ROOT, INC. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from such forward-looking statements. Factors that could cause or contribute to those differences include, but are not limited to, those identified below and those discussed in the sections titled "Risk Factors" and "Special Note Regarding Forward-Looking Statements" included elsewhere in this Annual Report on Form 10-K. Additionally, our historical results are not necessarily indicative of the results that may be expected for any period in the future. This Management's Discussion and Analysis does not discuss 2020 performance or a comparison of 2021 versus 2020 performance for select areas where we have determined the omitted information is not necessary to understand our current period financial condition, changes in our financial condition, or our results. The omitted information may be found in our Annual Report on Form 10-K for the year endedDecember 31, 2021 filed with theSecurities and Exchange Commission , or theSEC , onFebruary 23, 2022 . Overview Root is a tech-enabled insurance company revolutionizing personal insurance with a pricing model based upon fairness and a modern customer experience. We operate primarily a direct-to-consumer model in which we currently acquire the majority of our customers through mobile applications. We are also focused on expanding our embedded insurance platform, where we acquire customers through strategic partnerships. We believe the Root advantage is derived from our unique ability to efficiently and effectively bind auto insurance policies quickly, through direct and embedded channels, aided by segmenting individual risk based on complex behavioral data and proprietary telematics. Our customer experience is built for ease of use and a product offering made possible with our full-stack insurance structure. These are all uniquely integrated into a single cloud-based technology platform that captures the entire insurance value chain-from customer acquisition to underwriting to claims and administration to ongoing customer engagement. Our model benefits from portfolio maturity. As we scale the business and develop our embedded products, our results are disproportionately weighted towards new customers compared to traditional insurance carriers. As we build an underlying base of recurring customers, we expect the following financial impacts: •Improved loss ratio. Renewal premiums, referring to premiums from a customer's second term and beyond, have lower loss ratios as compared to new premiums in the customer's first term. As we grow our business, we anticipate, consistent with industry norms, that a greater proportion of our premiums will be from customer renewals and drive down the loss ratio across our portfolio. We also continue to revise contracts to tighten underwriting and implement rate increases to control the impact of increased loss costs. •Reduced marketing as a percentage of premium. Certain recurring customer premiums have no associated customer acquisition costs and minimal underwriting costs, driving profitability. As we grow our business, we anticipate, consistent with industry norms, that a greater proportion of our premiums will be from customer renewals without associated marketing costs. •Increased revenue per customer. Over time we expect to refine our fee schedules to be more consistent with industry norms. This, paired with strengthened underwriting, will facilitate the opportunity to generate additional fee revenue per customer. We use technology to drive efficiency across all functions, including distribution, underwriting, policy administration and claims in particular. We believe this allows us to operate with a cost to acquire and cost to serve advantage. We continue to develop machine learning loss models, which allows us to respond more quickly to changes in the market, improve pricing segmentation and take appropriate and timely rate actions. We efficiently acquire customers directly through multiple channels, including embedded, digital (performance), channel media, referrals and agency. Our evolving acquisition strategy includes utilizing our embedded platform through current and future embedded partners. Traditionally, our marketing costs have historically been well below industry averages, although in any given period, these costs can vary by acquisition strategy, channel mix, by state, or due to 59 -------------------------------------------------------------------------------- seasonality or due to the competitive environment. Today, we acquire the vast majority of our customers through the embedded platform, mobile app and mobile website. We believe that through prudent investment in and diversification of our marketing channels, including a focus on embedded insurance through our current and future strategic partners, and leveraging proprietary data science and technology will position us for more sustainable, long-term and profitable growth. As a full-stack insurance company, we currently employ a "capital-efficient" model, which utilizes a variety of reinsurance structures at elevated levels of reinsurance. These reinsurance structures deliver three core objectives (1) top-line growth without a commensurate increase in regulatory capital requirements, (2) support of customer acquisition costs and (3) protection from outsized losses or tail events. We expect to maintain an elevated level of third-party quota share reinsurance while scaling our business in order to operate a capital-efficient business model. As our business scales, we expect to have the flexibility to reduce our quota share levels to maximize the return to shareholders. We have included net loss and LAE ratio, net expense ratio, and net combined ratio as key performance indicators, which include the impact of reinsurance. These net metrics are useful to help illustrate the underwriting and operating expense performance and operating health of the overall business. A combined ratio under 100% indicates an underwriting profit while a combined ratio over 100% indicates an underwriting loss. Given the significant impact of reinsurance on our results of operations, we use certain gross basis key performance indicators to manage and measure our business operations and enhance investor understanding of our business model prior to reinsurance. We believe our long-term success will be apparent through the progression of our gross metrics. Results of operations on a gross basis alone are not achievable under our regulatory landscape given our historical top-line growth and resulting capital requirements, which are relieved, in part, by obtaining reinsurance. The gross metrics have historically included gross premiums written, gross premiums earned, direct contribution, gross loss ratio, gross LAE ratio and gross accident period loss ratio. We have added gross expense ratio and gross combined ratio as key performance indicators and we believe these metrics provide useful insight to illustrate the expense and operating health of the business, prior to reinsurance. A gross combined ratio under 100% indicates an underwriting profit, prior to reinsurance, while a gross combined ratio over 100% indicates an underwriting loss, prior to reinsurance. In addition to our gross basis metrics, management uses adjusted earnings before interest, tax, depreciation, amortization, or adjusted EBITDA, as an integral part of managing our business. We believe adjusted EBITDA provides investors with useful insight into our business because such measure eliminates the effects of certain charges that are not directly attributable to our underlying operating performance. For additional information, including definitions of these key metrics, see "- Key Performance Indicators" and for reconciliations of Direct Contribution and adjusted EBITDA to the most directly comparable generally accepted accounting principles inthe United States , or GAAP, metric, see "- Non-GAAP Financial Measures."
Key Factors and Trends Affecting our Operating Performance
Our financial condition and results of operations have been, and will continue to be, affected by a number of factors, including the following:
Our Ability to Manage Risk
We leverage technology to help manage risk. For instance, we leverage machine
learning to "clean" behavioral data obtained through a customer's mobile device,
and we use advanced statistical methods to model that data into usable behavior
scores. We leverage intelligent chat functions and various forms of machine
learning and advanced automation to help power our claims function. Technology
is a key differentiator in managing risk across our key functions. Our success
depends on our ability to adequately and competitively price risk.
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--------------------------------------------------------------------------------Our Ability to Attract New Customers
Our long-term growth will depend, in large part, on our continued ability to attract new customers to our platform. We intend to continue to drive new customer growth by leveraging our differentiated consumer experience, our embedded channel, machine learning loss models and our telematics-based pricing. Additionally, our proprietary dataset will continue to scale as we grow, enabling us to enhance our predictive models to further improve pricing and attract potential new customers. We will also continue to target attractive potential customer segments through our embedded experience and digital marketing channels. Our ability to attract new customers will depend on a number of factors, including the pricing of our products, offerings of our competitors, our ability to expand into new markets, success of our embedded channel and the effectiveness of our marketing efforts. Our ability to attract and retain customers depends on maintaining and strengthening our brand by providing superior customer experiences and competitive pricing. In particular, we are challenged by traditional insurerswho have more diverse product offerings and longer established operating histories. These competitors can mimic certain aspects of our digital platform and offerings, and as they have more types of insurance products, can offer customers the ability to "bundle" multiple coverage types together, which may be attractive to many customers.
Our Ability to Retain Customers
Our ability to derive significant lifetime value from our customer relationships depends, in part, on our ability to retain our customers over time. Strong retention allows us to build a recurring revenue base, generating additional premiums term over term without material incremental marketing costs. As we broadly retain customers and our book of business evolves to be more weighted towards renewals versus new business, as is the case with our mature competitors, we will benefit from the inherently lower loss ratios that characterize renewed premiums. Our ability to retain customers will depend on a number of factors, including our customers' satisfaction with our products, offerings of our competitors and pricing of products.
