Should you Invest in Lemonade Insurance?

Lemonade featured image

Lemonade Insurance (LMND), a US-based property and casualty company, became one of the largest day-one IPO gain of +140%, despite the ongoing pandemic crisis.

In this article, we breakdown Lemonade Inc. as a company, its unique selling point, growth plans and how to value an InsurTech company. More importantly, we are analyzing the company from an insurance perspective rather than a tech company, which we will explain why later in the article. We conclude by answering the most important question of it all – should you invest in Lemonade today?

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    The insurance industry and Lemonade Insurance

    The insurance industry has often been liken to a dinosaur. Slow, old-fashioned and resisting any new changes. Most insurance companies have long said that they’re in the business of paying claims. That is, of course, until insurance companies started invalidating claims citing obscure fine prints that customers did not bother to read. A recent example would be insurers denying coronavirus claims citing exceptions for virus, bacteria and pandemic clauses.

    Just for laughs

    Urban Dictionary refers to the term insurance as “a business that involves selling promises that are never fulfilled”.

    Founded in 2015 by Daniel Schreiber and Shai Wininger (also co-founded Fiverr), Lemonade Inc’s goal was to revolutionize the insurance industry. From the initial interaction through to claims, the New York based company plans to fundamentally challenge how the insurance business work by combining its technological prowess and social impact goals.

    According to its S1 fillings, Lemonade’s mission is to “Harness technology and social impact to be the world's most loved insurance company.”

    There you go.

    How is Lemonade different from traditional insurance?

    In our previous article, we wrote about how insurers make money. Here's a quick recap.

    How insurers to make money
    A brief diagram on how insurers make money

    On the surface, there is no difference between how Lemonade Insurance and traditional insurers make money. They make money primarily from underwriting and investment income.

    Here’s how Lemonade differentiates itself. Firstly, its business model is predicated on behavioural economics and retain a fixed fee as profit, currently at 25% of premiums. The remaining funds are first used to pay claims and expenses. Finally, funds that are left over are then donated to their common cause.

    Insurance companies and its customers has been long been entangled in a love-hate relationship. In essence, it’s a zero-sum game, where a gain for the customer is a loss for the insurer and vice-versa. Consequently, the fixed fee element of its business model is designed to address that issue.

    This is intended to partially neutralize the conflict of interest between insurers and its customers. Backed by evidence from behavioural economics, the introduction of a fixed fee component and its charitable initiatives are designed to maximize customers’ trust, reducing fraud and hence a win-win situation. Or at least, better than the traditional insurance model.

    Secondly, Lemonade is fully digital. It leverages technology, data and artificial intelligence to underwrite its policy. It is fully customizable, quick, user-friendly and available via you’re the Lemonade App or PC.

    Finally, Lemonade is an insurance carrier by itself. From a customers’ point of view, it may not matter at all. However, from an investing perspective, this is critical. For this reason, Lemonade is subject to insurance regulation in states and countries it operates in. This differs vastly for most InsurTech outfits, where they build a platform while leveraging established insurers to underwrite risk.

    Lemonade insurance products

    Lemonade Insurance offers renters and homeowners insurance in the US. In addition, it also offers contents and liability insurance in Germany and the Netherlands. Here's the list of possible future products, based on the most recent filings.

    Lemonade product suite
    Lemonade’s expanding product suite. Source: S1 Filings.

    Key drivers of Lemonade Insurance

    As an “emerging growth company”, Lemonade’s key drivers are

    • Acquiring more customers. Lemonade’s growth strategy has largely depend on social media advertising and word-of-mouth. With the stock now listed, we expect greater coverage and brand awareness, which will further drive top-line growth.
    • Growing its target market. Lemonade’s customers’ average age is around 30 years old, fairly tender in the insurance world. For homeowner and renters insurance, these are usually lower premium tickets. As customers move up the economic ladder, Lemonade can broaden its target market towards the higher premium / wealthier and older age group.
    • Launching new products. Lemonade can launch new products leveraging the firm’s DNA. For example, pet insurance.
    • Expanding to new geographies. Lemonade has tremendous potential in expanding geographically. In the US, Lemonade is currently only active in 29 states. Similar in Europe, it’s only operating in Germany and the Netherlands. Lemonade has no presence in Asia/Latam.

