Earnings Call Transcript - LMND Q2 2024

Operator, Operator

Hello and welcome everyone to the Lemonade Q2 2024 Earnings Call. My name is Maxine and I'll be coordinating the call today. I will now hand you over to Yael Wissner-Levy, VP, Communications at Lemonade to begin. Yael, please go ahead when you are ready.

Yael Wissner-Levy, VP Communications

Good morning and welcome to Lemonade's second quarter 2024 earnings call. My name is Yael Wissner-Levy and I'm the VP Communications at Lemonade. Joining me today to discuss our results are Daniel Schreiber, CEO and Co-Founder; Shai Wininger, President and Co-Founder; and Tim Bixby, our Chief Financial Officer. A letter to shareholders covering the company's second quarter 2024 financial results is available on our Investor Relations website, investor.lemonade.com. Before we begin, I would like to remind you that management's remarks on this call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in the Risk Factors section of our 2023 Form 10-Q filed with the SEC on May 1, 2024 and our other filings with the SEC. Any forward-looking statements made on this call represent our views only as of today and we undertake no obligation to update them. We will be referring to certain non-GAAP financial measures on today's call, such as adjusted EBITDA and adjusted gross profit which we believe may be important to investors to assess our operating performance. Reconciliations of these non-GAAP financial measures to the most direct comparable GAAP financial measures are included in our letter to shareholders. Our letter to shareholders also includes information about our key performance indicators, including customers, in-force premiums, premium per customer, annual dollar retention, gross earned premium, gross loss ratio, gross loss ratio ex CAT and net loss ratio. And the definition of each metric, why each is useful to investors and how we use each to monitor and manage our business. I'd also like to bring your attention to our upcoming Investor Day to be held on November 19, 2024 in New York City. We will be providing detailed updates on our strategic expansion plans, operating efficiencies and growth trajectory. Hope to see you there. With that, I'll turn the call over to Daniel for some opening remarks.

Daniel Schreiber, CEO and Co-Founder

Good morning and thank you for joining us to discuss Lemonade's results for Q2 2024. I'm happy to report continued consistent and strong progress across the board. Year-on-year, our top line grew 22%. Our adjusted EBITDA loss improved by 18% and our gross profit grew by a remarkable 155%. Despite a quarter that saw elevated CAT losses across the industry, our loss ratio came in at 79%, improving 15 points year-on-year. This is no accident. We have been laser-focused on reducing CAT volatility by growing products with lower CAT exposure, notably pet and renters, geographic diversification of growth, including via Europe where we recently launched homeowners insurance in the U.K. and France, continuing to sell Lemonade homeowners insurance in the U.S. only where our AI predicts attractive LTVs and simultaneously placing some home premiums with third parties in selected geographies. Tellingly, our trailing 12-month gross loss ratio continued its decline for the fourth consecutive quarter, also hitting 79%. We think this number in preference to the quarterly results neutralizes some of the volatility and provides a more bankable indication of our ongoing performance. But whatever your preferred metric is, the picture that emerges is the same. Great progress that enables us to deliver notably expanded gross margins. I'm also pleased to share that Q2 was net cash flow positive. We expect cash flow to be positive consistently here on out, excepting only Q4 this year where various timing issues will make that quarter a one-off exception. In any event, we don't expect our cash balances to decline by more than 1% or maybe 2% before climbing consistently. With these updates, we feel exceedingly well positioned to continue investing in robust and profitable growth. I also wanted to put a spotlight on our giveback program for a moment. A couple of weeks ago, we announced our contribution of more than $2 million to 43 nonprofits around the globe, our eighth consecutive year of giving back to dozens of local and global charities chosen by our customers. Social impact is a core pillar of who we are at Lemonade. Our contribution since inception now exceeds $10 million and this program reflects the collective power of the Lemonade community and its ability to drive meaningful change. It's something we're very proud of and we know this is only the beginning. Next, I'd like to hand over to Shai to tell you more about our recent efficiency improvements unlocked by our technology.

