A 3-Step Framework Evaluating One of the Most Fascinating Companies IPO-ed in 2020

Finally, a framework that works (for me, at least)

Introduction

Purpose of This Article

I wrote this article to educate you on my methodology for evaluating fast growing tech companies, using Lemonade (https://www.lemonade.com/) as an example.

Over countless iterations of shaping my thought process, I found this three-step process to be the most effective in evaluating such companies:

1. Identifying the problem each company is looking to tackle

2. Identifying their solution to the problem

3. Crafting a thesis to break down the key success factors of a company

Note: I did not invent this framework — this process has been adopted by countless people in different degrees of variation. The article serves to articulate my interpretation and dissection of such a framework

What this article isn’t about

This article is not:

  • A buy/sell/hold recommendation on the company’s shares
  • A conclusion as to whether the company is good or bad, but rather the thought process behind evaluating such companies

Disclaimer

This article makes no representation as to the timeliness, accuracy or suitability of any content on this article, and cannot be held liable for any irregularity or inaccuracy. Should you decide to invest, you should conduct their own independent research before making any investment decisions.

Investors should consider the source and suitability of any investment advice for their needs. Your use of this article, and its content, is at your own risk. Please read the full disclaimer here.

What is Lemonade?

Lemonade is an insurance company built on a digital substrate.

Their unique selling proposition is their promise to onboard a customer in 90 seconds, and pay out their claims under 3 minutes, on average.

This is made possible by using AI chatbots to onboard and payout claims to customers. AI Bot (“Jim”) handles, settles, and pays 1/3 of all claims instantly without human intervention.

Source: Daniel Schreiber on YouTube

Insurance: The Problem

1. An inherent conflict of interest

Lemonade’s CEO, Daniel Schreiber, sums up the inherent misalignment between insurance companies and their customers perfectly

“There’s an inherent conflict of interest in traditional insurance: every dollar insurance companies pay out in claims is a dollar less to their bottom line. This creates a misalignment between insurers and their customers, bringing out the worst behavior in people.” — Source: Forbes

2. Large agent network required

Partly resultant from #1 above, there is also a need for traditional insurance companies to house a large network of agents to sell insurance products, and assist with claims.

This results in high costs, which are ultimately passed down to the end-customers.

Lemonade’s Solution

1. Fixed fee model

In order to reduce the friction and misalignment between insurance companies and consumers, Lemonade promises to take a fixed 25% of the premium paid by customer

The remainder is used for reinsurance and payment of claims, with excess given to charity of user’s choice.

This business model seeks to bridge the misalignment in the behaviors of consumers and insurance companies, as both parties are no longer fighting for the same dollar.

2. Automated customer onboarding and payment of claims

Customers of insurance companies are inherently buying the right to settle a claim. Claims settlement is typically a labor-intensive process, with piles of paperwork to be filled before a claim is finally approved and issued.

This process diminishes the customer experience, and at the same time, poses a high cost to insurance companies.

Lemonade tackles this with their goal to automate the claims process as much as possible. In 2018, 6% of all claims were settled by their AI bot, Jim. This number has grown to 33% in 2020. This allows Lemonade to offer Insurance products at half the price of policies offered by traditional players

Understanding the key revenue drivers in Insurance

Insurance is inherently a product that holds strong retention rates. The average retention rate for the insurance industry is 84%, with the top companies in the industry are beating that average by 10% or more.

Policies typically last for a year or longer, and customers typically renew their policies, unless they find a better alternative than their current provider.

As a result, insurance companies often enjoy stable top-line (revenue) growth, driven by their total In-Force Premium (“IFP”)

Breaking down In-Force Premium

  • IFP = # of Customers x Premium Per Customer
  • Revenue = Earned premium over time, less amount ceded to re-insurers

What are the key drivers of growth for Lemonade?

Based on the formula for IFP, Lemonade’s top-line has 2 key levers of growth:

1. Growth in customers over time

Lemonade has shown strong growth quarter-on-quarter, a testament to their lovable product. Lemonade’s product boasts a Net Promoter Score of over 70, which is atypical of traditional insurance companies. An NPS of 70+ is seen in companies such as Apple and Tesla.

