Please Share:: 
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
India: Insurance
Equity Research
Neglected for too long, merits a relook; initiate on MAXI, BJFS
Initiating coverage on Max India (C-Buy) and Bajaj Finserv (Neutral)
We are initiating coverage on Max India with a Buy rating (on Conviction List)
and 12-m SOTP-based target price of Rs190. Key reasons: (1) big correction
in valuations (>60% underperformance vs. Sensex over last 2 years) despite
an improvement in operating performance; (2) turnaround in its life and
health care businesses driven by cost rationalisation/higher utilization; and
(3) lower capital requirement for the life business. We also initiate on Bajaj
Finserv with a Neutral rating and 12-m SOTP-based target price of Rs650.
Short-term concerns remain, but long-term potential is intact
Both changes in regulations and volatile equity markets will likely impact
industry volumes and margins in the near term. We expect industry
margins to stabilize at around 12%-14%, while volume growth will likely
range between 15% and 18% long-term, i.e. 1-1.3X nominal GDP growth.
While we expect FY12 growth to remain muted at 0%-5%, we believe it is
time to take a relook at the sector which is now making structural changes
to its operations and will see some companies emerge as strong players.
Changing strategies for the better, but still evolving
With the regulatory overhaul, insurers are implementing different strategies.
Most plan to focus on ULIPs (unit-linked investment policies (70% of sales),
though the share of traditional products will likely increase. The exceptions
are Max and Reliance, for whom traditional product sales constitute 60%-
70% of business. Within ULIPs there is a preference for single-premium
products among a few (e.g. ICICI) to reduce risk of persistency. We believe
most insurance sales in India will likely continue to be savings driven (given
demographics, income growth) and will continue to dominate this space.
Comparison vs. Asia: Scope for improvement for Indian companies
A comparison with Asia shows Indian companies have significant scope for
improvement: (1) 13M persistency ratios in India at 53% to 80% are far
below the 78% to 94% for Asian peers; (2) while expense ratios are not
strictly comparable, they are high for India at 14% to 27.2% vs. 5.2% to
7.9%; (3) Indian companies make amongst the lowest overall margins
(12%-14% vs. >20% for Asia), but similar on savings products. Despite this
we expect Indian companies to trade at a premium given likely higher
growth in India and a restructuring-driven improvement in persistency
ratio and cost ratios.
Overview: Industry has been neglected for too long, merits a relook
The insurance sector has gone through a bad patch for over two years – first due to the
financial crises which led to a significant correction in equity markets and therefore growth
for the sector, and then the regulatory changes, which forced companies to revisit their
strategies and business models. While the short-term volatility and uncertainty on volume
growth and margin will likely persist for some time, the long-term potential is undoubtedly
strong. We believe the market is reflecting the low growth and margin pressure in current
consensus estimates and think the downside risk is limited. While investors may still need
to be patient we believe it is time to revisit the sector. In this report, we compare the Indian
insurance industry with the rest of Asia’s, and initiate coverage on Max India (Buy, add to
Conviction List) and Bajaj Finserv (Neutral), both of which derive significant value from
their respective insurance businesses.
Initiating coverage on Max India (C-Buy) and Bajaj Finserv (Neutral)
In this report on the insurance sector we are initiating coverage on two stocks: Max India
(Buy, on Conviction List) and Bajaj Finserv (Neutral). Bajaj Finserv is a financial
conglomerate with lending, life and general insurance businesses, while Max India has
interests in life insurance, health insurance and the health care business (i.e. hospitals).
However, in both these companies a large part of the value is driven by their life insurance
businesses.
Max India: We initiate coverage on Max India with a Buy rating and add it to the
Conviction List, with an SOTP-based 12-month target price of Rs190 per share. We find
compelling reasons to buy: the stock has underperformed the index by 67% over the last
two years, while operating performance has been improving, a trajectory that will likely
continue. Additionally, life business will require limited/no capital for growth and Max India
is sitting on Rs5.8 bn of cash which can be used to fund health care and health insurance
businesses. Of these three, the life insurance business contributes 85% of its revenue and
accounts for 92% of its SOTP.
Bajaj Finserv: We initiate coverage with a Neutral rating and SOTP-based 12-month target
price of Rs650 per share. While its insurance business remains under pressure in the near
term, we expect the financial services arm to continue to show strong momentum and RoE
improvement on the back of its restructuring exercise. The upside to our insurance value
business could arise if FDI regulations do not change and the JV partner Allianz is required
to pay the market value for the entity rather than the price based on a contracted formula.
We currently assume full value for the 51% stake for Bajaj Finserv vs. potentially a 74%
stake. In terms of revenue, we see the life insurance business contributing 40%, general
insurance: 5% and finance: 42% of the business in FY11E.