Shai Wininger, President and Co-Founder

Thanks, Daniel. On the expense side, we've continued to deliver on our autonomous organization vision with remarkable stability. Our operating expense base, excluding growth spend which is now financed via the synthetic agents program, was unchanged year-over-year. This underscores the scalability of our tech vision which leads to measurable efficiency in our operations. This dynamic we're witnessing, robust predictable IFP growth alongside an expense base that remains comparatively steady and even shrinks at times, isn't a short-term anomaly. We expect this trend to persist in the coming quarters and years as we approach sustainable profitability at scale. This trajectory is a testament to the power of our technology-first approach and our commitment to operational excellence. Investors and analysts often ask about the practical impact of our investments in building our own tech-based insurance stack. I believe our recent quarterly results clearly demonstrate that. With large parts of our business running on code rather than people, I believe our tech obsession is paying off in a big way and helps separate us from incumbents in visible, measurable and impactful ways. What we've achieved so far is just the beginning. Our team has been hard at work on our next-generation technology platform, codename L2 which is designed to bring step-change improvements to areas such as underwriting, insurance operations, compliance and product development. With L2, we anticipate additional efficiency gains alongside acceleration of our product operations. These improvements should position us to adapt quickly to market changes as well as capitalize on new opportunities, products, markets and even business models. The potential impact of L2 extends beyond mere cost savings. It's about reimagining how insurance companies should operate in the AI era. We look forward to sharing more about all this at our Investor Day, November 19 in New York City. And with that, let me hand it over to Tim to cover our financial results and outlook in greater detail.

Tim Bixby, CFO

Great. Thanks, Shai. I'll review highlights of our Q2 results and provide our expectations for Q3 and the full year and then we'll take some questions. Overall, it was again a terrific quarter, with results very much in line with or better than expectations and continued notable loss ratio improvement across the board. In-force premium grew 22% to $839 million, while customer count increased by 14% to 2.2 million. Premium per customer increased 8% versus the prior year to $387, driven primarily by rate increases. Annual dollar retention or ADR was 88%, up 1 percentage point since this time last year. Gross earned premium in Q2 increased 22% as compared to the prior year to $200 million, in line with IFP growth. Our revenue in Q2 increased 17% from the prior year to $122 million. The growth in revenue was driven by the increase in gross earned premium, a slightly higher effective ceding commission rate under our quota share reinsurance as well as a 45% increase in investment income. Our gross loss ratio was 79% for Q2 as compared to 94% in Q2 2023 and 79% in Q1 2024. The impact of CATs in Q2 was roughly 17 percentage points within the gross loss ratio, nearly all driven by convective storm and winter storm activity. Absent this total CAT impact, the underlying gross loss ratio ex-CAT was 62%, in line with the prior quarter and fully 10 percentage points better than the prior year. Prior period development had a roughly 3% favorable impact on gross loss ratio in the quarter. Notably, the CAT prior period development was about 2% unfavorable while non-CAT was about 5% favorable, netting out to the 3% favorable impact. Trailing 12 months, our TTM loss ratio, was about 79% or 12 points better year-on-year and 4 points better sequentially. From a product perspective, gross loss ratio improved notably for all products with year-on-year improvements ranging from 5% to 30%. Operating expenses, excluding loss and loss adjustment expense, increased 13% to $107 million in Q2 as compared to the prior year. The increase of $12 million year-on-year was driven predominantly by an increase in growth acquisition spending within sales and marketing expenses. Other insurance expense grew 25% in Q2 versus the prior year, in line with the growth of earned premium, primarily in support of our increased investment in rate filing capacity. Total sales and marketing expense increased by $12 million as noted or 48%, primarily due to the increased gross spend, partially offset by lower personnel-related costs driven by efficiency gains. Total gross spend in the quarter was about $26 million, roughly double the $13 million figure in the prior year. We continue to utilize our synthetic agents growth funding program and have financed 80% of our growth spend since the start of the year. As a reminder, you'll see 100% of our growth spend flows through the P&L as always, while the impact of the new growth mechanism of synthetic agents is visible on the cash flow statement and balance sheet. And the net financing to date under this agreement is about $44 million as of June 30. Technology development expense declined 12% year-on-year to $21 million due primarily to personnel cost efficiencies, while G&A expense also declined 3% as compared to the prior year to $30 million, primarily due to both lower personnel and insurance expenses. Personnel expense and headcount control continue to be a high priority. Total headcount is down about 9% as compared to the prior year at 1,211, while the top line IFP as noted grew about 22%. Including outsourced personnel expense which has been part of our strategy for several years, this expense improvement rate would be similar. Our net loss was a loss of $57 million in Q2 or $0.81 per share which is a 15% improvement as compared to the second quarter a year ago. Our adjusted EBITDA loss was a loss of $43 million in Q2, a roughly 18% improvement year-on-year. Our total cash, cash equivalents and investments ended the quarter at approximately $931 million, up $4 million versus the prior quarter, showing a nice positive net cash flow trend in the quarter. This positive net cash flow contrasts markedly with a net use of cash of $51 million in the same quarter in the prior year. With these metrics in mind, I'll outline our specific financial expectations for the third quarter and full year 2024. Our expectations for the full year remain unchanged as compared to our guidance on our Q1 earnings call. As has been the case in some prior years, there's a notable seasonal difference in our expected results in Q3 and Q4. Specifically, Q3 is typically our highest growth spend quarter which tends to drive up sales and marketing spend and also, typically a higher expected loss ratio as compared to Q4. Our third quarter guidance and our implied Q4 guidance reflect these seasonal themes. From a gross spend perspective, we expect to invest roughly $25 million more in Q3 as compared to Q3 in the prior year to generate profitable customers with a healthy lifetime value. At the same time, we will be proactively non-renewing customers with unhealthy lifetime value, specifically certain CAT-exposed homeowners policies. As our AIs have become increasingly good at identifying such policies and as our latest underwriting rules have been approved by regulators, we now have the ability to identify older policies that we wouldn't write today. We expect this to remove between $20 million and $25 million of IFP from our book in the second half of 2024, dampening growth in the immediate term while concurrently boosting cash flow and profitability in the medium term and further reducing CAT volatility. Importantly, though, our IFP guidance for the year reflects these plans and remains unchanged. For the third quarter of 2024, we expect in-force premium at September 30 of between $875 million and $879 million, gross earned premium between $208 million and $210 million, revenue between $124 million and $126 million and an adjusted EBITDA loss of between $58 million and $56 million. We expect stock-based compensation expense of approximately $16 million, capital expenditures approximately $3 million and a weighted average share count for the quarter of approximately 71 million shares. And for the full year of 2024, we expect in-force premium at December 31 of between $940 million and $944 million, gross earned premium between $818 million and $822 million, revenue between $511 million and $515 million and adjusted EBITDA loss of between $155 million and $151 million. And we expect stock-based compensation for the full year of approximately $64 million, CapEx of approximately $10 million and a weighted average share count of approximately 71 million shares.

