Digital-insurance startup Lemonade, which last week filed for an initial public offering in New York, gives no indication what value the company expects to fetch. But it was valued in the private market at an estimated $2 billion (post-money), and presumably, the company will want to go public at even more.
Its prospectus shows that revenues tripled between 2018-2019 and while its net loss remains high, it has been steadily falling relative to revenue. It also shows a steady improvement in its loss ratio, meaning it’s paying out relatively fewer claims as premium income grows. There are some indications that Lemonade will be able to sell more products to its loyal customer base.
However, an in-depth look into the prospectus raises questions about the gap between the positive picture it presents of itself as an innovative young company disrupting the insurance industry and its financial results. The company is having trouble earning a return on its customer-acquisition costs and suffers from relatively high customer churn. Its technological advantage in actuarial and underwriting remains unproven.
Lemonade is a fully digital insurance company that sells home insurance online using bots and artificial intelligence. Its main value proposition is that everything from buying a policy to filing a claim is done via an application. Small claims are quickly approved without human mediation.
Its business model is based on taking a fixed percentage of premium revenues for itself and keeping the rest for paying claims. Any surplus is donated to a charity of the policyholder’s choice. The model aims to remove the conflict of interest traditional insurers suffer because their profits are earned on the difference between premium income and claims paid. The model has also enabled Lemonade to be deemed a benefit corporation, whose purpose is to contribute to society, not just earn a financial return.
Lemonade sees itself as an anti-insurance company, one that sells technology as a service, or SaaS in tech jargon. It has a well-designed product and a deep understanding of public relations.
For the past three years, Lemonade has voluntarily posted some of its financial results on its blog under the tag Transparency. However, it managed its transparency carefully and left out essential metrics. Data such as customer acquisition cost (CAC), the revenue generated from a single customer throughout his account (LTV), profit per customer after paying claims and customer service operation (unit economics), or the churn rate, were all missing.
Even in the prospectus, these numbers are not detailed, but we can try to extract them independently.
The analysis presented here is based on conversations TheMarker has had with sources in the insurance, investment and technology sector; A Balanced View, an anonymous blog written by a person identified as a former investment banker; and on the U.S. insurance news site Inside P&C.
Slow return on customer acquisition
Last year, Lemonade added 334,283 new customers and in the first quarter of 2020 another 86,207. Its marketing and sales expenses were $89.1 million and $19.2 million, respectively. Lemonade’s Customer Acquisition Cost came to an average of $267 per new customer in 2019 and $223 in first-quarter 2020.
The company states in the prospectus that it spends just $1 on marketing to earn a gross premium of $2. That’s true, but that doesn’t mean that marketing efforts are paying off well. Gross premiums are the top line – equivalent to sales – of which Lemonade must pay part to reinsurers or pay for the actual claims (for the component it does not insure).
Lemonade’s gross profit, as shown in the prospectus, shows it retained $33 out of an average premium of $183 in first-quarter 2020, or 18%, or $30 out of an average $177 premium in 2019, or 17%.
Taking the cost of the quarterly and annual customer acquisition calculated earlier ($223 and $267, respectively) and dividing them by the premium’s gross income ($33 and $30) shows that at current levels it will take Lemonade 7-9 years to return the cost of Its customer acquisition.
But the common rule of thumb for SaaS companies is that one year’s annual revenue from a customer should cover the marketing costs of recruiting the customer to begin with.
Brand loyalty or price loyalty?
One of the most important metrics in the SaaS world – directly related to the valuations these companies receive and their ability to achieve profitability – is called the LTV/CAC ratio. It is the ratio of the average revenue the customer is predicted to generate throughout their account and the average cost of gaining the customer. A ratio of less than 1 shows that the company is selling its products at a loss, even before research and development expenses.
Lemonade does not provide its LTV/CAC ratio in the prospectus, and there is a need for other data to calculate, such as churn rates, which are not explicitly stated either.
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To demonstrate customer loyalty, Lemonade does show its retention rate for the first two years. The rate includes the percentage of customers retained during the first 12 months after they have begun doing business with the company, and those who were insured at the end of the first year and remained customers until the end of their second year. In both cases, the number is a similar 75%-76%. In other words, the percentage of customers that leave the service over a given period (the churn rate) is 25%. The average customer lifetime is four years.