Our Ability to be Licensed in all States in
Our long-term growth opportunity will benefit from our ability to provide insurance across more states inthe United States . Today, we are currently licensed in 50 states (48 states for personal auto) and theDistrict of Columbia and operate in 34 of those states. Our state expansion has unlocked a large total addressable market for sustained growth, made our direct targeted marketing more efficient and created an opportunity to build a national brand, supporting our marketing holistically.
Our Ability to Expand Premiums Through Cross-Sell and Fee Income Per Policy
We are in the early stages of cross-selling non-auto products across our customer base. In 2019, we began offering renters insurance and, inMay 2020 , we launched our homeowners insurance product in partnership withHomesite Insurance , or Homesite. Cross-sales allow us to generate additional premiums (renters) and fee income (homeowners) without material incremental marketing spend, and ultimately higher revenue per customer. We have also observed that bundling products with auto insurance improves retention as the relationship with our customer expands. Our success in expanding revenues through cross-sales and greater fee income per policy depends on our marketing efforts with new products, continuous state expansion of these offerings and the pricing of our bundled products and continuing to refine the fee schedules in our policyholder contracts to be more consistent with industry norms. The success of our renters insurance offering is also subject to our ability to develop underwriting capabilities to adequately price renters risk.
Recent Developments Affecting Comparability
COVID-19 Impact
InMarch 2020 , theWorld Health Organization declared COVID-19 a global pandemic. The COVID-19 pandemic and governmental responses thereto have impacted and may further impact the broader economic environment, including creating or exacerbating supply chain disruptions and inflation and negatively impacting unemployment levels, economic growth, the proper functioning of financial and capital markets and interest rates. 61 -------------------------------------------------------------------------------- The economic instability caused by the COVID-19 pandemic has led to acute inflationary pressures, supply chain disruptions, rising interest rates and a downturn in equity markets. There is a risk of inflation remaining elevated for an extended period, which could cause claims and claim expenses to increase, impact the performance of our investment portfolio or have other adverse effects. Rising interest rates and reduced equity values have increased the cost of capital and may limit our ability to raise additional capital. In addition, we have seen an increase in the value of used vehicles and replacement parts. These cost increases have resulted in greater claims severity while being partially offset by higher subrogation recoveries on damaged vehicles. We continue to file in multiple states to establish rates that more closely follow the evolving loss cost trends. As the COVID-19 pandemic continues, there is ongoing uncertainty around the severity and duration of the pandemic and the pandemic's potential impact on our business and our financial performance. See the section titled "Risk Factors" for more details. Comprehensive Reinsurance We expect to continue to utilize reinsurance in the future, and our diversified approach to reinsurance allows us to be flexible in response to changes in market conditions or our own business changes, which allows us to strategically fuel profitable growth and technology investment by optimizing the amount of capital required. Key Performance Indicators We regularly review a number of metrics, including the following key performance indicators, to evaluate our business, measure our performance, identify trends in our business, prepare financial projections and make strategic decisions. There were certain key performance indicators that management no longer utilized to actively monitor the performance of the business and we believe are no longer useful metrics to provide as key performance indicators. These metrics include the renters policies in force, renters premiums per policy, renters premiums in force, adjusted gross profit/(loss), gross margin, ratio of adjusted gross profit/(loss) to total revenue, ratio of adjusted gross profit/(loss) to gross premiums earned, ratio of direct contribution to total revenue and ratio of direct contribution to gross premiums earned. 62 -------------------------------------------------------------------------------- We believe the non-GAAP and operational measures are useful in evaluating our performance, in addition to our financial results prepared in accordance with GAAP. See the section titled "- Non-GAAP Financial Measures" for additional information regarding our use of direct contribution and adjusted EBITDA and their reconciliations to the most directly comparable GAAP measures. Years Ended December 31, 2022 2021 2020 (dollars in millions, except Premiums per policy) Policies in force 220,354 354,371 322,759 Premiums per policy $ 1,220$ 1,006 $ 939 Premiums in force $ 537.7$ 713.0 $ 606.1 Gross premiums written $ 600.0$ 742.6 $ 616.8 Gross premiums earned $ 643.6$ 719.6 $ 605.2 Gross profit/(loss) $ (32.2)$ (51.9) $ (14.2) Net loss$ (297.7) $ (521.1) $ (363.0) Direct contribution $ 27.6$ 8.1 $ 18.9 Adjusted EBITDA$ (185.9) $ (446.1) $ (249.5) Net loss and LAE ratio 122.8 % 126.4 % 112.5 % Net expense ratio 72.2 % 134.5 % 78.1 % Net combined ratio 195.0 % 260.9 % 190.6 % Gross loss ratio 82.1 % 86.0 % 82.0 % Gross LAE ratio 10.3 % 10.5 % 10.1 % Gross expense ratio 45.4 % 71.3 % 56.5 % Gross combined ratio 137.8 % 167.8 % 148.6 % Gross accident period loss ratio 80.9 % 88.7 % 76.1 % Policies in Force We define policies in force as the number of current and active auto insurance policyholders underwritten by us as of the period end date. We view policies in force as an important metric to assess our financial performance because policy growth drives our revenue growth, expands brand awareness, deepens our market penetration, and generates additional data to continue to improve the functioning of our platform.
Premiums per Policy
We define premiums per policy as the ratio of gross premiums written on auto
insurance policies in force at the end of the period divided by policies in
force. We view premiums per policy as an important metric since the higher the
premiums per policy the greater the amount of earned premium we expect from each
policy.
Premiums in Force
We define premiums in force as premiums per policy multiplied by policies in
force multiplied by two. We view premiums in force as an estimate of annualized
run rate of gross premiums written as of a given period. Since our auto policies
are six-month policies, we multiply this figure by two in order to determine an
annualized amount of premiums in force. We view this as an important metric
because it is an indicator of the size of our portfolio of policies as well as
an indicator of expected earned premium over the coming 12 months. Premiums in
force is not a forecast of future revenue nor is it a reliable indicator of
revenue expected to be earned in any given period. We believe that our
calculation of premiums in force is useful to investors and analysts because it
captures the impact of fluctuations in customers and premiums per policy at the
end of each reported period, without adjusting for known or projected policy
updates, cancellations and non-renewals.
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--------------------------------------------------------------------------------Gross Premiums Written
We define gross premiums written, as the total amount of gross premium on policies that were bound during the period less the prorated impact of policy cancellations. Gross premiums written includes direct premiums and assumed premiums. We view gross premiums written as an important metric because it is the metric that most closely correlates with changes in gross premiums earned. We use gross premiums written, which excludes the impact of premiums ceded to reinsurers, to manage our business because we believe that it reflects the business volume and direct economic benefit generated by our customer acquisition activities, which along with our underlying underwriting and claims operations (gross loss ratio and gross LAE) are the key drivers of our future profit opportunities. Additionally, premiums ceded to reinsurers can change significantly based on the type and mix of reinsurance structures we use, and, as such, we have the optionality to fully retain the premiums from customers acquired in the future. Gross Premiums Earned We define gross premiums earned as the amount of gross premium that was earned during the period. Premiums are earned over the period in which insurance protection is provided, which is typically six months. Gross premiums earned includes direct premiums and assumed premiums. We view gross premiums earned as an important metric as it allows us to evaluate our premium levels prior to the impacts of reinsurance. It is the primary driver of our consolidated GAAP revenues. As with gross premiums written, we use gross premiums earned, which excludes the impact of premiums ceded to reinsurers to manage our business, because we believe that it reflects the business volume and direct economic benefit generated by our customer acquisition activities, which along with our underlying underwriting and claims operations (gross loss ratio and gross LAE) are the key drivers of our future profit opportunities.
