Insurance is a proven business globally and is part of the benchmark indices in most developed markets. The situation could soon be replicated in India as the domestic insurance sector is poised to grow exponentially due to low penetration levels, strong economic growth and high savings rate in the country. Even so, most retail investors in India have stayed away from insurance stocks because of lack of understanding of the insurance business and limited number of listed stocks that offer such exposure. Regulatory uncertainties have added to this reluctance.
According to industry estimates, insurance companies are likely to attract a cumulative inflow of about Rs 92 lakh crore of savings over the next 15-20 years. However, insurance is a highly capital-intensive business with a long gestation period. The encouraging fact is that many private Indian insurance companies have shown significant improvement in their profitability in the previous fiscal.
Growth potential
To understand why the life insurance sector makes for a sound investment proposition, we need to evaluate two factors—economics of the business and growth potential. Insurance is, perhaps, one of the few businesses in which cash is collected upfront (in the form of premiums) and services (claims settlement) rendered at a much later stage. In the meantime, insurers can use the funds they hold (known as float in insurance parlance) to invest and can keep the profits. Additionally, in the case of insurers, there is the possibility that the cost of capital is positive. However, this would depend on factors such as the competitive environment and underwriting efficiency.
Apart from the economics of the industry, there is also immense growth potential for the Indian life insurance sector. It is grossly under-penetrated, with per capita premium at only $41 (about Rs 1,900) compared with $2,500-5,500 (Rs 1.1-2.5 lakh) in the US, the UK and even some Asian countries.
The low penetration, coupled with a strong GDP growth and high savings rate of around 30 per cent, leads to the possibility of the life insurance space growing by five times over the next 10 years.
How to value insurance businesses
It is not always possible or advisable to apply the traditional valuation parameters, such as price to earnings (PE) ratio and price to book value multiples, in high-growth or relatively nascent markets such as India. This is because insurance is a highly capitalintensive business. In the first few years, insurance firms have to meet solvency requirements and set up distribution networks. As a result, they usually suffer accounting losses.
Traditionally, insurance companies are valued using the appraisal method, which is the sum of embedded value (present value of future earnings from the existing underwritten premiums) and structural value (captures potential of future policies by assigning a multiple to profits arising from sales in a year). However, in the initial years, the embedded value is a very small component (due to huge accumulated losses) and investors tend to use only the structural value. Once the companies gain critical mass and become profitable, it is advisable to use the appraisal value method.
Apart from this, investors also need to understand and consider the qualitative aspects, such as market share and scale of operations. The quantity of float that an insurer holds is a guiding factor, which determines the profitability of an insurance company and depends on distribution network and product innovation.
The other criteria that have a bearing on the profitability are commission ratio and operating expense ratio. Persistency ratio too has assumed increased importance in the current scenario. Persistency ratio measures the proportion of policies that continue paying premiums to the number of surrendered policies. A high persistency ratio means insurers can hold their float for a long duration.
Attractive entry point
The recent regulatory changes were introduced to enhance transparency and prevent mis-selling of insurance products. Although these will negatively affect growth and margins of insurers in the near term, the revised regulations will benefit insurance companies in the long run by improving the persistency ratio and allowing for sustainable growth.
Insurers are likely to realign their distribution models and business to minimise the impact of these changes. In fact, experience shows that aberrations driven by regulatory changes in a sunrise industry offer a good entry point. A case in point is the telecommunications services industry, which witnessed similar disturbances about five years ago when regulations were revised to allow more competition among wireless operators. It is currently a booming sector.
Bajaj Finserv and Max India currently offer pure exposure to insurance business. Max India's life insurance business turned profitable in 2009-10. The company recorded a profit before interest and tax (PBIT) of Rs 33 crore against a loss of Rs 402.5 crore in the previous financial year (2008-9). The gross premium for financial year 2009-10 rose by 26 per cent. These robust numbers were supported by a strong 50 per cent growth in renewal premium. The company's conservation ratio continues to be well above the industry average. In 2009-10, the company reported a conservation ratio of 83 per cent, an improvement of 100 basis points on a year-on-year basis. Conservation ratio indicates how much of the business underwritten in the previous years is being renewed. The higher the ratio, the better it is for the company.
The writer is Head of Research, Sharekhan
