Root, Inc. Q2 FY2023 Earnings Call

Thank you for standing by. My name is Robert McArthur, and I will be your conference operator today. At this time, I'd like to welcome everybody to the Root Incorporated Q2 2023 Earnings Conference Call.

Good morning, and thank you for joining us today. Root is hosting this call to discuss its second quarter 2023 earnings results. Participating on today's call are Alex Timm, Co-Founder and Chief Executive Officer; and Megan Binkley, Chief Financial Officer. During the question-and-answer portion of the call, our presenters will be joined by Matt Bonakdarpour, Chief Technology Officer; and Frank Palmer, Chief Insurance Officer. Last evening, we issued a shareholder letter announcing our financial results. While this call will reflect items discussed within that document, for more complete information about our financial performance, we also encourage you to read our Q2 2023 Form 10-Q, which was filed with the Securities and Exchange Commission last evening. Before we begin, I want to remind you that the matters discussed on today's call will include forward-looking statements related to our operating performance, financial goals, and business outlook, which are based on management's current beliefs and assumptions. Please note that these forward-looking statements reflect our opinions as of the date of this call, and we undertake no obligation to revise this information as a result of new developments that may occur. Forward-looking statements are subject to various risks, uncertainties, and other factors that could cause our actual results to differ materially from those expected and described today. In addition, we are subject to several risks that may significantly impact our business and financial results. For a more detailed description of our risk factors, please review our Form 10-K for the year ended December 31, 2022, where you will see a discussion of factors that could cause the company's actual results to differ materially from these statements, as well as our shareholder letter in Q2 Form 10-Q released last evening. A replay of this conference call will be available on our website under the Investor Relations section. I would also like to remind you that during the call, we will discuss some non-GAAP measures while talking about Root's performance. You can find reconciliations of those historical measures to the nearest comparable GAAP measures in our shareholder letter that was released last evening and our Form 10-Q filed with the SEC, which are posted on our website at ir.joinroot.com. I will now turn the call over to Alex Timm, Root's Co-Founder and CEO.

Thank you, Jodi, and welcome, everyone. Q2 was a great quarter for the company. This is the result of our intense work and focus on pricing and underwriting, which has allowed us to reignite profitable growth. Due to our loss ratio, we are uniquely positioned to capitalize on today's marketing environment, while much of the industry is continuing to struggle to underwrite profitability. As we've consistently stated over the last 18 months, we believe this was made possible by our superior technology that allows us to identify and react quicker than competitors to changes in the pricing environment. The early actions afforded by this advantage are now evident in our results, as we posted the highest margin in the history of the company, while growing new writing 65% quarter-over-quarter. In the second quarter, we launched a previously announced partnership and also launched our telematics capabilities on our embedded platform. Our current partnership funnel is strong and continues to grow. This growth has been fueled by our early proof of differentiation in our Carvana partnership, where we have tripled customer adoption by moving to our proprietary product. We are excited about the continued momentum that we are building on this platform. Our direct new writings growth in Q2 was driven by reactivating our marketing and product capabilities. This includes deploying marketing in additional states as loss ratios improve, expanding underwriting capabilities, and opening up additional product experiences to customers. With our strong loss ratio performance, we were able to drive this growth while exceeding our profitability targets. We believe we are currently experiencing strong tailwinds in this channel as we've seen highly favorable marketing costs driven by the competitive environment and are diligently monitoring this environment daily to ensure we continue to drive profitable growth. From the beginning, we stated our belief that machine learning and technology would revolutionize the insurance industry while delivering a superior customer experience. This founding principle continues to guide us today. We made progress on this strategy in our second quarter by deploying our newest loss cost model with an estimated 17% improvement in predictive power. We continue to believe this cornerstone of our strategy is in the early stages and that over time, these capabilities will provide outsized returns to our customers and shareholders. With the combination of loss ratio improvements, technology advancements, direct growth, and embedded momentum, we believe we are on the path to profitability with the capital that we have. We are focused on driving the business forward and are proud of the progress we have made to date. I'll now turn the call over to Megan to discuss our operating results in more detail.