Gross Profit/(Loss)
We define gross profit/(loss) as total revenue minus net loss and LAE and other insurance (benefit) expense. We view gross profit/(loss) as an important metric because we believe it is informative of the financial performance of our core insurance business. Direct Contribution We define direct contribution, a non-GAAP financial measure, as gross profit/(loss) excluding net investment income, net realized gains (losses) on investments, report costs, salaries, health benefits, bonuses, employee retirement plan related expenses and employee share-based compensation expense, allocated overhead, licenses, net commissions, professional fees and other expenses, ceded earned premium, ceded loss and LAE, and net ceding commission and other. Net ceding commission and other is comprised of ceding commission received in connection with reinsurance ceded, partially offset by amortization of excess ceding commission, and other impacts of reinsurance ceded which are included in other insurance (benefit) expense. After these adjustments, the resulting calculation is inclusive of only those gross variable costs of revenue incurred on the successful acquisition of business. We view direct contribution as an important metric because we believe it measures progress towards the profitability of our total policy portfolio prior to the impact of reinsurance.
See the section titled "- Non-GAAP Financial Measures" for a reconciliation of total revenue to direct contribution.
Adjusted EBITDA
We define adjusted EBITDA, a non-GAAP financial measure, as net loss excluding
interest expense, income tax expense, depreciation and amortization, share-based
compensation, warrant compensation expense, restructuring charges, and write-off
of prepaid marketing expense and reclassifications of certain sales and
marketing expenses, and related legal and other fees, net of anticipated
insurance recovery. After these adjustments, the resulting calculation
represents expenses directly attributable to our operating performance. We use
adjusted EBITDA as an internal performance measure in the management of our
operations because we believe it provides management and other users of our
financial information useful insight into our results of operations and
underlying business
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--------------------------------------------------------------------------------performance. Adjusted EBITDA should not be viewed as a substitute for net loss calculated in accordance with GAAP, and other companies may define adjusted EBITDA differently.
See the section titled "- Non-GAAP Financial Measures" for a reconciliation of net loss to adjusted EBITDA.
Net Loss and LAE Ratio We define net loss and LAE ratio expressed as a percentage, as the ratio of net loss and LAE to net premiums earned. We view net loss and LAE ratio as important metric because it allows us to evaluate loss trends as a percentage of net premiums and believe it is useful for investors to evaluate those separately from other operating expenses.
Net Expense Ratio
We define net expense ratio expressed as a percentage, as the ratio of all operating expenses less loss and LAE and less fee income to net premiums earned. We view net expense ratio as important because it allows us to analyze our expense and acquisition trends, net of fee income, and allows investors to evaluate these expenses exclusive of our loss and LAE expenses.
Net Combined Ratio
We define net combined ratio expressed as a percentage, as the sum of net loss and LAE ratio and net expense ratio. We view net combined ratio as important because it allows us to analyze our underwriting result trends and is a key indicator of overall profitability and health of the overall business. We believe it is useful to investors to evaluate these components separately and in the aggregate when reviewing our underwriting performance. A net combined ratio under 100% indicates an underwriting profit, while a net combined ratio greater than 100% indicates an underwriting loss.
Gross Loss Ratio
We define gross loss ratio expressed as a percentage, as the ratio of gross losses to gross premiums earned. Gross loss ratio excludes LAE. We view gross loss ratio as an important metric because it allows us to evaluate incurred losses and LAE separately prior to the impact of reinsurance.
Gross LAE Ratio
We define gross LAE ratio expressed as a percentage, as the ratio of gross LAE to gross premiums earned. We view gross LAE ratio as an important metric because it allows us to evaluate incurred losses and LAE separately. Currently, we do not cede any of our LAE to our third-party quota share reinsurance treaties; therefore, we actively monitor LAE ratio as it has a direct impact on our results regardless of our reinsurance strategy.
Gross Expense Ratio
We define gross expense ratio expressed as a percentage as the ratio of gross
operating expenses less loss and LAE and less fee income to gross premiums
earned. We view gross expense ratio as important because it allows us to analyze
the underlying expense base of the business and establish expense targets, prior
to the impact of reinsurance. We believe gross expense ratio is useful for
investors to further evaluate business health and performance, prior to the
impact of reinsurance.
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--------------------------------------------------------------------------------Gross Combined Ratio
We define gross combined ratio expressed as a percentage as the sum of the gross loss ratio, gross LAE ratio and gross expense ratio. We view gross combined ratio as important because it allows us to evaluate financial performance and establish targets that we believe more closely reflects the underlying performance and profitability of the business prior to reinsurance. Further, we believe it is useful for investors to evaluate these components separately and in the aggregate when reviewing our gross underwriting performance. A gross combined ratio under 100% indicates an underwriting profit while a gross combined ratio greater than 100% indicates an underwriting loss, prior to the impact of reinsurance.
Gross Accident Period Loss Ratio
Gross accident period loss ratio, expressed as a percentage, represents all losses and claims expected to arise from insured events that occurred during the applicable period regardless of when they are reported and finally settled divided by gross premiums earned for the same period. Changes to our loss reserves are the primary driver of the difference between our gross accident period loss ratio and gross loss ratio. We believe that gross accident period loss ratio is useful in evaluating expected losses prior to the impact of reinsurance.
Components of Our Results of Operations
Revenue
We generate revenue from net premiums earned, net investment income, net realized gains on investments, fee income and other income.
Net Premiums Earned
Premiums written are deferred and earned pro rata over the policy period. Net premiums earned represents the earned portion of our gross premiums written, less the earned portion that is ceded to third-party reinsurers under our reinsurance agreements. We expect net premiums earned to decrease in the short-term as our policies in force decrease continues to outpace premiums written from new business. In the near-term, we expect to grow new writings with our embedded products and greater average premiums per policy to generate growth in net premiums earned. Net Investment Income Net investment income represents interest earned from our fixed maturity and short-term investments and cash and cash equivalents and unrealized gains from our private equity investments less investment expenses. Net investment income is directly correlated with the overall size of our investment portfolio, market level of interest rates and changes in fair value of our private equity investments. Net investment income will vary with the size and composition of our investment portfolio, market returns and the investment strategy.
Net Realized Gains on Investments
Net realized gains on investments represents the difference between the amount received by us on the sale of an investment as compared to the investment's amortized cost basis.
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--------------------------------------------------------------------------------Fee Income
For those policyholderswho pay premiums on an installment basis, we charge a flat fee for each installment related to the additional administrative costs associated with processing more frequent billing. We recognize this fee income in the period in which we process each installment.
Other Income
Other income is primarily comprised of revenue earned from distributing website and app policy inquiry leads in geographies where we do not have a presence, recognized when we generate the lead; commissions earned for homeowners policies placed with third-party insurance companies where we have no exposure to the insured risk, recognized on the effective date of the associated policy; and sale of enterprise technology products to provide telematics-based data collection and trip tracking, recognized ratably as the service is performed.
Operating Expenses
Our operating expenses consist of loss and LAE, sales and marketing, other insurance (benefit) expense, technology and development, and general and administrative expenses.
Loss and Loss Adjustment Expenses
Loss and LAE include the costs incurred for claims, payments made and estimated
future payments to be made to or on behalf of our policyholders, including
expenses needed to adjust or settle claims, net of amounts ceded to reinsurers.
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 LAE. These reserves are a liability established to cover the estimated
ultimate cost to settle insured losses. The unpaid loss estimates consider loss
trends, mix of business, and other risk factors impacting claims settlement. The
method used to estimate unpaid LAE liability is based on claims transaction
data, including the relative cost of adjusting and settling a range of claim
types from express material damage claims to more complex injury cases.
Loss and LAE are net of amounts ceded to reinsurers. We enter into reinsurance
contracts to limit our exposure to potential losses as well as to provide
additional capacity to write more business. These expenses are a function of the
size and term of the insurance policies we write and the loss experience
associated with the underlying risks. Loss and LAE may be paid out over a period
of years.
Various other expenses incurred during claims processing are considered LAE.
These amounts include related salaries, health benefits, bonuses, employee
retirement plan related expenses and employee share-based compensation expense,
or Personnel Costs, for claims related employees; software expense; internally
developed software amortization; and overhead allocated based on headcount, or
Overhead.
