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Root Insurance IPO | S-1 Breakdown

By 

Max Motschwiller

Oct 27, 2020

Root Insurance, a personal insurance provider, filed for a $600M+ IPO and is the second insurtech company to file in 2020, following Lemonade’s IPO on July 2nd, 2020. Goldman Sachs is the leading the IPO and Root plans to trade on the Nasdaq under the ticker “ROOT.” Root aims to use technology to revolutionize personal insurance by pricing risk more accurately and fairly and offering a modern customer experience. The company operates in one of the largest and least digitized industries in the world. Alexander Timm, co-founder and CEO of Root, started the company in 2015, with a view that by utilizing technology and data science he could fundamentally change the way auto insurance was underwritten and move away from traditional pooled risk assessment. Today, Root’s core product is auto insurance, and they have added renter and homeowner lines as they seek to expand their relationship with customers.

While Root has only been around for 5 years, it is has grown its revenue to $290.2M in 2019, up 570% YoY, with 283,057 policies in-force, up 153% YoY. In June-2020 quarter, Root did $121.4M or revenue, up 94% YoY, but had a negative (2%) decline QoQ. Root is headquartered in Columbus, Ohio with an office in Chandler, Arizona and has 901 full-time employees as of June 30, 2020.

Product & Technology

Root began by offering auto insurance and has expanded their offering to renter insurance and homeowner insurance. Root’s core product differentiation is its use of technology and data to measure risk based on individual performance, which prioritizes fairness of underwriting and pricing compared to other providers. Root’s customer experience usually begins with downloading their mobile app on iOS and Android. During an initial driving period, Root will gather and analyze data from users’ sensors. Using this behavioral driver data, Root offers consumers coverage where user can bind in-app and proceed to manage their policy, claims and support from their mobile device.

Source: S-1

Root believes its product differentiation around risk and experience is made possible by the three following focus areas:

Behavioral Data and Proprietary Telematics. Root’s reinvention of auto insurance is predicated on transparent data collection and driver performance analysis. Compared to traditional insurance companies that group people into risk pools and rely on the ‘law of large numbers’ to produce acceptable aggregate pricing, Root believes their telematics and data analysis are the most powerful predictors of accidents and claims. Today, Root is capable of tracking thousands of behavioral driving variables to detect patterns like hard breaking, turning, mileage, and distracted driving.

Source: S-1

Root has collected and analyzed datapoints across over 10 billion miles and hundreds of thousands of claims. Their telematics process is synthesized into an individual usage-based insurance or UBI score, which determines underwriting eligibility and pricing. The idea of telematics has been around for decades, but mobile technology has only recently become robust enough to make it adoptable at mass-market scale.

Source: S-1
Source: S-1

Root Customer Experience. Root’s mobile-first experience is designed make insurance simple. On-boarding includes the applicant scanning their driver’s license, answering a few questions and taking their phone with them while they drive for two to four weeks. Customers use their mobile app to manage their policy and file claims.

Full-Stack Insurance Structure. Root is a full-stack insurance carrier arguing this gives them control over their product features, speed of innovation and reduces reliance on third parties. It also gives Root the flexibility to adjust their use of reinsurance in response to different market conditions.

Root’s believes their data capabilities establish a flywheel that enables the company to more accurately underwrite risk and more effectively price their product. Better pricing leads to increased growth and scale which feeds their data capture.

Source: S-1

Root also offers renters insurance (launched July 2019) and homeowners insurance through a partnership with Homesite (launched May 2020). Bundling policies can often be preferred by customers and helps improve unit economics.

Business Model Summary

Root, like other insurance P&C insurance providers, makes a majority of their revenue from charging consumers premium in exchange for coverage. Generally, premiums are collected prior to providing risk coverage, minimizing Root’s exposure to credit risk, but revenue is recognized pro rata over the policy period (typically 6 months).

Root utilizes reinsurance with both third-party reinsurers as well as their wholly-owned reinsurance subsidiary, Root Re. As of July 1, 2020 they shared approximately 70% of direct earned premiums to third-party reinsurers with a sequence of inception and maturity dates, and the majority of the ceded premiums covered on a cohort basis for four year duration. They quota share an additional 15% of direct earned premium to their captive. Sharing premiums between Root Insurance, Root Re and third-party reinsurers is a core part of the strategy and can be re-balanced over time. Reinsurance enables a more “capital light” business model and helps decreases market volatility. Specifically, U.S. insurance regulatory requirements have a target capital and surplus requirement for auto policies such that Root’s ratio of net premiums to capital and surplus does not exceed 3:1; today, Root’s captive reinsurer requirement is 8:1. The continued availability and terms of reinsurance protection has an important impact on Root’s business model and is dependent on the magnitude and variance of anticipated underwriting losses. If Root is unable to maintain adequate reinsurance at reasonable rates it could have a material impact on revenue, profitability or both. Root does not offer detail about their third-party reinsurance providers.

