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 forย LICย 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 theย #embeddedValueย 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 ๐ก๐จ๐ฐ ๐ข๐ญ ๐ฉ๐ซ๐ข๐œ๐ž๐ฌ ๐ซ๐ข๐ฌ๐ค 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.

๐„๐ฆ๐›๐ž๐๐๐ž๐ ๐ฏ๐š๐ฅ๐ฎ๐ž = ๐•๐š๐ฅ๐ฎ๐ž ๐จ๐Ÿ ๐’๐ฎ๐ซ๐ฉ๐ฅ๐ฎ๐ฌ ๐Ÿ๐ซ๐ž๐ž ๐œ๐š๐ฉ๐ข๐ญ๐š๐ฅ + ๐๐• (๐๐ซ๐จ๐Ÿ๐ข๐ญ๐ฌ ๐ญ๐จ ๐’๐ก๐š๐ซ๐ž๐ก๐จ๐ฅ๐๐ž๐ซ๐ฌ) where

๐๐• (๐๐ซ๐จ๐Ÿ๐ข๐ญ๐ฌ ๐ญ๐จ ๐’๐ก๐š๐ซ๐ž๐ก๐จ๐ฅ๐๐ž๐ซ๐ฌ) = ๐๐•( ๐€๐Ÿ๐ญ๐ž๐ซ-๐ญ๐š๐ฑ ๐ฉ๐ซ๐จ๐Ÿ๐ข๐ญ๐ฌ + ๐€๐Ÿ๐ญ๐ž๐ซ-๐ญ๐š๐ฑ ๐ข๐ง๐œ๐จ๐ฆ๐ž ๐จ๐ง ๐œ๐š๐ฉ๐ข๐ญ๐š๐ฅ – ๐ˆ๐ง๐œ๐ซ๐ž๐š๐ฌ๐ž ๐ข๐ง ๐œ๐š๐ฉ๐ข๐ญ๐š๐ฅ)

After-tax profits = Premiums collected + Investment Income (๐ถ๐‘ข๐‘ ๐‘ก๐‘œ๐‘š๐‘’๐‘Ÿ ๐‘๐‘Ÿ๐‘’๐‘š๐‘–๐‘ข๐‘š๐‘  ๐‘”๐‘’๐‘ก ๐‘–๐‘›๐‘ฃ๐‘’๐‘ ๐‘ก๐‘’๐‘‘ ๐‘–๐‘› ๐‘ ๐‘’๐‘๐‘ข๐‘Ÿ๐‘–๐‘ก๐‘–๐‘’๐‘ ) – 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.

๐‚๐š๐ฅ๐œ๐ฎ๐ฅ๐š๐ญ๐ข๐ง๐  ๐ž๐ฆ๐›๐ž๐๐๐ž๐ ๐ฏ๐š๐ฅ๐ฎ๐ž ๐ข๐ฌ ๐š ๐œ๐จ๐ฆ๐ฉ๐ฅ๐ž๐ฑ ๐ญ๐š๐ฌ๐ค, ๐ž๐ฌ๐ฉ๐ž๐œ๐ข๐š๐ฅ๐ฅ๐ฒ ๐Ÿ๐จ๐ซ ๐š ๐œ๐จ๐ฆ๐ฉ๐š๐ง๐ฒ ๐ฅ๐ข๐ค๐ž ๐‹๐ˆ๐‚, ๐ฐ๐ข๐ญ๐ก ๐ฆ๐š๐ง๐ฒ ๐ฉ๐จ๐ฅ๐ข๐œ๐ข๐ž๐ฌ ๐ฐ๐ข๐ญ๐ก ๐ฏ๐š๐ซ๐ฒ๐ข๐ง๐  ๐ฆ๐š๐ญ๐ฎ๐ซ๐ข๐ญ๐ข๐ž๐ฌ. 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 ๐ซ๐š๐ฉ๐ข๐๐ฅ๐ฒ ๐ฅ๐จ๐ฌ๐ข๐ง๐  ๐ฆ๐š๐ซ๐ค๐ž๐ญ ๐ฌ๐ก๐š๐ซ๐ž to the private insurers.

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