Sales and Marketing
Sales and marketing expense includes spending related to performance and
embedded channels, channel media, advertising, branding, public relations,
sponsorship, consumer insights and referral fees. These expenses also include
related Personnel Costs, Overhead and certain warrant compensation expense
related to our embedded channel. We incur sales and marketing expenses for all
product offerings. Sales and marketing are expensed as incurred. Certain warrant
compensation expense is recognized on a pro-rata basis considering progress
toward completing Carvana's online buying platform, or the Integrated Platform,
under the Carvana commercial agreement.
We plan to continue investing in and diversifying our marketing channels,
including costs incurred related to our embedded channel, to attract and acquire
new customers, increase our brand awareness, and expand our product offerings
within certain markets. We expect that in the long-term, our sales and marketing
will decrease as a percentage of revenue as the proportion of renewals to our
total business increases.
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--------------------------------------------------------------------------------Other Insurance (Benefit) Expense
Other insurance (benefit) expense includes underwriting expenses, credit card and policy processing expenses, premium write-offs, insurance license expenses, certain warrant compensation expense related to our embedded channel, and Personnel Costs and Overhead related to actuarial and certain data science activities. Other insurance (benefit) expense also includes amortization of deferred acquisition costs like certain commissions, premium taxes, and report costs related to the successful acquisition of a policy. Other insurance (benefit) expense is expensed as incurred, except for costs related to deferred acquisition costs that are capitalized and subsequently amortized over the same period in which the related premiums are earned. These expenses are also recognized net of ceding commissions earned. Certain warrant compensation expense is recognized on a pro-rata basis for policies originated from the Integrated Platform towards milestones as defined under the Carvana commercial agreement. Technology and Development Technology and development expense consists of software development costs related to our mobile app and homegrown information technology systems; third-party services related to infrastructure support; Personnel Costs and Overhead for engineering, product, technology, and certain data science activities; and amortization of internally developed software. Technology and development is expensed as incurred, except for development and testing costs related to internally developed software that are capitalized and subsequently amortized over the expected useful life. Over time, we expect technology and development to decrease as a percentage of revenue.
General and Administrative
General and administrative expenses primarily relate to external professional service expenses; Personnel Costs and Overhead for corporate functions; and depreciation expense for computers, furniture and other fixed assets; write-offs; and restructuring costs associated with the involuntary workforce reductions. Restructuring costs include severance, benefits, share-based compensation, employee compensation expense, dependent upon continuous employment for certain employees, and related employee costs, real estate exit costs and software costs. General and administrative expenses are expensed as incurred. We expect general and administrative expenses to decrease as a percentage of total revenue over time.
Non-Operating Expenses
Interest Expense
Interest expense is not an operating expense; therefore, we include these expenses below operating expenses. Interest expense primarily relates to interest incurred on our long-term debt, certain fees that are expensed as incurred and amortization of debt issuance costs. In addition, changes in the fair value of warrant liabilities that were associated with our long-term debt are recorded as interest expense.
Loss on Early Extinguishment of Debt
Loss on early extinguishment of debt is not an operating expense; therefore, we
include these expenses below operating expenses. Loss on early extinguishment of
debt primarily relates to the difference between the reacquisition price of the
debt and the net carrying amount of the extinguished debt. Upon extinguishment
of debt, the remaining unamortized discount and debt and warrants issuance costs
are recognized as expense.
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--------------------------------------------------------------------------------Results of Operations
Comparison of the Years Ended
The following table presents our results of operations for the periods
indicated:
Years Ended December 31,
% of Total % of Total
2022 Revenue 2021 Revenue $ Change % Change
(dollars in millions)
Revenue:
Net premiums earned $ 285.9 92.0 % $ 310.3 89.8 % $ (24.4) (7.9) %
Net investment income 6.2 2.0 % 5.0 1.4 % 1.2 24.0 %
Net realized gains on investments 0.5 0.2 % 2.4 0.7 % (1.9) (79.2) %
Fee Income 16.5 5.3 % 20.9 6.1 % (4.4) (21.1) %
Other income 1.7 0.5 % 6.8 2.0 % (5.1) (75.0) %
Total revenues 310.8 100.0 % 345.4 100.0 % (34.6) (10.0) %
Operating expenses:
Loss and loss adjustment expenses 351.0 112.9 % 392.3 113.6 % (41.3) (10.5) %
Sales and marketing 48.0 15.5 % 270.2 78.2 % (222.2) (82.2) %
Other insurance (benefit) expense (8.0) (2.6) % 5.0 1.4 % (13.0) (260.0) %
Technology and development 55.5 17.9 % 65.5 19.0 % (10.0) (15.3) %
General and administrative 127.4 41.0 % 97.6 28.3 % 29.8 30.5 %
Total operating expenses 573.9 184.7 % 830.6 240.5 % (256.7) (30.9) %
Operating loss (263.1) (84.7) % (485.2) (140.5) % 222.1 (45.8) %
Interest expense (34.6) (11.1) % (20.0) (5.8) % (14.6) 73.0 %
Loss on early extinguishment of
debt - - % (15.9) (4.6) % 15.9 (100.0) %
Loss before income tax expense (297.7) (95.8) % (521.1) (150.9) % 223.4 (42.9) %
Income tax expense - - % - - % - - %
Net loss (297.7) (95.8) % (521.1) (150.9) % 223.4 (42.9) %
Other comprehensive loss:
Changes in net unrealized losses
on investments (6.2) (2.0) % (5.2) (1.5) % (1.0) 19.2 %
Comprehensive loss $ (303.9) (97.8) % $ (526.3) (152.4) % $ 222.4 (42.3) %
Revenue
Net Premiums Earned
Net premiums earned decreased $24.4 million , or 7.9%, to $285.9 million for the
year ended December 31, 2022 compared to 2021. The decrease was primarily due to
lower policies in force throughout the year as a result of reduced marketing
expenditures, partially offset by an increase in premium per policy driven by
rate actions.
During the years ended December 31, 2022 and 2021, we ceded approximately 55.6%
and 56.9% of our gross premiums earned to third-party reinsurers, respectively.
The slight change in ceding percentage between the periods was driven by
retaining a marginally larger share of our overall book of business.
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The following table presents gross premiums written, ceded premiums written, net
premiums written, gross premiums earned, ceded premiums earned and net premiums
earned for the years ended December 31, 2022 and 2021:
Years Ended December 31,
2022 2021 $ Change % Change
(dollars in millions)
Gross premiums written $ 600.0 $ 742.6 $ (142.6) (19.2) %
Ceded premiums written (331.2) (397.3) 66.1 (16.6) %
Net premiums written 268.8 345.3 (76.5) (22.2) %
Gross premiums earned 643.6 719.6 (76.0) (10.6) %
Ceded premiums earned (357.7) (409.3) 51.6 (12.6) %
Net premiums earned $ 285.9 $ 310.3 $ (24.4) (7.9) %
The decrease in gross premiums earned was primarily due to lower gross premiums written as a result of reducing marketing expenditures. This decrease was partially offset by a 21.3% increase in premiums per policy for automobile insurance primarily attributable to rate actions.
Fee Income
Fee income decreased$4.4 million , or 21.1%, to$16.5 million for the year endedDecember 31, 2022 compared to 2021. The decrease was primarily due to a decrease in installment fees due to lower policies in force.
Other Income
Other income decreased
Operating Expenses
Loss and Loss Adjustment Expenses
Loss and LAE decreased
Gross accident period loss ratios decreased to 80.9% from 88.7% for the years endedDecember 31, 2022 and 2021, respectively. The change in the loss ratios was driven by growth in average premium per policy primarily attributable to rate actions and improved tenure mix as our book of business matures. This was offset by higher loss costs from increased severity per claim due to inflation, as the industry experienced higher replacement parts cost and growth in used car values. We experienced an 11% increase in severity per claim and 6% decrease in claim frequency for the year endedDecember 31, 2022 compared to 2021. The claim severity and frequency estimates are based on bodily injury, collision, and property damage coverages.