Shai Wininger, President and Co-Founder

Thanks, Tim. We now turn it over to our shareholders' questions submitted through the safe platform. I'll start with Matthew H. who asks, how are we leveraging AI technology to improve underwriting, claim processing and overall customer experience? And are there any major business risks or challenges to further leveraging AI? Thanks, Matthew. We've spoken about this at some depth in prior shareholders' letters. As I shared in the past, we're well underway to leverage AI at every stage of the customer journey as well as in many areas of our internal operations. We do that to drive efficiency, improve our underwriting and enhance customer experience with fast and always available smart service. Our underwriting, customer service and claims management, even employee management, administration, engineering, product operations, all use AI heavily. As an example, in just over a year, we went from a standing start to having a comprehensively rolled out generative AI platform to handle incoming customer communications. We handle email and text communications coming in and we're now handling more than 30% of these interactions with absolutely no human intervention. Progress to date is the tip of the iceberg though and I expect us to continue to focus on additional applications of these technologies, delivering concrete measurable impact to the business and helping us widen the gap between our tech and the competition's. Nomi K. asks if we can share the performance metrics and customer feedback from states where all 5 of Lemonade's insurance products are available and what are the main challenges or limiting factors preventing a broader rollout to additional states and how do we plan to address these? Thank you, Nomi. The specific order of state expansion is generally based on growth potential and expected profitability in those markets as well as prioritization aspects that have to do with focus and resource allocation. We expect cross-selling activity to be an increasingly powerful driver of growth as a result. In Illinois, for example, where we have all of our products available, we're seeing multiline customer rates that are roughly double the rest of the book. We also see other metrics improve, such as superior retention rates after bundling and outstanding customer feedback as measured by NPS. There were several questions about car rollout timing and expectations. And I'll just say that the organization is running around car in a remarkable way and we're expecting the growth rate of car to begin accelerating in the near future as a result. We plan to roll out car several additional states during 2025, with our main considerations being profitability predictions and regulatory approval rates. We aim to operate first in states where we can move quickly and write new business profitably. In the second half and beyond with the unlock of rate adequacy in multiple geographies, we'll be expanding investment in new customer acquisition as well as cross-selling to our existing user base.

Operator, Operator

Our first question today comes from Jack Matten from BMO.