Thanks, Alex. Our full GAAP financial results can be found within the shareholder letter and Form 10-Q published yesterday evening. We marked a return to growth in the second quarter. Our emphasis on deliberate and profitable growth was evident through an increase in policies in force during the quarter, representing our first increase in overall policies in-force count in nearly two years. We executed this growth while reducing our second quarter gross accident period loss ratio to 68%, a slight improvement over Q1. Gross written premium for the second quarter was $145 million, an 8% increase quarter-over-quarter. Gross earned premium for the second quarter was $132 million, a slight increase over the first quarter. On a year-over-year basis, gross written premium of $145 million represents a 3% increase, while gross earned premium of $132 million represents a 23% decline when compared to the second quarter of 2022. We continued to make significant strides in overall operating results, which is reflected in the 17-point improvement in our gross accident period loss ratio and the 12-point improvement in our gross expense ratio year-over-year. During the second quarter, our net loss was $37 million, a 62% improvement year-over-year. Adjusted EBITDA, or an approximation of operating cash consumption, improved 81% over the prior year to a loss of $12 million. Results for the second quarter reflect the continued progress we've made to strengthen the fundamentals of the business and our continued focus on operating efficiency. As a reminder, we focus on our unencumbered cash balance, or cash held outside of our regulated insurance companies, to help evaluate the overall strength of our current capital position. We ended the second quarter with $520 million of unencumbered cash, compared to $524 million at the end of the first quarter. The minimal consumption during the quarter was largely due to an improvement in our operating results as well as a reduction in required capital contributions to our insurance subsidiaries and the timing of various net cash settlements. As we turn to our financial outlook for the second half of the year, we expect continued investment in deliberate and profitable growth. And as a result, expect to see an elevated level of unencumbered cash burn compared to the first half of the year. With strict underwriting discipline, we anticipate new writings growth will continue in H2 and will be supported by increased acquisition spend, compared to H1. We will continue to prioritize loss ratio improvements and plan to take rate as needed as we monitor emerging loss trends. We are pleased with the progress we've made on operating results and believe we are positioning the company to achieve profitability with the capital we have. We appreciate your time and your attention and look forward to your questions.

Yeah. Hi everyone. Thanks for taking my question today. So you mentioned in your shareholder letter that your product with the new embedded partner went live with telematics capabilities. Can you walk us through how that actually functions from a consumer perspective? And are there plans to launch similar capabilities with the Carvana-embedded product? Thanks.

We're really proud of the traction that we've made throughout the year in our embedded platform. We believe that through our technology, not just telematics but more broadly, that we're able to meet a customer in their time of need. We think that the long-term growth opportunity in embedded is material. So in the second quarter, when we launched our telematics platform within the embedded platform, what really that allows us to do is to collect data in various manners that may be better for the consumer. For example, partnering with either financial service applications or different applications where a consumer may not be necessarily in the market for insurance, but will begin to collect telematics data in an ambient sense. They might download an app for a different purpose, begin to turn on telematics permissions to look at various things related to their driving, and then be presented with an insurance quote later. We also think that, by selling and getting closer to vehicles, there's an opportunity to actually embed telematics directly within vehicles. We have been pulling data directly from connected cars since 2017 and plan to expand that program. We think that particularly with Carvana, there is a very attractive opportunity to get closer to those vehicles when they're in the reconditioning centers to further expand our telematics platform. Telemetrics is something that's going to continue to grow. By having our own proprietary flexible platform, we can implement telematics capabilities in novel use cases for consumers. We believe, long-term, that this will significantly reduce the barrier to collecting telematics data from customers as we start to make it more attractive for them. Therefore, we're excited to continue to expand that.

Understood. That's very helpful. For my second question, I was curious, moving forward, how are you thinking about the mix for new writings between direct channels and the embedded platform?

In the near future, we are seeing a very favorable environment in direct channels, where we are exceeding all of our new business profitability targets while also significantly growing new writings in that area. We believe this is just the beginning, as we have only recently reignited our growth engines over the past 5 to 6 months. We are in the early stages of growth for that product, driven by our underwriting discipline and superior loss ratio within the industry, enabled by our advancements in technology and data science for pricing. Looking ahead, the Internet presents vast opportunities, and we currently hold only a small share. We expect our direct business, which has been our core, to continue to scale effectively. Additionally, we recognize that we are in the early phases of a significant shift in distribution. Long-term, we see more of our customers coming from embedded options, with that growth expected to be more pronounced in 2024 than in 2023.

Hi, guys. Good morning. This is Charlie on for Yaron. The first question I have is just in light of recent headlines around letters of credit and reinsurance structures. Are you guys considering any changes to your reinsurance program?

Hi, Charlie, thanks for the question. As it relates to the letters of credit issue, we became aware of the allegations of fraudulent collateral in connection with Vesttoo a couple of weeks ago. Firstly, I just want to clarify that Root has no direct relationship with Vesttoo. We do have one reinsurer that is potentially impacted. We are constantly evaluating our reinsurance structures to ensure that we've got the right terms for the business. Over the past 18 months, we've been decreasing our external session percentage as the business has been improving. As we look at this, the worst-case scenario for us would be to exercise our right to commute the deals for this particular reinsurer, and we believe that we could do that with minimal overall impact on our financial statements given our loss ratio performance. We've got a strong balance sheet and are ready and able to take back this business onto our books, if necessary, which would actually further support underwriting profitability over the long term. Our longer-term strategy is to continue to retain more business and reduce our reinsurance costs going forward, which is consistent with our existing plan.

