Lemonade: Reinsurance Can’t Save This Company, 90% Downside (NYSE:LMND)

Lemonade’s Founders, Shai Wininger (left) and CEO Daniel Schreiber (right)

Source: Medium

Lemonade (LMND) is a drink, it’s also the name of a ~$6 billion dollar insurance company that booked just $10.5 million of net earned premiums in Q3, for an annualized price-to-premium multiple of 143x. For reference, Progressive (PGR) trades at 1.4x its annualized Q3 net earned premiums.

Such ludicrous valuation must come with a story, so here’s the story. Management presents Lemonade as an insurance company that uses “AI” to optimize underwriting while using reinsurance to retain a “take” of 25%. This narrative is parroted by analysts and bulls alike, below is an excerpt from a Motley Fool contributor, which recommended the stock on this basis, emphasis mine:

This means, as long as Lemonade keeps its gross loss ratio (how much it pays out in claims, divided by how much it earns in premiums) under 75%, which it has done for the last four quarters, Lemonade will keep a minimum of 25% of gross earned premiums as operating profit, and Lemonade’s reinsurers will also make a profit. Management believes this strategy will generate high levels of recurring revenue, while stabilizing gross margins within a ±3% range. That’s impressive, considering the financial performance of many insurance companies can literally depend on the weather.

In this article I will detail why this claim, which is central to Lemonade’s business model, is highly questionable, detail several other management claims which I find dubious, and why the stock is only worth $10 today.

Reinsurance = Free Money?

Before we dig in, here’s another excerpt straight from the horse’s mouth. During Morgan Stanley’s investor conference on November 12, 2020, the CEO, Daniel Schrieber said:

So we come to the consumers with the notion of a 25% flat fee. For every dollar you pay me, I’m going to retain 25 cents on the dollar. And the rest I’m going to use to pay your claims. You say, oh, but what if there’s not enough money? And the answer is reinsurance. We buy reinsurance. And if there’s a bad year, they have the bad year rather than us.

Let me illustrate why I don’t believe this is possible within the below table I’ve built.

LemonadeSource: author

Above is a very simple of example of how quota share reinsurance (the type extensively used by Lemonade) works, by giving up some of the risks, the cedant (e.g. Lemonade) will incur proportionally less losses at the expense of proportionally less income. In our fictional scenario, there is zero economic change in the underlying profitability of the operation. While losses shrunk, profits also shrunk accordingly as the business is no longer receiving the ceded premiums.

There are of course good non-profit related reasons to use reinsurance, such as when the insurer wants to smooth out its risk profile. For example, an insurer can still underwrite a $100 million policy with $1 million in capital if the insurer cedes most of the risk. There are also circumstances where reinsurance may generate an economic benefit (such as a pricing arbitrage), but the notion that reinsurance alone can produce and maintain a 25% margin is completely untenable in my view.

What is even more shocking to me is that this “25% fee” narrative is also written in the 10-Q, which usually tends to be much more conservative. On page 23 of the Q3 10-Q, the company states, emphasis mine:

Under the proportional reinsurance contracts, which cover all of our products and geographies, we transfer, or “cede,” 75% of our premium to our reinsurers (“Proportional Reinsurance Contracts”). In exchange, these reinsurers pay us a ceding commission of 25% for every dollar ceded, in addition to funding all of the corresponding claims, or 75% of all our claims. This arrangement mirrors our fixed fee, and hence shields our gross margin, from the volatility of claims, while boosting our capital efficiency dramatically.

This paragraph insinuates that by ceding 75% of the company’s gross premiums, it would be able to protect the remaining 25%, thus producing the 25% “margin” or “take” hailed by bullish investors. I disagree with this assertion. To demonstrate why, we can play around with the above model and assume that the loss ratio increases to 100%, would our fictional company retain its 5% margin?

LemonadeSource: author

The answer is no! And that is to be expected considering everything is shared proportionally between the cedant and reinsurer. Contrary to what the CEO said, reinsurance isn’t going to magically protect your margins.