Jack Matten, Analyst

Just wondering if you could provide some more details on the non-renewals of the CAT-exposed home business. In which states are your actions primarily taking place? And are there particular years of business that you're focused on? I guess in general, if you can talk about any insights that you've learned from your more recent models that led to your decision.

Daniel Schreiber, CEO and Co-Founder

Yes. I have a few thoughts on this. The distribution across states is quite concentrated, primarily focused on the expected lifetime value, which is heavily influenced by a higher than target loss ratio. This concentration is almost entirely within the home book, where we face our toughest loss ratio challenges. We mentioned in our letter that we are targeting a range of 20 to 25, which is not a fixed number but rather based on our analysis and what we know. This range seems the most appropriate at this time. It's important to highlight that while this situation creates some downward pressure on IFP growth—as every customer contributes to the total IFP number—it has a very high return on investment from a cash or value perspective. We are removing more expected costs than the contribution from premiums. For instance, if we eliminate $25 million of IFP with a high loss ratio, our model suggests we can generate approximately $50 million to $60 million in net positive value. There may be some short-term pressure on IFP, but this strategy offers long-term value. Typically, these are older policies we wrote 2, 3, or 4 years ago. Our underwriting rules and AI models improve continuously, which affects this concentration. Most of this business would not meet our current underwriting standards if we were writing today.

Jack Matten, Analyst

That's helpful. Thank you. The second question is on capital. Can you talk about the premium to surplus ratio that Lemonade expects to maintain as your business mix evolves? And I guess somewhat relatedly, it looks like your invested asset balance has been falling in recent quarters. Is that something that the company expects to continue doing moving forward? I think just trying to get some insights into that investment income. Thank you.

Tim Bixby, CFO

Sure. Regarding the capital surplus, we haven't discussed it lately because there hasn't been much change. Our goal remains a ratio of about 1:6 for acquired surplus to gross earned premium. We have effective strategies in place to achieve what is considered best-in-class in the industry, which many insurance companies aim for. I believe we are doing well in that area. Our quota share and Cayman captive structures are designed not only to reduce volatility but also to enhance capital surplus efficiency, maintaining that 1:6 ratio. In terms of cash investments, you may have noticed that cash balances have increased somewhat as a percentage of the total. This isn't due to a specific strategy, and I expect that trend to stabilize or flatten out soon. The interest rate situation is as we all expect, with possibly more downward pressure on rates. We have taken the latest forecasts into account for our guidance on expected investment income. The good news is that our total cash investment balance rose this quarter, showing strong returns from both cash and investments, which I want to emphasize. We anticipate that cash and investments balance will reach a low point, potentially dropping another 1% or 2%, but it will remain well above a total of $900 million going forward. Compared to three or four years ago, when we faced greater uncertainty about our growth, this represents a significant improvement, laying a solid foundation for our future.

Michael Phillips, Analyst

A question first on auto and kind of follow-up from the opening comments about new state expansion as you get into next year. The last 10 I had, I think you were in 11 states. I'm not sure that's still right. As you look out over the next maybe 18 months, given kind of the decent rate environment for auto, it might be slowing down. But should we expect state expansion by say yearend '25 to being close to like 20 states or 40 states or just kind of how aggressively you want to be over the next 18 months?

Daniel Schreiber, CEO and Co-Founder

No, I don't think we'll be at 40 states. And of course, to state the obvious, not all states are born equal. We will be expanding throughout 2025. We haven't given specific numbers and so my answer today is going to remain a little bit vague still. One of the driving factors is going to be the graduation of renters to be car customers. We will be looking and one of the guiding principles Shai spoke about, regulatory environment and some predictive loss ratios. Another one is where we have the largest footprint of renters who have cars but don't have car insurance with us and that will be another driving force. But we're not ready to disclose numbers of states yet.

Michael Phillips, Analyst

I understand your point. Thank you, Daniel. Building on that, I’d like to follow up by asking, as we expand into new states, we might experience some pressure on our auto margins. Do you think this pressure might be less pronounced than usual, considering the insights you have from your current renters and homeowners? How do you believe that knowledge could influence your initial pricing for auto as you continue to grow?

