LIC IPO: The challenges for Milliman to calculate 'embedded value'

The government has kicked off the process of discovering the IPO price of the 64-year-old Life Insurance Corporation (LIC) by appointing actuarial firm Milliman Advisors. Milliman, which is among the world's largest providers of actuarial services, has got the mandate to compute the embedded value (EV) of the LIC, which is a key valuation metric for life insurance companies. The lenders like banks and NBFCs are valued in the stock market as a multiple of their book value (BV).

Investment companies like mutual funds are valued as a multiple of their AUMs. Similarly, the life insurance companies are valued at a multiple of their EVs. Currently, LIC is exempted from disclosing its EV. In fact, the EV calculation would mean a comprehensive exercise because of its legacy assets. Since LIC is also vastly different from private life insurance companies in terms of ownership structure, product mix, profitability sharing structure, agency model, there is a tough task ahead for the global actuarial firm.

Let's look at the key issues:

Present value of future profits

Life insurance is a long term business where the insurer receives recurring premium from policyholders over a period of 5 to 25 years.The valuation of such a long term recurring revenues is calculated by finding out the present value of the future cash inflows. The LIC issues life policies for a maximum period of 25 years, which means the actuarial firm has to compute the future value of all the businesses till up to 25 years.

Skewed product basket

LIC's product mix has a higher share of savings product than protection. Historically, LIC has thrived on savings products as policyholders invested money for getting twin benefit of protection and good sum of money at the end of the maturity. But the profitability of a savings product is significantly higher than the profitability of a protection plan.

LIC's protection profitability would be far less, which would be a key parameter for its valuation. The valuer Milliman has to first segregate the savings products and protection plans. Once this is done, the actuarial will have to make assumptions of mortality rate, profit margin for protection plans.

Distorted persistency figures  

While computing the present value of future cash flows in protection business, Milliman has to study persistency levels, which show how long policyholders are staying and paying premium. As per IRDA, companies have to declare persistency for 13 months to 61 months. Clearly, the overall persistency levels in LIC  are higher because of larger component of savings products where policyholders stay put till maturity.

Higher payout liabilities

Payout liabilities in savings products or the savings products is very high as LIC is obligated to pay the money at the end of maturity. Unlike pure protection plan where the money is paid only in the event of death.

Net worth adjustment

The EV is a sum total of present value of future business returns and net worth. LIC's net worth is very low because of the low capital base. LIC never felt the need for higher capital and net worth because of a sovereign guarantee. The corporation's capital base is only Rs 100 crore.

The balance sheet of LIC has to be restructured, accordingly, by revaluation of assets including real estate and investments. The other option is enhancing the capital base and the government pumping in money, which looks difficult in current scenario. The new revised capital structure post revaluation would give a correct picture of LIC's valuation as net worth is a critical pat of the EV computation.

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