Root Insurance (NASDAQ:ROOT) stock IPO received a frosty reception this week. Shares of the car insurance company opened below its $27 offer price, settling at a 10% discount by the end of the trading week.
While it’s refreshing to see Wall Street finally show some pricing discipline, the ROOT stock pullback also opens the door for investors looking to ride the Internet of Things (IoT) wave.
That’s because Root Insurance could revolutionize the stodgy world of auto insurance. By using telematics data from smartphones, they’re opening a whole new world for auto insurance pricing.
Though the company still has a lot to prove, here’s why ROOT could be one of the most exciting insurance/tech companies of 2020.
ROOT Stock: Cheaper Car Insurance with Telematics
Root Insurance offers a simple proposal: to lower your car insurance, you can download the app, let the app track your driving style for several weeks and receive a massive insurance discount if you’re a safe driver.
There’s a compelling reason why car insurance companies would do this. According to TeenSafe, a phone monitoring service, aggressive drivers cause over half of all accidents, with speeding being the most prevalent contributor. Alcohol also plays a significant factor. Between midnight and 3 a.m., 70% of speeding drivers involved in fatal crashes are alcohol-impaired.
By removing the highest-risk drivers, the logic goes, auto insurance companies can provide massive discounts to safer ones. And that’s what Root Insurance aims to do.
An IoT Play
Root Insurance isn’t the first company to try using telematics – Progressive has offered Snapshot, a standalone tracking dongle, since 2008. But growth was somewhat slow to take off. Many users felt uncomfortable installing a tracking device that would beep repeatedly and send the data to Progressive every time you tapped on the brakes too hard.
Progressive even added a mobile-only version in 2015, dispensing with the dongle altogether. But the app’s constant tracking still turned people off.
Root Insurance, on the other hand, monitors drivers for three or four weeks before offering a quote. And unlike Progressive, Root will reject users who they deem as too high a risk.
That’s allowed Root to quote cheaply and grow like wildfire. In 2016, its first year, the company wrote just $150,000 in direct premium in its home state of Ohio. Only three years later, the company did $451 million across eight states.
Root Can Succeed, But Not Without Growing Pains
Root targets a massively lucrative market for younger drivers. According to data from the Safety Insurance Company, 43% of first-year drivers and 37% of second-year drivers are involved in car crashes. That means the average annual cost of car insurance for an 18-year-old is a staggering $5,335, more than five times more than the average driver.
But a great market also opens the insurance startup to growing pains.
That’s because pricing insurance is challenging, as the company’s 32-year-old CEO Alexander Timm is discovering. In the fourth quarter of 2018, the company saw a spike in claim volume. In response, Root slowed new business growth, brought its claims function in-house, and moved its portion of direct premiums written ceded to reinsurers from 28% back to 70%.
These actions haven’t made the company profitable yet – it lost $282 million in 2019 – but it’s a good start.
Even better would be if Root Insurance hired executives with more insurance experience. Jack Byrne, the luminary CEO credited with saving Geico in the mid-1970s, was an example of such talent. Byrne, who investor Warren Buffett called “the Babe Ruth of insurance,” was an experienced executive from Travelers (NYSE:TRV) who knew how to price risk and allocate capital.
Root’s executive team, on the other hand, lacks in-house insurance experience. Its 34-year-old chief data scientist has telematics experience, not an actuarial background. And its CFO hails from aviation finance.
Root Insurance could still succeed. But investors should expect more bumps, like its Q4 2018 surprise, along the way.
What’s Root Stock Worth?
Loss-making insurers are notoriously hard to value. Auto-insurer Esurance was writing $839 million in premiums when AllState (NYSE:ALL) bought it in 2011 for $1 billion. Meanwhile, property and casualty insurer Lemonade (NYSE:LMND) wrote $116 million in 2019 and is worth $2.65 billion.
Why the discrepancy? That’s because, in the world of insurance, profitability matters far more than growth. An insurer could write billions in coverage but then go bankrupt the following year if they underpriced the insurance.
Put another way, an insurance company looking to inflate its growth figures could quote $2,000 per year auto insurance to all 18-year-olds (assuming state insurance regulators don’t step in first). The company might steal market share from rivals offering the average $5,335 per year insurance. But then, the high-flying insurer will eventually go bankrupt when claims start coming in.
Assuming Root Insurance avoids this path, its net earned premiums could still easily top $1 billion by 2022. The firm will have a negative book value, making it worthless by its balance sheet alone. But its sales funnel would make the company a tempting takeover target for P&C insurers looking to diversify from their commission-based model.
If Root can maintain its steady growth clip and prove that its telemetric models work (i.e., consistently achieve a combined ratio above 85%), ROOT stock could easily be worth $10 billion, or $40 per share. But if they fail to price insurance products correctly, its value would plummet as insurers conclude Root’s telemetric system doesn’t work.
Whatever happens, know this: Root has hit upon a wonderfully lucrative market and has the right technologies at its disposal. There are only two more things the company needs to succeed – a management team that can prove itself and a little luck.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.