Is it a good idea to invest in the LIC IPO? The good, bad, and downright ugly aspects are here.

There aren’t many things that can compare to this. The government-owned insurance behemoth LIC is gearing up for its first public offering (IPO) next month. The figures are astounding. Even by conservative estimates, the issuance may be worth Rs 52,000-90,000 crore, dwarfing Paytm’s Rs 18,000 crore IPO last year, which was India’s largest to date. After Reliance Industries and TCS, the insurer might become the country’s third most valuable firm after its IPO.

LIC’s sheer size is unrivalled. LIC still sells over 70% of all life insurance policies in the country and collects 65% of all new premiums, despite private insurance companies entering the market 20 years ago. It has roughly 16 times the assets under control of the next largest insurer and more than the whole mutual fund sector!

Does it matter how big you are? Is LIC able to compete with the more agile private insurers? There are some unsettling truths lurking beneath the eye-popping figures and visuals. Sixty years of government control have put a lot of pressure on this company, causing it to lose money and become inefficient. It took some work to transform the IPO into a credible offering that can withstand the scrutiny of significant domestic and international investors. ET Wealth dug through the figures in the draught red herring prospectus (DRHP) and sorted through the good, bad, and ugly to obtain the full picture. Here’s what we discovered.

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As a result of being subjected to government directives

LIC has always been obligated to perform the government’s bidding whenever it is requested. Its vast cash reserves are routinely utilised to recapitalize public sector banks, complete public offerings of PSUs in order to satisfy disinvestment targets, and other purposes. If IDBI Bank’s capital status deteriorates below the minimum capital requirements for at least five years, LIC is ready to inject money into the bank. Such directives may have a negative impact on LIC’s finances.

“Our corporation may be forced to perform certain activities in advancement of the GoI’s economic or policy objectives,” the DRHP states. There’s no way of knowing whether such steps will be advantageous to our company.” As a result, any action taken by the government could be detrimental to shareholders. This is apparent in LIC’s high gross nonperforming assets (NPA) ratio, which was 7.78 percent in 2020-21, the highest among all listed insurers. “LIC has to remove the appearance of being the rescuer in the government’s financial woes,” says Deepak Jasani, Head of Retail Research at HDFC Securities. “This may not be accepted well by its minority shareholders.” Such actions will now be scrutinised more closely.”

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Profits for policyholders are being reduced.

To make the IPO more appealing to shareholders, LIC had to change its excess distribution strategy. It divided the combined Life Fund last September. The profits or gains from LIC’s investments are held in this pot. The fund has been divided into two parts: one for participating policyholders and another for those who are not. A participating policyholder is entitled to a share of the company’s profits, whereas a non-participating policyholder is not. Previously, policyholders received 95 percent of the Life Fund’s assets, while shareholders received the remainder.

The non-participatory fund will now be distributed to all shareholders. The participatory fund is first split 95:5 between policyholders and stockholders, and will subsequently be split 90:10 between them. The surplus available to LIC’s participating policyholders—who make up the majority of the company’s product mix—will be reduced as a result of this reorganisation. It may lessen the allure of LIC for some clients, possibly leading to surrenders. “It will be interesting to see how policyholders react to this new structure.”

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Increased embedded value

The Life Fund’s segregation provided another key purpose for LIC: it preserved the fund’s underlying value (EV). This statistic is used to determine how much an insurance is worth. It’s the total of all future profits from an existing business plus net wealth. The embedded value is usually expressed as a multiple of the company’s valuation. Following the separation of the Life Fund, LIC’s embedded value increased five-fold, allowing for larger distributions to shareholders. It’s worth noting that the EV is calculated using a variety of assumptions, including interest rates, persistence, mortality, price, and business growth.

This isn’t a reliable valuation metric, especially if the company is losing market share or is subject to severe government regulation. Before comparing LIC’s EV to that of its peers, investors should be aware of these weaknesses. “Even slight adjustments in a few assumptions can make a lot of difference in the embedded value of the insurance,” says Vikas Gupta, Chief Investment Strategist at OmniScience Capital. This makes valuing based on EV extremely difficult.” Despite this, analysts expect that owing of its public sector status and weaker profitability, LIC will be assigned a lower EV multiple than private peers.

