Valuing LIC

Valuing LIC

The insurance business does not need any introduction. Almost everyone is a customer, and the majority are unhappy as they are either unsatisfied with the claim process or the coverage they receive for the premium is lesser than what they pay. Most of us do not know how insurance companies determine the premium for a customer except that the premium increases with age. During COVID, many affected people didn’t receive health coverage for the premium they paid. An analyst reviewing an insurance company finds its financials challenging compared to any other industry. In this post, I give my insights on reviewing insurance companies before investing and then finish this post with a case study by valuing LIC.

Business Model Of the Insurance Industry

The insurance industry operates in three segments:

1. Property and Casualty
2. Life and Health Insurance
3. Reinsurance

Reinsurance firms sell insurance to insurance companies and protect them against risk. Insurance companies make money by underwriting/selling insurance to customers, and they invest the premium they collect from customers in the markets (fixed assets, equity, debt). There is a time between the premium collected and the claim; the firms invest the premiums in financial assets (equity, debt) and generate returns during this time.

Insurance companies face regulations, including the premiums they charge. For example, during COVID, when insurance companies did not anticipate the COVID risk, they refused to cover COVID expenses, but the government intervened and forced them to cover the expenses.

Insurance firms face the following risks:

• Customers with high-risk demand higher coverage than low-risk customers.
• Customers tend to engage in riskier behaviour after taking insurance policies as they expect the insurance will cover them for any mishaps.
• Customers indulge in fake claims.

When we analyze the Insurance firm’s financials, they ignore the following strategic assets that fundamentally drive value creation.

• Changes in insurance premiums.
• Frequency of claims.
• Severity of claims
• Insurer strategy to manage risk.

Most of the above questions are addressed in the annual reports’ management discussion and analysis section. At the same time, basic details like policy renewals and churn are not standardized, and we cannot compare these numbers with the competitors.

Identify Strategic Assets

Any investor/analyst looking to invest money in an insurance firm must understand its assets that drive value creation and sustained competitive advantage. A successful insurance firm generates a constant cash flow stream when they have loyal low-risk customers and competitors cannot imitate their brand. For instance, a new upstart firm cannot easily replicate LIC’s brand, trust and reputation.

A critical factor of any insurance firm’s success revolves around customer management which is acquiring the right customers (not any customers) and ensuring they stick with them (high policy renewals). Unfortunately, we don’t get these details from the financials but from the other sections of the annual report.

Due to high competition, insurance companies often reduce premiums to gain market share. When firms reduce premiums, more customers enrol policies, but at the same time, they draw high-risk customers. Thus it is crucial firms weed out wrong customers from their policies. An ideal scenario is to add customers at low advertising/marketing expenses, hold on to the good customers and maintain low operating expenses to service the customers.

When firms reduce premiums, the financials will portray low earnings because firms charge low premiums, which attracts high-risk customers. The high-risk customers make claims that the low premium cannot service. However, low premiums do not indicate management failure because it takes time to stabilize the book and reap benefits from any change in premium. Moreover, earnings are not a good indicator of an insurance firm’s growth potential because of poor revenue expense matching, as earnings include adjustments on prior reserves for future payment of claims without any corresponding allocation of revenues.

Valuing LIC

Let us apply the following parameters to LIC and its latest earnings reports.

LIC reported a profit of Rs.16,635 crores in H1FY 23 against Rs.1,437 crores in H1FY22. The significant jump in net profit is due to changes in accounting policy and income from tax refunds. The company transferred Rs.14,272 crores from its non-participating policies to the shareholder’s accounts, due to which the net profits soared. In addition, LIC received Rs.25,527 crores in a tax refund, of which Rs.6,627 crores is the interest from tax refunds from the earlier years. LIC has transferred Rs.11,544 crores of this non-recurring income as an additional provision for its employee retirement benefits.

Below are LIC’s key financial metrics

As i discussed earlier in my post, net profit is not the right indicator to assess an insurer’s growth potential due to an accounting mismatch of revenues and expenses. However, the recent results resulted in a LIC stock price increase.