This calculation is a rough one, as it assumes that customer revenue will stay the same throughout the years. But Lemonade’s data are biased: Lemonade notes that its retention rates don’t include company-initiated cancellations and non-renewals based on risk assessment. Those came to 13% in the first year and 5% in the second year. In other words, Lemonade’s retention rates are in reality a much lower 62% and 71%, respectively, and its churn rates are much higher.
If we multiply the average customer lifetime of four years with the average gross income per customer in the first quarter of 2020 of $33, we get an LTV figure of $132. The ratio between the LTV and the $223 customer acquisition cost is 0.59. The ratio obtained from 2019 data is 0.45, and for 2018 was 0.57. In SaaS companies, the rule of thumb is an LTV/CAC ratio of at least 3 to “qualify” for a growth financing round.
Lemonade claims that its retention rates are “strong,” but Inside P&C show that retention rates in competing companies range from 83% to 88%. The relatively high churn rates may imply that Lemonade’s customers are price-driven, rather than brand-driven.
High reliance on ‘inferior’ customers
Lemonade’s market share for renters insurance is estimated at 3%. It has a top-notch product, a good reputation, and an innovative corporate culture. The fact that such a small company can annoy much larger rivals is a win. But Lemonade’s business is skewed toward the renters market.
Renters pay a relatively low premium to Lemonade – $150, compared with $900 on average homeowners’ premiums. Its business model assumes that many of its renting customers will stay with it when they become homeowners. That is a big bet as the insurance market for homeowners is more competitive, more complex and requires more information.
Inside P&C points out that Lemonade’s prospectus shows that 61% of its premiums come from New York, California and Texas, and that much of its early focus was on urban centers. These are populations that tend to be long-term renters. “If you were going to target a group of people least likely to buy a home in the near future, these have to be around the top of the list,” says Inside P&C.
Lemonade also notes that 70% of its customers are younger than 35, close to the median home-buyer age in the United States. But they do not show the group’s geographical and socioeconomic distribution, which could indicate their potential to become homeowners.
Customer acquisition costs in the homeowner’s insurance market are also very high. The blog A Balanced View, which extracted these costs from company reports, shows the average CAC for captive agents (agents who only work for one insurance company) is $367, and for independent agents (who work with several insurance companies) is $234.
For insurance companies that market directly to consumers, the CAC is $160. So Lemonade already pays costs similar to independent agencies, for “inferior” customers from the rental world.
A tech company or an insurer?
Insurance companies use reinsurance to reduce portfolio risk and capital requirements. The payment transferred (ceded) to reinsurance can vary depending on the company’s decision and risk management.
Lemonade’s prospectus says that 75% of the premiums it writes are ceded to reinsurers, which in turn pay Lemonade a commission of 25% on every dollar ceded. Some 56% of its gross revenue is transferred out.
A Balanced View points out that the decision to cede the majority of premiums to the reinsurers raises the question of whether Lemonade’s technology is indeed more efficient at calculating prices and risks (underwriting) than traditional insurance companies Or is it still in the data collection phase to improve its algorithms?
To demonstrate its technology edge, Lemonade’s prospectus notes that it has more than 2,000 customers per employee, compared with 150-450 at traditional insurers.
But to fully understand this number, one should note a few more differences. The average premium for Lemonade is about $180, while for large insurance companies it is $1,100. The salaries in technology startups are several times higher than in insurance. Lemonade does not yet bear the costs of more complex insurance offerings.
The Israeli tech industry believes that Lemonade is moving too soon to the public market. It’s valuation as a private company was 30 times the revenue it made in 2019. The company’s 18% gross margin amounts to $5 million in first-quarter 2020, which is considered extremely low for a company planning an IPO.
Lemonade’s losses are higher than its revenues, and its improvement in the loss/revenue ratio over time, is a minor one (1.4 in the first quarter of 2020 compared to 1.6 in 2019), which implies that the loss increases along with revenue.
“This is a company that should have gone public in another 3-4 years,” said one source, who asked not to be identified. “It’s taking advantage of the delusional state of the market after 12 years during which central banks have emptied the economy of all rules and formulas.”