Thanks for the color. And then just in terms of direct premiums written growth, given that you guys have already inflected back to growth now, do you expect full year growth to be positive?

Thank you, Charlie. I appreciate the question. As we look ahead to the second half of the year, reflecting on our performance in the first half, we have seen growth in policies in-force and gross written premiums that has surpassed our expectations. This growth has been a result of our efforts in 2022 and ongoing work in 2023 to enhance the fundamentals of our business. We are now in a position to increase the number of policies in-force sooner than we anticipated. We will maintain this trajectory as long as we continue to achieve strong, profitable unit economics for new business and remain confident in our loss ratio performance. For the second half of the year, we anticipate continued growth in both policies in-force and gross written premiums compared to the first half.

Thanks. And then one last one, if I may. You guys had favorable development in the quarter. So I'm just curious number one, what the source was if you're able to identify it and number two, if any, development was intra-year, including development from the first quarter of 2023.

Yes. Thanks for the question. This is Matt. I thought maybe I could tell you a little bit about how we think about reserving internally and some of the actions we've taken over the last 1.5 years. Internally, we maintain an ensemble of different types of reserving models, spanning a continuum that looks at both short-term trends and long-term trends. That allows us to ensure we're diversifying our modeling capabilities and not really risking efficiencies of any one type of strategy. On the short-term side, we are heavily invested in the data and technology required to power these models. It enables us to refit these models on a weekly basis, taking into account the actual experience that's coming in and the trends in the business. This allowed us in 2022 to identify trends in repair costs related to supplemental payments. In 2022, we adopted some adverse developments to reflect those trends that we were observing. On a go-forward basis, we're ensuring our reserves reflect those trends we've identified. From a favorable perspective, favorable development was seen outside of the repair costs. On a year-to-date basis, we're feeling very good about the development, which is essentially zero when you look at the Q1 versus Q2 results.

Great. Thank you, guys.

Hi, good morning. I had a question about the new pricing model. What does that mean for loss ratios moving forward? I get that it's 17% more accurate, but how quickly can we see that benefit? Are there possibly higher costs associated with it, given that there's double the data that there was in the old model? If you could quantify using the old model in 2023 versus the new model, how could that benefit loss ratios?

Yeah, hi. Thanks for the question. This is Matt again. We're really proud of the work we've done in the pricing space. We've invested heavily over the last two to three years in the technology that powers the pipeline from research and development all the way through deploying these models in production. This allows us to take advantage of new data sources, increased exposure volume, and test new statistical methodologies that improve the predictive power of our segmentation models. The power of segmentation comes through in mitigating adverse selection. We believe that improvements to the predictive power of these models, combined with the underwriting changes and the base rate increases we're implementing, will allow us to continue to see favorable development in our loss ratio on a go-forward basis.

Got it. Thank you. For my second question, could you talk a little bit more about the Carvana partnership and the traction there? Because embedded as a percentage of new writings was lower compared to prior quarters just because direct was up so much. Can you discuss what you've seen in recent months in that channel?

Absolutely. For Carvana specifically and our embedded platform more generally, we are seeing, and believe that we will continue to see, consistent growth, especially on a year-over-year basis that we observed in Q2. We believe that in terms of new writings, this will continue, and we want to push more new writings growth in the future, not just for the remainder of this year but also through 2024. Some of that will stem from our Carvana partnership, which has been very strong, and we continue to see positive results from Carvana, as well as growth from our broader platform as we onboard more partners. Currently, we are seeing favorable traction in our funnel to acquire more partners, driven by two factors. The first is that we now have a clear differentiation that's proven in the adoption rates we've been able to achieve with Carvana. We have actually tripled customer adoption of insurance on the Carvana platform by transitioning from what they were using, which was an industry-standard product, to our product. This has been noticeable to potential partners, and we continue to see significant traction moving forward. We are excited to continue to expand our platform. It will take time to activate these partnerships and find product-market fit with each partner, but we believe that long-term, this will serve as a healthy growth engine.

Hey guys, good morning. Could you talk a little bit more about what exactly is driving the elevated cash burn in the second half of the year, particularly if you said there's caution on extrapolating these growth levels moving forward? Do you not expect as much underwriting improvement, or is it truly just a result of the ramped marketing and acquisition spend? Thanks.

First, I think it's critical to understand that we're not growing at the expense of profit. While you may see near-term capital burn increase, we believe this growth will lead the company to profitability. Given our strict underwriting discipline and our now industry-leading loss ratio, we think that this is an ideal time to begin turning back on many of our growth levers. As we do that, you may see an acceleration in cash burn.