Root also makes a small amount of revenue from net investment income (1.8% of 2019 revenue) and fee income (3.3% of 2019 revenue). Direct losses and loss adjustment expense (LAE) reserves are Root’s biggest cost and come from customer claims and expected future claims.

‍Summary Metrics and GTM (Go-to-Market)‍

Auto insurance is required for the vast majority of drivers in the United States and Root believes it is typically the first insurance policy purchased by consumers helping to establish a long-term consumer relationship to add other lines of personal insurance lines as customer needs develop.

Root’s primary marketing channel is advertising direct to consumers on digital channels like Google and Facebook.  Over 75% of their customers are acquired on mobile, while Root also implements an API-enabled partnership channel where they have integrations into user bases on other platforms.

  • From August 2018 to August 2020, average customer acquisition cost was $332.
  • Currently spend $1 in marketing to generate more than $2 of in force premium ("IFP"), which has been approximately equal to annualized gross written premium.
  • Root is licensed in 36 states and currently active in 30. Notably, their active geographies exclude California, which represents approximately 50% of the U.S. driving population. Root hopes to be licensed in every U.S. state by early 2021.
  • Approximately 40.1% of Root’s gross written premium for the six months ended June 30, 2020 originated from customers in Texas, Georgia and Kentucky.
Source: S-1
  • For renters insurance, Root is licensed in 14 states and active in 8 states.
  • In states where Root writes renter’s policies, 5.4% of eligible auto customers have elected to bundle a renters policy with an auto policy.
Source: S-1
  • Root currently provides homeowners insurance in 13 states, representing 32% of their auto footprint and seeks to extend to their entire auto market in the near term.
  • Root’s first enterprise product, launched in March 2020, includes telematics-based data collection and trip tracking. The company has signed enterprise agreements with multiple clients including Carvana, Chime, GasBuddy, SoFi and Stash.
  • As of June 30, 2020, the company has 4 non-provisional patent applications pending examination in the United States.

COVID Impact

In the second quarter of 2020, Root claims their business was favorably impacted by shelter-in-place as their customers drove less and had a resulting material decline in loss coverages during the quarter. This has now returned back to pre-COVID-19 levels. It is also worth pointing out that COVID may be having a negative impact on customer growth and premium growth. Q2-2020 policy growth was only 1% QoQ and gross written premium experienced negative growth QoQ.

Market Opportunity

Insurance is one of the oldest and largest markets in the world, touching every corner of the globe and protecting our most important assets. Root’s primary addressable market today is U.S. personal lines insurance. This market exceeded $370 billion in 2019 premiums and has grown at a 5% compound annual growth rate, or CAGR, since 2014.

The largest insurance companies offer multiple lines of insurance products to the same user (e.g. auto and home). As customers accumulate wealth and have changing life events their insurance needs also grow. Root has the opportunity to continue to expand its product offering and coverage to retain consumers and increase their lifetime value without having to spend incremental marketing dollars.

‍Competition

The auto, renters and homeowners insurance markets are well established and highly competitive. Primary competitors include large national insurance companies with well established brands such as Geico, Progressive and Allstate, as well as up-and-coming companies and new market entrants in the insurtech industry, some of whom also utilize telematics and offer forms of usage-based insurance. Many of the well-established brands have significant competitive advantages including name recognition, higher financial rating, larger pools of capital and other resources and broader insurance coverage lines including life and umbrella policies.

Competition is based on many factors, including the reputation and experience of the insurer, coverages offered, customer service, size, price and other considerations. Root believes they can compete favorably across many of these factors given their behavioral data collection and machine learning that we will be difficult for incumbent insurance providers to copy.

% Ownership, Pre-Offering

Source: S-1

Preferred Stock Prices by Series

Source: S-1

Financials and Other Metrics Output

Historical P&L ($M)

Source: S-1

Quarterly KPIs

Source: S-1

Direct Written Premium (DWP)

Total amount of direct premium on policies that are bound during the period. Root identifies DWP as the core top-line reflection of their business volume, as it notably excludes the impact of premium ceded to re-insurers and is the most direct economic connection to customer acquisition spend.

Source: S-1

Annualized Revenue ($M)

Quarterly revenue multiplied by 4.

Source: S-1

Quarterly Net New Annualized Revenue ($M)

Source: S-1

Gross Profit / (Loss), Net Loss and Loss Adjustment Expense (LAE)

Gross profit equals total revenue minus net loss and LAE expense and other insurance expense inclusive of depreciation and amortization.

