High flying renter’s insurance startup Lemonade filed for an IPO last week. While I have many opinions on Lemonade’s business, I’ll save those for a later day.
Today, in the interest of public service, I’ve put together a detailed summary of the S-1 filing. What follows is essentially a highlight reel. I pulled all sections of interest and pasted below so you don’t have to read the entire document yourself.
I have added some limited commentary where helpful (preceded by an “Ed:”) to explain the disclosure, but otherwise this is a cut and paste job. Think of it as Lemonade Cliff’s Notes.
Everything is presented in order of its appearance in the document. Any emphasis added is mine unless otherwise specified. And yes, this is lengthy relative to my normal missives (it is likely a record for word count), but, trust me, it’s a lot shorter than reading the S-1 on your own!
Prospectus Summary
This section starts on page 1. We begin with the corporate mission:
Our Mission
Harness technology and social impact to be the world’s most loved insurance company. p.1
Overview
Lemonade is rebuilding insurance from the ground up on a digital substrate. p.1
Ed: They use this term “digital substrate” over and over but never explain what it means. Substrate typically refers to a biological growth process, e.g. “A substrate is a solid substance or medium to which another substance is applied and to which that second substance adheres.”
It is unclear what a digital substrate would be. The only example I could find related to technology is making semiconductors (the wafer is the substrate for the chip). I believe what they are trying to say is that technology is the foundation of the company. Best to use the simpler language!
Our Strategy
We seek to capitalize on the structural advantages inherent in being a digitally-native, customer-centric, and vertically-integrated insurance company. p.3
Approximately 70% of our current customers are under the age of 35, and about 90% of our customers said they were not switching from another carrier. p.3
We currently spend $1 in marketing to generate more than $2 of in force premium…we believe that the lifetime value of our customers is significantly higher than our cost of acquiring them. p.4
Our Business Model
(We have) no contractual obligation requiring us to donate leftover premiums to nonprofits. p.6
Our Product Offerings
The Giveback is paid only if payment is authorized by Lemonade Insurance Company’s board of directors p.8
Reinsurance
Beginning on July 1, 2020, we will have proportional reinsurance protecting 75% of our business…In exchange, these reinsurers pay us a “ceding commission” of 25%. p.9
(W)ithout reinsurance we would need to reserve as much as 50 cents for every dollar of premium sold, known as a 2:1 ratio. Our proportional reinsurance structure shifts most of that surplus capital requirement to the reinsurer, such that the capital surplus requirement for the Company is expected to be approximately 7:1. p.9
We believe our reinsurance structure achieves important goals: making us capital-light, buffering our gross margins from the vicissitudes of claims, and leaving room for our gross margins to grow…our probability models suggest that we have crafted a ±3% collar around our gross margins, with underwriting results expected to impact our gross margins no more than ±3% in 95 years out of 100. p.9-10
Operating Leverage
Since March 31, 2019, our marketing efficiency roughly doubled, such that we are currently able to acquire more than $2 of in force premium for each $1 of marketing investment…we would earn back the cost of acquiring our customers in just over two years. p.10
Our Challenges
Our business model is premised on the expectation that a significant number of our customers who are renters will continue to retain coverage with us as they transition from being renters to homeowners. p.11
Our Giveback may not function as intended and may not align our interests with those of our customers to the extent anticipated. p.11
The unavailability of acceptable reinsurance protection in the future would have an adverse impact on our business model, which depends on reinsurance companies to absorb any unfavorable variance. p.11
Future legislation may affect our ability to use artificial intelligence in our business and operations. p.11
Public Benefit Corporation
We are incorporated in Delaware as a public benefit corporation. Public benefit corporations are a relatively new class of corporations that are intended to produce a public benefit and to operate in a responsible and sustainable manner. p.14
Certified B Corp
Refers to companies that are certified by B Lab, an independent nonprofit organization, for meeting rigorous standards of social and environmental performance, accountability, and transparency. p.14
Ed: More on both of these below, but this is an important nuance investors should understand!
Risk Factors
“Our future revenue growth and prospects depend on attaining greater value from each user.”
Currently, the large majority of our users are renters. In order to increase our PPC, we must increase the number of higher-priced customers, such as homeowners. p.22
“The novelty of our business model makes it efficacy unpredictable and susceptible to unintended consequences.”