Sales and Marketing
Sales and marketing decreased$222.2 million , or 82.2%, to$48.0 million for the year endedDecember 31, 2022 compared to 2021. The decrease was primarily due to a decline in performance marketing of$175.9 million and branding and advertising of$39.4 million . The reduction in sales and marketing expense is due to a shift in direct marketing strategy in response to changing macroeconomic factors and competitive environment. This was partially offset by$5.4 million increase in content development as we focus on diversifying our marketing channels. 70 --------------------------------------------------------------------------------
Other Insurance (Benefit) Expense
Other insurance (benefit) expense decreased$13.0 million , or 260.0%, to a benefit of$8.0 million for the year endedDecember 31, 2022 compared to 2021. The decrease was primarily driven by a$22.8 million decrease in underwriting costs and premium taxes and a$3.5 million decrease in premium write-offs primarily attributable to a decline in gross premiums written. In addition, we experienced a$3.1 million decrease in personnel costs as a result of a decrease in headcount, primarily attributable to the involuntary workforce reductions. This was partially offset by a$10.8 million decrease in earned ceding commission contra-expense due to a decrease in gross premiums written and a$5.7 million increase in Carvana warrant expense as a result of policies originating from the Integrated Platform. Technology and Development Technology and development decreased$10.0 million , or 15.3%, to$55.5 million for the year endedDecember 31, 2022 compared to 2021. The decrease was primarily driven by a$9.7 million decrease in personnel and overhead related costs as a result of a decrease in headcount, primarily attributable to the involuntary workforce reductions.
General and Administrative
General and administrative increased$29.8 million , or 30.5%, to$127.4 million for the year endedDecember 31, 2022 compared to 2021. The increase was driven by$18.6 million of restructuring costs related to the involuntary workforce reductions and a$9.5 million increase in personnel costs primarily attributable to share-based compensation expenses relating to our equity incentive plan. This was partially offset by a decrease of$4.9 million in professional services and$2.7 million in rent expense as we focused on materially reducing our fixed expenses in 2022 in our drive towards profitability. In addition, we recognized write-off of prepaid marketing expense and reclassifications of certain sales and marketing expenses to general and administrative expenses of$10.2 million , legal and other fees of$1.2 million , partially offset by an anticipated insurance recovery of$1.9 million , related to the purported misappropriation of funds by a former senior marketing employee. Non-Operating Expenses Interest Expense Interest expense increased$14.6 million , or 73.0%, to$34.6 million for the year endedDecember 31, 2022 compared to 2021. The increase was primarily due to an increase in debt interest expense as a result of higher average outstanding debt and a greater average interest rate for the year endedDecember 31, 2022 compared to 2021.
Loss on Early Extinguishment of Debt
Loss on early extinguishment of debt decreased$15.9 million , or 100.0%, to zero for the year endedDecember 31, 2022 compared to 2021. The decrease was driven by$15.9 million of accelerated amortization of unamortized discount and debt and warrant issuance costs from the extinguishment of our$100.0 million term loan, or Term Loan B, which was early extinguished in 2021. 71 --------------------------------------------------------------------------------
Comparison of the Years Ended
The following table presents our results of operations for the periods indicated:
Years Ended December 31,
% of Total % of Total
2021 Revenue 2020 Revenue $ Change % Change
(dollars in millions)Revenue: Net premiums earned$ 310.3 89.8 %$ 322.5 93.0 %$ (12.2) (3.8) % Net investment income 5.0 1.4 % 5.4 1.6 %$ (0.4) (7.4) % Net realized gains on investments 2.4 0.7 % 0.3 0.1 %$ 2.1 700.0 % Fee income 20.9 6.1 % 17.4 5.0 %$ 3.5 20.1 % Other income 6.8 2.0 % 1.2 0.3 %$ 5.6 466.7 % Total revenue 345.4 100.0 % 346.8 100.0 % (1.4) (0.4) % Operating expenses: Loss and loss adjustment expenses 392.3 113.6 % 362.8 104.6 % 29.5 8.1 % Sales and marketing 270.2 78.2 % 139.7 40.3 % 130.5 93.4 % Other insurance expense (benefit) 5.0 1.4 % (1.8) (0.5) % 6.8 377.8 % Technology and development 65.5 19.0 % 52.9 15.3 % 12.6 23.8 % General and administrative 97.6 28.3 % 78.5 22.6 % 19.1 24.3 % Total operating expenses 830.6 240.5 % 632.1 182.3 % 198.5 31.4 % Operating loss (485.2) (140.5) % (285.3) (82.3) % (199.9) 70.1 % Interest expense (20.0) (5.8) % (77.7) (22.4) % 57.7 (74.3) % Loss on early extinguishment of debt (15.9) (4.6) % - - % (15.9) 100.0 % Loss before income tax expense (521.1) (150.9) % (363.0) (104.7) % (158.1) 43.6 % Income tax expense - - % - - % - - % Net loss (521.1) (150.9) % (363.0) (104.7) % (158.1) 43.6 % Other comprehensive (loss) income: Changes in net unrealized (losses) gains on investments (5.2) (1.5) % 5.0 1.5 % (10.2) (204.0) % Comprehensive loss$ (526.3) (152.4) %$ (358.0) (103.2) %$ (168.3) 47.0 % TheDecember 31, 2021 and 2020 results of operations discussion can be found in Part II, Item 7, "Results of Operations" of our Annual Report on Form 10-K for the year endedDecember 31, 2021 .
Non-GAAP Financial Measures
The non-GAAP financial measures below have not been calculated in accordance
with GAAP and should be considered in addition to results prepared in accordance
with GAAP and should not be considered as a substitute for, or superior to, GAAP
results. In addition, direct contribution and adjusted EBITDA should not be
construed as indicators of our operating performance, liquidity or cash flows
generated by operating, investing and financing activities, as there may be
significant factors or trends that they fail to address. We caution investors
that non-GAAP financial information, by its nature, departs from traditional
accounting conventions. Therefore, its use can make it difficult to compare our
current results with our results from other reporting periods and with the
results of other companies.
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Our management uses these non-GAAP financial measures, in conjunction with GAAP
financial measures, as an integral part of managing our business and to, among
other things: (1) monitor and evaluate the performance of our business
operations and financial performance; (2) facilitate internal comparisons of the
historical operating performance of our business operations; (3) facilitate
external comparisons of the results of our overall business to the historical
operating performance of other companies that may have different capital
structures and debt levels; (4) review and assess the operating performance of
our management team; (5) analyze and evaluate financial and strategic planning
decisions regarding future operating investments; and (6) plan for and prepare
future annual operating budgets and determine appropriate levels of operating
investments.
Direct Contribution
For the definition of direct contribution and why management believes this measure provides useful information to investors, see "- Key Performance Indicators."
The following table provides a reconciliation of total revenue to direct
contribution for the years ended
Years Ended December 31,
2022 2021 2020
(dollars in millions)
Total revenue $ 310.8 $ 345.4 $ 346.8
Loss and loss adjustment expenses (351.0) (392.3) (362.8)
Other insurance benefit (expense) 8.0 (5.0) 1.8
Gross profit/(loss) (32.2) (51.9) (14.2)
Net investment income (6.2) (5.0) (5.4)
Net realized gains on investments (0.5) (2.4) (0.3)
Adjustments from other insurance benefit
(expense)(1) 38.4 56.0 40.9
Ceded premiums earned 357.7 409.3 282.7
Ceded loss and loss adjustment expenses (243.7) (302.5) (194.8)
Net ceding commission and other(2) (85.9) (95.4) (90.0)
Direct contribution $ 27.6 $ 8.1 $ 18.9
______________
(1) Adjustments from other insurance benefit (expense) includes report costs,
personnel costs, allocated overhead, licenses, net commissions, professional
fees and other.
(2) Net ceding commission and other is comprised of ceding commissions received
in connection with reinsurance ceded, partially offset by amortization of excess
ceding commission and other impacts of reinsurance ceded.
