Art Of Pricing Insurance IPOs

There is quite a bit of euphoria in the stock market around the initial public offerings (IPOs) of insurance companies these days. Four IPOs of leading companies - ICICI Prudential Life, ICICI Lombard, SBI Life and General Insurance Corporation of India - have already been concluded. Some more, such as public sector insurer New India Assurance and private sector companies HDFC Standard Life and Reliance Nippon Life, are expected in the near future.

All the stocks of insurance companies that have been launched so far were oversubscribed. However, doubts have been raised about valuation of these stocks, and most analysts have cautioned that they may not give good returns in the short term.

Let's see how valuation is done in the insurance sector.

The valuation exercise in the context of an insurance company (as it is in any valuation exercise) is more of an art than science. It involves not only measurement of past performance numbers, which is not difficult, but also a reasonably accurate estimate of future performance which is always tricky as it involves lot of assumptions. Through an insurance contract, insurer and insured enter into a multi-year contract (except for certain short tailed lines of businesses like travel, motor etc.). This has a direct implication as profits of an insurer cannot be determined with accuracy at the end of each financial year. They would hold considerable amount of capital and premiums in the reserves account to ensure they have ready capacity to meet the claims obligations as and when the need arises in future.

To assess the value of an insurance company, more specifically a life insurer, three components should be taken into consideration: Adjusted net asset value, value of in-force business (the sum of these two constituents is known as the embedded value), and value of future new business.

The new business is generally calculated on the basis of the value of one year's new business after factoring in capitalisation. To determine the growth of new business in future, one needs to consider the expected profitability of the business and the period over which the performance is expected to be repeated. The efficiency of an insurance company's management is determined by the net earned premium (NEP) given out in the process of acquiring, writing and servicing insurance payments, also termed as the expense ratio. This expense ratio varies a lot between companies and is still on the higher side for majority of the companies.

Measurement of the losses resulting from the risks insurers take and the cost of acquiring new customers are other important factors in the highly competitive insurance industry today.

Valuation of Recent IPOs

Let's have a look at the media reports about the valuation of just concluded ICICI Lombard and SBI Life IPOs.

At the upper end of the price band, ICICI Lombard is valued at `30,000 crore. That means the trailing price earnings (P/E) multiple of 46.2 and price book value (P/B) multiple of 8.6. This valuation is steep, particularly because top non-banking finance companies trade at P/B of under 6 and there is no direct listed peer for comparison.

At `700 per share, the initial share sale of SBI Life values it at `70,000 crore. This value is much higher than its `46,000 crore valuation in December, when the insurer had off-loaded 3.9 per cent shares to investors Temasek Holdings Pte Ltd and KKR and Co. LP for about `1,794 crore. Then SBI Chairperson Arundhati Bhattacharya, however, justified the significantly higher valuation at a recent press conference, saying that the minority stake sale to KKR and Temasek was a low liquidity private deal, while in an IPO there is much greater liquidity.

Factors Affecting Valuation

So, should we conclude from the above examples that though the valuation of insurance stocks look exaggerated, they would pay off in the long run? The reason why there cannot be a straight answer lies in the very nature of insurance industry. The business model of insurance companies involves a complex web of actuarial calculations and a number of variables and dynamic (and possibly changing every year!!) assumptions that make it difficult to predict accurately futureperformance.

There is considerable play of natural and man-made disasters in insurance business, which requires a complicated set of parameters to work out pricing and projection of number of claims, etc. All this makes it very difficult to accurately predict growth rates. For instance, sudden rise in cancellation of policies and increase in claims can have dramatic impact on performance of life insurance companies. On the other hand, if profitable business is retained year-on-year, this would be the most ideal scenario for any insurer.

Also, while business performance metrics are an important factor assessing valuation, the softer parameters such as quality of business are often overlooked in the numerical analysis of a valuation number. Such factors often play out on business valuation but not before a period of three-five years.

Reasons For Optimism

Despite the above mentioned difficulties in estimating financial performance of insurance companies, the following factors lead to the optimism witnessed among investors vis a vis insurance stocks.

Firstly, penetration of insurance in India is too low at about 3.4 per cent compared to around 6 per cent global average. Combined with the fact that the number of insurers available in India, relative to the size of the country and its population, is very less compared to some other developing as well as developed countries, it provides enough market space for the existing companies to grow significantly.

Available data suggests that the insurance industry is headed north-wards. In case of life insurance industry, the total new business premium touched `11,801 crore in May this year compared with `10,610 crore in the same month last year. The growth clocked by private insurers has been particularly impressive in the same period.

Another reason for the success of recent spate of IPOs lies in the scarcity premium that the current company stocks are drawing. While the high valuations might continue for the upcoming IPOs, however once we have 8-10 companies listed, the same may go away.

We must also understand that dynamics of the insurance market in India are changing very rapidly. New insurers are entering the market. Companies have started to be innovative in products and distribution by focusing on customer specific needs and requirements. IRDAI has been continuously and vigilantly monitoring the companies very closely. Disclosure requirements for the insurers are increasing and the pressure is on them to turn the loss-making businesses into profitable ones.

Reinsurance capacity has increased when IRDAI allowed foreign re-insurers to set up branches in India. This would result in competitiveness in the reinsurance rates and would allow companies to offload risks to reinsurers in a bigger way than early days. The reinsurance rates are expected to become competitive as well. From the customer perspective, the demand for protection is increasing - thanks to the growing awareness and education of population on the insurance requirements.

Online channel for buying insurance is witnessing a high double digit growth every year and the effort put-in by distributors, web aggregators and bank channel partners are contributing immensely in increasing the insurance penetration not only in metro cities but also in Tier 2 and Tier 3 cities.

Due to all the above reasons, it can be concluded that the current valuations may not be a good proxy for the future where the industry is headed northward. Insurance products must look to provide protection against the unforeseeable future events and insurance companies stocks should provide an opportunity for a steady capital growth but over a longer time frame.

Author is Co-founder & CFO of PolicyBazaar.com