Our business model is predicated on behavioral economics…our commitment to charitable giving through our Giveback program may not align our interests with those of our customers to the extent anticipated. p.22-23
“We could be forced to modify or eliminate our Giveback, which could undermine our business model and have a material adverse effect on our results of operations and financial condition.”
If a state, federal authority or foreign jurisdiction was to find that the Giveback was a rebate rather than a charitable contribution, or impermissible on other grounds, we may not be able to donate the residual value of our customers’ premiums to nonprofits in certain, or any, of the states or foreign jurisdictions in which we operate. If even one regulator were to disallow the Giveback, it could force us to abandon the Giveback in part or entirely…Additionally, we could modify, reduce or eliminate the Giveback at our discretion for a variety of reasons. p.23
Ed: More on this below, too. The Giveback is far from set in stone.
“Reinsurance may be unavailable at current levels and prices, which may limit our ability to write new business.”
If we are unable to obtain adequate reinsurance at reasonable rates, we would have to increase our risk exposure or reduce the level of our underwriting commitments, each of which could have a material adverse effect upon our business volume and profitability. Alternatively, we could elect to pay higher than reasonable rates for reinsurance coverage, which could have a material adverse effect upon our profitability. p.26
“If we are unable to expand our product offerings, our prospects for future growth may be adversely affected.”
Our ability to attract and retain customers and therefore increase our revenue depends on our ability to successfully expand our product offerings…our intention to launch pet insurance, and we may in the future choose to enter…auto and life insurance. p.26
“We are currently undergoing…a full scope examination by our primary state insurance regulator, which could result in adverse examination findings and necessitate remedial actions.”
The NYDFS may require us to take one or more remedial actions or otherwise subject us to regulatory scrutiny, such as pursuant to an enforcement action…(which) could have a material adverse effect on our business. p.33-34
“Our exposure to loss activity and regulation may be greater in states where we currently have most of our customers.”
61% of our gross written premium for the three months ended March 31, 2020 originated from customers in California, New York, and Texas. As a result of this concentration, if a significant catastrophe event or series of catastrophe events occur…our business, financial condition and results of operation could be materially adversely affected. p.43
Ed: This becomes a bigger issue as they expand in homeowners.
“Our ability to…expand our business is partially dependent on us maintaining our Demotech, Inc. rating, and may be negatively affected by the fact that we do not have a rating from A.M. Best.”
We have never been reviewed by A.M. Best and do not currently intend to seek a rating from A.M. Best. Unlike Demotech, Inc., A.M. Best may penalize companies that are highly leveraged, including those companies that utilize reinsurance to support premium writings. We do not plan to give up revenues or efficiency of size as a means to qualify for an acceptable A.M. Best rating. p.58
“We operate as a Delaware public benefit corporation. As a public benefit corporation, we cannot provide any assurance that we will achieve our public benefit purpose.”
We are required to produce a public benefit or benefits and to operate in a responsible and sustainable manner…we are required to publicly disclose a report at least biennially on our overall public benefit performance and on our assessment of our success in achieving our specific public benefit purpose. p.60
“If we lose our certification as a Certified B Corp…or if state or federal regulators restrict, delay or otherwise interfere with our ability to make charitable contributions, our reputation could be harmed and our business could be adversely affected.”
Certified B Corp status is a certification that requires us to consider the impact of our decisions on our workers, customers, suppliers, community and the environment…any change in our status could create a perception that we are more focused on financial performance and no longer as committed to the values shared by Certified B Corp. p.61
Ed: So they have to prioritize ESG by law, but keep reading, there’s more…
“As a public benefit corporation, our focus on a specific public benefit purpose and producing a positive effect for society may negatively impact our financial performance.”
Our directors have a fiduciary duty to consider not only the stockholders’ interests, but also the company’s specific public benefit and the interests of other stakeholders affected by our actions…we may take actions that we believe will be in the best interests of those stakeholders materially affected by our specific benefit purpose, even if those actions do not maximize our financial results.
As a public benefit corporation, we will be less attractive as a takeover target…Under Delaware law, a public benefit corporation cannot merge or consolidate with another entity if…the surviving entity’s charter “does not contain the identical provisions identifying the public benefit or public benefits,” unless the transaction receives approval from two-thirds of the target public benefit corporation’s outstanding voting shares. Additionally, public benefit corporations may also not be attractive targets for activists or hedge fund investors because new directors would still have to consider and give appropriate weight to the public benefit along with shareholder value. p.61-62
Ed: There goes the exit strategy!