Long-term prospects attractive, despite short-term concerns
Despite the significant regulatory changes that came into effect from 1 September 2010
(see Appendix 2), we believe the long-term prospects for the insurance industry remain
attractive on the back of favourable demographics (> 51.7% of the population is aged
between 20 and 60, which the United Nations projects will increase to 54.5% by 2020 – an
increase of 117mn people), strong growth in GDP (c. 12%-14%) and per-capita income, and
urbanization. In the short term, changes in regulations (lower commission payments, lower
penalties on surrenders, and longer lock-in) will likely put pressure on volume growth, and
margins for the industry. However, we believe this will be long-term positive for the
industry as it is already reflected in the changing strategies of companies, which are now
attempting to build stronger business models with an increased focus on higher persistency. In
addition to regulatory changes, near-term volume growth will also likely be impacted by
volatile equity markets, as nearly 70% of product sales are still ULIP-driven, with 70%-80%
of the funds flowing into equity-linked products. We expect the insurance industry to
deliver 12%-13% growth (private sector negative growth of 2%, LIC growth of 14%) in
FY11E, 0%-5% in FY12E and 15%-18% over the next five years between FY13E and FY18E.
Shifting/changing/evolving strategies, for the better
With the new regulations in place, insurance companies have gone back to the drawing
board to revisit existing strategies and formulate new ones. Based on our discussions with
industry participants, we see three types of product strategies that companies could follow:
1. Focus on traditional savings products (i.e., savings products that are non-transparent,
thus the investor does not get details on the policy as they do in ULIPs in terms of
charges and investments) vs. ULIPs – given more assured returns and commissions –
Max India, Reliance Life.
2. Focus on ULIPs to build their business as these remain a very transparent product and
are in the interests of consumers – ICICI, HDFC, Kotak, Bajaj.
3. For those focusing on ULIPs, selling more single premium vs. regular premium
products within ULIPs – ICICI, Max.
Companies have also been pushed into revisiting their preferred distribution channels, i.e.
banks vs. agents given forced reduction in cost of acquisition.
We believe that strategies will likely evolve for some time as volume growth implications
may push companies to revisit their strategies based on their experience. While it is
difficult to identify what might be the right strategies at this point in time, we prefer
companies with these characteristics:
Focused on ULIPs vs. traditional products. This is for two reasons, in our view: (1)
like ULIPs, traditional products could be targeted by regulators, who may reduce the
higher commission payouts that currently are key in driving traditional product
volumes; and (2) insurance products in India are driven more by savings needs vs. risk
products, a transparent ULIP product therefore will likely continue to dominate the
market space.
That are building solid regular premium business with increased focus on
persistency (HDFC, Bajaj).
Companies with banking tie-ups to market products (ICICI, HDFC).
Margins – market likely factoring in the worst
The new regulations have led to a reduction in surrender charges on lapsed policies (one of
the key factors that was driving new business margins for companies) and could thus
impact reported margins. To offset margin pressure, and reduce losses, companies have
been reducing costs (cost ratios down to 11% to 23% in 3QFY2011, vs. 20% to 32% in
FY2008 and 16% to 31% in FY2010). This process had started even prior to the regulatory
changes and the cost-cutting measures have been continued in FY2011. We believe the
industry’s margins could range between 12% and 14% on a sustainable basis, assuming an
increase in persistency ratio and reduction in cost (given renewed efforts on this front) vs.
the 17%-20% reported historically.
Moderate growth, lower capital requirements and lower losses
Given the slowdown in volumes and sharp cost reduction measures adopted by companies,
we expect insurance companies’ capital requirements to fall. Over the last 10 years, the
industry has invested close to US$4.7bn. Both upfront write-offs and volume growth have
till now led to higher capital requirements for insurance companies.
Of the key companies we have covered in this note, Bajaj Allianz and SBI Life have been
the most efficient users of capital. Likely higher upfront charges and lower expense ratios
for the companies have been key reasons for this. Max, Reliance and Birla, on the other
hand, have been the least efficient users of capital.
Valuation challenges remain, but we see value emerging
It is always a challenge valuing insurance businesses given the need to make a range of
assumptions in order to arrive at EV/MCEVs. This is further complicated by the new
regulations in India, which will likely lead to changes in margins that carry relatively lower
predictability vs. the historical numbers/margins, as business models were supported by
higher lapsed policies. Under the new regulations, this will now have to be supported and
driven by persistency, a difficult task given the industry trends so far. The 13th Month
Persistency ratios for Indian companies range between 52% and 80% vs. 78% and 93.7% for
their Asian peers.
We use the appraisal value method to arrive at our implied value estimates (Embedded
value + New Business Value X Multiple). We are assuming a margin of 12% vs. the 18%-
21% declared by the companies in FY10 and multiple on NBV of 14X (arrived at using a
three-stage VNB discount model – Stage 1 CAGR 17% for 5 years, stage 2 CAGR 14% for 10
years, terminal year growth of 5%, discount rate of 12.5%). Note that recent data shows
that the margin for 3Q has been higher for select companies like ICICI Prudential Life at
17.6%. Our implied value estimates range between 1.6X and 2.02X EV vs. 0.44X and 2.45X
for listed entities in the rest of Asia.
How to value? Appraisal value preferred, despite pitfalls
We are initiating coverage on Max India with a Buy rating (and adding it to the Conviction
List) and Bajaj Finserv with a Neutral rating, both of which have a significant degree of
exposure to the insurance business. We use the appraisal value method to value their
insurance businesses, which is based on the EV (Embedded Value) of FY12E + FY2012E
NBV (New Business Value) X implied multiple on VNB (Value of New Business). Both these
companies have a range of businesses and we use the SOTP methodology to arrive at our
implied value estimates given the disparate businesses.
