“2023’s second quarter delivered better than expected top and bottom lines” – says lemonade in the Shareholders letter – “as well as reinsurance and growth financing programs which herald a step function improvement in our capital efficiency, enabling both faster growth and deeper cash reserves”.
Here are main point from the letter:
- Top line: At $687 million, in-force premium (IFP) grew by 50% year over year.
- Reinsurance: Our 55% quota share program was reupped and oversubscribed, with ceding commissions expected to be roughly equivalent to those under the outgoing agreements.
- ‘Synthetic Agents’: We secured customer acquisition cost (CAC) financing, designed to close the cash-flow gap and unlock cash-friendly scaling.
- Rates: California recently approved a 30% increase in our homeowners rates, and a 23% increase for Lemonade Pet. Across the board we are taking more rate, and seeing an acceleration in our rate approvals. We expect this will register on our loss ratio as new rates ‘earn in’ over the coming quarters.
- Bottom line: At $53 million, Adjusted EBITDA loss came in better than expected, notwithstanding heightened CAT losses. Net loss for the quarter was $67 million.
Capital Light
Our reinsurance agreement was successfully renewed despite difficult market conditions – one reinsurance market report called it “one of the hardest reinsurance markets in living memory” (The Great Realignment, Howden). With ceding commissions that are expected to be roughly inline with our previous deal, at the same cede level, and with the same partners, the new reinsurance program is a vote of confidence from some of the world’s most substantial and respected reinsurers.
In effect from July 1, 2023 for the standard 12-month term, the renewed 55% quota share allows Lemonade to continue to operate in a capital-light manner.
This capital efficiency is supplemented by two new structures: a new risk-bearing entity, Lemonade Re, domiciled in the Cayman Islands, where we plan to hold some of the retained risk, and a captive cell at a Bermuda transformer, where we plan to retain most of our windstorm exposure.
‘Capital light’ was also one of the goals of our newly launched Synthetic Agents program, which we recently wrote about in depth on our blog.
The ratio of our customer lifetime value to CAC (LTV/CAC) is compelling, yet our direct-to-consumer (DTC) distribution strategy front-loads our costs, making fast growth capital intensive: we must finance 100% of the CAC upfront, and it typically takes ~24 months to realize payback on that spend. Given today’s elevated cost of capital, these dynamics led us to pull back on growth.
By advancing up to 80% of our growth spend each month, our Synthetic Agents (aka, General Catalyst’s Customer Value Fund) will effectively close the ‘cash flow gap’ associated with DTC distribution. This is expected to enable us to nearly double the IRR on our CAC spend, from ~50% to ~90%. The structure enables capital-light growth, boosting – rather than draining – cash reserves, even as we lean into growth. For a deep dive on Synthetic Agents, including the mechanics and example financial presentation, please refer to the Synthetic Agents Detail section on page 15.
Synthetic Agents act as ‘time shifters’ – aligning our distribution cash outflows with the incoming premium collections, and this has significant implications for our business. With Synthetic Agents in place, we can accelerate growth in order to drive the required scale to breakeven, without facing the troublesome ‘cash flow gap.’ On a 5-year horizon, a faster growth rate can yield several fold more IFP and Net Income – all while retaining significantly higher cash reserves along the way. Therein lies the transformational potential of the Synthetic Agents.
That said, we plan to leverage this capability only once our new cohort lifetime loss ratios are inline with our target model. We’re on our way, though it’s a process that involves one step backwards, for every two steps forward.
Two Steps Forward; One Step Back
The second quarter was marred by the unseasonable weather catastrophes (CATs) that weighed on our gross loss ratio, ending the quarter at 94%. The extent and timing of this severe weather generated headlines around the world, with the insurance industry reporting some of the worst loss ratios in years.
When reviewing our loss ratio excluding CAT, the continued, strong underlying trend suggests we’re making real strides towards our target loss ratios notwithstanding episodic reversals. More on that later in this Letter, but first, it’s worthwhile to understand the unusual nature of the CATs experienced this quarter.
Introducing: Severe Convective Storms
Typically, loss ratios impacted by weather are seasonal for US property carriers, with Q1 and Q4 usually the lowest loss quarters and Q2 and Q3 the highest, due to hurricanes, wildfires, and the relatively less studied “severe convective storms” or SCSs.
While hurricanes and wildfires are fairly well understood and models have proven fairly predictive, SCSs remain “at the bottom of academia’s current understanding” (Gallagher Re Natural Catastrophe Report of 2022).
