Is Lemonade Really the Future of Insurance?

Insurance startup Lemonade opened for business in New York in September this year to great fanfare. If you haven’t heard, Lemonade is heralded as a mobile-first, legacy-system-free, peer-to-peer insurance carrier that is poised to usher in a new era of personal insurance.

When I saw Lemonade co-founder Daniel Schreiber at InsureTech Connect 2016 I was finally able to confirm the rumors—Schreiber is a genius.

But the reason why he’s a genius is bigger than Lemonade itself. With a background rooted in tech, Schreiber has been able to establish himself on the front lines of insurance and build an audience for his innovative approach to a legacy-laden industry.

Lemonade introduces a whole new vision of selling insurance. Time will tell if it really revolutionizes the industry, but one thing is clear—there are still many questions to answer before we get ahead of ourselves.

Lemonade Distribution—Is It Really Peer-to-Peer?

When you look at Lemonade on the surface, it’s clear that the user experience is amazing. Having a mobile-first approach to selling insurance will help the industry align itself with the broader scope of digital transformation that is sweeping businesses in all sectors.

It’s not that Lemonade is the only insurtech application out there—it’s just that Lemonade simply has the best user interface.

Once you look deeper than the user experience, the peer-to-peer model becomes interesting. Lemonade’s peer-to-peer insurance model is based on the insurance carrier model (Lemonade is a licensed carrier in New York) where policy holders form small groups online and part of their insurance premiums flow into a group fund for paying claims.

Essentially, Lemonade’s business model calls for users to divide risk amongst themselves. However, if you look a little closer, it seems unclear whether Lemonade is actually offering a peer-to-peer approach to insurance or if it’s a virtual/mobile-first version of a regular insurance company.

Lemonade has dramatically cut the typical insurance industry debt ratio by eliminating offices and agents. But Lemonade’s reinsurance through Lloyd’s of London makes it tough to really understand this peer-to-peer model.

The distribution model will become clearer over time, but the bigger question is profitability in this new vision of insurance sales.

Fraud and Insurance Profitability—What’s the Lemonade Approach?

At the end of the day, it doesn’t matter how much an insurance company collects in premiums—it only matters how much of that money is staying in your pocket.

Traditional insurance companies consistently post combined loss ratios above 100%, so there is an obvious concern for increasing profitability. Lemonade has said this led incumbent insurers to put $0.40 on the dollar of their premiums toward expense ratios. As Dan Ariely, Lemonade’s Chief Behavioral Officer, puts it:

In the very structure of the old insurance industry, every dollar your insurer pays you is a dollar less for their profits. So when something bad happens to you, their interests are directly conflicted with yours. You’re fighting over the same coin. Basically if you tried to create a system to bring out the worst in people, you would end up with one that looks a lot like the current insurance industry.

This contention between insurers and their customers has led to 25% of Americans believing that it’s okay to embellish claims, according to Lemonade. Fraud is a real problem that new insurtech players must contend with, and Lemonade is no exception.

Lemonade has worked to restructure the insurance model in a way that aligns with behavioral economics and game theory. According to the company, the current insurance model breeds fraudulent activity because consumers feel slighted by insurers and their distrust leads to fraud. In response, Lemonade looks to signal to consumers that they can be trusted by being transparent about the 20% management fee and giving all unclaimed money to charity.

Lemonade believes that if consumers see that fraud is slighting charity rather than slighting an insurer, they won’t be pushed to commit fraud. It’s a little troubling that Lemonade’s Giveback program is an expression of intent, not a contractual obligation to policyholders nor their selected charities. But aside from this point, there are still inconsistencies in the overarching Giveback theory.

The problem with this signaling theory is rooted in Schreiber’s explanation of the Prisoner’s Dilemma. He says that when playing the Prisoner’s Dilemma, neither party trusts the other which leads to bad results for both. However, when you look at real-world results of the Repeated Prisoner’s Dilemma, an initial defect response will force punishment that inevitably leads to a cooperate response later. A defect/defect response is a Nash Equilibrium, but in the long run the optimal solution and best strategy is cooperate/cooperate. This isn’t necessarily consistent with Lemonade’s explanation of consumer/insurer distrust.

This inconsistency complicates the signaling behavior that Lemonade’s model aims for. The 20% management fee and charity policy are Lemonade’s signals to the other party that the insurer won’t change its strategy no matter what happens. If we employ Lemonade’s logic, the other party has no choice but to defect—but we expect the exact opposite. If a policyholder signals to an insurance company that he/she won’t commit fraud (per behavior data and shared privacy), the insurance company has no choice but to pay claims. This isn’t consistent with the current state of insurance as companies lose money and consumers don’t trust the industry.

As Lemonade matures, we’ll see if this plan works out. It’s just hard to imagine that Lemonade doesn’t have a backup plan for insurance fraud (or, maybe we just aren’t getting a complete picture of the business model just yet).

Lemonade Success Spells Success for all Insurtech Entrpreneurs

The growth of Lemonade and the insurtech space seems poised to put an end to the idea that insurance companies can only make money by not paying claims. Insurtech entrepreneurs are rooting for Lemonade’s success. But keep in mind that insurance innovation will only take us so far—we have to address fraud to ensure we’re profitable.

Despite the rise of these “disruptors,” we can be sure that insurance companies aren’t going anywhere. As Chairman of InsureTech Connect Caribou Honig says, “Many entrepreneurs overestimate changes that will be in 2 years and underestimate changes that will be in 10 years.”

Insurtech is on the rise and Lemonade is certainly poised for success, but the insurance industry as a whole must buckle down and solve the problem of fraudulent claims before we can succeed in the digital future.