Appraisal value appropriate, given uncertainty on earnings
Appraisal value method appropriate…: We value insurance companies using the
appraisal value method (EV + NBV X multiple). We believe this method is still the most
appropriate method for valuing insurance companies in India, given: (1) uncertainties
surrounding the P&L from new regulations. We believe companies are in the process of
revisiting and re-jigging their strategies and the full impact of the changes will likely get
reflected in the profit and loss over the next two years; and (2) Indian accounting is far
more conservative vs. the other markets as companies are required to charge off their
entire expenses upfront, reducing profit numbers in high-growth periods and distorting
relative valuations of companies.
…though this too has issues: Even the appraisal value method has shortcomings: (1)
not all companies disclose EVs in India, and those that do, do not provide details of noneconomic
assumptions used in arriving at their NBV. Margin for companies could be
influenced by assumptions pertaining to persistency ratios, term of the product – i.e., the
longer the term, the higher the margin will be, actual expenses vs. estimated, tax rates, and
so on; and (2) regulatory changes will impact margins earned by companies, the extent of
which is not yet clear. For the purposes of our valuations, therefore, we have assumed
significantly lower margins at 12% vs. declared numbers of 18%-20%. We arrive at our
multiples using a 3-stage VNB discount model.
Focusing on key assumptions to get comfort on margins: We believe it is fairly
difficult at this stage of the market’s development, especially with the regulatory changes,
to arrive at companies’ bottom-line numbers with some degree of confidence. Getting
comfort on margins is therefore key in arriving at implied value estimates of companies.
We have therefore highlighted a few key assumptions that we think will drive margins for
companies, e.g. the higher the persistency the better the margin should be (more so under
the new regulations
Comparability difficult: some companies disclosing MCEV, most EV
Currently four insurance companies – ICICI Prudential Life, Max New York Life, Bajaj Allianz
Life and Birla Sun Life – are declaring EV and HDFC Standard Life MCEV. While eventually
all the companies will in our view move to MCEV, the EV and MCEV margin varies, with
MCEV being high in India given the significant ULIP proportion of policy sales. In addition,
not all companies are declaring the EV on the entire business, i.e. only on the retail business
(e.g. Birla Sun Life, HDFC SL). Comparing numbers across companies therefore remains a
challenge.
Impact of MCEV on margin
Term insurance – increases, as discount rates are lower.
Traditional policies – margin falls when asset risk premium is reduced.
ULIPs – in between the above two. Low-risk products such as ULIPs without
guarantees show higher economic profit compared to traditional products.
Multiple factors influencing valuations
We believe multiple factors could influence the long-term value assigned to insurance
companies in India. Key amongst them:
NBV multiple will reflect growth potential: While the life insurance industry has
suffered over the last two years, first due to stock market volatility and then regulatory
changes, we think the long-term growth trajectory for premium income remains strong.
Rising disposable income, changing demographics and a strong economy will, we believe,
drive growth rates of over 15%-18% (vs. nominal GDP growth of 12%-15%) over the next
10-15 years in premium collection. We believe this will translate into higher multiples on
the NBM for Indian companies compared to other Asian markets.
Margin likely to stabilize in FY2012: We estimate the industry’s average new business
margin will come down from historical levels of 17%-20% and stabilize at around 12%-14%,
reflecting regulatory changes and a higher tax rate. We assume the tax rate for the industry
will increase to 25% post implementation of the Direct Tax Code vs. the current level of 14%.
Stock market performance: Given the high proportion of ULIPs and equities as a
proportion of overall sales, significant swings in markets can influence premium growth
and therefore valuations of insurance companies.
Regulatory risks: Post the major changes made on the ULIPs and Universal Life (a
traditional product with features similar to ULIPs), regulators may at some stage we believe
make changes to traditional products. This could impact volumes and margins. Based on
our discussions with industry participants, we believe the regulator may also try to
regulate/issue norms on distribution channels.
Market likely to ignore ea rnings for now: In the long term, the market will likely focus
on both earnings growth and EV to value insurance companies. In the near term, though,
projecting earnings will be a challenge as companies struggle to implement and stabilize
new strategies.
Premium income: Strong potential, despite short-term challenges
Macro analysis indicates that the potential for insurance premium income still remains
high in India. At 4.6%, the life insurance premium income to GDP ratio for India is lower
than for developed countries such as Korea (6.5%), Japan (7.8%), Taiwan (13.8%) and the
UK (10%). Note that the penetration level in the US is lower at 3.5% as savings are
garnered by mutual funds and under 401Ks. While the premium income to GDP is not right
at the lower end, the per capita income is still low, plus we believe India’s premium income
to GDP ratios are likely inflated by the higher savings component vs. other markets. A
comparison with developed markets indicates that premium growth increases significantly
when income levels reach US$10,000. India is currently at US$1,176 and we see this
increasing (11.5% CAGR growth last ten years). This is likely as disposable income will
increase at a faster pace then the GDP, with a lower proportion of income going towards
basics such as food.
This is also supported by favourable demographics, expectations of higher returns and the
risk-taking capability of the younger portion of the population (32% aged between 20 and
40). Insurance in India is not just a risk product, but more of a savings product, and will
benefit from this demographic dividend. Unlike the West, where mutual fund plays a
bigger role in channeling the savings of retail investors, the insurance industry in India is
channeling retail savings to the equity and debt markets.