So does that mean the price increase is due to an increase in net profits?

I believe the price increase is due to the improvement in LIC’s operational performance.

Any investors wanting to invest money in an insurer must focus on the following metrics:

• Policies in force
• Written premium (in Rs)
• Annualized Premium equivalent
• New policies
• Value of New Business
• Renewal ratio

Thus, revenue growth which relies on Annualized premium equivalent, is a yardstick to measure business sales in the insurance industry. LIC calculate APE as the sum of annual first-year premiums on regular premium policies and 10% of single premiums written. LIC reported a 48% increase in APE in H1FY23 against H1FY22.

When we compare these numbers with its competitors, we get the following:

The above table indicates that LIC is growing its market share at the expense of private insurers.

LIC has improved its product mix by focusing more on non-participating products against its conventional participating products. In participating products, LIC assures a minimum guaranteed return and shares the profits with the policyholders. Therefore, looking at LIC’s product mix historically, most of its sales come from selling endowment plans and participating products.

When we look at the private insurance player, their product mix has a higher component of non-participating products like term plans. Non-participating products are pure protection policies and are more profitable than endowment plans.

However, LIC is slowly improving its product mix from participating to non-participating products. Thus, for LIC, the growth in profitability has come because of the change in the product mix towards non-participating products. LIC’s new products – LIC Bima Ratna, LIC Dhan Sanchay and LIC pension plus, launched this quarter, are non-participating.

Below are the critical ratios for LIC:

The Value of new business – Present Value of future profits from the new business written in a year is a crucial parameter to evaluate the growth potential of an insurer. The VNB measure growth and margins and is equivalent to EPS growth that investors use to measure the profitability of other industries.

LIC’s VNB increased by 132%, primarily driven by changing the product mix that focuses on non-participating products that generate higher margins. Further, for non-participating products, LIC distributes 100% of the surplus allocation to shareholders, whereas for participating products, the distribution is 95% for policyholders and 5% for shareholders.

Though the VNB margin for LIC improved, it still lags when we compare it against its competitors. Though the product mix improved, LIC has not increased the annual premium. However, its operating expenses as % of premium increased to 17% in H1FY23 against 15.3% in H1FY22.

The positive thing for LIC is that there is a scope for the firm to improve its VNB margins and bring it to par with private insurers by improving its product mix and lowering operating expenses by investing in technology. LIC is focusing on that direction and has reduced reliance on agents for selling its policies which is evident by the decrease in commission ratio in H1FY23 against H1FY22.

Insurance in India is under-penetrated, and 17% of the population has insurance policies. Life insurance is all about protection, and LIC has an opportunity to shift its product mix and improve its VNB margins.

Despite the growth in VNB margins, LIC’s embedded Value has not changed dramatically. Embedded Value in Insurance is equivalent to Enterprise value and is the sum of the present Value of expected profits from existing policies and the net worth. The reason is that LIC is a behemoth, and given its sizeable existing book, its contribution from incremental business is smaller. Thus, LIC’s EV will not grow significantly despite improved operational performance.

Final Thoughts

LIC’s market capitalization is Rs.4,19,664 crores, and its embedded Value is 5,44,291 crores.

Implied multiple = 4,19,664/5,44,291 = 0.8x

When we compare this multiple against private players like ICICI (2.1x), HDFC (3.5x), and SBI (2.9x), LIC trades at a 50% discount. Despite the concerns about government interference and slower technology adoption compared to private players, LIC trades at a steep discount.

LIC’s cash flow from operations = Rs.722,190 million

LIC’s book equity = Rs.269,600 million

LIC’s unlevered beta = 1.07

LIC’s cost of capital = 10%

Value created = (722190 – (269600*10%)) = Rs.6,95,230 million

Value created as % of market cap = 17%

This value creation is substantial for a large, matured company like LIC.

Thus, though LIC’s embedded Value may not grow significantly due to its size, its valuation multiple can expand to grow at par with private insurers.