Daniel Schreiber, CEO and Co-Founder

We are very optimistic about the medium to long-term prospects for car insurance. We believe it offers a unique product with significant competitive advantages, particularly because our customers consistently utilize telematics, unlike many incumbents who do not. This serves as a major differentiator alongside our exceptional user experience and high customer satisfaction. Regarding renters who purchase car insurance, we observe that their loss ratios are notably lower. Their overall economics are quite different, with customer acquisition costs essentially being zero or possibly even negative due to the profitability of our renters segment. Existing customers, who have already paid us, provide another profitable avenue as we can sell them car policies without additional acquisition costs. We have found these customers highly profitable due to the lack of customer acquisition expenses and the fact that they represent lower risk, allowing us to price them effectively without experiencing the typical business penalty associated with growth. This creates very distinct unit economics and lifetime value for our existing customers. We view this as a strategic priority and intend to elaborate further during our Investor Day later this year. We currently have over 2 million existing customers, many of whom already have car insurance, just not with us. This presents a substantial and, we expect, very profitable opportunity for our company.

Shai Wininger, President and Co-Founder

It's also worth mentioning that the external environment is getting better. For a while, we and other car providers were trying to meet targets while dealing with inflation's negative effects on repair and claim costs. The data is showing that this trend has slowed, if not stopped, and in some cases may even be reversing. As a result, targeting these goals is now more effective. The impact of our rate increases, both those that are already implemented and those in progress, is now more significant, which gives us greater confidence in our planning for car insurance for the remainder of this year and into next year. We observed that our gross loss ratio across our product lines improved by 5% to 30%. Car insurance was at the higher end of that range, indicating many positive signs.

Tommy McJoynt, Analyst

Tim, kind of going back to the first question that you got on the nonrenewal side, you mentioned the $25 million of non-renewed IFP and that's going to be offset by it sounded like I think you said $50 million to $60 million of sort of net positive value. Let's call it $50 million. Sorry, is that saying that the LTV of those policies, instead of being presumably positive when you wrote it, is now being sort of reassessed at negative $50 million? And hence, by not writing, non-renewing that business, it will now be 0? Just kind of help explain sort of what that $50 million to $60 million number that you mentioned actually is.

Tim Bixby, CFO

Yes, your understanding is correct. If a customer has an expected lifetime value of around three times their acquisition cost, which is common for us, it means we anticipate generating that additional cash flow or value over their lifetime, which could range from two to four years, or even longer depending on the product. In the scenario I mentioned regarding an IF, we expect the lifetime value to be a negative $50 million or $60 million, indicating a negative two-to-one ratio. This outcome is primarily influenced by the high loss ratio. For instance, if a customer has a 150% loss ratio and we retain that customer for a few years, that is the key factor at play. Your analysis is mostly accurate; it's a rough estimate, but it indicates a significantly positive return on investment for those changes.

Tommy McJoynt, Analyst

Okay, got it. And do you know what the impact on the loss ratio from that sort of $25 million in IFP was in the first half of the year? Or even in absolute dollars, kind of how much sort of operating loss that business generated, contributed?

Tim Bixby, CFO

It's difficult to give an exact figure. I would estimate that the range of $20 million to $25 million is anticipated for the year, primarily in the latter half, specifically Q3 and Q4. This is a forward-looking estimate of expected impact. We have initiated the process, with a minimal amount in Q2 that is nearly negligible. The expectation is mainly focused on Q3 and Q4, with a stronger emphasis on Q3. Our loss ratio has been affected by that business, but it's worth noting that our loss ratio improved significantly year-over-year despite this pressure. All these changes, including not just rate adjustments, will continue to have a positive effect on the loss ratio moving forward.

Daniel Schreiber, CEO and Co-Founder

And Tommy, I'll just add one other perspective that Tim mentioned briefly in his comments. This is really a homeowners focused area. It's the one part of our business that has experienced ongoing negative lifetime value. In addition to being negative in lifetime value, we've often faced challenges in getting rate approvals. While theoretically, any risk can be priced appropriately, we don't always receive the necessary approvals from regulators. This segment of the business has not allowed us to obtain those approvals, and we do not expect that to change. If we believed it was on the verge of becoming profitable, we would have shown more forbearance. However, in addition to being persistently unprofitable, this area is heavily concentrated in volatile regions of the country. Even if we were to achieve long-term average profitability, we have always aimed to steer clear of the areas most exposed to catastrophic risks. We have avoided writing business in the most exposed locations since our inception, where we have found volatility to be higher than we are comfortable with. Given what we currently know, we're also taking this opportunity to stop renewing that part of the business.