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--------------------------------------------------------------------------------Adjusted EBITDA
For the definition of adjusted EBITDA and why management believes this measure provides useful information to investors, see "- Key Performance Indicators." The following table provides a reconciliation of net loss to adjusted EBITDA for the years endedDecember 31, 2022 , 2021 and 2020: Years Ended December 31, 2022 2021 2020 (dollars in millions) Net loss$ (297.7) $ (521.1) $ (363.0) Adjustments: Interest expense 31.9 14.4 69.1 Income tax expense - - - Depreciation and amortization 12.1 16.6 15.6 Share-based compensation 25.2 19.3 3.7 Tender offer - - 25.1 Loss on early extinguishment of debt - 15.9 - Warrant compensation expense 14.5 8.8 - Restructuring costs(1) 18.6 - - Write-off(2) 9.5 - - Adjusted EBITDA$ (185.9) $ (446.1) $ (249.5) ______________ (1) Restructuring costs consist of severance, benefits, related costs and real estate exit costs comprising of accelerated amortization of certain right-of-use assets, leasehold improvements, furniture and fixtures. This includes$5.3 million of share-based compensation for the year endedDecember 31, 2022 . This also includes$1.7 million of depreciation and amortization for the year endedDecember 31, 2022 . For further information on restructuring costs, see Note 10, "Restructuring Costs," in the Notes to Consolidated Financial Statements.
(2) Write-off of prepaid marketing expense and reclassifications of certain
sales and marketing expenses to general and administrative expenses of
Liquidity and Capital Resources
General
Since inception, we have financed operations primarily through sales of insurance policies and the net proceeds we have received from our issuance of stock and debt and from sales of investments. Cash generated from operations is highly dependent on being able to efficiently acquire and maintain customers while pricing our insurance products appropriately. We are continuously evaluating alternatives for efficiently funding our ongoing operations. We expect, from time to time, to engage in a variety of financing transactions for such purposes, including the issuance of securities.
Regulatory Considerations
We are organized as a holding company, but our primary operations are conducted by two of our wholly owned insurance subsidiaries,Root Insurance Company , anOhio -domiciled insurance company, andRoot Property & Casualty Insurance Company , aDelaware -domiciled insurance company. The payment of dividends by our insurance subsidiaries is subject to restrictions set forth in the insurance laws and regulations of the States ofOhio andDelaware . To date, our insurance subsidiaries have not paid any dividends and as ofDecember 31, 2022 , they were not permitted to pay any dividends without approval of the applicable superintendent, commissioner and/or director. 74 -------------------------------------------------------------------------------- If our insurance subsidiaries' business grows, the amount of capital we are required to maintain to satisfy our risk-based capital requirements may increase significantly. To comply with these regulations, we may be required to maintain capital in the insurance subsidiaries that we would otherwise invest in our growth and operations. As ofDecember 31, 2022 , our insurance subsidiaries maintained a risk-based capital level that is in excess of an amount that would require any corrective actions on our part. Our wholly owned,Cayman Islands -based reinsurance subsidiary,Root Reinsurance Company, Ltd. , or Root Re, maintains a Class B(iii) insurer license underCayman Islands Monetary Authority , or CIMA. AtDecember 31, 2022 , Root Re was subject to compliance with certain capital levels and a net earned premium to capital ratio of 15:1, which was maintained as ofDecember 31, 2022 . The capital ratio can fluctuate at Root Re's election, subject to regulatory approval. Root Re's primary sources of funds are capital contributions from the holding company, assumed insurance premiums and net investment income. These funds are primarily used to pay claims and operating expenses and to purchase investments. Root Re must receive approval from CIMA before it can pay any dividend to the holding company. Financing Arrangements InAugust 2022 , a subcommittee of our board of directors approved a reverse stock split of our Class A and Class B common stock at a ratio of 1-for-18, which became effective onAugust 12, 2022 . Accordingly, all stock, equity award, warrant, and per share amounts have been adjusted to reflect the reverse stock split for all prior periods presented. OnJanuary 26, 2022 , we closed on a$300.0 million five-year term loan, or Term Loan. The maturity of this Term Loan isJanuary 27, 2027 . Interest is payable quarterly and is determined on a floating interest rate calculated on the Secured Overnight Financing Rate, or SOFR, with a 1.0% floor, plus 9%, plus 0.26161% per annum. Concurrently with the Term Loan, we also issued to the lender warrants to purchase approximately 0.3 million shares of Class A common stock. Under certain contingent scenarios, the lender may also receive additional warrants to purchase shares of Class A common stock equal to 1.0% of the aggregate number of issued and outstanding shares of our Class A common stock on a fully-diluted basis as of the triggering date. InNovember 2021 , we repaid the outstanding Term Loan B principal balance of$100.0 million and accrued interest, including paid-in-kind, or PIK interest, and fees of$20.9 million . As a result, we recognized a$15.9 million loss on early extinguishment. InOctober 2021 , we consummated the transactions contemplated by the investment agreement with Carvana, or the Investment Agreement, that we entered into onAugust 11, 2021 . We received$126.5 million of gross proceeds from the issuance of 14.1 million shares of redeemable convertible preferred stock designated as the Series A Convertible Preferred Stock. We also issued Carvana eight tranches of warrants to purchase shares of our Class A common stock. In connection with the Investment Agreement, we incurred issuance costs of$19.6 million ,$9.0 million of which are contingent upon the success of the Investment Agreement as measured by achievement of certain warrant vesting milestones.
In
InOctober 2020 , we completed our initial public offering, or IPO, which resulted in the issuance and sale of 1.3 million shares of Class A common stock at the IPO price of$486.00 . Concurrently, we issued and sold 1.0 million shares of our Class A common stock in private placements. We received total net proceeds of$1.1 billion after deducting underwriting discounts and other offering costs.
Liquidity
As ofDecember 31, 2022 , we had$762.1 million in cash and cash equivalents, of which$559.2 million was held outside of regulated insurance entities. We also had$128.8 million in marketable securities. 75 --------------------------------------------------------------------------------
Our cash and cash equivalents primarily consist of bank deposits and money
market funds. Our marketable securities consist of
We believe that our existing cash and cash equivalents, marketable securities and cash flow from operations will be sufficient to support short-term working capital and capital expenditure requirements for at least the next 12 months and the foreseeable future thereafter. Our long-term capital requirements depend on many factors, including our insurance premium growth rate, rate adequacy, renewal activity, the timing and the amount of cash received from customers, the performance of our products, including the success of our embedded partnerships, loss cost trends, the timing and extent of spending to support development efforts, the introduction of new and enhanced products, the continuing market adoption of offerings on our platform, operating costs, and the ongoing uncertainty in the global markets resulting from the global COVID-19 pandemic. In the first quarter 2022, in response to inflation and loss cost trends and to further drive efficiency and increased focus on our strategic priorities we instituted an organizational realignment, including an involuntary workforce reduction affecting approximately 330 employees, which represented approximately 20% of our workforce at the time. During the fourth quarter 2022, we initiated a company-wide involuntary workforce reduction affecting approximately 160 employees, which represented approximately 20% of our workforce at the time. The action taken as part of our efforts to improve efficiency and operating costs, and prioritize resources to further strengthen our pricing and underwriting foundation and the continued development of our embedded products. In 2023, we expect to incur approximately$6.6 million of employee compensation expense, dependent upon continuous employment for certain employees, to be recognized ratably through the fourth quarter of 2023. We expect a cash expenditure related to these employee compensation costs in the first quarter of 2024. For additional information regarding organizational realignment and involuntary workforce reductions refer to Note 10, "Restructuring Costs," in the Notes to Consolidated Financial Statements. Currently, our debt covenants require cash and cash equivalents held in entities other than our insurance subsidiaries to be at least$200.0 million at all times. This threshold may be reduced to$150.0 million under two sets of circumstances: issuing 62,500 insurance policies through our Carvana embedded product and achieving a ratio of direct contribution to gross premiums earned of 12%; or ceasing any customer acquisition spend outside of the Carvana commercial agreement and reducing our monthly cash burn to no greater than$12.0 million .