Short-term growth impacted by IRDA regulation
We estimate a flat to lower growth in premium income for FY2011 as companies struggle
to change their models on the back of recent regulatory changes pertaining to lower
commission/charges, lower AUM fees, and surrender charges on ULIP products (key
changes implemented by IRDA are provided in Appendix 2). However, this does bode well
from customer’s perspective and should translate into higher growth in premium collection
long-term. We estimate FY2011 premium income to grow at 0%-5%, rising to 15%-20% in
FY2013 to FY2015.
Recent shake-up forcing companies to focus on persistency
Till now the market has largely been focused on new business income and not renewal
premium for valuing insurance companies. As a matter of fact, higher lapses or surrenders
helped companies report higher margin or profit or lower losses as companies charged
hefty surrender charges and retained a large part of the lapsed funds. Reduction in
surrender charges was thus a game-changer, from the company making money to the
customer making money.
Companies will now have to focus on persistency to protect margins. For example, if
persistency falls to 75% from 85%, the margin will fall to 10% from 15%.This we believe is a
clear challenge given: (1) the market is not necessarily developed for long-term products,
(2) sales benefit from churn and encourages early withdrawals, and (3) lower surrender
charges on surrender/lapsed policies will make it easier for customer to withdraw funds
given removal/reduction of disincentive, i.e. lower surrender charges. We believe
companies are therefore planning to focus on single-premium products, link commissions
to persistency and even changed policies to annual payment vs. quarterly to reduce lapses.
Some companies plan to sell more SP to avoid persistency issues
Premium income can be received by insurance companies in any of the following three
forms:
Single-premium product – the premium is received upfront.
Limited pay product – the premium is received over a couple of years.
Regular premium product – typically quarterly/half-yearly or annual premium
received over 5-15 years (till recently products were sold for a minimum period of
three years, and generally most policy sales were skewed towards the three-year
product with very little coming in a longer tenure).
Till now most private companies were focused on regular premium products – likely given
higher profitability and likely low success ratio in selling single-premium products.
However, given changes in regulations and concerns relating to the higher lapse ratio,
most private companies now seem to indicate a preference for single-premium products.
Additionally, the commission structure too is better for the distributors on single-premium
products encouraging in a shift to these products. The two companies that have managed
to sell single-premium products are LIC and SBI Life.
Despite persistency issues, ULIP remains preferred choice
Unlike other parts of Asia, the Indian market is largely driven by ULIPs. Higher returns
(given investments in equities) and transparency have been key reasons for the product
finding a strong demand. Even companies have preferred this product given the relatively
higher margin on ULIPs vs. traditional products. In India, companies have to share 90% of
the profit earned on traditional products with policyholders (vs. 70% in China). In addition,
65% of the funds under traditional products have to be invested in government bonds,
where yields/returns are low relative to equity, making this a less attractive investment.
Nearly 70% of incremental sales (even post the new regulations) is driven by ULIPs, with an
estimated 65%-75% of the funds flowing to equity-linked funds.
Fluctuating market share and ranking
Over the last ten years, LIC has lost market share to private players (down to 43% in FY09)
as the latter started expanding the market. However, post the financial crises and recent
regulations, LIC regained some of its lost share given government ownership with a strong
franchise and reach (52.8% ytd). Despite the loss of market share over the last three years,
ICICI Prudential Life Insurance has retained its number one position (8.1% share) amongst
private companies. It now has a 200 bps gap over SBI Life (6% market share), which over
the last two years, has gained significant share. The market share of other players has
moved around significantly.
We think the key reason for the changing market share and ranking of participants has
been the inconsistent strategies and investments made by promoters in the business.
Given the advantage of strong brand, franchise, distribution strength and strategy, we
expect ICICI Prudential Life and SBI to remain the top two players. A large part of the loss
in market share and ranking at Bajaj Allianz Life we believe was driven by a strategy of
cleaning the portfolio and focusing on quality of product sales. Other strong players in the
market are HDFC SL and Max New York Life, while Kotak Life remains a niche, profitable
company.
Distribution models: Advantage banks
Insurance companies distribute products through their own agency force, banks, direct
sales and brokers (the internet/mobile phones etc have had a limited impact to date). On
average, 50% of products sold by private insurance companies in India are through the
agency channel and 25% through the banking channel. Till 2008, we saw insurance
companies expand their network aggressively. However, over the last two years we have
seen a sharp reduction in the size of agency forces and number of branches and employees
at these companies. Volume pressure post crises and regulatory changes in the recent past
are two key reasons for the shift in strategy from being in every nook and corner to
focusing on key markets.
Bancassurance turning out to be an advantage
Indian banks have been selling both traditional and ULIP products through their
branches(most banks sell ULIPs, though there are few exceptions like Axis Bank for which
90% of sales are traditional products). Given that India follows a closed architecture, i.e.
Indian banks can sell only one insurance company product, the banks have been charging
higher rates of commission for distribution vs. the agency channel. In addition, banks may
discontinue their tie-ups beyond the contract period, which is typically for three years.
