IPO Review: LIC IPO – 3 factors to consider before subscribing

The Indian government, deciding to take its chances with market moods, has launched the long-awaited IPO of Life Insurance Corporation of India (LIC). This is entirely an offer for sale by the government to offload 3.5% of its holdings (22.14 crore shares) to the public, at an offer price band of Rs 902-949.  LIC will not receive any proceeds from the sale. Retail bidders will get a Rs 45 discount while LIC’s policyholders will get a Rs 60 discount. 

Life insurance is a unique business where companies collect payments from their customers upfront while promising to make contingency-based payouts in future. Therefore, traditional metrics used to evaluate prospects of manufacturing companies or even banks are not all that relevant to evaluating life insurers. 

Before deep diving into LIC’s IPO, you will need to familiarise yourself with some of the common terms used to assess the growth prospects of insurers. This article may help you get to the bottom of the jargon such as Gross Written Premium (GWP), New Business Premium (NBP), Annualised Premium Equivalent (APE), Value of New Business (VNB) and Embedded Value (EV)

As LIC’s IPO is an offer for sale, factors such as use of IPO proceeds aren’t relevant. There are just three questions to which you need answers, to decide on whether to subscribe to this IPO. 

• What kind of growth rates can LIC achieve in its business? 
• What kind of profit margins is it likely to earn? 
• Does the offer price build in realistic expectations about growth and profitability? 

Let’s tackle these in turn.

What will LIC’s likely growth be?

#1 Industry growth potential

The standard argument for investing in life insurers in India is that this is an extremely under-penetrated industry, with most Indians not owning a life cover. Data on life insurance premiums accounting for just 3.2% of India’s GDP are advanced to support this argument. But the under-penetration argument is a bit overdone because, as financial products go, life insurers have achieved far higher penetration than competing financial products. While India’s life insurers have about 32 crore policies in-force, the mutual fund industry has about 13 crore folios, and depositories service 9 crore demat accounts. 

While the industry had been growing briskly just before Covid, it hasn’t managed secular growth in the past. It saw negative growth in premiums between FY12-FY14 and just 8% growth in FY15 and FY16. 

However, life insurance in India is mostly sold as a savings product, with a hefty investment component embedded in the premium. Therefore, the real opportunity for growth for insurers may lie in selling the less-popular pure term covers and annuities to investors, while urging folks who already own life insurance, to top up their cover.

It may be realistic to peg growth expectations for the industry at 14-15% and at 9-10% for LIC over the next five years.

When Covid hit, business growth for Indian life insurers was quite strong. Total premium averaged a 12% CAGR from FY16 to FY20 while New Business Premium (NBP) registered a 17% CAGR. But growth rates moderated to 7-7.5% in FY21 as Covid hit selling operations. 

Given that LIC collects 2 times as much premium as all the private players put together, its growth rates have historically been lower than the private players. Its NBP growth from FY16-FY21 was at 13.5% against 18% for private insurers.

The latter half of FY21 and the first half of FY22 saw life insurers suffer sharp setbacks to their NBP growth. Given LIC’s heavier reliance on physical distribution which was hard-hit by Covid, it took a bigger dent to growth during this period. The second half of FY22 saw both the industry and LIC chart a comeback. NBP growth for private players has rebounded to 19.7% in FY22, while LIC has returned to 7.9%. With the unlock theme playing out, LIC has managed a significant 34% growth in NBP in the fourth quarter of FY22, recouping some of the market share it lost during Covid. 

Going forward, with Covid lifting insurance awareness, CRISIL expects the industry to manage 17-18% growth in NBP between FY21-FY26, levelling off to 13-15% thereafter. But given that the industry has never sustained such a long spell of high growth in the past, it may be realistic to peg growth expectations for the industry at 14-15% and at 9-10% for LIC over the next five years.

#2 Market share

LIC has grown its franchise to its current enormous size with minimal equity infusion from its promoter and significant support from policyholder funds. Private players certainly cannot take this route.

If growth in the overall pie proves elusive for Indian life insurers, they will need to deliver growth by cannibalising on each other’s market share. LIC has steadily lost market share to private players in the five years from FY16 to FY21 - with Covid accelerating this shift. From the table below it is clear that LIC has lost greater share in the individual business than in the group business, where it continues to dominate. 