Tim Bixby, CFO

And maybe just to put a fine point on it based on a couple of questions I've gotten already, I'll answer a question that has not been asked which is, if this number is 25 as we expect it to be, the question might be, would your IFP expectations have been $25 million greater if not for the impact of this? The answer is yes. Yes.

Bob Huang, Analyst

Great. The first question is about your 17 points of improvement in CAT losses, which represents a 5-point improvement. This trend aligns with the industry. As you non-renew the homeowner side, what are your expectations regarding the run rate for CAT losses going forward? Can you provide some additional details on how we should assess that impact? I know you previously discussed the implications on the homeowner renewal side, but I would like to see if there’s any more insight regarding the CAT aspect.

Tim Bixby, CFO

That's probably a little beyond some of the guidance we've provided. I can share some thoughts on how to approach it. Our home business is slightly decreasing as a percentage of the total business. For the quarter, combining home and condo, it was just under 20%, down a couple of points compared to the previous year. You could estimate the impact if we were to remove $25 million of IFP. Specifically addressing the reduction in loss ratio is somewhat complex, so I'm not going to go too far into that. CAT losses are primarily related to home, not entirely but mostly. These policies are certainly the most challenging ones we will pursue. I will let you do some calculations based on that information.

Bob Huang, Analyst

Okay. Maybe second one on just how we should think about ceding commission. If we look at a ceding commission as a percent of premium last call it 5 quarters, it's generally about 20%. This quarter was notably lower than that. Is this more of a one-time thing? What's driving that? And should it go back to about 20% of premium going forward?

Tim Bixby, CFO

Yes. There are a few ways to consider the ceding commission. There is a year-on-year change due to a change in structure. Last year, we had a fixed structure leading up to our July renewal, which resulted in an effective commission of around 20%. Currently, our commission is split into two parts due to our accounting practices, and the effective commission rate is around 23%. The most significant aspect is that it was a static number before, but now it is variable. This makes it somewhat more complex when modeling. Looking at Q1 and Q2, the net commission was approximately 18% compared to 20% last year, which is a modest decrease of a couple of points. However, it introduces more volatility, with Q1 being significantly lower and Q2 higher. We expect to see fluctuations quarter-to-quarter, but these will be adjusted over the year. I think it will end up being a couple of points lower than last year, although there are some offsets. Our renewal this year started in July and follows a similar sliding scale, which should result in a slightly better effective rate. It’s difficult to predict if it will return to the previous level, but it could improve by 1 or 2 points in a direct comparison. Additionally, it's worth noting that the loss ratio often fluctuates quarter-to-quarter, with Q4 typically having the lowest loss ratio. We expect this trend to continue this year, which would positively influence the commission rate. So while there's more volatility from quarter to quarter, if historical patterns hold, we could see a favorable impact throughout the year, helping to bring us back in line compared to previous quarters, even if the commission rate is somewhat lower.

Matthew O'Neill, Analyst

I just wanted to ask a little bit about premium per customer. It's been growing impressively but the rate may be decelerating slightly. I was just curious if you could give us an assessment of kind of how far through the rate increases you are on the in-force book?

Tim Bixby, CFO

Yes, that can change from quarter to quarter. It has consistently contributed, but our customer growth has played a bigger role in this year's quarter-over-quarter growth compared to the price increase. This differs by product. In cars, for instance, there's a significant effect on rent, but it's less pronounced because it is very optimized. The loss ratio is quite strong, and pricing is favorable. As for our progress, a couple of quarters ago, we noted that we were about halfway through. We still have around $100 million left to earn in, which hasn't changed much because our rate earning pace and the new rate filing pace have been roughly balanced. We're in a similar position now, with a substantial amount of rates left to earn in. This won't last indefinitely, as there will always be rate filings and increases, even in a low or no inflation environment, but we're still quite a distance from that point. This is taken into account in our Q3 and Q4 guidance, which indicates that we will continue to earn at this rate into next year. Approved items will continue to earn well into next year.

Matthew O'Neill, Analyst

Thanks. That's very helpful. And maybe just a quick one and I realize I may be jumping the gun on potential Investor Day content but I know you've spoken about the long-term or ultimate target for the loss ratio in the high 60s to 70s. I don't know if there's kind of an internal or a way to think about the ultimate target for the expense ratio going forward.