There have been expectations that the regulator may allow banks to distribute three
insurance companies’ products vs. one now. Manufacturers with their own bank stand to
have a clear advantage, i.e. a low cost of distribution. With most part-time agents falling by
the way-side/exiting the industry (given low commissions on the back of new regulations),
dependence on the banking sector will increase.
Issues/challenges in this model are: mis-selling, low profitability for manufacturers – as
bankers claim the high commissions, product development (as products are made more for
bankers rather than for investors/insurers), single-premium or short-term products sold
with less focus on persistency.
Reserving and expenses, comparison across countries difficult
Accounts/profits across Asia are not comparable, given different expensing and reserving
policies followed by companies. For example:
Expenses are written-off upfront in India, Japan, Taiwan, and China, whereas in Korea
this is deferred evenly over seven years. This issue will be resolved as India moves to
implement IFRS in April 2012.
Besides regulations, expense ratios across countries and companies will also be
influenced by the maturity of the business, and the growth trajectory. For example, in a
country like India the expense to total income ratio is higher than peers in other
markets given a higher growth trajectory and the cost of building the business. Within
companies as well, this ratio varies significantly depending on the scale of their
operations and strategy adopted. Additionally, companies in India had built bloated
cost structures given higher surrender/lapsing charges that were used to offset these
costs.
Earnings and RoE likely to emerge despite lower margins
Insurance companies have been reporting huge losses since inception. This reflects factors
such as: faulty business models – high cost structures, aggressive network expansion, low
productivity levels; strong growth in volumes; and upfront write-off costs. Most companies,
therefore, are still sitting on huge accumulated losses. We believe this is now likely to
change, as companies have effected significant cost-cutting measures and have seen
moderation in volume growth – most of which have been forced by market changes
(regulations and volatile equity markets). In the near term, the surrender charges booked
by companies on old policies will also support income. After that, profit will have to be
driven by reducing the cost of operations, as surrender charges fall to a minimal level as
per new regulations and may provide a real test of the models now being built by the
various companies
Solvency ratios not an issue for Indian companies
Private sector insurance companies have invested over Rs200bn in capital in the insurance
space since 2000. We believe the amount of capital investments will now reduce as
companies have moderated growth, and see lower losses on cost-cutting. Based on the
IRDA data, all insurers are well capitalized. Analysis of the capital invested vs. AUMs, total
premium income generated and market share shows that SBI Life, Kotak and Bajaj have
been most efficient users of capital – likely due, we think, to lower expense ratios (SBI Life)
and in some cases (Bajaj and Kotak) higher upfront charges on products to recover higher
costs.
General insurance: Structurally a low-profitability business
Low level of penetration: In India, the non-life insurance business is less penetrated vs.
life, with a premium income to GDP ratio at 0.6% vs. the international range of 2.9% to
4.5% (see Exhibit 134 in Appendix 1). The non-life insurance business/premium income is
driven largely by motor and health insurance, both of which account for 64.6% of the policy
premium income. We expect the motor insurance business to grow in line with the auto
market at around 10% to 15%, while we estimate the health insurance business could grow
at faster pace of 15% to 20% given lower penetration levels.
Few private players and four PSU companies dominate: Bajaj Allianz, ICICI Lombard
and Reliance General Insurance dominate this space amongst private companies with 21%
share, with the largest piece of the pie still with the public sector entities which enjoy 61%
market share.
Low profitability on high competition, PSU dynamics: As is the case with life, the
retail business is the more profitable business, with significant competition in the group.
Even within retail, non-life products are priced competitively given the strong presence of
PSU entities, which have resorted to mis-pricing. They managed to do so due to high
investment income driven from past investments made at low valuations. Within the
private insurers, Bajaj Allianz General Insurance is the best run and most profitable
company, generating RoEs of 15% vs. 8% for ICICI Lombard
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
India: Insurance
Equity Research
Neglected for too long, merits a relook; initiate on MAXI, BJFS
Initiating coverage on Max India (C-Buy) and Bajaj Finserv (Neutral)
We are initiating coverage on Max India with a Buy rating (on Conviction List)
and 12-m SOTP-based target price of Rs190. Key reasons: (1) big correction
in valuations (>60% underperformance vs. Sensex over last 2 years) despite
an improvement in operating performance; (2) turnaround in its life and
health care businesses driven by cost rationalisation/higher utilization; and
(3) lower capital requirement for the life business. We also initiate on Bajaj
Finserv with a Neutral rating and 12-m SOTP-based target price of Rs650.
Short-term concerns remain, but long-term potential is intact
Both changes in regulations and volatile equity markets will likely impact
industry volumes and margins in the near term. We expect industry
margins to stabilize at around 12%-14%, while volume growth will likely
range between 15% and 18% long-term, i.e. 1-1.3X nominal GDP growth.
While we expect FY12 growth to remain muted at 0%-5%, we believe it is
time to take a relook at the sector which is now making structural changes
to its operations and will see some companies emerge as strong players.
Changing strategies for the better, but still evolving
With the regulatory overhaul, insurers are implementing different strategies.