Through prudent deployment of capital we believe we have sufficient resources, and access to additional debt and equity capital, to adequately meet our obligations as they come due.
Cash Flows
The following table summarizes our cash flow data for the periods presented:
Years Ended December 31,
2022 2021 2020
(in millions)
Net cash used in operating activities $ (210.6) $ (403.4) $ (287.2)
Net cash (used in) provided by investing activities (16.6) 76.9 (114.1)
Net cash provided by (used in) financing activities 283.3 (80.3) 1,098.5
Comparison of Years Ended
Net cash used in operating activities for the year endedDecember 31, 2022 was$210.6 million compared to$403.4 million of net cash used in operating activities for the year endedDecember 31, 2021 . The decrease in cash used in operating activities was due to a decline in net loss incurred primarily as a result of a reduction in sales and marketing expense due to a shift in direct marketing strategy in response to changing macroeconomic factors and competitive environment and lower payroll, employee-related expenditures and facility costs due to an organizational realignment and involuntary workforce reductions. In addition, timing of premium receipts, timing of 76 -------------------------------------------------------------------------------- cash receipts and payments related to reinsurance activity, and claims payments contributed to the decrease in cash used in operating activities during the year endedDecember 31, 2022 compared to the prior year. Net cash used in investing activities for the year endedDecember 31, 2022 was$16.6 million , primarily due to purchases of investments, capitalization of internally developed software, and purchases of indefinite-lived intangible assets, partially offset by proceeds from maturities, calls and pay downs, and sales of investments. Net cash provided by investing activities for the year endedDecember 31, 2021 was$76.9 million , primarily due to proceeds from sales, maturities, calls and pay downs of investments, partially offset by purchases of investments and other debt obligations. Net cash provided by financing activities for the year endedDecember 31, 2022 was$283.3 million , primarily due to proceeds from our Term Loan. Net cash used in financing activities for the year endedDecember 31, 2021 was$80.3 million , primarily due to the pay down of debt and payment of preferred stock and related warrants issuance costs, partially offset by proceeds from the issuance of preferred stock and related warrants in connection with our partnership with Carvana.
Comparison of Years Ended
The
Material Cash Requirements from Contractual and Other Obligations
As ofDecember 31, 2022 , our material cash requirements from known contractual and other obligations consisted of purchase commitments, as discussed in Note 13, "Commitments and Contingencies,", operating leases, as discussed in Note 8, "Leases," and a Term Loan, as discussed in Note 7, "Long-Term Debt," in the Notes to Consolidated Financial Statements. We believe we have sufficient resources, and access to additional debt and equity capital, to adequately meet our obligations as they come due. d
Critical Accounting Estimates
Our financial statements are prepared in accordance with GAAP. The preparation of the consolidated financial statements in conformity with GAAP requires our management to make a number of estimates and assumptions relating to the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the period. We evaluate our significant estimates on an ongoing basis, including, but not limited to, estimates related to reserves for loss and LAE, premium write-offs, and valuation allowance on our deferred tax assets. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates. We believe that the accounting estimates described below involve a significant degree of judgment and complexity. Accordingly, we believe these are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of operations. For further information, see Note 2, "Basis of Presentation and Summary of Significant Accounting Policies," in the Notes to Consolidated Financial Statements.
Loss and LAE Reserves
Loss and LAE reserves represent management's best estimate of the ultimate
liability for all reported and unreported claims that occurred prior to the end
of each accounting period but have not yet been paid. These reserves are
established to cover the estimated ultimate cost to settle insured losses. Loss
and LAE reserves include an amount determined using adjuster determined
case-base estimates for reported claims and on actuarial unpaid claim estimates
using past experience and historical emergence patterns for unreported loss and
LAE. Case reserve amounts are determined by claims adjusters following our case
reserving practices, which consider the circumstances presented with each
claimant, applicable policy provisions, and state law. The unpaid claim
estimates consider loss cost trends, mix of business, and other risk factors
impacting claims settlement. The methods used to
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estimate ultimate loss reserves by accident month include reported loss
development, paid loss development, expected loss ratio, or ELR,
frequency-severity, premium based Bornhuetter/Ferguson, or B/F, and exposure
based B/F using frequency-severity. The method used to estimate unpaid LAE
reserves is determined by a transaction-based allocation method where historical
claim department activities are measured by their relative effort or cost for
handling different claim types. Our estimation for unpaid LAE reserves includes
the ultimate cost of settling a range of claim types from express material
damage claims to more complex bodily injury cases.
The evaluation and estimation of ultimate losses and LAE requires considerable
judgment in understanding how claims mature, how claims differ between lines of
business, and how changes in the business impact claims settlement over time.
Loss reserves represent a liability estimate at a given point in time based on
many input variables including historical and statistical information,
inflation, contract interpretation, weather catastrophe impacts, regulatory
environment, and economic conditions. While we consider many inputs into the
loss reserve valuation process, as well as several actuarial methodologies,
there is no single method for determining the exact ultimate claims liability.
In many cases, we use multiple estimation methods based on the particular facts
and circumstances of the claims and liabilities being evaluated, resulting in a
range of reasonable estimates for reserves for losses and LAE. We do not
discount reserves.
Our actuarial reserving team performs monthly reviews of the claims experience
and loss emergence to support our estimation of ultimate losses and LAE. A few
considerations and assumptions in estimating ultimate claim liabilities includes
relative case reserve adequacy over time, claims cycle time, claims settlement
practices, exposure growth, actuarial projections, current economic conditions,
driving patterns observed from telematics, weather catastrophes, and claim
litigation. Our loss reserves can be grouped by claim type, where amounts
related to material damage of vehicles and property tend to settle within six to
12 months, while claims that involve injuries or personal liability have a much
longer time period between the occurrence of a loss and the settlement of the
claim. In general, the longer the time span between the incidence of a loss and
the settlement of the claim, the more the ultimate settlement amount can vary.
Because actual experience can differ from key assumptions used in establishing
reserves, there is potential for significant variation in the development of
loss reserves. There is considerable uncertainty associated with the actuarial
estimates, and therefore the actual losses and LAE paid in the future may differ
materially from the reserves we have recorded. Our loss estimates are
continually reviewed by management and adjusted as necessary; with adjustments
included in the period determined.
The key assumptions that materially affect the estimate of the reserves for loss and LAE are as follows:
•Many of the actuarial estimation methods assume that the speed of claim payments and claim closures, also known as cycle time, remains relatively consistent over time. While fluctuations and improvements in cycle time are expected as we grow, these timing changes can be difficult to discern from normal process risk variability in the data.
•For actuarial methods that rely on case reserve data, there is an implicit assumption that the adequacy of case reserve estimates stays relatively constant over time. For example, if the held case reserves represent the 50th percentile outcome for each claim, then any changes to this case reserve level, either higher or lower, would impact the ultimate loss estimates. •Actuarial methods that rely on exposure bases, such as premiums or car years, perform better when the mix of business is relatively stable over time. Business growth can change the mix of business across several dimensions: new business versus renewal, geography profile, and underwriting profile. As such, prior estimates of claim frequency, claim severity, or loss ratio may not be as predictive of future results when the mix of business changes.
•Broader macro level economics can have a material impact on loss reserve estimates, such as a rapid change in miles driven, unanticipated inflation, regulatory restrictions, and legal developments as they relate to contract and coverage interpretation and enforceability.