Lemonade’s Customer Growth Over Time — Source: S-1 Filings (adapted)
Lemonade’s NPI is comparable to Tesla and Apple — Source: Daniel Schreiber on YouTube

2. Growth in Premium per customer

70% of Lemonade’s current customers are below the age of 35. This means that majority of Lemonade’s customers are (1) First time policyholders and (2) in the early stages of their life.

Newly acquired users tend to start out buying a low-cost policy with Lemonade, and as Lemonade continues to delight and retain its existing customer base, customers’ need for insurance grows as they go through various life cycle events.

Illustration of Lemonade’s customer profile and purchases over time — Source: S-1 Filings
IFP and Premium Per Customer over time — Source: S-1 Filings (adapted)

Understanding the key cost drivers in Insurance

1. Loss Ratio

While insurance companies typically enjoy stable top-line growth, their bottom line fluctuates heavily based on the amount of claims they have to pay out. The key metric to pay attention to here is their loss ratio:

  • Gross Loss Ratio (%) = Gross incurred claims / Gross earned premium
  • Net Loss Ratio (%) = (Gross incurred claims — amounts ceded to re-insurers) / Net earned premium

These are simplified metrics, with the actual calculation including a few adjustments to the above ratios. An example detailing the loss ratio calculations in full can be found on APRA (Australian Prudential Regulation Authority).

Based on a 2018 KPMG report, the average loss ratio of insurance companies hover at c.60%

Loss Ratio Over Time (Right Hand Side) — Source: KPMG
IFP and Loss Ratio over time — Source: S-1 Filings (adapted)

How does Lemonade reduce its loss ratio over time?

As seen above, Lemonade has been consistent in lowering their loss ratio in the past 2 years, with its loss ratio at 72% in 3Q2020 — inching closer to the industry average over time.

Lemonade collects its customers’ data across multiple touchpoints, and processes these data points within their central database.

Using machine learning, Lemonade’s algorithm is able to segment customers in to various categories, identify their risk profiles, and charge premiums according to each user’s risk profile

The more data Lemonade collects, the stronger the predictive accuracy of Lemonade’s algorithm in foreseeing the risk profile of each customer. This allows Lemonade to accurately price their policies based on each user’s profile.

Lemonade’s customer onboarding process is done via its AI chatbot, Maya. Maya asks 13 questions to each prospect, but collects over 1,600 data points during the process.

Illustration of AI (Maya) onboarding a customer — Source: Daniel Schreiber on YouTube

2. Customer Acquisition Costs

Customer Acquisition Cost (CAC) is a vital metric to track, with any fast-growing B2C company.

It seems that Lemonade is making progress in lowering their acquisition costs per user. I will not dive too deeply into the calculations of CAC and Lifetime Value (LTV) / CAC, as this has already been covered in my previous article relating to SaaS companies.

CAC over time — Source: S-1 Filings (adapted)

As YCombinator Partner Kevin Hale pointed out, if a company can only grow through paid acquisition channels, then its growth will be quickly eroded as soon as more companies enter the space. Great companies are the ones that can grow by word-of-mouth, bringing CAC to near zero over time.

This is why Lemonade built their company under the principles of first “Delighting Customers” — with the understanding that a good product focused on improving customers’ life would eventually lead to organic growth, as existing users recommend Lemonade as a product to friends and family.

Forming your Thesis

Based on the above understanding of Lemonade and its key success factors. Your evaluation of Lemonade and its success should be shape by the two questions below:

1. Can Lemonade grow its customer base while simultaneously lowering its loss ratio?

2. Can Lemonade grow its customer base at a sustainable CAC?

Conclusion

It is my inherent passion to understand and evaluate the business model of disruptive companies that seek to improve our lives exponentially.

The above analysis on Lemonade is only the first half of the process — evaluating how Lemonade will grow in the next coming years is the other half of the equation, which is typically done through a financial model.

If you want deeper insights into how I evaluate fast-growing companies like Lemonade, subscribe to my newsletter below.

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