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Lemonade acquires Metromile: When life gives you lemons

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Consolidation in insurance happens due to one (or sometimes several) of the following reasons:

1. A complementary fit.

2. A discounted seller looking for an exit.

3. A buyer with excess capital.

4. Reframing the narrative to draw attention away from the buyer’s current issues.

5. A purely financial transaction where the accounting benefit outweighs the strategic advantage.

You would be right to think that 2, 3, and 4 happen way more often than necessary. A value-add insurance consolidation is tricky to pull off, as we discussed in our consolidation piece. Unlike many other sectors, there is a lag between the cost of goods sold (future claims) and the actual premiums paid for the products.

A diligent buyer might value the future claims differently than a seller looking for a premium multiple would, and that’s why we see the best franchises making acquisitions at a measured pace. Of course, that general rule applies to well-established players (think Chubb). But the rule is often not true for the less established players with less experience in the M&A space.

In our July note Unsurtech and the temple of underwriting doom, and more recently in our P2P piece, we discussed how the promise of a revolutionary change to the marketplace often takes materially longer to be realized.

In the most recent quarter, InsurTechs have faced myriad challenges, including valuations heading towards run-off multiples, business models which have continually failed to deliver, leading to lowered expectations, capital depletion, and regulatory and rating agency scrutiny.

Compare this experience to that of the established carriers playing the long game, waiting it out, and then picking out the winners to acquire.

Unfortunately, InsurTechs don’t have the capital to play this waiting game, and their hands are increasingly being forced into premature acquisitions. Last night we saw an example of this when Lemonade announced that it was “acquiring” Metromile.

Metromile’s stock has been in free fall since its SPAC as the company has struggled to deliver and had to revisit its expectations.

Lemonade stock has been a relative outperformer compared to other InsurTechs but an underperformer vs. insurers and the S&P 500.

The company has struggled to control its narrative and evolve beyond the hype of its rental market play. Last week after months of talk, it launched its auto product - which seemed a head-scratcher at that time.

So, let’s call this acquisition what it really is.

For Lemonade, the deal allows for a more extensive capital base and gives it headroom to pursue its growth strategy. Although Metromile’s IP and its value-add is still TBD, the acquisition still helps Lemonade move along the product lifecycle curve.

For Metromile shareholders, this is a lifeboat, although time will tell if the shareholders end up living in this lifeboat instead of getting to dry land.

In terms of deal metrics, Lemonade is acquiring Metromile in an all-stock transaction at a 19:1 ratio, equating to a share price of $3.71 ($70.50/19) vs. Metromile’s closing price of $3.16, a premium of 17%.

Additionally, the deal equates to $500mn of equity value and an enterprise value of $209mn vs. Metromile’s enterprise value of $146mn as of Q2 = 1.4x.

This deal has positive implications for the broader InsurTech market. It accelerates the consolidation of smaller/less-relevant players, which positively impacts the industry's overall competitiveness. It also forces any capital/companies on the sidelines to rethink their launch and eventual exit strategy.

Below we evaluate some of the competitive considerations for the deal and their implication.

First, the transaction provides capabilities for Lemonade and a lifeline for Metromile.

Only days after Lemonade launched its car product, the announced Metromile acquisition provides an accelerated platform, pushing up the timeline to what would otherwise be a long process of state approvals and product filings, while providing Lemonade with a cache of auto data.

While Lemonade and Metromile are framing the acquisition as a combination of complementary strengths, it also has the benefit of saving a struggling Metromile from poor performance as its own company. Since its SPAC, Metromile’s stock is down 81%, from $17 on February 10, 2021, to $3.16 at market close on November 8 2021.

The decline has been furthered by management lowering 2021 guidance last quarter, cutting PIF outlook by ~25,000, increasing the accident-year loss ratio outlook by 5pts, and reducing the premium run rate outlook by $40mn.

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Although Metromile has suffered underwriting losses, Lemonade is painting the loss ratio as impressive given the lower premium costs vs. competitors.

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While the loss ratio is generally in line with peers, this achievement brings with it a high expense ratio. Therefore, it remains to be seen what success this combined franchise can generate post-integration.

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Second, the transaction reflects Metromile’s repeated struggles to get the growth/retention matrix right.

Metromile has struggled with customer retention, noting a one-year new customer retention of 68% for the second quarter of the year. Meanwhile, other InsurTechs, such as Lemonade, reported an annual dollar retention of 82% for the same year. At the same time, Allstate, a more traditional insurer, had a renewal ratio of 87.1% in the same quarter.

Metromile in the second quarter of the year saw a 3% contraction in policies-in-force. Lemonade, on the other hand, had a policies-in-force growth of 10% for the same period. Lemonade CEO Dan Schreiber even obliquely acknowledged Metromile's challenged growth in his long blogpost on the deal, noting that "Metromile may not be celebrated for its growth".

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It appears Metromile is aware of how Lemonade’s marketing has translated to higher growth.

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Lemonade’s advertising capabilities have the potential to accelerate Metromile’s PIF growth. However, the company may find it challenging to widen Metromile’s attractiveness to a broader audience while balancing competitive pricing and stable underwriting results.

Third, this is a challenging time to grow personal auto.

The personal auto insurance market has faced hurdles over the past year, making new ventures' profitability less likely.

Frequency benefits that the industry enjoyed over the pandemic have receded, just as severity has begun to climb. In addition, rising inflation and an ongoing supply chain crisis pushed the prices of new and used cars to record levels, along with replacement car parts.

A labor crunch has increased the price of car repairs, also contributing to worsening severity trends. Normalized frequency and high severity have led to rising loss-cost trends, which punish carriers with overweight exposure to personal auto lines.

As loss-cost trends rise, personal auto carriers reach for rate to compensate, but regulators have slowed the process. Some might argue that challenging times are the best to enter a market, entering the personal auto space when other carriers have yet to get the needed rate. But this means that Lemonade could be tempted to underprice to win over customers and end up facing the same issues as the existing carriers.

In summary, this acquisition is an attempt to maintain relevance in a highly competitive market faced with pressures on the top and bottom line. Don’t sell the skin till you have caught the bear.

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