“Our directors have a fiduciary duty to consider not only our stockholders’ interests, but also our specific public benefit and the interests of other stakeholders affected by our actions. If a conflict between such interests arises, there is no guarantee such a conflict would be resolved in favor of our stockholders.”
Directors of a public benefit corporation have a fiduciary duty to consider not only the stockholders’ interests, but also the company’s specific public benefit and the interests of other stakeholders affected by the company’s actions. Under Delaware law, directors are shielded from liability for breach of these obligations if they make informed and disinterested decisions…In the event of a conflict between the interests of our stockholders and the interests of our specific public benefit or our other stakeholders, our directors must only make informed and disinterested decisions that serve a rational purpose; thus, there is no guarantee such a conflict would be resolved in favor of our stockholders. p.62
“As a Delaware public benefit corporation, we may be subject to increased derivative litigation concerning our duty to balance stockholder and public benefit interest, the occurrence of which may have an adverse impact on our financial condition and results of operations.”
Stockholders of a Delaware public benefit corporation…are entitled to file a derivative lawsuit claiming the directors failed to balance stockholder and public benefit interests. This potential liability does not exist for traditional corporations. p.62
Ed: So increased D&O risk and the directors have no incentive to prevent it because they have a liability shield. Note to D&O underwriters: price accordingly!
“A joint investment committee consisting of our Co-Founders and an executive of SoftBank will have sole voting and dispositive control over the shares owned by the entities affiliated with SoftBank Group Corp. This joint investment committee further concentrates voting power with our Co-Founders, which could limit your ability to influence the outcome of important transactions, including a change in control.”
SoftBank Group Capital Limited has delegated all of its investment and voting power with respect to the shares of Lemonade that it owns to a three-member joint investment committee consisting of our Co-Founders and an executive of SoftBank, and which shall act unanimously. As a result, each of our Co-Founders will have an effective veto over the voting and dispositive decisions related to our shares held by SoftBank. p.62-63
MD&A
Our Business
Our gross margins are expected to change little in good years and in bad. At Lemonade, excess claims are generally offloaded to reinsurers, while excess premiums are usually donated to nonprofits selected by our customers as part of our annual “Giveback”. p.85
Ed: As noted earlier, dependence on reinsurance is a business risk and the Giveback is discretionary at best and subject to regulatory action at worst.
Since our launch in late 2016, our gross written premium (“GWP”) grew from $9 million in 2017, to $47 million a year later, and to $116 million in 2019. For the three months ended March 31, 2020, our GWP was $38 million. p.86
Risk Management
We believe our fixed fee business model combined with our Giveback discourages fraud and promotes greater trust between us and our customers. p.89-90
Ed: I would amend this from “discouraging fraud” to “our reinsurers bear the cost of fraud”.
Adjusted Gross Profit
We define adjusted gross profit, a non-GAAP financial measure, as
total revenue, excluding net investment income, plus ceding commission earned, less loss and loss adjustment expense, net of amounts ceded to reinsurers, less payment processing fees, and less amortization of deferred acquisition costs. p.93
Ed: In other words, this excludes advertising, technology spend, and G&A. You can find the detailed calculation on p.106.
Our Ability to Retain Customers
As of March 31, 2020, our Year One Customer Retention Rate and Year Two Customer Retention Rate were 75% and 76%, respectively
Our Year One Retention Rate excludes company-initiated cancellations, rescissions and non-renewals based on underwriting risk assessment consistent with regulatory requirements. This accounts for an additional 13% and 5% decrease in Year One Customer Retention Rate and Year Two Customer Retention Rate, respectively. p.94
Ed: So 57% of customers remain after two years (.75 * .76). Adding in the ones they ask to leave, only 44% remain after two years (.62 * .71). This suggests the Giveback may not be a sufficient incentive.