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    Potential challenges

    A tech-enabled, digital only, no-frills high growth insurance company, Lemonade is championing a new way how we buy insurance. So, what’s not to like about Lemonade? We highlight a few possible headwinds for Lemonade.

    For those who haven't been caught up with the InsurTech space, Lemonade’s business model is actually nothing new. Here’s a table of some of Lemonade’s peers.

    Lemonade competitors
    Global insurance startups. Info correct as of 6 July 2020.

    Firstly, one of the challenges is how can Lemonade effectively differentiates itself from its competitors. The world of insurance revolves around data. The more you collect, the better your underwriting process will be.

    Currently, the stumbling block is that every InsurTech start up is boasting the same data-driven capabilities. Ultimately, Lemonade will need to prove to the market that its underwriting capabilities, backed by its cutting-edge technology, is a unique edge that is hard to replicate.

    Secondly, for regulated financial companies, size matters. In fact, the larger the better, we would argue. Insurance is a business of pooling risk, hence, by the law of large number, bigger is usually better. In addition, a larger and more diversified company is able to underwrite risk more economically versus a young and less diversified company.

    Consequently, incumbents have a natural cost advantage relative to new entrants. While Lemonade has so far been able to provide the value proposition for its customers, one of the key headwinds as the company expand is economies of scale.

    Like Peloton, Lemonade is unprofitable so far. At the time of writing, it has not yet provide a clear time-line as to when the company will break even. We expect management to provide some guidelines on its path to profitability in the medium term.

    Industry jargon

    Unfortunately, this is unavoidable. A small detour into a few key industry jargon / concept is needed before we continue.

    • Gross written premium (GWP) is the amount received (or expected to be received) without the reduction for premiums ceded to reinsurance.
    • Ceded premium represents premium that are paid to reinsurer, in return for its protection. For example, in exchange for a fee, the reinsurer will share both the profit and loss of the policies written by Lemonade.
    • Net earned premium (NEP) is the premium earned by the insurance company after deducting reinsurance course.

    The difference between “earned” and “written” are best explained in the figure below. Assume you bought a two-year insurance policy today that requires a one-off payment of $1000, ie: you’re covered for the next two years.

    written vs earned premium
    An illustration of written and earned premium.

    From an accounting perspective, it’s simply saying that you can only recognize premium over the lifetime of the contract, not everything at the beginning, which makes perfect sense.

    • Combined ratio (COR) is widely used in the P&C insurance industry as a measure of profitability. Mathematically, expressed in percentages, this is

    Combined ratio = (Claims/Losses + Expenses) / NEP

    Broadly speaking, COR>100% means the company is making a loss, having to spend more for each NEP. A COR of 90% means its making 10% of insurance profit per NEP.

    Lemonade's financials

    Unlike most analysis in the market, we classify Lemonade as a high growth insurance company, not a SaaS (software as a service) company. We intentionally avoided the analysis of non-GAAP measures, revenue multiples that are commonly used for the tech industry.

    We have good reasons for it. The financial sector is unlike any other sector. Known for its complexity and heavy regulation, an insurance carrier with capital constraints (like Lemonade) should be viewed as one. Ultimately, Lemonade will be subject to the same (if not worse) economics as any other large insurance company in the industry.

    While we’re confident that Lemonade will continue to deliver strong top-line growth, Lemonade is a high growth insurance company that has yet to be profitable.

    lemonade insurance revenue statistics
    Lemonade revenue and inforce premium build. Source: S1 Filings.

    The Group's exponential growth is evident. In 1Q20 itself, it delivered NEP of greater than the whole of 2018!

    Customary to all start up, Lemonade is currently in the explosive growth phase. Consequently, this also means heavy customer acquisition costs to grow top-line.

