If you're looking for a stock that has absolutely crushed it, look no further than Root (NASDAQ: ROOT). Over the past year, the upstart insurance company has shot up over 1,250%.
The company's surge began a few months ago, when it surprised investors with its stellar growth and impressive turnaround in profitability. Here's the story behind Root's most recent success and what investors should watch for from here.
Root's ambitious automotive insurance goal
Founded less than a decade ago, Root Insurance looks to disrupt the $300 billion automotive insurance industry. The company believes that traditional insurers do a poor job of pricing policies based on the individual. It seeks to use technology to measure risk and provide its customers with the best rates possible based on their personal habits.
The company uses driving performance data to model risk and price policies. This technology, known as telematics, has been around for a while, with Progressive leading the way over two decades ago.
Root sees modern technology, people's smartphones, as a way to deploy its technology on a large scale. The company uses driver behavior, mileage driven, and actual claims filed to identify factors more likely to cause accidents. Its risk-scoring models allow it to identify some of the riskiest drivers on the road and only insure those with responsible driving habits.
It's been a difficult journey for the insurer
Root hasn't been around all that long. Consider that many of the industry old-timers have been writing insurance policies for decades. The company was founded in 2015, went public through an initial public offering (IPO) in 2020, and has faced a steep uphill battle to catch up to its competitors.
It's been a challenge. One of the hardest parts of breaking into the insurance industry is the data disadvantage. Many of the largest automotive insurers in the U.S. have been in business for nearly a century and have built up tremendous knowledge and data over that time. As a new entrant in the space, it takes time to build up that knowledge and tweak the algorithms so that you effectively balance risk to underwrite profitable policies consistently.
Chart by author.
In the past couple of years, Root has scaled back its growth to dial in its pricing models better. From the fourth quarter of 2021 to the first quarter of 2023, its policies in force fell by 44%, while gross written premiums declined by 15%.
Root is dialing in its underwriting model
In the last year, Root's policies in force and gross written premiums have grown by 100% and 246%, respectively. This staggering growth rate has happened while the company has drastically improved its underwriting profitability, as measured by the combined ratio.
The combined ratio takes the sum of incurred losses on policies and expenses by the premiums earned. The industry average combined ratio is around 100%, and profitable insurers achieve a ratio of around 5% to 10% below this consistently.
In 2022, Root's quarterly net combined ratio rose above 200%, meaning the company was losing twice as much on the policies as it was taking in. This measure has gradually improved for several quarters in a row. In the first quarter, the company's net combined ratio came down to 102% -- a very impressive turnaround over two years.
Chart by author.
Root has benefited from a favorable pricing environment
Root has done an excellent job of refining its pricing models and is inching closer to achieving an underwriting profit. Its impressive progress is a big reason why the stock has surged nearly 1,000% in a few short months. However, investors should take a cautious approach to the emerging insurer.
While its underwriting has improved, it still hasn't turned a profit. Not only that, but the company has likely benefited from a favorable pricing environment for insurers over the past few quarters.
Rising repair and replacement costs weighed on auto insurers last year, as the industry experienced its worst loss ratio in two decades. In response, insurers raised their premiums across the board to cover costs, and profits at industry giants like Progressive and Allstate have soared in recent quarters.
According to the credit ratings company Fitch Ratings, the favorable pricing environment will likely continue "but taper off in 2024."
A stock to watch
Root's story is one that I will keep a close eye on going forward. The company is growing at an impressive pace while perfecting its behavioral driving model, dramatically improving its profitability.
However, it is still in the early stages of its growth story, and I want to see the company prove that it can consistently underwrite profitable policies across different pricing environments while growing its customer base. For that reason, I'd keep the stock on a watchlist, but wouldn't buy it quite yet.
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Courtney Carlsen has positions in Allstate and Progressive. The Motley Fool recommends Progressive. The Motley Fool has a disclosure policy.
