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Artificial Intelligence (AI) is all the rage these days, promising to revolutionize industries and transform how businesses operate. Since OpenAI released Chat GPT in November 2022, interest in companies using AI has exploded.

One sector where AI is making waves is finance. Companies are harnessing AI's power to reshape traditional finance and disrupt industries ranging from consumer finance to insurance. Upstart Holdings (UPST -2.04%) and Lemonade (LMND -0.21%) are all building and improving their AI algorithms to gain a competitive advantage. In this article, we'll explore how these companies leverage AI and whether it makes them solid additions to your portfolio.

Upstart Holdings is on a mission to fix the consumer lending business, which it says shuts out countless individuals because of inadequate risk models. The company argues that Fair Isaac's traditional FICO scoring system is inherently flawed because it only considers a few variables, making it harder for people to obtain personal loans.

Upstart weighs about 1,500 data points which it then runs through its homegrown AI-powered risk model to assess the risk a borrower has of defaulting.It looks to create a flywheel effect, a concept popularized by Jim Collins in his book Good to Great, where gradual improvements to its model lead to higher approval rates and lower interest rates -- creating a win-win scenario for its lending partners and borrowers.

Image source: Getty Images.

Management at Upstart has argued that its scoring model separates high-risk and low-risk borrowers more precisely than the traditional FICO scoring model. The models have come under pressure over the past year, and borrowers it deemed lower risk under its model have seen an uptick in defaults.

Much of this is because Upstart's data before last year was in a lower interest rate environment. However, Upstart should be able to continue refining its model with the insights it gains from its loans made in today's higher interest rate environment.

Last year it faced pressure as its banking partners reduced the amount of funding they provided it, leading the company to have to hold more loans on its books than expected. It alleviated these concerns when it announced that global alternative investment manager Castlelake committed to funding $4 billion of its loans.

Upstart has had an up-and-down journey since going public in December 2020, plunging at one point 97% from its all-time high in late 2021. The stock has had a strong run this year, though, and is up about 120%. Even so, the stock trades at a price-to-sales ratio of about 4 -- still far below its peak of 48.4.

Upstart has done a solid job of growing its lending platform by expanding its offerings to other segments. Because the stock has soared this year, so buying today could be a little riskier -- but the long-term investment thesis remains solid, especially as it continues refining its AI lending model.

Lemonade looks to revolutionize insurance by leveraging AI to handle everything from underwriting to getting quotes and resolving insurance claims.

The company makes AI a core component of its business. Its AI Maya chatbot helps customers get insurance policies by asking 13 simple questions. Then it aggregates 1,700 data points based on their answers and interaction with its website. From here, it can instantly provide personalized insurance quotes, dramatically reducing customer onboarding time. Its AI Jim chatbot can handle up to one-third of all customer insurance claims while forwarding more complex claims to human experts.

Lemonade has done a solid job leveraging AI to expand its product offerings and grow its business quickly. Over the last three years, the company has expanded its customer base by 154% while its in-force premium, or the annual premium amount of its policies written, has risen by 390%.

While its customer base has multiplied as it expanded into homeowners, pet, life, and auto insurance, the company still must improve its policies' loss ratio. In the first quarter, its net loss ratio (the ratio of losses and loss adjustment expenses less amount ceded to reinsurers to the net earned premiums) of 93% was an improvement from the two quarters that preceded it. However, the company still has work to get this ratio down to management's long-term target of 75%.

Image source: Lemonade.

Lemonade still needs to dial in its AI models to deliver consistent net income, which is why I haven't bought into the stock yet. Ultimately I want to see if the company can continue to improve its ratios as it incorporates more data into its AI model, which would ultimately make the stock a more appealing long-term buy for me.

Courtney Carlsen has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Lemonade and Upstart. The Motley Fool recommends Fair Isaac. The Motley Fool has a disclosure policy.

Excerpt from:
Artificial Intelligence Meets Finance: These 2 Fintechs Are Shaping ... - The Motley Fool