SCSs refer to hail, straight line winds, tornadoes, thunderstorms, and suchlike, and due to their limited historical impact, predicting them hadn’t been a priority for the industry until recently. In contrast, hurricanes have been more reliably modeled and forecasted (after major hurricanes in the mid 2000s) and wildfires similarly ‘earned’ the industry’s attention (following the deadly 2017 wildfires). The losses from these events forced models to iterate, leading to an increase in the precision of hurricane and wildfire CAT predictions.
This is significant because Q2 ‘23 was marred primarily by a series of SCSs. In fact, the first half of 2023 turned out to be one of the worst H1s ever recorded for SCS-related insured losses, highlighting the intensity of this year’s convective weather and related perils (Gallagher).
Back to Lemonade. Our reinsurance did what it was designed to do, shielding our financials from the worst of these CATs, and, indeed, our EBITDA came in ahead of expectations notwithstanding the spike in gross loss ratio and CAT related claims. This was significant, because CAT-related losses increased by more than 4x year on year, representing 21 points of our Gross Loss Ratio in Q2.
Our gross loss ratio ex-CAT was again in the low 70s, continuing its promising trajectory. Indeed there were notable and significant portions of our book that demonstrated best-ever results this quarter:
- Our Renters gross loss ratio was below 50% for the first time (all-in, inclusive of CAT impact)
- Our Pet gross loss ratio was in the 70s for the first time
- Our Homeowners gross loss ratio excluding CAT was in the 60s for the first time
- For our newest product, Car, we’ve not yet made material improvements in the gross loss ratio
We’re encouraged by these underlying improvements, and believe it is a solid signal that our ongoing loss ratio efforts, including improved underwriting and consistent rate filings, will continue to bear fruit.
Indeed, our rate filing pace remains high, and these are being approved more quickly than industry averages. Our accelerating pace of approved filings is due, in part, to the efficiencies offered by newly automated processes: streamlined responses to regulator inquiries, more accurate resource planning, and proactive collaboration with state regulators.
As rates are earned in (the California regulator recently approved a 30% increase for homeowners, and a 23% increase for Lemonade Pet insurance rates) they will continue to favorably impact our results over time. Currently, only roughly half of our newer rates have ‘earned in’, which means we’ll see the full impact of these rate changes in the coming quarters. More rate changes are needed and are being sought, and things are moving in the right direction. The moderating rate of inflation, coupled with a quickening pace of filings and approvals, bodes well – though all these will take several quarters to fully register on our book.
In related news, our team is conducting a thorough review of our book of homeowners business based on multiple factors, such as predicted loss ratio, age of the home, age of roof, predicted CAT exposure, and more. As our readers will remember, with every iteration of our lifetime value model (LTV) we get notably better at predicting risk, and as our data gets more textured and refined, it’s clear that a portion of our book should not be renewed based on the learnings we’ve accumulated. Already, around 2,000 homeowners policies have been non-renewed, and while actions like this slow the upward trend of metrics like Annual Dollar Retention rate (ADR) and Premium per Customer, they benefit our long term profitability. This will be an ongoing process with a lagging impact, but we believe we’ll see it deliver a double digit impact on our loss ratio over the next couple of years.
Metromile
Last month we marked the one year anniversary of closing our Metromile acquisition. The Metromile team has merged into the Lemonade team seamlessly, and the Metromile book of Pay Per Mile has shown stronger retention levels than we had modeled, and its loss ratio is trending down consistently. All told, with the perspective of 12 months, we are thrilled with this mo
The one year milestone also marks the point where the step-function increase Metromile delivered (in IFP, customers, premium per customer) will no longer be reflected in our year on year comparisons. For example, earlier in this letter we reported 50% IFP growth year-on-year, while organic growth (ex-Metromile) was 28%. As we move into the third quarter, it’s important to anticipate that our growth rate will normalize across our metrics, as the effect of this acquisition will no longer be a significant factor in our year-on-year comparisons.
Looking to H2 ‘23
With H1 delivering better top and bottom lines than we’d anticipated, we are modestly raising our guidance for the second half of 2023. We won’t, however, put pedal to the metal until the loss ratio for new cohorts is in line with our targets across the board. We are already within that range for some of our offerings – Renters and Pet broadly, and Home and Car in certain geos – and this is where our moderate growth will come from. More accelerated growth will wait until more rates come online.
We believe we are on the way. Faster rate filings and more approvals bode well, as does slowing inflation. With Synthetic Agents and reinsurance in hand, our capital structure is in place too.
And so while H2 should bring with it a growing top line and an improving bottom line, it will be dedicated to continued improvements: more automation, more ‘earning in’, more filings – all of which should set us up well for yet more growth in 2024, and further progress on our path to profitability.