The market share is dwindling.

With a 60% market share, LIC is the industry leader, but it has lost ground to private sector competitors over time. In the first half of 2021-22, LIC’s market share of individual new business premiums fell from 56 percent in 2015-16 to 44 percent. It’s also lost ground in the group insurance market, which was once its strong suit. Private insurers offer a broader selection of products geared toward younger customers, as well as improved internet presence and customer service. LIC’s market share was eroded as a result of the Covid-induced lockdowns.

Analysts predict that the insurer’s loss of market share will reduce as it corrects its flaws. “LIC will try to strengthen presence in banking and online channels as well as deliver a larger set of solutions to stop the market share erosion in individual business,” says Parag Jariwala, Director – Investments, White Oak Capital Management.

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A higher Return on Investment (ROI) is a ruse.

The profitability of LIC, as measured by its return on equity (RoE), is unrivalled among its rivals. According to the company’s DRHP, its three-year average RoE is a whopping 289 percent. This number, however, is not strictly comparable to peers. LIC has never required traditional funding because it is wholly controlled by the government. Until this year, it had never clawed back profits as reserves. All proceeds have been transferred to policyholders or as dividends to the government.

This has allowed it to keep its equity share capital low (just Rs 100 crore!) until recently, resulting in a very high RoE. The company’s RoE fell from 405 percent in 2018-19 to 82 percent in 2020-21 after bolstering its equity capital. As the corporation seeks greater equity dilution over time, this figure will become more moderate. “The high RoE should be overlooked,” says Jyothy Roy, DVP-Equity Strategist at Angel One. “With surplus transfer to reserves, LIC’s net value will rise, bringing its RoE to more realistic levels reflecting its profitability.”

Agent reliance is high.

The 13.5 lakh strong force of independent agents that make up LIC’s distribution strength. In 2020-21, this network was responsible for almost 94% of the new business premium. Private insurers, on the other hand, rely largely on online and financial methods. “LIC’s agency force is an incredibly driven, well-oiled machine educated to market its range of plans and thoroughly enmeshed into the LIC ecosystem,” Jariwala insists. There is, however, an opposing viewpoint. Agents’ capacity to provide services was greatly hampered by the lockdowns. Individual agents who sold at least one insurance in the previous 12 months declined by 17.48% from 10.86 lakh on March 31, 2021 to 8.96 lakh on September 30, 2021.

Because of its reliance on its agents, LIC is more susceptible to attrition. In 2020-21, it terminated the services of almost two lakh agents (or 16.6% of its total network). As of 30 September 2021, LIC’s commission ratio (gross commission paid to gross premium) was 5.2 percent, compared to 4.2 percent for HDFC Life and 3.6 percent for SBI Life. “We may need to enhance commission and other advantages in order to recruit and keep adequate agents,” the DRHP says, “subject to the commission cap payable to our agents.” To boost its online presence, LIC recently partnered with insurance marketplace Policybazaar. Efforts are also being made to increase sales through the company’s own website.

When it comes to policy continuance, LIC likewise performs poorly. It has a 13-month persitency rate of 78.8%, which means that every fifth insurance it offers is cancelled after the first year. In the 13th month, private sector players have a higher persistency rate of 84-85 percent. LIC, on the other hand, had the highest persistency in the 61st month, at 60.6 percent, compared to 45-52 percent for private players.

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Product mix is skewed

LIC continues to place a major emphasis on conventional non-linked savings products with demand that is unaffected by market cycles. In 2020-21, nonlinked items made up 99.7% of the company’s portfolio. HDFC Life comes closest to the peer group, with non-linked products accounting for 71% of its premium. This allows for greater certainty in returns and, as a result, greater peace of mind for policyholders. Because it is not exposed to mortality risk, LIC pays less premium to reinsurers with a modest protection-oriented portfolio.At the same time, this product mix keeps investment yields lower than non-participatory products like Ulips and deferred annuities, which generate higher returns. Furthermore, because savings plans are not as profitable as others, it keeps LIC’s profits low. “LIC’s value of new business (VNB) margins are quite low in comparison to private players,” says Agrawal, “due to the product skew toward lower margin plans.”