Most plan to focus on ULIPs (unit-linked investment policies (70% of sales),
though the share of traditional products will likely increase. The exceptions
are Max and Reliance, for whom traditional product sales constitute 60%-
70% of business. Within ULIPs there is a preference for single-premium
products among a few (e.g. ICICI) to reduce risk of persistency. We believe
most insurance sales in India will likely continue to be savings driven (given
demographics, income growth) and will continue to dominate this space.
Comparison vs. Asia: Scope for improvement for Indian companies
A comparison with Asia shows Indian companies have significant scope for
improvement: (1) 13M persistency ratios in India at 53% to 80% are far
below the 78% to 94% for Asian peers; (2) while expense ratios are not
strictly comparable, they are high for India at 14% to 27.2% vs. 5.2% to
7.9%; (3) Indian companies make amongst the lowest overall margins
(12%-14% vs. >20% for Asia), but similar on savings products. Despite this
we expect Indian companies to trade at a premium given likely higher
growth in India and a restructuring-driven improvement in persistency
ratio and cost ratios.
Overview: Industry has been neglected for too long, merits a relook
The insurance sector has gone through a bad patch for over two years – first due to the
financial crises which led to a significant correction in equity markets and therefore growth
for the sector, and then the regulatory changes, which forced companies to revisit their
strategies and business models. While the short-term volatility and uncertainty on volume
growth and margin will likely persist for some time, the long-term potential is undoubtedly
strong. We believe the market is reflecting the low growth and margin pressure in current
consensus estimates and think the downside risk is limited. While investors may still need
to be patient we believe it is time to revisit the sector. In this report, we compare the Indian
insurance industry with the rest of Asia’s, and initiate coverage on Max India (Buy, add to
Conviction List) and Bajaj Finserv (Neutral), both of which derive significant value from
their respective insurance businesses.
Initiating coverage on Max India (C-Buy) and Bajaj Finserv (Neutral)
In this report on the insurance sector we are initiating coverage on two stocks: Max India
(Buy, on Conviction List) and Bajaj Finserv (Neutral). Bajaj Finserv is a financial
conglomerate with lending, life and general insurance businesses, while Max India has
interests in life insurance, health insurance and the health care business (i.e. hospitals).
However, in both these companies a large part of the value is driven by their life insurance
businesses.
Max India: We initiate coverage on Max India with a Buy rating and add it to the
Conviction List, with an SOTP-based 12-month target price of Rs190 per share. We find
compelling reasons to buy: the stock has underperformed the index by 67% over the last
two years, while operating performance has been improving, a trajectory that will likely
continue. Additionally, life business will require limited/no capital for growth and Max India
is sitting on Rs5.8 bn of cash which can be used to fund health care and health insurance
businesses. Of these three, the life insurance business contributes 85% of its revenue and
accounts for 92% of its SOTP.
Bajaj Finserv: We initiate coverage with a Neutral rating and SOTP-based 12-month target
price of Rs650 per share. While its insurance business remains under pressure in the near
term, we expect the financial services arm to continue to show strong momentum and RoE
improvement on the back of its restructuring exercise. The upside to our insurance value
business could arise if FDI regulations do not change and the JV partner Allianz is required
to pay the market value for the entity rather than the price based on a contracted formula.
We currently assume full value for the 51% stake for Bajaj Finserv vs. potentially a 74%
stake. In terms of revenue, we see the life insurance business contributing 40%, general
insurance: 5% and finance: 42% of the business in FY11E.
Long-term prospects attractive, despite short-term concerns
Despite the significant regulatory changes that came into effect from 1 September 2010
(see Appendix 2), we believe the long-term prospects for the insurance industry remain
attractive on the back of favourable demographics (> 51.7% of the population is aged
between 20 and 60, which the United Nations projects will increase to 54.5% by 2020 – an
increase of 117mn people), strong growth in GDP (c. 12%-14%) and per-capita income, and
urbanization. In the short term, changes in regulations (lower commission payments, lower
penalties on surrenders, and longer lock-in) will likely put pressure on volume growth, and
margins for the industry. However, we believe this will be long-term positive for the
industry as it is already reflected in the changing strategies of companies, which are now
attempting to build stronger business models with an increased focus on higher persistency. In
addition to regulatory changes, near-term volume growth will also likely be impacted by
volatile equity markets, as nearly 70% of product sales are still ULIP-driven, with 70%-80%
of the funds flowing into equity-linked products. We expect the insurance industry to
deliver 12%-13% growth (private sector negative growth of 2%, LIC growth of 14%) in
FY11E, 0%-5% in FY12E and 15%-18% over the next five years between FY13E and FY18E.
Shifting/changing/evolving strategies, for the better
With the new regulations in place, insurance companies have gone back to the drawing
board to revisit existing strategies and formulate new ones. Based on our discussions with
industry participants, we see three types of product strategies that companies could follow:
1. Focus on traditional savings products (i.e., savings products that are non-transparent,
thus the investor does not get details on the policy as they do in ULIPs in terms of
charges and investments) vs. ULIPs – given more assured returns and commissions –
Max India, Reliance Life.
2. Focus on ULIPs to build their business as these remain a very transparent product and
are in the interests of consumers – ICICI, HDFC, Kotak, Bajaj.
3. For those focusing on ULIPs, selling more single premium vs. regular premium
products within ULIPs – ICICI, Max.
