LIC IPO – How To Calculate Embedded Value

LIC IPO – How To Calculate Embedded Value

GOI has finalised the price range and the stake it looks to offload to the public for LIC IPO. Despite the reduced valuation and the lot size, LIC IPO is the largest in the Indian public equities market history. Although there are mixed opinions regarding the attractiveness of the subscription price, i observe analysts primarily pricing LIC with the #embeddedValue multiple.

Insurance companies work differently when valuing other industries by assessing the present value of the future expected cash flows. The success factor of an insurance company is determined by 𝐡𝐨𝐰 𝐢𝐭 𝐩𝐫𝐢𝐜𝐞𝐬 𝐫𝐢𝐬𝐤 because people buy insurance to protect against future risks. Thus, the insurance company’s policy premium should be adequate to cover future policyholder claims and early surrender of the policies. Further, insurance companies need to adhere to the regulatory norms by parking a surplus capital in reserves to cover the case of high claims due to discrete risks like COVID, earthquakes, or cyclones.

The embedded value determines this measure and is the sum of the present value of future profits of existing policies and the value of the surplus free capital. Therefore, analysts/investors who intend to invest in LIC or any insurance company need to understand how to calculate the embedded value. This amount will eventually get distributed to the shareholders.

𝐄𝐦𝐛𝐞𝐝𝐝𝐞𝐝 𝐯𝐚𝐥𝐮𝐞 = 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐒𝐮𝐫𝐩𝐥𝐮𝐬 𝐟𝐫𝐞𝐞 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 + 𝐏𝐕 (𝐏𝐫𝐨𝐟𝐢𝐭𝐬 𝐭𝐨 𝐒𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬) where

𝐏𝐕 (𝐏𝐫𝐨𝐟𝐢𝐭𝐬 𝐭𝐨 𝐒𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬) = 𝐏𝐕( 𝐀𝐟𝐭𝐞𝐫-𝐭𝐚𝐱 𝐩𝐫𝐨𝐟𝐢𝐭𝐬 + 𝐀𝐟𝐭𝐞𝐫-𝐭𝐚𝐱 𝐢𝐧𝐜𝐨𝐦𝐞 𝐨𝐧 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 – 𝐈𝐧𝐜𝐫𝐞𝐚𝐬𝐞 𝐢𝐧 𝐜𝐚𝐩𝐢𝐭𝐚𝐥)

After-tax profits = Premiums collected + Investment Income (𝐶𝑢𝑠𝑡𝑜𝑚𝑒𝑟 𝑝𝑟𝑒𝑚𝑖𝑢𝑚𝑠 𝑔𝑒𝑡 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑖𝑛 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠) – Claims accrued – operational expenses – increase in actuarial reserve – Taxes

Discount rate/Hurdle rate = expected rate of return for an equity investor and is higher than the interest rate.

PV (Increase in the capital) = PV (Hurdle rate * Capital) – Locked in Capital where

Locked-in capital is the capital that the insurer has to pay.

𝐂𝐚𝐥𝐜𝐮𝐥𝐚𝐭𝐢𝐧𝐠 𝐞𝐦𝐛𝐞𝐝𝐝𝐞𝐝 𝐯𝐚𝐥𝐮𝐞 𝐢𝐬 𝐚 𝐜𝐨𝐦𝐩𝐥𝐞𝐱 𝐭𝐚𝐬𝐤, 𝐞𝐬𝐩𝐞𝐜𝐢𝐚𝐥𝐥𝐲 𝐟𝐨𝐫 𝐚 𝐜𝐨𝐦𝐩𝐚𝐧𝐲 𝐥𝐢𝐤𝐞 𝐋𝐈𝐂, 𝐰𝐢𝐭𝐡 𝐦𝐚𝐧𝐲 𝐩𝐨𝐥𝐢𝐜𝐢𝐞𝐬 𝐰𝐢𝐭𝐡 𝐯𝐚𝐫𝐲𝐢𝐧𝐠 𝐦𝐚𝐭𝐮𝐫𝐢𝐭𝐢𝐞𝐬. Thus, actuaries usually conduct a sensitivity analysis against their future reinvestment rates on fixed income assets/equities and inflation rates to determine the embedded value as the actual value might diverge from the calculation.

Investors wanting to purchase LIC IPO need to judge the embedded value because the value of its new business will be less than the value of policies in force and need to account for the fact that LIC is 𝐫𝐚𝐩𝐢𝐝𝐥𝐲 𝐥𝐨𝐬𝐢𝐧𝐠 𝐦𝐚𝐫𝐤𝐞𝐭 𝐬𝐡𝐚𝐫𝐞 to the private insurers.