Daniel Schreiber, CEO and Co-Founder

We are committed to maintaining an expense load that surpasses the industry standard. We're starting to shift our focus away from traditional ratios as we aspire to be a price leader. While this might obscure how our technology is providing us with an advantage, it will ultimately be evident in our high-performing expense ratio and even more so in our actual expense load. If you compare it directly with competitors charging similar premiums, our advantage will be even clearer than when assessed alongside our own lower premiums. We believe we can pass some of those savings on to our customers, which could boost growth, improve retention, reduce acquisition costs, and help us reach our ambitious objectives for the company. More directly answering your question, we anticipate that at scale, our expense ratio will be in the teens. Last quarter, we reported that the Loss Adjustment Expense (LAE) component of our expenses had already matched the best in the industry, with a reported 7.6% LAE. We have seen significant efficiencies arise from automation, resulting in impressive improvements in our headcount expenses and the number of personnel needed to generate revenue. Over the past few years, as we've doubled our business, we've reduced the workforce required for every dollar of premium by half. These advancements will be reflected in our competitive expense structure, leading to lower prices and maintaining a top-tier expense ratio. Additionally, we view growth as a continually rewarding process. The figures I've presented and the direction outlined will, in time, become unmistakable. As we grow and have doubled our operations while keeping our expense structure constant, we've observed a decline in expenses relative to customer acquisition, even amid record growth. This trend is expected to continue, ultimately leading to a highly profitable business model. As we expand further, the benefits will become increasingly apparent. When our business doubles again, the differences will be clearer, and by the time we reach ten times our current business size, the advantages will be glaringly obvious.

Operator, Operator

Thank you. The next question comes from Yaron Kinar from Jefferies.

Unidentified Analyst, Analyst

This is Charlie on for Yaron. A couple of questions. The first one, with the decision to non-renew certain CAT-exposed homeowners, was that previously contemplated in guidance?

Tim Bixby, CFO

No.

Unidentified Analyst, Analyst

Okay, thanks. And then are you guys able to give us CAT prior year development and LAE on a net basis?

Tim Bixby, CFO

The prior period development, you can split into 2 pieces. It was 3 points favorable. It was 2 points unfavorable from a CAT perspective and 5 points favorable from a non-CAT perspective. Netting out to the 3 favorable.

Unidentified Analyst, Analyst

Okay, sorry. And just to clarify, was that gross CAT or net CAT impact?

Tim Bixby, CFO

That is gross.

Unidentified Analyst, Analyst

Gross, okay. And are you guys able to give it net?

Tim Bixby, CFO

Yes. And then that breakdown would be roughly similar on a net basis, the prior period development. The total CAT impact on a net basis was about 15 points, whereas on a gross basis, it was about 17 points. LAE came in about 8%. It's been 7 point, mid-7s, edged up a little bit but in that sort of 7% to 8% range, by 8% this quarter.

Unidentified Analyst, Analyst

Okay, great. And then last one if I could, just looking at the underlying loss ratio, it looks like contemplating those components, you guys saw about 22 points of underlying improvement. But if we look at the first quarter of 24% on a year-over-year basis from first quarter of '23, it looks like it was relatively flat. Is there anything underlying that that you guys could provide some color on?

Tim Bixby, CFO

Pretty distinct quarters. Yes, on a full quarter basis, it was pretty stable. I think that it's really important to look at the year-on-year comparison from a seasonal perspective. And on a trailing 12 months basis obviously continued significant improvement. Any given comparison of quarters, you might see some trends that are interesting but not necessarily indicative of a longer-term trend. Nothing in particular to call out that was distinct between Q1 and Q2. Q2 was a really interesting quarter as it evolved, really significant impacts early in the quarter and really dramatic favorable outcomes by the end of the quarter, netting out to what ended up to be a quarter that was even better, just modestly better than our expectations. The months can be pretty unpredictable but the quarters are a little more predictable.

Operator, Operator

We have a follow-up question from Bob Huang from Morgan Stanley.

Bob Huang, Analyst

Maybe just a follow-up on the PYD question. 5 points of favorable on everything else and 2 points unfavorable on the CAT PYD. On the 5 points, can you give us maybe a little bit more color on the geography of those? Like what are those 5 points coming from if possible? Sorry if I missed this a little earlier.

Daniel Schreiber, CEO and Co-Founder

We did not. It's a little more concentrated in the pet product but it was distributed across products other than home. The CATs are primarily a home dynamic and the increase was driven by those really significant storms from a year ago and a bit earlier this year that have evolved, continue to evolve. But the underlying favorable development I think is really testament to the non-CAT portion of the business which is really all the product lines other than home.