Companies have also been pushed into revisiting their preferred distribution channels, i.e.
banks vs. agents given forced reduction in cost of acquisition.
We believe that strategies will likely evolve for some time as volume growth implications
may push companies to revisit their strategies based on their experience. While it is
difficult to identify what might be the right strategies at this point in time, we prefer
companies with these characteristics:
Focused on ULIPs vs. traditional products. This is for two reasons, in our view: (1)
like ULIPs, traditional products could be targeted by regulators, who may reduce the
higher commission payouts that currently are key in driving traditional product
volumes; and (2) insurance products in India are driven more by savings needs vs. risk
products, a transparent ULIP product therefore will likely continue to dominate the
market space.
That are building solid regular premium business with increased focus on
persistency (HDFC, Bajaj).
Companies with banking tie-ups to market products (ICICI, HDFC).
Margins – market likely factoring in the worst
The new regulations have led to a reduction in surrender charges on lapsed policies (one of
the key factors that was driving new business margins for companies) and could thus
impact reported margins. To offset margin pressure, and reduce losses, companies have
been reducing costs (cost ratios down to 11% to 23% in 3QFY2011, vs. 20% to 32% in
FY2008 and 16% to 31% in FY2010). This process had started even prior to the regulatory
changes and the cost-cutting measures have been continued in FY2011. We believe the
industry’s margins could range between 12% and 14% on a sustainable basis, assuming an
increase in persistency ratio and reduction in cost (given renewed efforts on this front) vs.
the 17%-20% reported historically.
Moderate growth, lower capital requirements and lower losses
Given the slowdown in volumes and sharp cost reduction measures adopted by companies,
we expect insurance companies’ capital requirements to fall. Over the last 10 years, the
industry has invested close to US$4.7bn. Both upfront write-offs and volume growth have
till now led to higher capital requirements for insurance companies.
Of the key companies we have covered in this note, Bajaj Allianz and SBI Life have been
the most efficient users of capital. Likely higher upfront charges and lower expense ratios
for the companies have been key reasons for this. Max, Reliance and Birla, on the other
hand, have been the least efficient users of capital.
Valuation challenges remain, but we see value emerging
It is always a challenge valuing insurance businesses given the need to make a range of
assumptions in order to arrive at EV/MCEVs. This is further complicated by the new
regulations in India, which will likely lead to changes in margins that carry relatively lower
predictability vs. the historical numbers/margins, as business models were supported by
higher lapsed policies. Under the new regulations, this will now have to be supported and
driven by persistency, a difficult task given the industry trends so far. The 13th Month
Persistency ratios for Indian companies range between 52% and 80% vs. 78% and 93.7% for
their Asian peers.
We use the appraisal value method to arrive at our implied value estimates (Embedded
value + New Business Value X Multiple). We are assuming a margin of 12% vs. the 18%-
21% declared by the companies in FY10 and multiple on NBV of 14X (arrived at using a
three-stage VNB discount model – Stage 1 CAGR 17% for 5 years, stage 2 CAGR 14% for 10
years, terminal year growth of 5%, discount rate of 12.5%). Note that recent data shows
that the margin for 3Q has been higher for select companies like ICICI Prudential Life at
17.6%. Our implied value estimates range between 1.6X and 2.02X EV vs. 0.44X and 2.45X
for listed entities in the rest of Asia.
How to value? Appraisal value preferred, despite pitfalls
We are initiating coverage on Max India with a Buy rating (and adding it to the Conviction
List) and Bajaj Finserv with a Neutral rating, both of which have a significant degree of
exposure to the insurance business. We use the appraisal value method to value their
insurance businesses, which is based on the EV (Embedded Value) of FY12E + FY2012E
NBV (New Business Value) X implied multiple on VNB (Value of New Business). Both these
companies have a range of businesses and we use the SOTP methodology to arrive at our
implied value estimates given the disparate businesses.
Appraisal value appropriate, given uncertainty on earnings
Appraisal value method appropriate…: We value insurance companies using the
appraisal value method (EV + NBV X multiple). We believe this method is still the most
appropriate method for valuing insurance companies in India, given: (1) uncertainties
surrounding the P&L from new regulations. We believe companies are in the process of
revisiting and re-jigging their strategies and the full impact of the changes will likely get
reflected in the profit and loss over the next two years; and (2) Indian accounting is far
more conservative vs. the other markets as companies are required to charge off their
entire expenses upfront, reducing profit numbers in high-growth periods and distorting
relative valuations of companies.
…though this too has issues: Even the appraisal value method has shortcomings: (1)
not all companies disclose EVs in India, and those that do, do not provide details of noneconomic
assumptions used in arriving at their NBV. Margin for companies could be
influenced by assumptions pertaining to persistency ratios, term of the product – i.e., the
longer the term, the higher the margin will be, actual expenses vs. estimated, tax rates, and
so on; and (2) regulatory changes will impact margins earned by companies, the extent of
which is not yet clear. For the purposes of our valuations, therefore, we have assumed
significantly lower margins at 12% vs. declared numbers of 18%-20%. We arrive at our
multiples using a 3-stage VNB discount model.
Focusing on key assumptions to get comfort on margins: We believe it is fairly
difficult at this stage of the market’s development, especially with the regulatory changes,
to arrive at companies’ bottom-line numbers with some degree of confidence. Getting
comfort on margins is therefore key in arriving at implied value estimates of companies.
