Lemonade Inc., the New York based fintech startup that sells home and renters insurance has been in the news recently. It has raised tens of millions in venture capital and also considerable interest in the top echelons of corporate Australia. I know because I was asked to reflect on it as part of a workshop on behavioral economics/behavioral science that I conducted a couple of months ago. I have to admit that I did not know about Lemonade before that request.
Turns out that Lemonade uses “Behavioral Science (and Technology) To Onboard Customers and Keep Them Honest”, so the title of a piece in Fast Company earlier this year. Lemonade bets that insights from Behavioral Economics (BE) will give it the edge over incumbent competitors. It bets specifically that the BE insights of Dan Ariely (he of Predictably Irrational and TED talk fame, and now Lemonade’s CBO = Chief Behavioral Officer) will provide that edge, important components being “trusting our customers” and “giving back” to charity all unused excess funds. On top of these components, or maybe undergirding it, is the promise that Lemonade commits to spending at most 20 percent of its income on administration and marketing, which presumably prevents it from profit maximizing at the expense of its customers. Lemonade also promises that it will process claims fast and relatively un-bureaucratically, at least by the standard of an industry that has a reputation for delaying tactics and for its persistent attempts to evade having to pay up. Examples of speedy processing are featured prominently on Lemonade’s website.
And not only that: A couple of months ago, Lemonade launched its Zero Everything policy which gets rid of deductibles and rate hikes after claims and is supposed to pay for itself through elimination of the paperwork that comes with relatively small claims.
BE principles are also appealed to when customers that make claims are asked to submit a brief video outlining their claim and to provide at the same time a honesty pledge which supposedly induces more honesty.
In sum then, Lemonade builds its business allegedly on the trust(worthiness) of its customers, and of itself, and also honesty on the part of both parties.
Let’s start with the (laboratory) evidence for trust(worthiness). On its web page, Lemonade illustrates the advantages of trust(worthiness) with one of the workhorses of experimental economics, the trust, or investment, game. According to the web page, a person that invests (the trustor) will see her investment to a trustee of $100 quadruple and then see the trustee return half of that $400 to herself (the trustor), for an impressive ROI of one hundred percent. Trust pays off, we learn: “We are more trusting and reciprocating than what standard economic theory predicts.”
Ignoring the stab at economic theory (which shows little more than a lack of elementary knowledge of modern economic theory), there are at least three problems with the Lemonade narrative. First, it is not clear at all why this particular game, in this particular parameterization, captures the customer – insurance company situation. Second, I am not aware of anyone ever having experimentally tested this game with that specific parametrization (specifically, a multiplication factor of 4), and I am not aware — the multiplication factors typically used being 3 or 2 — of responders returning more than what was invested. In fact, the results of my own work (which are very much in line with the literature in this area) suggest that trustors invest about half of what they were given and trustees return slightly less than what was invested. It is noteworthy that there is much heterogeneous behavior to be found in these experiments, with many of those that trust (“invest”) being brutally exploited.
“Everyone has a price, the important thing is to find out what it is.” (P. Escobar)
Which brings us to the question of honesty. There is indeed some evidence that the way in which people are being prompted makes a difference and, more generally, that context matters (see Various, JEBO 2016). Friesen & Gangadharan (Economics Letters 2012) use an individual performance task (“matrix task”) after which they ask their subjects to self-report the number of successes that participants had. While very few of their participants – only one out of 12 — are dishonest to the maximal extent, about one out of 3 are to different degrees, with men (in particular those of Aussie and NZ provenance) being more dishonest, and more frequently so, than female participants. Rosenbaum, Billinger, & Stieglitz (Journal of Economic Psychology 2014) review experimental evidence of (dis)honesty 63 experiments from economics and psychology (including Friesen and Gangadharan EL 2012) and find the robust presence of unconditional cheaters and non-cheaters with the honesty of the remaining individuals being particularly susceptible to monitoring and intrinsic lying costs. Most of these experiments involve fairly low stakes, so those intrinsic lying costs are unlikely to be much of a constraint when stakes increase. The fraction of unconditional non-cheaters is almost certain to shrink towards the Escobar limit when stakes increase.
Interestingly, notwithstanding its public declarations in the good of people, Lemonade tells itself that, while trust is good, control is better. It runs its claimants, on top of the honesty pledges, through 18 different fraud detection algorithms before it pays up. On top of this, Lemonade engages in blatant cream-skimming. For example, it did not quote half of their customers that wanted to insure their homes. And it reports that the customers that are joining, or allowed to join, are younger, educated, tech-savvy, above-average earners, and female. So much for trust, trustworthiness, and all that BE marketing horsemanure. Pretty cold-blooded standard economic theory if you ask me. Note that this screening takes care of a key problem with their advertised approach: the likely adverse selection of bad types that mere trusting would invite, a very likely whammy on top of the moral hazard problem that every insurer faces.
So is Lemonade a viable business model?
Time will tell.
In the State of New York, Lemonade claims to have overtaken Allstate, GEICO, Liberty Mutual, State Farm, etc. in what is probably the single most critical market (renters and home insurance) share metric of all: NY renters buying new insurance policies since 1 Jan 2017.
Lemonade, we are told, is growing “exponentially” = “new bookings have doubled every ten weeks since launch, and show no sign of letting up.” According to its most recent Thanksgiving Transparency ‘17 report, Lemonade has now branched out into, and is selling in, Illinois, California and Nevada, Texas, New Jersey and Rhode Island, and has been licensed in 15 other states.
Of course, collecting insurance premia is one thing. Paying insurance claims and balancing the books is another thing altogether and the verdict on that one will be out for a while.
If Lemonade succeeds – and we all should hope it does –, it will do so because it engages in cream-skimming, targeting of low-risk market segments, and massive control and surveillance of its clientele. It will not do so because of its invocation of the feel-good alleged BE findings so prominently displayed on its web page.