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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 that 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 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 profits shall continue to be 5 per cent 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 per cent share by total life insurance premium, it grew at just 9 per cent CAGR from FY16 to FY21 when private insurers grew at 18 per cent. 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.
|Components of Insured’s Estimated Value||March 31, 2021||September 30, 2021|
|B||Total Adjusted Net Worth||6,361||8,203|
Present Value of Future Profits
|D||Time value of Future Options and guarantees||(1,596)||(1,208)|
|E||Frictional cost of required capital||(149)||(656)|
|F||Cost of residual non-hedgeable risks||(13,782)||(13,645)|
Value in Force Business (C+D+E+F)
|H||Indian Embedded Value (B+G)||95,605||539,686|
Figures in Rs cr; Source: LIC DRHP
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First Published: Wed, February 16 2022. 17:26 IST