Root Insurance (ROOT): A Worse Mousetrap

Root: A Worse Mousetrap

·         Root is new Insurance technology company with quick growth and worrying fundamentals

·         Pricing model based solely on telematics will lose in low-end, highly competitive Property and Casualty market

·         Probable long-term premium price increases based on poor risk pool pricing and customer churn lead to poor operating results

·         Insider lock up expiration for ¾ outstanding shares will be race to “cash-in” at wild valuation – avoid, or better, front run insiders to exit by selling short

Root insurance was founded by Alex Timm and Dan Manges, and received significant VC investment interests due to its rapid premium growth and insatiable thirst for capital. As with many companies in hyper-growth mode, Root needed capital to gain scale and ultimately become profitable. Under the surface, the real need for capital was to show impressive premium growth and feed narrative of changing insurance for the better. This false narrative hides the fact that Root is at staggering disadvantage to competitors and will struggle to ever write profitable auto insurance.

Root’s “differentiated” business model relies on two cornerstones: using telematics to most accurately price a customers P&C risk AND actively avoiding the big data factors relied upon by more established insurance companies (State Farm, Progressive, et al.). These factors include simple and sometimes controversial qualities like age, Zip Code, education status, credit score, and many more (>1000 factors in some cases). Exclusion of these factors is the center of their main feel-good narrative of caring for individual and not discriminating based on non-driving demographics.

Ultimately, telematics will show who is lower risk for accidents based on history; however, it will not predict which customers will be profitable due to under reliance on proven factors. Example: your credit score/report is highly predictive (correlated) to your likelihood of filing loss claims. In this example, a non-driving related factor is being discarded by Root yet can cause certain mispricing in insurance premiums.

Forbes, Lance Cothern https://www.forbes.com/advisor/car-insurance/auto-insurance-score/

Furthermore, the use of telematics isn’t special anymore with many carriers bringing their tech to market Over time, this disadvantage spot Root has put itself should lead to higher premiums than competitors (mainly GEICO and Progressive) making their service less desirable and increasing customer churn.

Drivewise from Allstate:

 

Customer churn is tough for P&C insurance companies fighting it out in the lower-end market. Typical insurance carrier retention is approximately 85% annually and reacquiring customers can be expensive. In Root’s case, extremely expensive. Per the company’s IPO prospectus, they only retained 47% of customers after one year! They have to stop the bleeding of losing customers and acquire new customers to continue their capital destroying growth. Capital destroying? Yes – Root is lighting money to keep warm and as Ned Stark said, “Winter is coming”.

Root IPO Prospectus:

Root is having to re-acquire ~50% of premiums every year PLUS all growth premiums. Progressive only requires 8 cents to acquire $1.00 in premium; where Root required 22 cents on the dollar. To be fair, this cost is falling compared to 2019 of almost 44 cents per $1.00 in premium. Most likely this will approach a steady-state level higher than competitors necessitating an increase in premium cost and reducing pricing competitiveness. It’s like the flywheel effect, except opposite.

A common strategy to retain customers is to bundle auto with home policies. Root does offer bundling which could/does lead to better retention. However, this service is outsourced through Homesite. This does not lead to scale advantage by pulling more premiums over same fixed cost structure, but instead should pass along more to cost to customers if Root is concerned with profit.

 

Progressive 2019 Annual Report:

 

Altogether, Root lost a staggering $144 million in insurance operations in first 6 months of 2020. This massive loss should be expected as they advertise aggressively to grow premiums at blistering pace. The catch is replacing churn customers and acquiring new customers will continue resulting in significant losses on P&L which in turn translates to lower capital available for mandated reserve requirements. This acquisition cost plus longer-term inefficient risk pricing will cause business impairing price increases to written premiums or dilutive capital raises. Existing capital held on balance sheet, $1,220 million cash, can evaporate quickly if they continue to stack up losses like these.

Valuation and Lock-up expiration:

Root following the IPO and some trading now sports a value of ~$5.3 Billion as of Friday, 11/6l. With recent capital infusion from the IPO, injecting significant cash to raise Book Value to ~$1.19 Billion. Yet again, the increase in book value is not a result of prudent underwriting and retained capital but outside investors injecting cash. The need for continual capital infusions aside, Root trades at about 4.5x book value – which implies strong growth outlook and compounding book value over time; however, book value is expected to fall over time due to significant underwriting losses.

Best in class Progressive trades at 3x BV due to strong capital position, profitable underwriting, and above industry growth. Weakness in IPO action is only the beginning of a predictable, large slide in Root’s share price due to upcoming wave of insider selling.

Insiders only have to wait 180 days to cash in their lottery tickets and unload to unsuspecting retail investors. Watch out for participating investment banks to write glowing reviews of this “barrier breaking” insurance company as insiders ring the register. So what? What is there to do? Well, this is where it gets interesting…

The IPO on October 28th, introduced a miniscule amount of float compared to outstanding shares. IPO included ~26 million shares sold to public with additional shares generated by other stock and warrant conversions (specifics not as important here) representing only 25% of total shares outstanding. This is classic way to promote rapid stock price movements up if there is decent interest in IPO and not unexpected. The initial action is weak, so the doubts may already be forming. Once the lockup ends on about May 1st, watch for insiders, and VC investors to scream for exit due to already weak stock performance and poor business results. This sets up nice opportunity to get ahead of expected price action by selling Root shares short ahead of lockup expiration.