How they calculated LIC's Rs 5 trillion plus embedded value

My two observation pieces on LIC--both these versions appeared in Business Standard newspaper earlier as https://mybs.in/2atEn9b & https://mybs.in/2atELZ4 Both are necessary readings to appreciate the scale of India's largest public issue.

One:

When you buy an insurance cover for your car each year, the agent asks a question—what do you think is the value of the car! In insurance jargon it is the insured’s estimated value or IEV.

It is this same question which LIC has been asked and which forms the basis of its share sale. What is the IEV of LIC! It has been reckoned upwards of Rs 5 trillion.?

To reach that number, the government of India has offered a change in how the largest life insurer distributes the?surplus?it receives from its business between the policy holder and the shareholder. To understand the nature of the changes, we need to do a deep dive into the insurance business. But we promise to keep it easy.

Till March 31, 2021, LIC had a single profit basket into which it transferred 5 per cent of all the premium it earned, i.e. it was a single?life?fund. This basket is built based on the assumption that of every 100 rupees a policyholder pays to LIC, Rs 5 shall be considered a profit and kept aside accordingly. The rest is kept to pay out insurance claims to the policy holders.

Budget FY21 wrote in a provision under which this treatment had to be changed (see box). The LIC profit basket was split into two, based on the nature of the policy people bought from it.

Other than ULIPs which are market linked policies, LIC and other life insurance companies sell two types of policies. These policies are classified based on the nature of benefits the insured wants. If she wants a policy where she wants a fixed annual payout as profit, those are known as “non-participatory” policies. If she is adventurous, she can decide to keep her payouts linked to the performance of the company in terms of the profit it earns every year. These latter are known as participatory policies. For both types of policies, the pay outs are made from the profit basket of LIC.

Not surprisingly life insurance agents prefer their customers to buy participatory policies as it reduces the scale of fixed liability for the life insurance companies. Surprisingly, however, people without realising this challenge, buy more of participatory policies too.

LIC’s valuers for the IPO, Milliman Advisors expects that in future, people will be more savvy and decide to instead buy non-participatory policies. This seems a wise assumption, since LIC’s competitors have also made the same discovery. For the top life insurance companies, non-participatory policies account for almost 82 per cent of their business. But LIC has a market share of just 39 per cent of the new business premium in this line of business (page 124).

The change brought in by Budget FY21 is as follows. LIC has to maintain two profit baskets from this financial year, FY22.?In the case of participatory policies the treatment of?(surplus or)?profits shall continue to be 5 percent of the total?surplus pay in, rising to 10?per cent by 2025. In the case of non-participatory policies, the shareholder claims shall rise to 100 per cent. The reasons are clear, since the dues to the policy holders can be estimated accurately, any accrual after making allowance for those payout is a profit for the company and therefore belongs entirely to the shareholders.

The change has had a profound impact on the IEV of LIC. The report by Milliman Advisors to the department?of disinvestment and asset management notes “The increase IEV is due to the shareholders’ interest in the non-participatory funds increasing to 100% following the decision of the Board of Directors of the Corporation on 8 January, 2022 for the bifurcation of the single policyholders fund into participating and non-participating funds”.?(page 584 of DRHP)

How sizable is the impact? By the earlier yardstick, the present value of the future profits was Rs 1.05 trillion as on March 31, 2021. Applying the new yardstick it rises five times to Rs 5.5 trillion as on September, 30, 2021. Making allowances for future options and guarantees, hedging risks and others, the LIC?management can claim that their IEV is Rs 5.39 trillion. In other words this is the embedded value of LIC, which has been used to calculate all the ratios for the company, like earnings per share and therefore the price of the forthcoming issue.

The valuer is making the assumption that LIC will pivot towards non-participating policies, as it indeed is trying to do. So there shall be more accrual to the second basket where shareholder interest shall be 100 per cent.

They have also been very careful to subject these numbers to various shocks. These include impact on the assets backing the statutory liabilities, provisions for solvency margin and non-participating global reserves residing in the non-participating funds, hardening of the interest rates, increase in mortality rates, climate risks and so on. But the biggest of those is that while LIC holds a 64 percent share by total life insurance premium, it grew at just 9 percent CAGR from FY16 to FY21 when private insurers grew at 18 percent. in the same period. The valuation model assumes LIC will grow at a much healthier pace. The embedded value of the company is subject to these assumptions.

Note: Finance Act, 2021 amended the LIC Act, 1956, with a requirement for the insurer to establish separate funds for participating business and non-participating business, as well as a shareholders’ fund. The Finance Act also amended the relevant provisions of the Act?covering the distribution of surplus arising between policyholders and shareholders. As per the Finance Act, the maximum share of distributed surplus that is payable to shareholders is 10% for participating business and 100% for non-participating (including unit-linked) business.?