For the sake of argument, let’s examine a scenario in which our fictional company could significantly improve its margin with quota share reinsurance.

Source: author

Here we can see that the company actually made money despite a 100% loss. This is possible because of the spread between acquisition cost and ceding income, which amounts to a riskless commission, not unlike a fee earned by an insurance agent. Unfortunately, Lemonade is not an insurance agent, and this is a fairy tale situation that doesn’t apply in the real world. As the reinsurer here would be losing money hand over fist, and would either terminate the relationship or demand a lower ceding commission for the low quality business. So unless Lemonade finds a hack reinsurer to whom they can offload risk for pennies on the dollar, a “25% fee” as promoted by the management isn’t something that I believe could be achieved in the real world.

Multiple Dubious Claims By Management

Combing through company’s transcripts and press releases, I’ve found many statements that I view as potentially misleading, the biggest of which relates to my concerns about management’s presentation of reinsurance discussed above. Let’s take a look at some of the others.

Improving net losses per dollar of premium?

In the Q3 earnings release, the company stated that “net loss – per dollar of gross earned premium – halved.” Crunch the numbers and the statement checks out. This figure was $1.48 in Q3 2019 and $0.72 in Q3 2020, roughly a 50% decrease. Losing less money per dollar of business underwritten sounds great, but what does the number actually represent? If you thought that operation became twice as profitable, you would be wrong. The reason is that gross earned premium does not adjust for reinsurance, meaning that the year over year comparison is totally useless as the company had significantly increased reinsurance usage in Q3, with ceded premiums growing 10-fold year over year from $3.2 million to $32.4 million.

As I’ve shown in the first table in the reinsurance section, margins differed significantly when measured against the gross premium despite no change in unit economics. After all, if you move the numerator (the net income) towards zero using reinsurance (decreasing both profits and losses), and keep the denominator unchanged (the gross premium), then of course the margin would trend towards zero. Net loss over gross premium in this scenario is a useless figure as the it includes the ceded premiums, which do not affect the bottom line at all. If we were to recalculate the figure using net premiums instead of gross, we would get a loss of $1.74 per dollar of net premium in Q3 2019 and a loss of $2.94 per dollar of net premium in Q3 2020, meaning a 69% deterioration in profitability instead of an improvement as the management would have you believe.

We use reinsurance, but we actually don’t need it?

During a Goldman conference on December 9, 2020, the CEO stated that “… one of the realizations we came to is we don’t actually need reinsurance,” implying that despite the company’s significant usage of reinsurance in Q3, it was apparently a business decision that could be turned “on and off” at any time. I disagree with this assertion.

Running an insurance business requires surplus capital as protection for policy holders. As Lemonade is losing money, it has no hope of rapid expansion unless investors inject more capital. Of course, rapid increases in capital requirement for a loss making company necessarily leads to a downward spiral in the stock price, an outcome that the management would like to avoid. And so to maintain headline “growth”, the company must use reinsurance to decrease its capital requirement. There is no free lunch of course, as we’ve learned earlier, reinsurance in general does not alter the economics of the underlying business. But by employing reinsurance, management can now talk about the growth of headline numbers such as the number of customers and in force premiums, regardless of their actual effect on the bottom line. To illustrate why this is the case, we can imagine that if Lemonade were to reinsure 100% of its book but loses $50 on each policy, it would be unconstrained by capital requirements, and could grow customers ad infinitum while destroying shareholder value along the way.

Why I Believe The Stock Is Headed Towards $10 or Lower

There is no question in my mind that the stock is overvalued against its “old school” insurance peers like Travelers (TRV) or Progressive, but what about the “cool” peers? When we benchmark Lemonade against Metromile (INAQ), Root (ROOT) and Trupanion (TRUP), the stock is also significantly overvalued.

Source: author, 10-Qs, prospectuses

Quick note on Metromile. The stock is currently significantly more expensive than Trupanion and Root due to the fact that it is in a frothy SPAC market and its year-to-date net earned premiums have been negatively impacted by COVID-19 since they are based on customers’ miles driven. Once we exclude this outlier, Lemonade’s massive downside becomes even more obvious.