In comparison to peers, the product mix also results in a smaller ticket size. LIC’s average new business premium (NBP) per person insurance was Rs 26,892, much less than its competitors. “LIC’s product mix is biassed towards savings and long-term participating goods,” Jasani says. This may limit the company’s ability to take higher-risk investments. However, the company’s decision to split 10% of its surplus with shareholders (rather than the previous 5%) may encourage it to take more risks in the future so that policyholder payouts are not impacted.” LIC now has a stronger incentive to focus on higher-margin non-participating items as a result of the changed surplus distribution strategy.

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Cash position is weaker.

While LIC has unrivalled cash reserves, its cash position has deteriorated in recent years. Due to significant other operating expenses, it reported negative cash flows from operating activities in the first half of 2021-22 at Rs 11,114 crore, after reporting positive cash flows in the preceding three financial years. From Rs 67,899.5 crore in 2018-19 to Rs 26,050 crore in the first half of 2021-22, the company’s cash balance has decreased significantly. Apart from greater claim-related payouts, this is mostly due to pandemic-related disruptions in normal economic activities. During this time, private insurers’ balance sheets were similarly stressed.

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superiority in price

LIC’s expense ratio is significantly lower than that of private players, despite its commission-heavy cost structure. Operating expenditure ratios as a proportion of total premium for 2020-21 (8.7%) and six months of 2021-22 (10.1%) are lower than the median operating expense ratios of the top five private players for the same period. In addition, the total cost ratio (which includes commission and operating expenditures) is lower than that of private players. According to analysts, LIC’s cost advantage over more effectively operated private players stems from the fact that it is a mature business. “Insurance is a business of operating leverage that comes with size,” says Agrawal. LIC is simply reaping the rewards of 65 years of business.”

Investments are skewed.

LIC made the most money from share sales in its 65-year history in 2020-21. In excellent years, big benefits from investments shine through in the company’s financials. But, as Gupta points out, investors must learn to discriminate between market-linked earnings and company profits. “Such large capital gains are unlikely to occur on a regular basis in the market.” The marked-to-market value of an investment portfolio can plummet in a bad year.” According to Agrawal, a sensitivity analysis suggests that LIC’s equity book is more sensitive to corrections than its peers. It’s also worth mentioning that LIC’s investment portfolio has a noticeable tilt. It has the greatest debt-to-equity ratio among peers, with 80 percent in fixed income and 20 percent in equities.

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Should you put money into LIC?

The scale and reach of LIC make it a one-of-a-kind proposition. Given the millions of people who trust the LIC brand, it’s a massive moat. Simultaneously, it faces a number of operational issues, including excessive government meddling, a skewed product and distribution mix, a tough competitive climate, and so on. LIC, despite its strong position, trails its private competitors on numerous criteria. It is likely to prove difficult, despite the fact that it is now aggressively pursuing several ways to boost profitability and stop market share decline. “While it has various levers at its disposal to enhance margins,” Roy says, “given its mass, it is likely to play out over a long period of time.”

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Private insurers, on the other hand, will keep their foot on the gas pedal. According to Avinash Singh, Senior Research Analyst, Emkay Global Financial Services, the overall quality and growth track record of private sector leaders is far superior to that of LIC. “They stand apart from the giant behemoth LIC because of their track record over the last decade, their business approach, adaptability, and stranglehold on the affluent class.”

Even so, the excitement surrounding LIC’s IPO will be palpable. Even if the shares are sold at a discount, Gupta says that investors should not feel obligated to invest now. The government will continue to dump more stakes in tranches in the coming years, even after this 5% divestment. Analysts believe that the supply glut will keep stock prices low. “That kind of supply tends to keep the stock price under control,” Roy explains. He goes on to say that the IPO would take place in difficult market conditions, therefore the offer’s pricing will be crucial. The Ukraine situation has further heightened the sense of unease. Take a look at the contrasting fates of two previous government monopolies for context.