Loss and LAE include an amount determined using adjuster determined case-base estimates for reported claims and actuarial determined unpaid claim estimates using past experience and historical emergence patterns for unreported losses and loss adjustment expenses. These reserves are established to cover the estimated ultimate cost to settle insured losses.

Loss and LAE is net of amounts ceded to reinsurers. Loss and LAE may be paid out over a period of years.

Adjusted Gross Profit/(Loss): A non-GAAP financial measure, defined as gross profit/(loss) excluding net investment income, and report costs, personnel costs, allocated overhead, licenses, professional fees and other expenses, which are included in other insurance expense. After these adjustments, the resulting calculation is inclusive of only those variable costs of revenue incurred on the successful acquisition of business.

Source: S-1

The June-2020 was the first quarter where Root generated a positive gross profit and positive adjusted gross profit. It is unclear how much of this gross profit expansion is due to fewer claims due to shelter in place from the COVID-19 pandemic and what near term gross profit trends will look like.

Source: S-1

Sales & Marketing and Research and Development Expenses ($M)

Source: S-1

Free Cash Flow ($M)

Root continues to have heavy losses driven by loss expenses and sales and marketing expenses. With only $241M of cash on the balance sheet as of June 30, 2020, $162M of negative FCF in the six month ended June-2020, and cash restrictions to maintain capital requirements, it seems that Root is in need of cash as it looks to the public markets for an infusion to continue to fund losses.

Source: S-1

Policies In Force

Number of current and active policyholders by Root at period end-date.

Source: S-1

Net New In Force Policies

Source: S-1

In Force Premium Per Policy

Source: S-1

Direct Earned Premium as % of New and % of Renewal

Renewal policies have lower loss ratios.

Source: S-1

Customer Retention

As of June 30, 2020, Root reports term one and term two policy retention rates of 84% and 75% respectively, excluding policies that do not make it through the underwriting period and company initiated rescissions. Adjusting for these lost customers through underwriting and rescissions, reduces term one and term two policy retention by 33% and 10%, respectively. It is critical to note, that a term is typically 6 months, so term two policy retention rates is equivalent to one-year retention.

Taking all churn into account, “adjusted” term one (6 month retention) is 51% and “adjusted” term two (one year) retention is 65%. One-year retention as a percentage of starting policies ("Effective adjusted" term two retention) is only 33%.

Source: S-1

Loss Ratios

Direct Loss Ratio and Direct LAE ratio are expressed as a percentage, as the ratio of losses to direct earned premium.

Loss ratios typically improve over the term of a customer relationship.

Source: S-1

Valuation

Public property & casualty (P&C) insurers and reinsurers today are, generally speaking, mature businesses with low revenue growth and are profitable on a net income and free cash flow basis. These businesses (a select group of which are shown in the comps table below) typically trade on multiples of earnings (e.g., price / NTM EPS) or book value (price / book value per share).

Source: Capital IQ

The investment banks advising Root on its IPO are likely to point toward Lemonade (LMND) to frame its valuation, where many analysts have looked at forward adjusted gross profit multiples to explain LMND’s valuation. Given the similarities in business model, brand, customer demographics, and technology forward approach this is the closest public market comparable.

Source: Capital IQ

In its updated S-1/A on October 20, 2020, Root included expected share price ranges. At $23.50 per share, this implies an equity value of approximately $6.1B. This is a 43% premium from the $16.49 per share price of the Ribbit Capital and Drive Capital led Series E in September 2019. Given the multiple layers of assumptions required to perform a discounted future value analysis and future adjusted gross profit estimates, we’ve opted to include a simpler valuation approach here for reference. We show an analysis at various prices (AVP) model along with implied revenue and gross profit multiples based on assumed NTM revenue growth rates and NTM adjusted gross profit.

Source: S-1/A. Note: Growth rates and GP Est. are illustrative

Root’s IPO comes on the heels of strong reception and stock performance by LMND (up 76% since IPO, but the 180 day lock-up has not yet expired). Given the similarities, Root will benefit from public market appetite for technology companies in large markets. Like LMND, investors are betting on Root’s ability to continue to gain market share and grow at a rapid rate, increase its customer LTV through cross-sell and improved retention and lower its loss ratio through renewal customer mix and improved underwriting. Root must continue to illustrate progress toward these goals and depict a compelling path to generating large amounts of free cash flow. As fintech and insurtech companies continue to reach the public markets, many will be tracking Root’s IPO closely hoping for continued public market appetite for next-generation players in these categories.

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Special thanks to my partner Anthony DeCamillo for his help on this post.

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