While group insurance is directly sold by companies, individual business is procured through a mix of channels consisting of individual agents, banks (bancassurance), brokers etc.

Two factors have led to LIC ceding market share to private insurers in the individual business. One, with over 95% of its business sourced via individual agents, LIC has been slow to tap the bancassurance channel that has accelerated growth for private insurers. Leading private insurers such as SBI, HDFC and ICICI also have captive banking arms that hard-sell insurance to those taking loans. 

Two, digital presence and tie-ups with insurance aggregators drove insurance sales during Covid and LIC had a very marginal presence in these channels.   

But with the post-Covid unlock taking shape, LIC’s agent force now has ample room to revive its activities. This perhaps explains the 34% NBP growth for LIC in Q4FY22, which helped it claw back some market share from private players.

Over the long term, LIC will need to make its presence felt in the bancassurance and digital channels to attract new customers. It has taken some steps in this direction in inking a tie up with policybazaar, but payoffs may take time. 

Growth in the insurance business also requires substantial capital infusion. LIC has grown its franchise to its current enormous size with minimal equity infusion from its promoter and significant support from policyholder funds. Private players certainly cannot take this route. LIC’s size advantage is thus likely to remain for good, though sourcing capital for future growth will prove harder.  

However, private players have far greater scope to grow by chipping away at LIC’s market share rather than vice versa.

Can it improve margins?

If LIC’s size reins in its growth rates relative to private peers, can it drive future earnings through margin improvements? 

If the profit margins of manufacturing or service companies are measured in terms of operating profits by sales, the profit margins of insurers are measured in terms of the Value of New Business (VNB) margins.

Though LIC hopes to get to private players’ VNB margin levels of 20%, getting to 10-11% appears more achievable in the medium term.

VNB is the present value of future profits likely to flow to the insurer as a result of new business procured during the year. VNB margins are calculated by dividing the VNB by the Annualised Premium Equivalent (the normalised premium flowing to an insurer in a year). LIC has traditionally not calculated either its VNB or VNB margins (these require actuarial calculations). But the RHP presents these numbers from September 2021. 

Compared to private players who have made a conscious effort to improve their VNB margins to 20% plus levels in recent years, LIC’s margins have stayed at 9-9.9%.

LIC’s low VNB margins mainly reflect its current product mix.

#1 Product mix

LIC’s product mix being geared more towards non-market and participating products is good for steady growth. A bear phase in stocks may not affect its sales and a rising interest scenario which we are in today, can be good for returns.  But LIC’s product mix is not ideal from a margin perspective. 

Industry experts estimate that in life insurance, non-participating products offer higher VNB margins (at about 30-40%) compared to participating products (10-15%). Traditional products (10-40%) offer better margins than market linked ones (5-8%). And individual plans offer better margins than group plans. Individual protection plans are in fact the most margin - accretive offering scope for 70-100% margins.  

Compared to private players, LIC is more geared towards non-market linked plans. But its high reliance on group insurance plans and participating plans, where investors share in surpluses by way of bonuses, weigh on its margins. 

Going forward, if it is to enjoy better market valuations, LIC needs to shift its product mix in favour of protection and non-participating products. Given that LIC products have traditionally been a hit with customers for their ‘assured’ returns and good bonus record, this pivot may not be easy, especially as the agent force may be geared to selling traditional products.

#2 Investment performance

Apart from underwriting profits, a key profit driver for insurers is the management of ‘float’ - the monies that customers park with the insurer hoping for a payout in the distant future. Successful insurers the world over (including Warren Buffett’s Berkshire Hathaway) excel at generating good returns from floats. 

LIC’s investment moves often make news for all the wrong reasons - whether it is its bailout of the teetering IDBI Bank, subscription to shaky PSU bank AT-1 bonds, extending lines of credit to the Indian Railways or participating in PSU divestment offers to bail them out. The 7.8% NPA in LIC’s bond portfolio, is far higher than private peers.  

But suboptimal as these investment moves are, they don’t make a significant dent in LIC’s overall investment performance given the enormous size of its accumulated float. 

With Rs 40.1 lakh crore worth of assets under its belt, LIC In December 2021 managed 3.2 times the assets of all private life insurers put together and had over 15 times the assets of the second largest player. Problem areas such as bad loans or ‘other investments’ make up a relatively small portion of LIC’s portfolio.