COVID-19 Impact
On April 30, 2020 our IFP was about 130% higher than it was April 30, 2019…every marketing dollar spent during April 2020 generated 129% more IFP than the equivalent spend did during April 2019. p.96
Comparison of the Three Months Ended March 31, 2020 and 2019
Net earned premium increased $14.8 million, or 141%, to 25.3 million…due primarily to a 96% increase in net added customers. We also saw a 19% increase in PPC. p.101
Loss and LAE, net increased $10.3 million, or 130%…in line with premium volume growth. p.101
General and administrative expense increased $15.4 million, or 550%, to $18.2 million…the Company made a contribution to the Lemonade Foundation of 500,000 shares of common stock with a fair market value of $24.36 per share. p.102
Comparison of the Years Ended December 31, 2019 and 2018
Net earned premium increased $42.6 million, or 201%, to 63.8 million…due primarily to a 108% increase in net added customers. We also saw a 22% increase in PPC. p.102-103
Loss and LAE, net increased $30.6 million, or 201%, to $45.8 million. p.103
Liquidity and Capital Resources
As of March 31, 2020, we had $304.0 million in cash and short-term investments. From the date we commenced operations, we have generated negative cash flows from operations. p.107
Business
Grow With Our Customers
Our customers tweet about Lemonade in a tone and volume unprecedented in insurance. p.123
Our Technology
AI Maya…uses natural language to guide customers through an easy and fun process of joining Lemonade…AI Maya is able to dramatically reduce onboarding times. p.127
AI Jim is our claims bot, and, as of March 31, 2020, 96% of the time, it is AI Jim that will take the first notice of loss from a customer making a claim. AI Jim handles the entire claim through resolution in approximately a third of case…with zero…LAE. p.128
CX.AI is our bot platform built to understand and instantly resolve customer requests without human intervention. About a third of of all customer inquiries are handled this way…The efficiency boost CX.AI delivers is exemplified by its impact on ‘moving’ tickets…once CX.AI learned to handle moving requests, we saw an 87% drop in the number of moving-related tickets handled by humans. p.129
Growth Opportunities
We acquired our first customer in New York in late 2016, and within three-and-a-half-years captured approximately 7% of the New York renters insurance market. p.131
Giveback Feature
Our 2019 annual Giveback for the 12 month period ended June 30, 2019 amounted to about 1.5% of earned premiums…we donated over $600,000 to 26 nonprofit organizations. p.133
Sales and Marketing
Last year we entered into a co-marketing agreement with GEICO Insurance Agency, whereby in designated markets GEICO may sell our renters insurance. p.133
Intellectual Property
We do not own any U.S. or foreign patents and do not have any U.S. or foreign patent applications pending. p.137
Corporate Structure
The group consists of the following entities…
1) Lemonade Insurance Company, an insurance corporation organized under New York law
2) Lemonade Insurance Agency, LLC…acts as the distribution and marketing agent for Lemonade Insurance Company and provides certain underwriting and claims services, and receives a fixed percentage of premiums for doing so.
3) Lemonade Ltd., a company organized under the laws of Israel; this company provides technology, research and development, management, marketing, and other services to the companies in the group, charged on a “cost plus” basis. p.137
Ed: There are also some foreign subs but these are the main three. The full tree is below. What is important to understand is the agency is getting the 25% MGA fee and the technology costs sit outside the insurer.
Employees
As of March 31, 2020, we had 329 employees, 193 of whom were based in the United States. p.139
Ed: At this point, the document largely ceases to be about the business and turns more to compensation, capital raising, and regulation so I will race ahead to the footnotes.
Consolidated Financial Statements
I’m not going to reproduce every chart. I think the best approach here is to create a short index of where the important information is.
Balance Sheet F-3
Income Statement F-4
Cash Flow Statement F-6
Reinsurance F25-27 (note: list of reinsurers on F-26)
DAC F-28
Unpaid Losses F-29
Incurred Losses F-30
Paid Losses F-31
Preferred Stock F-33 (this all converts to common pro forma)
Deferred Tax Asset F-39
Statutory Financials F-45 (capital is $48M @ YE)
GPW by State F-45 (1/2 is CA + TX)
Pro Forma Balance Sheet F-51
The Finish Line
If you made it this far, congratulations! You saved yourself a lot of time even if it doesn’t feel like it at the moment!
The key topics to follow up on for me would be the reinsurance dependence, why adjusted gross margin is a useful financial metric, what are the challenges in moving from renters to homeowners (both acquiring customers and claims management), the sustainability of the Giveback, and the constraints of the public benefit corporation.