Embedded Value: What LIC’s proposed IPO means for investors

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November 27, 2020 12:30 AM

LIC has the potentiality to generate wealth for investors due to its consistent growth record, firm grip on market share and an enviable claims settlement record

The books of accounts of a life insurance company is necessarily moderated by the inputs provided by the actuary.The books of accounts of a life insurance company is necessarily moderated by the inputs provided by the actuary.

The initial public offering (IPO) of LIC is going to be a major event in the history and growth of the Indian securities market. LIC is not only an institution of systemic value to the nation but one of the largest investors in the stock market.

Stocks are valued on the basis of the net worth of a company, its potentiality for growth and generating profit. They depend on the sustainability of the business, ability to ride on the technology wave and the competence of the management to take on disruptions in its stride and continue to generate profit for shareholders.

Yardsticks of valuation
LIC is a monolith not explored by the market so far. Life insurance companies are subjected to very different yardsticks of valuation and their real worth cannot be judged on the basis of recent profit or business performance. Life insurers are judged on the basis of the embedded value (EV) that they are able to create over a long period of time. Simply speaking, the EV is the current value of all premiums that the company expects in future from all the policies in its books as on a particular date. The calculation is a complex exercise conducted by an actuary who takes into account probable exits by death, lapsation, surrenders, maturity and estimates future income based on probable cash flow and likely rate of return on investments.

The books of accounts of a life insurance company is necessarily moderated by the inputs provided by the actuary. The Appointed Actuary of the company also submits to the company’s board a report on the financial health of the company as the visible figures do not necessarily reflect the strengths or weaknesses of a company. The potential investor must have some understanding of these technical aspects of the valuation of a life insurer before jumping into the fray with a fat purse.

Protection and annuity needs
Protection as well as the annuity needs of the people will make the insurers grow for a long time. Hence, there is a very optimistic scenario unfolding as far as the profitability of the industry is concerned. It would be quite reasonable to expect very decent returns to the investors who would be eligible to buy LIC’s shares. So far the policyholders and the government alone benefited from the wealth creation by the nation’s best known brand.

As per the LIC Act 1956, out of the valuation surplus generated every year an amount equal to 5% is payable to the Government of India and the rest is allotted to the policyholders by way of reversionary bonus. It is expected that before the IPO the government will amend the LIC Act to allocate 10% of the surplus to the shareholders. Currently private sector insurers are entitled to 10% of the valuation surplus. In all the previous years, LIC has been declaring valuation surplus. For the year 2019-20, LIC’s valuation surplus has been `53,955 crore. This may provide a fair idea to the investing public about the earning potentiality of LIC’s scrips. LIC has the potentiality to consistently generate wealth for investors because of its consistent growth record, firm grip on market share for two decades since opening of the sector and an enviable claims settlement record. But a discerning investor will expect LIC to be more transparent and accountable in all its activities including the investment of its huge fund and allocation of bonus to policyholders.

As LIC’s fund size is higher than the total fund with mutual funds in India, investment decisions and returns will be closely monitored by the market and will greatly impact the share value. For commanding a high price, LIC will have to ensure that the employees and the managers disengage themselves from their old work habits and the management is able to take tough decisions with the interest of policyholders and shareholders only in mind.

The writer is former MD & CEO, Star Union Dai-ichi Life

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