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How to evaluate LIC IPO and other insurance companies?
Based on the valuation of its initial public offering (IPO), Life Insurance Corporation of India (LIC) is likely to be among the top three or five companies by market capitalisation after its listing, worth around $80 to $100 billion.
Market capitalisation is the valuation of a company by Mr Market at any point of time, depending on the prevailing investor sentiment for the overall equity market, the specific sector or industry and the specific entity.
A scientific investor can independently think about the actual value of the company on an objective basis and then compare it with its current market value.
If the actual or intrinsic value of the company is much higher than its prevailing market value, the investor can consider buying shares in it; when the intrinsic value is lower than market value, one can consider selling the stock and taking profit.
The question is this: how does one value life insurance companies?
The components of value are as follows:
Real estate held
Value of other non-operating assets
Value of existing business
Value of future business
According to various sources of information, LIC has thousands of buildings across cities. The value of these assets could be in lakhs of crore but needs to be determined on the basis of specifics.
The main component of value is the value of existing business. This is the primary component in the embedded value calculation and is estimated at nearly Rs 5.4 lakh crore.
On top of this one can add the value of future business depending on the rate of growth. Keep in mind that India is a highly underpenetrated market as far as life insurance is concerned.
Growth can go on for decades. Estimates for the insurance industry's growth are in the range of 13-15% for the next five years or so. It is likely that LIC grows slower than the industry, but still close to double digits or high single digit.
What is the concept of embedded value?
Due to the long-term mutual commitment of the customer and life insurers to each other, life insurance business is very different from any other business. And Generally Accepted Accounting Principles (GAAP) do not reveal the true economics of the business, so the use of traditional ratios like Price-to-Earnings or Price-to-Book Value does not make sense. On these traditional valuation metrics, life insurance companies would always look overvalued.
For example, currently, listed life insurance companies are trading at PE ratios ranging from 70 to 100. At the upper end of its IPO price band, LIC would trade at nearly 200.
The correct way to value a life insurance player is to value the committed business from each policyholder over the lifetime. For example, an individual policyholder will pay a fixed premium for the next 20 years and there is some likelihood of paying for his life within that period.
The expected surplus left after paying off a policyholder is the profit to the company. Then there is the concept of present value—that getting Rs. 100 today has more value than getting Rs 100 one year later.
Without getting into the nitty-gritty of these concepts, one can value a group of customers of a life insurance company using this concept of embedded value. Then there is additional value from selling additional products and services to the same customer and value to the company from getting new customers.
How does a life insurer make money?
It becomes important to understand how a life insurance business makes money. In life insurance, the customer is paying the insurance company an annual premium to ensure that on his death a certain sum—the sum assured—is paid to the nominees or beneficiaries, typically, his wife or children.
The insurance company is receiving this premium from numerous other individual customers annually, say, thousands to hundreds of thousands of customers. However, only a very small fraction, typically less than 1%, of these customers, are going to die in any given year. The younger the age group, the lower is the mortality i.e., the death rate, and hence the annual premium charged is lower.
If the insurance company estimates the chances of paying out accurately and prices the annual premiums to be paid appropriately, it will be in profits over the lifetime of the policy. Thus, each policy has an embedded value which is positive if the insurance premium is priced properly.
Each insurance company has a team of experts called actuaries who are enabled with an extremely large sets of data and mathematical models to estimate the survival rates and death rates of different groups of individuals based on their age, gender, background, and medical history etc. Actuarial science is quite accurate.
LIC's IPO is at a Price-to-Embedded value (PEmV) of 1.1, compared to the other listed insurance rivals with a PEmV of 2.5 to 4.
The PEmV incorporates the value of new business the company is likely to generate in the future. With private entities likely to grow faster, they are justified in having a higher PEmV compared to LIC, but it looks likely that a 1.1 PEmV is probably understated. Further, the value of real estate is probably not accounted for in the LIC valuation. This could provide a hidden value to investors. However, when, and how it will be unlocked is clearly not known and is something which is completely beyond the control of minority investors. But it does provide a margin of safety.
If LIC starts becoming more efficient and increases its focus on pure-term and ULIP-like products, its profitability could increase. ULIP is short for Unit-Linked Insurance Plan. These and other factors could further increase its value. Also, an aggressive growth focus like private players could also increase the value of future business.
Valued at a significant discount
The expected growth of the listed private players is higher compared to LIC and hence the premium. How much should be the premium based on how much these existing private players grow faster than LIC is a question for detailed calculations and assumptions.
Prima facie, it does look like LIC is available at a significant discount compared to the listed insurers. After the IPO, too, it is likely to be at a discount to the other listed life insurance companies. It is likely to be in the top-five largest companies in India, by market capitalisation, after the listing.
Of course, this discussion cannot be taken as investment advice. One must do one's own analysis and see if it makes sense to invest in the state-owned insurer. There is no hurry. Once the company is listed, its stock will be available for ever. The scientific investor invests at the time and price of his or her choosing and is not dictated to by market forces.
Zerodha (Trading & Demat Account)
RHP
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