Two:

The risks emerging for LIC, from which the government plans to sell 5 per cent of its stake, are that its strengths do not address the expanding opportunities in the Indian insurance sector. The brand LIC may have been recognised as the third strongest and the 10th most valuable global insurance brand in 2021 by Brand Finance but millennials, the biggest buyers of insurance, are looking elsewhere. A reading of the draft red herring prospectus (DRHP) of India’s largest life insurance company with a market share of 64.1 per cent gross written premium—GWP) is therefore somewhat worrying.?

"The IPO-bound state-owned insurer appears to be ill-equipped to handle the new dynamics of the insurance market"

?LIC is a vast employer of agents—1.34 million -- and is the largest asset manager in India with Rs 36.8 trillion as of March 31, 2021. The management bandwidth needed to administer this vast network is impinging on LIC’s core business of selling life insurance cover profitably. Of every individual life cover sold in India in the past five years recent LIC accounted for only 50 per cent from 56 per cent in 2016.?Even among the products sold, it is the single-premium policies where LIC is the boss. In other words, those who pay premiums annually prefer the private sector companies who offer easy to use digital channels.?

?Given the hugely asymmetric shape of the Indian life insurance business, LIC needs to grow fast to offer more insurance cover to the expanding Indian middle class. But it is the companies next in line that are reading the growth story better, as the DRHP itself points out. This will not help, however, since the LIC straddles the Indian market as a giant. Nowhere in the top seven markets globally is the difference in market share between the largest and the second largest life insurer as stark as in India. SBI Life has a GWP of 8 per cent, Bajaj Allianz and HDFC Life come even lower.?(see table 1)?

?LIC identifies the problems well in its DRHP but what the markets will watch is how nimble it is with the solutions. As of now the indications are not encouraging. For instance, since the company was busy restructuring itself for the IPO it was unable to respond to a mandatory order from the insurance regulator during the Covid crisis to furnish a business continuity plan to manage processes, transactions, reporting and customer services. LIC was the only large life insurer not to respond. The lesson is clear. The company has problems pivoting rapidly to respond to crises or opportunities.?

Of LIC’s huge agency population, bigger than the combined agency force of all other life insurers, only two thirds had sold even one policy in FY21. Of course, it was a Covid-wracked year, but the problems are not short term. A Crisil research report commissioned for the DRHP notes, LIC’s average ticket size for new business policies was Rs 26,892 in FY21. The median number for its top five competitors was more than three times larger at Rs 96,619. LIC depends on its agents to sell 94 per cent of its policies and to keep them interested it can only touch the digital opportunities sparingly. Despite the army of agents, LIC’s share of new business premium from individuals has slipped below 50 per cent in FY21 and for the half year of FY22 it is just 44 per cent. And those customers are not sticking long term with it. The persistency ratio, a measure of how long individuals hold on to an insurance policy, shows SBI Life as the industry leader, followed by ICICI Prudential. LIC is in third position.

Yet the company continues to keep faith with its agent channel for securing business. In the DRHP it argues that only individual agents can establish a personal connection with the customers. “They can provide hand holding to these customers, make them understand the various advantages of the policies and differences amongst various products…it becomes important for insurers to have trained individual agents to assist customers while selecting any policy”. It makes most money from the group premium business where it accounts for 81 per cent of the market and agents hardly count. The result is between FY16 and FY21 while private insurers business grew at an 18 per cent CAGR, LIC grew at half the rate, at 9 per cent.

Post listing, LIC will also have to turn attention to milking its assets well. For comparison LIC’s total assets (debt plus equity) as of September 30, 2021 is more than 3.3 times higher than the total of all private life insurers in India. The next largest company, SBI Life, has assets under management of Rs 2.4 trillion. LIC’s total investments in listed equity had a market value of approximately Rs 8 trillion, which represented around 4 per cent of the total market capitalisation of the National Stock Exchange as on March 31, 2021.?But these shareholdings are the result of?the government’s penchant for treating LIC as a prop for falling markets, a practice that will need to be pared down once the state insurer is listed.?

But despite those mammoth sizes, LIC’s net worth for the half year ended September 2022 at Rs 78.2 billion ranks it only fifth in the league of insurers (see table 2). The relative differences will make the company less attractive to investors. Irdai rules also say of the surplus generated by an insurer they have to allocate approximately 10 per cent to shareholders’ account. The other five in the list did so, but LIC has transferred only 5 per cent to the shareholder’s account in FY21.?If it had done more, the net worth would have eroded further. There are some other key ratios like value of new business margin that analysts use to understand the industry, which cannot be calculated for LIC because it has just been reorganised. Those available, like solvency ratio, puts LIC in the back bench among the top six.

Despite those caveats, it would be too much to say that LIC is in trouble. There is no doubt, however, the IPO has come at just the right time for it to take some very hard decisions on its business plans.