Softbank has a winner on its hands. It’s called Lemonade and we need to talk about it.
Lemonade’s IPO was a runaway success. Everybody’s talking about it. CNN, New York Times, the Wall Street Journal — you name it. And yet, despite all the chatter, people don't seem to fully understand what the company does.
For starters — Lemonade is an insurance company. A new age tech-based insurance company, but an insurance company nonetheless. They primarily operate in the US and like most of Softbank’s investments, they’re a loss-making enterprise right now. The company made revenues of about $67 million whilst racking up losses close to $108 million (for 2019).
However, there’s something different about Lemonade and its radical approach to insurance.
Wind back the clock to 2017.
A policyholder files a claim for a stolen laptop. Lemonade approves the claim and wires the funds to his account almost instantaneously. It’s part of what makes the user experience so delightful. However, a few days later, the gentleman approaches Lemonade’s Claims Officer, asking to return the money from the payout. He has recovered his laptop and he no longer needs the funds. It‘s the right thing to do, he says. The veteran claims officer is stunned. He has never seen anything like this before. After all, there is a general sense of distrust between insurers and their customers and the policyholder’s behaviour in this instance is highly unusual.
But what if it isn’t?
Lemonade asserts that it can process claims faster than most traditional insurance companies. And it’s true. For the most part, they process claims within minutes. However, this setup exposes them to fraud i.e. If you dilute the verification process, you will inevitably start paying off spurious claims. And while Lemonade claims to battle insurance fraud with AI (Artificial Intelligence), it certainly won’t be robust enough to fully shield them from financial ruin. However, they have another ace up their sleeve and it’s this little nugget that truly defines the company’s unique approach to this problem.
A deep dive into Behavioural Economics
Unlike traditional insurance companies, Lemonade’s corporate structure is rather unique. It has 2 separate silos — a for-profit silo that charges a fixed fee when a customer buys insurance and a not-for-profit silo that settles claims. Here’s how it works. Lemonade takes a flat fee and treats the rest of the money as yours. They’ll pool this money with funds collected from other policyholders and use it to pay claims as and when they’re due. However, every year once they’ve paid out most claims in full, they’ll give back what’s left to charities you choose. They won’t keep it.
Meaning there’s a tacit understanding that they will do everything in their power to settle your claim since they cannot potentially benefit from denying your claim. This feature of “giveback” underpins their approach to insurance. And they contest that customers are unlikely to commit fraud since they know they’ll probably be cheating some poor charity of much-needed funds.
As Dan Ariely, their Chief Behavioural Officer writes
This is not merely the phenomenon of finding someone’s wallet and returning it to the owner (which is also an admirable act). This act is the very essence of reciprocity: when someone does something nice for us, we feel compelled to return the favor, often in a similar way, and it comes very naturally. At Lemonade… we trust our customers, and therefore often pay their claims instantly. We’re doing so in a fair and transparent way, hoping to effect a virtuous cycle of trust and reciprocity. With this fairness in mind, some people simply feel the need to ‘return the favor.’ This yearning for reciprocity is deeply rooted in our evolutionary instincts. Reciprocity has long helped to strengthen social bonds. When there’s no fairness, there’s no reciprocity. When both are absent, it often causes distrust. In insurance, that can translate to fraud.
So technically they want to battle fraud and make money leveraging trust. However, there is a problem with this approach. What if the premiums paid by customers isn’t enough to cover the payouts? What if there’s no money left for charity? What if this whole scheme goes bust?
Well, for starters, Lemonade protects its downside using reinsurance. In fact, most of their policies are reinsured — Meaning Lemonade buys insurance from other companies to make sure these companies bear most of the risk. The reinsurance companies will tag along as long as they believe they can turn a profit from Lemonade's business eventually — a few years from now perhaps. However, if they repeatedly have to pay out more money than the premiums earned, they won’t be all too enthusiastic about reinsuring the company.
This will have a cascading effect on both pricing and Lemonade's eponymous giveback clause. Unless the company starts charging higher premiums, they won’t have enough money left to buy reinsurance. In fact, it’s one of the biggest criticisms levied on Lemonade since most of their reinsurance partners are losing money right now. If that equation doesn’t change, this relationship will soon be tested. More importantly, there won’t be a lot left for charity. There’s also a very real risk of this whole thing devolving into a marketing gimmick. That doesn’t bode well for anyone.
And therefore, it’s incumbent on Lemonade to improve what is called — the loss ratio.
As Lemonade notes — “In simple terms, it’s the claims you pay divided by the premium you earn. If your loss ratio is too high, you are not charging customers for the risk they represent — and that makes it hard to be around for the long term. Charge too much, and the insurance company is making lots of money, but not providing a particularly compelling product to its customers.”
Walking this tightrope can be extremely hard and if you can’t find the right balance you won’t be in the business for long.
However, this hasn’t deterred people one bit. In fact, the company’s stock price has rallied by a whopping 150% since the IPO last week. Clearly, most people are hoping that Lemonade will be able to carve a niche in the insurance market by offering a more intuitive user experience and leveraging data to price their policies better.
In fact, Lemonade has talked extensively about this seeming data advantage.
We’re getting smarter. Lemonade started at a data disadvantage, building up a data set from scratch and collecting information at every customer interaction. We knew it was only a matter of time before we were at a data advantage. If we’re not there yet, we sure are close. Interacting with our customers directly and digitally means we know them really well, even if we’ve never met them face-to-face. That knowledge is translated to a ‘risk score’ that accurately predicts future loss ratios, and can be used across the organization, from marketing to acquisition to policy management and claims. It has not yet impacted our pricing sophistication, but that day will come — just like credit history did.
Whether they will be able to leverage data, cut costs and build a profitable business is still a question that needs answering. After all, WeWork promised to disrupt the real estate (sub-letting) industry by leveraging tech and AI. And yet, for all its sophistication, no amount of data could fix the flawed unit economics that’s driving the business to oblivion. Hopefully, Lemonade can buck the trend and give Softbank something to cheer about.
Go on Lemonade. Become a flying horsie now…
Until next time…