[U48] Lemonade: winning with leading indicators
Innovating insurance with models and customer cohorts over time
Dear Readers,
In this Update for Product | Strategy | Innovation I will share more insights into innovating insurance. Lemonade sells and underwrites insurance direct to consumers for renters, homeowners, automobile, pet and term-life policies. The company also collects premiums and processes claims for active policies with its customers. The user experience is digital with substantial process automation to help manage quality and cost.
Earlier this year, I wrote about Lemonade and whether it could innovate insurance. I questioned if Lemonade has enough capital to withstand ongoing losses while it improves its technology to build a sustainable business.
Lemonade reports its loss ratio on a quarterly basis. This metric represents the claims paid out relative to premiums collected for a cohort of customers over a specific time horizon (monthly, quarterly, or annually).
Loss ratios that are too high challenge the sustainability of an insurance business. Loss ratios that are too low indicate insurance policies were priced too high for the risk during that period. The trend for Lemonade’s quarterly gross loss ratio has improved over time. Lemonade’s target loss ratio is 70%.
Lemonade uses a comprehensive model to price insurance based on calculating the lifetime value (LTV) of a prospective customer. Lemonade’s LTV model is proprietary but predicts indicators like the conversion rate to bundle other insurance products, insurance premium growth over time, lifetime loss ratio, customer retention, and other factors over the estimated lifetime relationship for a prospective customer.
Lemonade is currently deploying its 9th generation LTV model (LTV9) and tracks the predicted cohort lifetime loss ratio for its LTV models on a quarterly basis.
Leading vs. Lagging Indicators
A leading indicator for the LTV model is the predicted loss ratio over the 1st year of a cohort. The lagging indicator is the actual loss ratio over the same one year period for the same cohort. The objective is to build more precise models over time using a growing base of real-world data to train new models.
This figure above shows the predicted cohort lifetime loss ratio (total claims paid / total premiums collected) with the magenta color on a quarterly basis. This predicted cohort lifetime loss ratio improves from 85.8% in Q1 21 to 60.6% in Q3 22.
The dotted black line shows the predicted 1st year loss ratio which is typically higher in the 1st year than the lifetime loss ratio and falls in line with the lifetime loss ratio by the 3rd year. The solid black line is better than predicted and represents the actual 1st year loss ratio using Q2 23 (78%) and Q3 23 (68%) data.
Lemonade has also reached 2 million customers with active policies to keep refining its technology using actual premiums collected and claims data.
As loss ratios improve, Lemonade will have more flexibility to balance profitability and growth.
Lemonade communicated in its recent 2023 Q3 earnings report that its LTV/Customer Acquisition Cost (CAC) or LTV/CAC Ratio is 4. This indicates a healthy business to sustain growth.
So, this is a positive trend if Lemonade can maintain its LTV/CAC Ratio for a business with such a large total addressable market (TAM) as the global insurance industry. And it also provides a lever for growth with a buffer to innovate more effective ways to acquire customers or accept more risk for a cohort to improve the conversion rate of acquiring new customers.
Lemonade is also well positioned to benefit from advances in AI and machine learning technology over time. They can use their data at scale to backtest new models using the latest technology against past and current models.
Premium Growth and Gross Profit Improvement
The LTV model combined with an expanded product portfolio in 2022 are driving revenue growth from more insurance premiums collected. Bundling multiple products and cross-selling existing customers to additional products drives more premiums collected from a customer.
Insurance regulations can also constrain how much premiums can increase to offset higher claim payouts due to inflation. This has posed significant challenges for insurance companies during 2022 and 2023 with rising inflation. Lemonade has benefitted with a direct to consumer model and automated processes to increase efficiencies. This lean model has allowed Lemonade to adapt and still underwrite new policies. The result was an 18% increase in premium revenue to $719 million in 2023 Q3 relative to Q3 in the prior year.
Gross profits for Lemonade also increased 170% to $22 million in 2023 Q3 relative to the prior year. This was due to the increase in premium revenue and a decrease in the loss ratio for the quarter.
Innovating Customer Acquisition
Lemonade does not sell insurance through licensed independent agents who bear the cost to acquire customers and then receive commissions on premiums paid as compensation. Lemonade bears the full cost to acquire its customers, but also does not have to pay out commissions on premiums.
This requires capital for Lemonade to fund customer acquisition. The cost of capital has also increased with inflation in recent years. Lemonade announced on June 29, 2023 that is had partnered with the venture capital firm General Catalyst to create “synthetic agents” as a financial structure to unlock growth without depleting cash.
Through this financial structure, General Catalyst funds 80% of the CAC for a cohort of customers and then receives 16% of premiums generated from the policies they help to finance up to recovering their investment and a capped return for the cohort. Lemonade does not have to share any premium revenue from these customers once the terms of the General Catalyst deal are satisfied.
Lemonade can also innovate low-cost means to acquire new customers with other programs. They acquired new customers through the acquisition of Metromile for not only the automobile policies that were in force, but to cross-sell other policies by bundling insurance across multiple lines.
Lemonade partnered with Chewy to promote pet insurance. Chewy has a strong relationship with many pet owners, so Lemonade was able to access a loyal base of prospects to share the value provided with pet insurance. These policies could also be bundled with other lines of insurance to drive added value.
However, as Lemonade continues to scale with more traditional means of acquiring customers to improve its leading indicators, LTV models and optimally priced insurance for the level of risk, it will have more options for growth. Lemonade will be able to partner with larger companies to underwrite insurance for specific customer cohorts.
Consumer brands favored by young adults like Apple, Amazon, and Cash App could partner with Lemonade to promote specific insurance with certain benefits. Lemonade would be able to use their LTV model to price insurance for a new cohort of customers assuming the CAC is near zero. This benefits all involved including the consumer brand, its customers and Lemonade.
Some Final Thoughts
Lemonade will be judged by its performance on lagging indicators like the loss ratio each quarter and trends in these indicators over time. However, leading indicators like the LTV for a customer and predicted cohort 1-year loss ratio drive more innovation. AI models and machine learning are core to this innovation at Lemonade.
Process automation using various tools like machine learning build scalable solutions and drive efficiencies to manage cost. As Lemonade improves its precision to manage the LTV for a cohort of customers and innovates ways to reduce its cost to acquire these customers, the growth potential is significant. But this also requires superior customer experiences when serving these customers. Lemonade has many levers to help it optimize financial performance.
The next 1-2 years are critical for Lemonade to continue improving its technology and processes with manageable growth and scale with just over 2 million active customers. But the vertical integration and direct to consumer model it is building make Lemonade a viable candidate to disrupt the legacy insurance industry over the next 5-10 years.
Best,
Stephen
I’m long AMZN, LMND and SQ mentioned in this Update. Nothing in this Update is intended to serve as financial advice. Do your own research. The opinions and views expressed in this newsletter are those of the author. They do not purport to reflect the opinions, views or policies of any other organization, company or employer.