight how much more wealth is being generated to the founders and employees than for the charitable foundations that policyholders may think they are supporting.
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