Thanks, Alex. At the risk of sounding repetitive, I think it's important to understand that our main priority is to protect our capital in the business while focusing on both disciplined and cautious new writing growth and profitability. For the second half, we'll continue to monitor the competitive environment to determine what optimal spending levels will be. I'm happy to provide more clarity on our expected acquisition costs. In H1, we incurred around $25 million in acquisition costs, and in H2, we're expecting to spend roughly $50 million in acquisition costs. About 50% of that will be performance marketing. Again, it will depend heavily on the environment, and we will not sacrifice profitability for growth. Additionally, we still expect favorable results in capital consumption in 2023 compared to 2022.

My second question is about the 8% severity, which is lower than it was in Q1. Can you discuss what you've observed and why you believe the severity has decreased for Root?

Sure. Thank you. We have seen both a decrease in frequency and an increase in severity, which vary quarter to quarter and are driven by our mix of business and our new to renewal. As we consider the historical severities alongside the overall impact of frequency and severity, we think the overall loss trend will remain in the high single digits, and we anticipate taking rate to keep up with that pace.

Thank you. Good morning. Following up on Peter's question, Alex mentioned that this growth you see will help Root achieve profitability. Is there a level of premium that you think you need to reach in the next few years or whenever to attain profitability?

We identify three primary levers we've started to execute on to drive the company to profitability, which is our laser focus right now. Our top priority is to achieve profitability with the capital we have. The first lever is the loss ratio, where we are significantly improving year-over-year and now have a superior loss ratio compared to most of the top 10. The second lever is reducing fixed expenses, where we pulled 12 points of expense ratio improvement year-over-year and continue to search for ways to cut expenses further. The third lever you're mentioning is to drive profitable growth. We're currently experiencing significant growth, alongside improvements in our loss ratio. However, we believe we still have a long way to go, and we want to ensure that we continue to chase growth while maintaining favorable loss ratio performance. If we ever experience a downturn in that performance, we will cease aggressive growth efforts.

Great. Thanks. Regarding the marketing spend, can you discuss how the efficiency of that spend is tracking versus Root's historical averages? To what extent do you foresee this benefiting from the challenging loss environment at your larger competitors?

Thanks for the question. In terms of our marketing investment, we focus on channels where we have a competitive edge due to our data and technology investments. Currently, we target performance marketing channels, such as vertical search, search engine marketing, and direct mail. These channels allow us to leverage the machine we've built, which uses granular machine learning models to deploy our marketing budget in a precise manner based on input metrics for profitability and the competitive landscape. As those metrics evolve, we expect our approach to adapt accordingly. Profitability is our main objective; we do not set a specific budget just to hit a financial target, but we aim to optimize our return on investment. We believe this growth is driven in part by the competitive landscape, but more significantly by our superior loss ratio, allowing us to identify and react quicker than the industry.

Thank you.

Hey, good morning, guys. Can you discuss the trajectory of the convergence of the gross and the net loss ratio? Is that merely a function of reaching a gross loss ratio threshold where you're no longer hitting loss corridors?

Yes, that's a big part of the function. It's important to note that we have continued to drive remarkable improvements in both our direct and gross loss ratios, which will lead us out of those loss ratio corridors. It's vital for us to manage reinsurance costs down, and we expect to see less business as we move forward to support our operating income.

Okay. Got it. Can you provide more details about those items mentioned for the quarter that prevented unencumbered capital from declining more? You listed a few items, so I want a deeper understanding of what those entailed.

At the end of the second quarter, our unencumbered capital was $520 million, compared to $524 million at the end of the first quarter. This minimal change is due to an improvement in our net loss primarily driven by a reduction in losses and loss adjustment expenses, which contributed immaterially to our insurance companies. We also experienced a couple of one-time items that resulted in around $5 million in cash inflows, but we do not expect these to be recurring. Therefore, the $520 million represents the funds available to run the business.

Hey, good morning. Could you break out what percentage of your states are now rate adequate? I think in the past it was in the low single-digit range, so curious if you have an update there.

We believe that 80% of our footprint is now rate adequate or at single-digit indications.

Okay. Great. What do you have factored in for future pricing assumptions around frequency? Can you explain a bit more on the recent larger declines you've seen?

Initially, we review our premium trends and our overall loss trends. We believe that we still need a robust amount of rate just to keep pace. We're targeting high single digits as far as our overall trends. This reflects both frequency and severity. Overall, we see trends in the 4% range. We believe the figures may indicate that we're experiencing something twice the rate on average.

Great. Could you provide insight regarding your average tenure compared to historical figures or the mix between preferred and non-standard? How has that shifted?

We don’t disclose those figures publicly. However, as we build our data sets and observe customers over longer tenures, we are refining our pricing and segmentation models. We are focusing on lifetime-based pricing, and we have noticed that as we engage with more preferred segments, we become increasingly competitive. Thank you.

Ladies and gentlemen, that concludes today's conference call. Thank you for joining. You may now disconnect.