In December 2021, 95.9% of LIC’s debt AUM was in sovereign and AAA-rated securities. Over 90% of policyholders’ equity investments were held in Nifty200 or BSE200 stocks.  

While LIC’s enormous float gives it stability and helps it maintain its claims record during adversity, the investment returns it generates is modest compared to private players. The table below shows the returns it manages on its life funds. On the investment funds, its yield of 7.42% lags the 8-10% yield for private players.

While a rising rate environment would improve LIC’s investment yields, it may need to take non-promoter driven investment decisions to deliver better performance to its investors. 

Traditionally, the policyholders in LIC’s participating plans earned high rates of bonus as the insurer did not bifurcate its funds into its par and non-par components and didn’t have any external shareholders. But with its life fund bifurcated just before the IPO and shareholders likely to demand reasonable returns, LIC’s bonus rates may need to correct unless it materially improves its investment performance.

#3 Costs

Costs incurred by insurers on compensating distributors and running their operations have a bearing on profitability. Though LIC incurs high commission costs on its physical agent force, its overall cost structure compares well with most private players except for the very efficient SBI Life.

Though LIC has stated its objective of getting to private players’ VNB margin levels of 20%, getting to 10-11% appears more achievable in the medium term.

Valuations

Overall, LIC is likely to continue to enjoy advantages arising from a dominant and unassailable market share, difficult-to-replicate distribution reach, high brand recall and trust (with sovereign backing for its policies) and the stability resulting from its large asset base and float. But it is likely to lag private players in terms of growth and margins.

The offer pricing amply compensates for the possibility that LIC will deliver far lower growth and margins than its leading private rivals.

In the stock market, life insurers tend to be valued based on two metrics – their Embedded Value (EV) and Value of New Business (VNB). The EV is the sum of two components – the insurer’s book value (or net worth) and the present value of profits it will make from the policies it has already sold (which is an actuarial estimate). VNB is the addition to an insurer’s operating profit due to new business acquired during a year. 

While EV captures the static value of the business an insurer has built so far, the VNB captures the rate at which it is adding to this value each year. 

LIC, unlike private insurers, calculated its EV for the first time only in September 2021, after dividing its capital into shareholder and policyholder funds and deciding on their relative profit shares. 

The actuary Milliman Advisors has calculated LIC’s Indian EV at Rs 5,39,686 crore as of September 30 2021 and VNB at Rs 1583 crore for the six months ended September 2021. LIC’s EV by virtue of its large legacy assets, dwarfs leading private insurers. But its VNB, by the same yardstick, is at a small fraction of its EV.  

Based on latest brokerage notes, current market valuations for leading private life insurers work out to 2 to 3 times their estimated EV for FY23, after factoring in an EV expansion of between 20% and 40% from current levels and VNB margin assumptions of 23-29% by FY23. The valuations translate into multiples of between 29-38 times their FY23 VNB. 

The LIC offer, in contrast, is priced very modestly. At the upper end of the price band, the offer price asks for an EV multiple of just 1.1 times LIC’s September 2021 EV of Rs 5.4 lakh crore. In the past, EV growth for India’s life insurers has closely tracked AUM growth. LIC’s AUM growth in the last five years has been at 13.5% CAGR compared to 16-22% for the top three private players. 

Conservatively assuming that LIC’s EV expands just 15% in absolute terms over H2FY22 and FY23, the asking price for the offer would value LIC at 0.96 times its forward EV, factoring in almost no growth.  

The offer pricing therefore, amply compensates for the possibility that LIC will deliver far lower growth in its NBP and EV than its leading private rivals. It also factors in far lower VNB margins than private players. This offers a comfortable margin of safety to investors subscribing to the IPO.

Though LIC may not qualify to be a growth stock on the lines of private insurers, its size lends stability and visibility to its prospects. Its market cap of over Rs 6 lakh crore will also assure it a berth in every bellwether index, making the stock a must-own for global and local passive funds. 

The offer pricing makes sure that the LIC stock would be far less vulnerable to earnings disappointments than those of private insurers, should the ‘India-is-an-under-penetrated-insurance-market’ story fail to play out. We believe investors with expectations of regular dividends with steady growth of 9-10% can subscribe to the IPO. 

It is true that elephants can’t dance, but they can definitely walk at a brisk pace! 

Please note that this review does not take into consideration the possibility of listing gains.

General Disclosures & Disclaimers