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Due to the inherent uncertainty in determining our ultimate cost of settling
claims, we evaluate what the potential impact on consolidated results of
operations, financial position, and liquidity would be based on a hypothetical
5% and 10% increase or decrease in key assumptions described above. The loss
reserve range noted below represents a range of reasonably likely reserves, not
a range of all possible reserves. Therefore, the ultimate losses could reach
levels corresponding to reserve amounts outside of the range provided. Given our
growth from inception in 2015, we believe evaluating sensitivity based on a
hypothetical increase or decrease of 5% and 10% is reflective of management's
best estimate and provides an illustrative range of variability in key
assumptions. The below tables present this sensitivity analysis:
Scenarios for Changes in Bodily Injury Claim Severity for all Accident Years
(10)% (5)% -% 5% 10%
Bodily injury liability $ 100.3 $ 105.9 $ 111.4 $ 117.0 $ 122.6
Uninsured and underinsured
bodily injury 25.0 26.4 27.8 29.2 30.5
All other coverages 36.1 36.1 36.1 36.1 36.1
Total losses-net of reinsurance
Our loss and LAE reserves are recorded net of external reinsurance and net of amounts expected to be received from salvage (the amount recovered from the damaged property after the we pay for a total loss) and subrogation (the right to recover payments from third parties).
Premium Revenue, Fee Income and Related Expenses
Premiums written are deferred and earned pro rata over the policy period. Unearned premium is established to cover the unexpired portion of premiums written. A premium deficiency, as measured on a gross basis, is recorded when the sum of expected losses, LAE, unamortized acquisition costs and maintenance costs exceed the recorded unearned premium reserve and anticipated investment income. A premium deficiency reserve is recognized as a reduction of deferred acquisition costs and, if necessary, by accruing an additional liability for the deficiency, with a corresponding charge to operations. We did not record a premium deficiency reserve in 2022 or 2021. InAugust 2021 , we commenced a fronting arrangement with an unaffiliated Texas county mutual insurance company, or the fronting carrier. We route all of our new auto policies and, over time, expect to route certain renewal auto policies, inTexas through the fronting carrier whereby we assume 100% of the related premium and losses on those policies. The fronting arrangement allows us to have greater rating and underwriting flexibility. Premiums assumed are deferred and earned pro rata over the policy period. Unearned premium is established to cover the unexpired portion of premiums assumed. Through this fronting arrangement, we have greater rating and underwriting flexibility that we believe will allow us to more accurately segment risk inTexas to improve profitability. Premiums receivable represents premiums written but not yet collected. Generally, premiums are collected prior to providing risk coverage, minimizing our exposure to credit risk. Due to a variety of factors, certain premiums billed may not be collected, for which we establish an allowance for doubtful accounts based primarily on an analysis of historical collection experience, adjusted for current economic conditions. Allowance for credit losses was$2.8 million and$5.4 million as ofDecember 31, 2022 and 2021, respectively, on the consolidated balance sheets. A policy is generally considered past due on the first day after its due date and policies greater than 90 days past due are written-off. We recognized premium write-offs, or bad debt expense, of$17.4 million ,$20.9 million and$23.6 million for the years endedDecember 31, 2022 , 2021 and 2020 respectively. For those policyholderswho pay premiums on an installment basis, we charge a flat fee for each installment related to the additional administrative costs associated with processing more frequent billings. We recognize this fee income in the period which we process each installment. Policy acquisition costs, which consists of premium taxes, certain marketing costs and underwriting expenses, and certain commissions, net of ceding commissions, related to the successful acquisition of new or renewal business, are deferred and amortized over the same period in which the related premiums are earned. Ceding 79 -------------------------------------------------------------------------------- commissions relating to reinsurance agreements are recorded as a reimbursement for both deferrable and non-deferrable acquisition costs. The portion of the ceding commission that is equal to the pro rata share of acquisition costs based on quota share percentage is recorded as an offset to the gross deferred acquisition costs. Any portion of the ceding commission that exceeds the acquisition costs of the business ceded is recorded as excess ceding commission, a deferred liability, and amortized over the same period in which the related premiums are earned. Reinsurance In the ordinary course of business, we cede and retrocede a portion of our business written and assumed, respectively, to reinsurers to limit the maximum net loss potential arising from large risks and catastrophes. These arrangements, known as treaties, provide for reinsurance coverage on quota-share and excess-of-loss basis. All reinsurance contracts provide for indemnification against loss or liability relating to insurance risk and have been accounted for as reinsurance. Although the ceding of reinsurance does not discharge us from our primary liability to the policyholder, the insurance company that assumes the coverage assumes the related liability. Amounts recoverable from and payable to reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured business. Reinsurance premiums, commissions and expense reimbursements related to reinsured business are accounted for on a basis consistent with the basis used in accounting for the original policies issued and the terms of the reinsurance contracts. Premiums ceded to other companies have been reported as a reduction of premiums earned and are recognized over the remaining policy period based on the reinsurance protection provided. Amounts applicable to reinsurance ceded for unearned premium reserves are reported as a prepaid reinsurance premiums asset in the accompanying consolidated balance sheets and as a reduction of unearned premiums in Note 6, "Reinsurance," in the Notes to Consolidated Financial Statements. Ceding commissions earned in connection with reinsurance ceded have been accounted for as a reduction of other insurance (benefit) expense in the consolidated statements of operations and comprehensive loss. Some of our reinsurance agreements provide for amount of coverage based on loss experience referred to as loss corridors and loss ratio caps. We recognize the asset or liability arising from these adjustable features in the period the adjustment occurs, which is calculated based on experience to-date under the agreement. In the event that all or any of the reinsuring companies might be unable to meet their obligations under existing reinsurance agreements, we would be liable for such defaulted amounts. We evaluate and monitor the financial condition associated with our reinsurers in order to minimize our exposure to significant losses from reinsurer insolvencies. We obtain reinsurance from a diverse group of global reinsurers and monitor concentration as well as financial strength ratings of the reinsurers to minimize counterparty credit risk. For our reinsurance partnerswho are not rated, we require adequate levels of collateral or letters of credit to be available to us in the event of downside scenarios. To recognize this risk of credit loss, we have established an allowance for credit losses based on the probability of default and the expected loss given default as influenced by factors such as the reinsurer's credit rating and average life of our reinsurance recoverables. Allowance for credit losses was$0.2 million as ofDecember 31, 2022 and 2021.
Recoverability of Net Deferred Tax Assets
We calculate the tax effects of temporary differences that give rise to deferred
tax assets and deferred tax liabilities in accordance with Accounting Standards
Codification 740, Income Taxes, or ASC 740. The application of ASC 740 requires
a company to evaluate the recoverability of deferred tax assets and to establish
a valuation allowance if necessary to reduce the carrying value of the deferred
tax asset to an amount that is more likely than not to be realized. Considerable
judgment is required in determining whether a valuation allowance is necessary
and, if so, the amount of such valuation allowance. In evaluating the need for a
valuation allowance we consider many factors, including: (1) the nature of the
deferred tax assets and liabilities; (2) whether they are ordinary or capital;
(3) the timing of expected reversal; (4) taxable income in prior carry back
years as well as projected taxable earnings exclusive of reversing temporary
differences and carry forwards; (5) the length of time that carryovers can be
used; (6) unique tax rules that would impact the utilization of the deferred tax
assets; and (7) any tax planning strategies that we would employ to avoid a tax
benefit expiring unused.
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We may be unable to fully use our net operating losses, or NOLs, if at all. Under Section 382 of the Internal Revenue Code, or the Code, if a corporation undergoes an "ownership change" (generally defined as a greater than 50% change, by value, in the corporation's equity ownership by certain shareholders or groups of shareholders over a rolling three-year period), the corporation's ability to use its pre-ownership change NOLs to offset its post-ownership change income may be limited. The limitation may be such that it prevents the Company from fully utilizing its NOLs existing at the time of the ownership change prior to their expiration, which could also result in a substantial reduction in the deferred tax asset. We currently carry a valuation allowance against our entire net deferred tax asset. As such, any reduction in the deferred tax asset would also result in an offsetting reduction in the valuation allowance. We have experienced an ownership change. In connection with this ownership change, we do not expect that the limitation under Section 382 of the Code will result in any material reduction in our ability to use pre-ownership change NOLs in the future nor require a reduction in the associated deferred tax asset (or adjustment to the valuation allowance). We may still experience additional ownership changes in the future as a result of subsequent shifts in ownership, which could result in additional limitations on our NOL usage.
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