Bob Huang, Analyst

Okay. Basically, CAT was unfavorable and dogs were favorable. Thank you for that, that's very helpful. On the other one, maybe on the LTV to CAC side. I know that you talked about previously, you kind of mentioned LTV to CAC is about 3x, then that would be the ratio. And then I think one thing we're trying to figure out is that if you have these homeowner non-renewals, going forward, does that 3x LTV to CAC equation still holds? How should we think about that renewal impact on the LTV to CAC?

Tim Bixby, CFO

Yes. LTV to CAC is an important metric but it's a forward metric. It's based on a model. It's based on all the information we collect. it improves a little bit every day, every week, every month as we go forward. When we acquired that business, when our models were by definition less sophisticated than today, we expected those to be profitable customers. As we learn more in our models and our existing customer base and claims activity, invariably a certain portion of the customer base, their expected LTV will change. For newly acquired customers, there is no change, so we expect customers we acquire today and tomorrow to be fully profitable. We've seen a ratio greater than 3:1. 3:1 is a good rule of thumb but we've seen certainly periods where it's 3.5 or 4 or more. There tends to be a little bit more pressure when you spend more. We're spending double today what we spent a year ago and that tends to put downward pressure on LTV to CAC but that's a good thing. And we earn our way in and we develop channels, we expand our spending. And overall, 3:1 is a good metric to think about. I'll add one other comment in that area which I think is helpful which is LTV to CAC is kind of policy by policy focused. And if you look at our spending per net added customer, you might think things got more expensive for us in the quarter. And while that exact math is correct, it's important to look at IFP. Net added IFP, gross added IFP really is what we're acquiring with that tax spend. And by that measure, we were actually more efficient in the second quarter than we were in the year-ago quarter and even in the prior quarter. All around, that number is stable and that's what's enabling us to really say we're very comfortable with growth rates that are accelerating. You started out the year in the low 20s, going into the mid-20s and now we're pushing towards the high 20s growth rate and that's a core driver for them.

Daniel Schreiber, CEO and Co-Founder

I want to highlight a point about the relationship between Lifetime Value (LTV) and Customer Acquisition Cost (CAC). Ideally, we want this ratio to be as high as possible for each customer. Our goal is to continue increasing it until we reach the point where the LTV equals the CAC for the marginal customer. This means if we spend $1 and receive $1.10 in return, that’s still a good outcome for the business. Our LTV calculations already factor in the time value of money at a robust discount rate. While our average LTV to CAC ratio is 3, we have many customers with ratios even higher than that, often in the double digits. We will stop making investments when we approach the marginal customer whose LTV to CAC is around 1. We take a cautious approach, but this is the principle we follow. We always aim for marginally profitable customers and have consistently adhered to this strategy, avoiding the acquisition of customers with negative LTV. This can sometimes be confusing for investors since customer acquisition costs can negatively affect our financials in the short term. As we incur these costs upfront—because we are not an agent-based business—we recover them over time. Thus, our growth may appear to result in short-term losses, but this is simply due to the timing of cash flows. The aim is to spend $1 now to earn $3 back in present terms. If this leads to a temporary dip in our EBITDA, we are okay with it. However, we do not experience a decrease in cash flow due to our synthetic agent program, which helps us manage cash and EBITDA fluctuations. For the past couple of years, facing inflationary pressures, we found it challenging to grow positively on an LTV basis in certain market segments. We have acknowledged this and adjusted our growth strategy accordingly, which we are now ramping back up. Many of these areas have become profitable again as we achieved adequacy, returning to the levels we anticipated. Moreover, we are committed to maintaining a conservative approach by not acquiring knowingly unprofitable business and striving to restore profitability to businesses that fell short. We are also no longer renewing contracts for business that hasn’t proven to be profitable. Therefore, our focus remains on profitability, and we are even reconsidering our participation in markets that don’t contribute positively. Tim mentioned earlier that although there may be a potential $25 million impact on IFP, we stand by our guidance and believe we can manage this within our existing projections. We are confident that we are exceeding our targets for the year, allowing us to uphold our guidance despite this impact. While there may not be a hit to IFP, we recognize that it could have been more significant. Our primary focus has always been on maximizing the overall value of our book, and we see this decision adding a significant $50 million to $60 million in LTV to our business.

Operator, Operator

Thank you. That was our final question for today. So this does conclude today's call. Thank you all for joining. You may now disconnect your lines.