Lemonade’s only saving grace is its $569 million of equity value on the balance sheet, which would be close to the company’s liquidation value today. This equates to ~$10 per share, or a ~90% downside based on the $100 level around which the stock has been trading last week.

But how low can we go? I believe that there is a significant possibility over the next five years that the stock will drop to $0. How we get there will be all thanks to the management.

While I am extremely bearish on the future of Trupanion and believe that Root is overvalued as well, I believe that neither company is a zero. Trupanion is headed by an extremely crafty albeit highly promotional CEO/Founder who understands the insurance business as demonstrated by his coherent delivery of rudimentary insurance concepts during earning calls (what I vehemently disagree with him is the underlying profitability of the business), and Root’s CEO is a competent insurance professional who studied actuarial science in university.

Meanwhile at Lemonade, the CEO’s last stint was at Powermat, a wireless charging gadget that caught a little buzz a decade ago, his co-founder was from Fiverr, and perhaps the strangest of them all, the CFO worked at Shutterstock (SSTK) (yes that photo company) before “resigning” when the stock collapsed from $100 to $30. My assessment is that prior to Lemonade, management had little-to-no insurance experience, and I still very much question their know-how.

Without any insurance experience, I don’t think the company will be able to achieve meaningful underwriting profitability and will continue to burn a significant amount of cash. With the management guiding to a ~$100 million EBITDA loss in 2020, it is clear to me that they will continue to “invest” the company’s cash to chase headline numbers that don’t help the business. We are already seeing hints of this over the last two earnings release, where the company repeatedly emphasized to investors that gross premiums, the number of customers, and premiums per customer are what matters. As I’ve stated earlier, if the company reinsures 100% of its book and takes a loss on every policy acquisition, headline numbers would still look wonderful despite contributing no value to the company.

In terms of a potential catalyst that could push the stock down, lock-up is expected to end on December 29, 2020 (181 days after the July 1 IPO). With 30 million more shares coming online, I expect the stock to trade in the $50s in short order, which would still make Lemonade incredibly expensive. Over the long-term, given my belief that the executive team aren’t effective managers of an insurance business and is actually proud enough to put their critical misconceptions on the 10-Q, I believe that it is only a matter of time before the company is run into the ground.

Trading Strategies

Due to a lack of borrow, shorting shares is extremely difficult. The limited float and thin liquidity have also led to wild price swings as retail investors poured into the stock likely based on the recommendation from Motley Fool. As such, the recommended way to short the stock is through options.

As I believe that the stock is likely to drift towards zero over the coming years, a long-term deep in the money put such as the $140 put expiring on December 17, 2021 could be used as a great portfolio hedge to mimic a straight short due to its high delta and lack of early assignment risk (as opposed to shorting a deep in the money call).

For the more adventurous, I believe that the lack of skew in the implied volatility across maturities could present a more risky but lucrative opportunity. Despite the upcoming lockup that would double the float on December 29, the implied volatilities for options expiring December 31, 2020 and January 15, 2021 do not differ significantly, thus one could initiate an out of the money calendar spread. For example, one could buy a January $60 put and sell a December $60 put to capitalize on the potential increase in volatility post lock up while putting up less capital upfront. This trade would result in close to a 100% loss should the stock increase or stay flat, but could triple or quadruple assuming that there is a sizable drop post lock-up expiration to the $60 level that would elevate the implied volatility while increasing the delta of the January put.

Conclusion

Even in today’s frothy market, it is still quite rare to see companies fetch multi-billion dollar valuations based on an empty promise.In my view Lemonade’s executive management are not capable of successfully running an insurance company and I believe that their promoted business model is fundamentally broken. As shareholders will likely find out, that is a problem that won’t go away no matter how much reinsurance the company uses.

When the lock-up expires and the current market froth inevitably recedes, I believe that Lemonade will trade below its $10 liquidation value very soon.

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