Embedded value: Know how life insurers make money

In almost all the predictable scenarios, the actual death claim experience is better than what is assumed for pricing each product.

The sum assured may be much higher than the premium paid in most of the death claim cases and yet the insurers make profit.

One of the most significant events likely to hit the Indian financial market during the current financial year is the proposed listing of Life Insurance Corporation of India (LIC) at the stock exchanges. In view of the sheer size of the IPO, one must understand what makes listing of India’s largest insurer such a major event.

Type of policies

Let us understand how life insurance companies earn profit. The products they offer are broadly of four types: Term Insurance, Endowment Insurance, Whole Life Insurance and Annuities. A term insurance policyholder pays premium every year during the chosen term in exchange for a probable death benefit, commonly known as sum assured. The insurer might have to pay a sum as high as Rs 50 lakh or Rs 1 crore against premium regularly collected from the deceased policyholder to the extent of any amount ranging from Rs 10,000 to Rs 15 lakh depending upon age at entry and the term elapsed since the purchase of the policy up to the date of death.

The sum assured may be much higher than the premium paid in most of the death claim cases and yet the insurers make profit. Similarly, policyholders pay risk premium under the endowment policy, but in addition to that they pay a fixed amount with every instalment towards systematic savings to be received as a lumpsum amount equal to the sum assured on maturity. The sum assured is further augmented by bonus that accrues to the policy every year based on the investment income of the company.

Under the whole life policy the insurer undertakes to pay to the nominee full sum assured with bonus or even without bonus as per the policy terms and conditions, on death of the policyholder after commencement of risk. All these may sound simple but the puzzle is yet to be solved.

Profits of life insurers

In the above examples, it sounds almost impossible for the life insurers to be making profit always. After all, many people die daily and it is certain that everybody’s life will come to an end one day, hence the insurers must pay more than what they collect from each such policyholders. The source of profit and surplus cash flow is therefore somewhere else.

If one million people are insured in a year it is certain that all of them will not die in one year or even during the next 25 years which we may consider as the average term of a policy. Though the risk premium is collected from everybody every year, the insurer is not required to consume all such premium in settling death claims every year as the business moves on. In almost all the predictable scenarios the actual death claim experience is better than what is assumed for pricing each of the products. In this regard the insurers are characteristically conservative and quite justifiably they need to be so as they undertake risk of the unforeseen.

If the claim experience is better by even 0.2 to 0.5% in a year, it results in substantial savings for the insurer over a period of time. Such surplus and the daily cash flow is invested every day to grow the fund further. Good underwriting of risk plays an important role in income generation. On the other hand, the premium collected under endowment or annuity policies are very meticulously invested leaving no money idle even for a day. During 2018-19, LIC’s investment income from equities alone was more than Rs 14,000 crore. The market value of LIC’s stock market investments at the end of FY19 was more than Rs 28 lakh crore.

Yearly surplus

This income is again reinvested after paying dividends to the shareholders. The yearly surplus is arrived at by an actuary who estimates the liability of the insurer, the embedded value of all the business in the books and the available fund for current expenses and future appropriation.
What the insurer returns to the policyholders on death or maturity is the sum assured and accrued bonus for with-profit policies out of the life fund which is so grown after meeting all business procurement and management expenses.

The total assets of LIC are worth more than `31.11 lakh crore. It is estimated that after the IPO, LIC will become India’s most valuable listed company. As per market analysts, even 10% of LIC’s estimated value may need investors to bring in more than Rs 1 lakh crore during the offer period. For the common man or a policyholder this will be a great investment opportunity.

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