    In contrast to Uber, Lemonade actually has a pretty strong retention rate, with ~90% of its customers saying they were not switching from another carrier. Clearly, Lemonade is filling the gaps in the market that others are not willing to. Here's a snapshot of the Group's revenue build and income statement.

    lemonade revenue build
    Lemonade’s revenue build. Source: S1 Filings.
    lemonade income statement
    Lemonade’s income statement and underwriting profitability ratio. Source: S1 Filings.

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    Insider ownership

    Here’s a table of the top institutional shareholders post the IPO offering.

    We estimate that insiders owns ~40% of the company post the IPO offering. The two co-founders of Lemonade, Daniel Schreiber and Shai Wininger being the two largest shareholder of Lemonade.

    Lemonade top shareholders
    Lemonade’s top institutional ownership. Source: S1 Filings.

    Potential stock dilution

    Dilution happens when a company issues additional stocks. This could be due to options or convertibles that has yet to be converted into common stocks. New equity increases the total shares outstanding. For this reason, it can affect fundamentals such as voting control, ownership percentages, earnings per share (and other per share data) and potentially the value of the share.

    For example, assume that you own 20 shares of a company that has 100 share outstanding. This makes you a 20% owner of the company. Now, if the company decides to issue an additional 25 shares, the new total shares outstanding would be 125 shares. Consequently, your ownership percentage has now fallen to 16%, or a dilution of 20% (20% to 16%).

    As an investor, earnings dilution could have a material impact on the market valuation of its stock. Turning our attention back to Lemonade’s, the table on the right shows our calculation of potential dilution.

    Assuming all share issuance are realized, we’re looking at a potential dilution of 10%, which is significant. The question remains how Lemonade will deploy this additional capital towards generating greater shareholder return.

    Lemonade share count and dilution
    Lemonade total shares outstanding and potential dilution calculation. Source: S1 Filings.

    Lock up arrangements

    As per most offerings, companies have a lock-up agreement. This is a contractual provision preventing insiders (and existing holders) from selling their shares for a specific period of time. For Lemonade, this is 181 days from the S1 Filings on 6 June 2020. In other words, management and existing (pre IPO) institutional owners are prevented from selling its shares until around 4 December later in the year.

    Should you invest in Lemonade?

    Finally, we are in the position to answer is decided whether we should include Lemonade in our portfolio. The answer is, unfortunately, no. At least for now. Here's why.

    First, we believe that tech-enabled insurance companies (ie those that are licensed insurance writers) should be considered as an insurance company. Unlike the market, we are cautious in acknowledging a regulated insurance company as a tech company.

    Secondly, Lemonade’s moat is dependent on its technology not the product line. Today, Lemonade operates primarily in the homeowners and renters insurance segment, which is a highly competitive segment dominated by incumbents. See table on the right.

    Furthermore, relative to its peers (PLMR and KNSL), who are in the business of writing earthquake and specialty insurance, respectively. Lemonade is not operating in any niche segment of the market.

    For this reason, we believe there is a lower bound in its loss ratio. To put into perspective, the industry’s average loss ratio was 73.9% in 2019. This gives very little room for Lemonade to further grow its margin, if any.

    Lemonade homeowners market share
    Top 10 writers of homeowners insurance by direct premiums in 2019. Source: NAIC data, sourced from S&P Global Market Intelligence, Insurance Information Institute.
    lemonade peers comparison table
    TNAV = Tangible net asset value. * excludes intangibles and deferred acquistion costs. Prices are as of 6 July 2020. Source: Company reports.

    Finally, valuation. Lemonade came to the market at $29. At time of writing (2 days after the IPO), it’s trading at ~$80. Broadly, this implies a P/TNAV of ~13x, which one of the most expensive insurer we’ve seen by a mile, even with its growth. Not to mention, Lemonade is unprofitable and doesn’t pay a dividend.

    In all fairness, Lemonade can continue to grow rapidly. We, however, think that the risk/reward ratio is unfavorable to long-term investors like us, at the present moment. We acknowledge that in the future, Lemonade can be well suited as part of a larger insurance group, which could make it a potential takeover candidate.

    Lemonade or Lemon-aid?

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    2 thoughts on “Should you Invest in Lemonade Insurance?”

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