For the past two years, there has been little evidence of lemons. (LMND -2.80%) CEO Daniel Schreiber was right in his belief that artificial intelligence (AI) would transform the insurance industry. As a result, investors lost faith in Schreiber and the company, and the stock has fallen 92% since January 11, 2021, to an all-time high of $183.26.
However, investors’ confidence in the company has recently increased. First-quarter results showed a positive trend in one key metric used to assess whether Lemonade’s AI-based insurance revolution can replace conventional insurance business models. The share price has gained more than 11% this year due to signs of growth S&P 500.
So has Lemon changed course by proving that its AI-fueled business model can outperform traditional insurance? If so, the company can prove that it is the future of the insurance industry.
Let’s take a closer look.
The good news is that the total loss ratio is declining.
When evaluating the performance of the insurance company, it is important to consider the loss ratio. This measure is determined by dividing the total claims paid by the premiums received. In general, a well-run insurance company generates 60 percent to 70 percent of total losses, which gives the company enough margin to meet future claims while still making a profit.
A company with more than 100 losses pays out more in claims than it collects in premiums. This is a sign that customers need to start valuing the risk they bring, otherwise it will be difficult for the insurer to survive. However, if a company charges premiums too high, it may lose business as customers look for cheaper alternatives. A proper balance is required.
The company’s founders started Lemon with the idea that AI could set premiums more efficiently and accurately than humans. They established a long-term goal for AI to maintain a gross loss ratio of less than 75% in order to achieve profitable growth. One of the significant reasons why this company’s stock price has fallen over the past two years is that the company’s cumulative total loss ratio is over the magical 75 percent. In other words, it was fundamentally unprofitable, leading many investors to conclude that its AI wasn’t really up to the task of pricing.
The good news, however, is that management has internal projections that show the loss ratio is on track to fall to 75% and below over the next several quarters. And among the reasons the stock rose after recent earnings was that the company’s results showed that its loss ratio was moving in the right direction, convincing many investors that AI could work in insurance.
The chart below shows the top loss trends over the last three quarters. It’s worth noting that if it weren’t for the unusually high number of severe weather events the company calls CAT events, the total loss would have been 72% (shown in the previous CAT trend line).
Image source: Lemon
The cherry on top is that Lemonade AI is learning how to price premiums in a time of unprecedented inflation in 40 years. Inflation makes insurance-premium pricing especially difficult. If the AI can reduce its loss ratio in the current high inflation environment, it bodes well for its future performance under less stressful conditions.
The company plans to use creative AI
In the company’s latest shareholder letter, management discussed plans to use the same technology behind ChatGPT for about 100 of the company’s business processes.
Management believes it will cut significant costs over the next 18 months and “will have some impact on our financial results later this year,” according to the letter. For example, management said it expects 2023 adjusted earnings before interest, taxes, depreciation and amortization (EBTDA) to be between $205 million and $200 million in 2023, while spending cuts expected by generative AI are expected. This adjusted EBITDA forecast is down from the previous forecast of a loss of $245 million to $240 million.
Let’s say Lemon Management is right in saying that it can achieve significant cost savings through generative AI by 2024 and beyond. The company could become profitable even faster than the current price-to-sales ratio of 3.7 suggests.
Why do you still want to be careful?
Investing in this company may involve some uncertainty as management has yet to provide details on how the developer plans to use AI. The company also admits that the technology still has problems. Those issues include bias, wrong answers, data privacy and copyright concerns. Therefore, the company said that it will be “careful” in implementing generative AI. Still, there is a risk of dropping the ball and potentially causing significant reputational damage to the company.
Consumers don’t trust AI and want it controlled. So investors in the company should accept the risk that government regulation could eventually stop Lemon’s AI-based business in its tracks.
Why should you consider buying the stock?
Lemon started monetizing chat interfaces, AI and bots eight years ago, before OpenAI made chatbots cool with ChatGPT. So it has a head start before other companies.
If you’re looking for an easy way to invest in AI, Lemon may be one of the first companies to effectively monetize AI. As a result, aggressive growth investors should consider buying the stock at a relatively low price.