We have therefore highlighted a few key assumptions that we think will drive margins for
companies, e.g. the higher the persistency the better the margin should be (more so under
the new regulations
Comparability difficult: some companies disclosing MCEV, most EV
Currently four insurance companies – ICICI Prudential Life, Max New York Life, Bajaj Allianz
Life and Birla Sun Life – are declaring EV and HDFC Standard Life MCEV. While eventually
all the companies will in our view move to MCEV, the EV and MCEV margin varies, with
MCEV being high in India given the significant ULIP proportion of policy sales. In addition,
not all companies are declaring the EV on the entire business, i.e. only on the retail business
(e.g. Birla Sun Life, HDFC SL). Comparing numbers across companies therefore remains a
challenge.
Impact of MCEV on margin
Term insurance – increases, as discount rates are lower.
Traditional policies – margin falls when asset risk premium is reduced.
ULIPs – in between the above two. Low-risk products such as ULIPs without
guarantees show higher economic profit compared to traditional products.
Multiple factors influencing valuations
We believe multiple factors could influence the long-term value assigned to insurance
companies in India. Key amongst them:
NBV multiple will reflect growth potential: While the life insurance industry has
suffered over the last two years, first due to stock market volatility and then regulatory
changes, we think the long-term growth trajectory for premium income remains strong.
Rising disposable income, changing demographics and a strong economy will, we believe,
drive growth rates of over 15%-18% (vs. nominal GDP growth of 12%-15%) over the next
10-15 years in premium collection. We believe this will translate into higher multiples on
the NBM for Indian companies compared to other Asian markets.
Margin likely to stabilize in FY2012: We estimate the industry’s average new business
margin will come down from historical levels of 17%-20% and stabilize at around 12%-14%,
reflecting regulatory changes and a higher tax rate. We assume the tax rate for the industry
will increase to 25% post implementation of the Direct Tax Code vs. the current level of 14%.
Stock market performance: Given the high proportion of ULIPs and equities as a
proportion of overall sales, significant swings in markets can influence premium growth
and therefore valuations of insurance companies.
Regulatory risks: Post the major changes made on the ULIPs and Universal Life (a
traditional product with features similar to ULIPs), regulators may at some stage we believe
make changes to traditional products. This could impact volumes and margins. Based on
our discussions with industry participants, we believe the regulator may also try to
regulate/issue norms on distribution channels.
Market likely to ignore ea rnings for now: In the long term, the market will likely focus
on both earnings growth and EV to value insurance companies. In the near term, though,
projecting earnings will be a challenge as companies struggle to implement and stabilize
new strategies.
Premium income: Strong potential, despite short-term challenges
Macro analysis indicates that the potential for insurance premium income still remains
high in India. At 4.6%, the life insurance premium income to GDP ratio for India is lower
than for developed countries such as Korea (6.5%), Japan (7.8%), Taiwan (13.8%) and the
UK (10%). Note that the penetration level in the US is lower at 3.5% as savings are
garnered by mutual funds and under 401Ks. While the premium income to GDP is not right
at the lower end, the per capita income is still low, plus we believe India’s premium income
to GDP ratios are likely inflated by the higher savings component vs. other markets. A
comparison with developed markets indicates that premium growth increases significantly
when income levels reach US$10,000. India is currently at US$1,176 and we see this
increasing (11.5% CAGR growth last ten years). This is likely as disposable income will
increase at a faster pace then the GDP, with a lower proportion of income going towards
basics such as food.
This is also supported by favourable demographics, expectations of higher returns and the
risk-taking capability of the younger portion of the population (32% aged between 20 and
40). Insurance in India is not just a risk product, but more of a savings product, and will
benefit from this demographic dividend. Unlike the West, where mutual fund plays a
bigger role in channeling the savings of retail investors, the insurance industry in India is
channeling retail savings to the equity and debt markets.
Short-term growth impacted by IRDA regulation
We estimate a flat to lower growth in premium income for FY2011 as companies struggle
to change their models on the back of recent regulatory changes pertaining to lower
commission/charges, lower AUM fees, and surrender charges on ULIP products (key
changes implemented by IRDA are provided in Appendix 2). However, this does bode well
from customer’s perspective and should translate into higher growth in premium collection
long-term. We estimate FY2011 premium income to grow at 0%-5%, rising to 15%-20% in
FY2013 to FY2015.
Recent shake-up forcing companies to focus on persistency
Till now the market has largely been focused on new business income and not renewal
premium for valuing insurance companies. As a matter of fact, higher lapses or surrenders
helped companies report higher margin or profit or lower losses as companies charged
hefty surrender charges and retained a large part of the lapsed funds. Reduction in
surrender charges was thus a game-changer, from the company making money to the
customer making money.
Companies will now have to focus on persistency to protect margins. For example, if
persistency falls to 75% from 85%, the margin will fall to 10% from 15%.This we believe is a
clear challenge given: (1) the market is not necessarily developed for long-term products,
(2) sales benefit from churn and encourages early withdrawals, and (3) lower surrender
charges on surrender/lapsed policies will make it easier for customer to withdraw funds
given removal/reduction of disincentive, i.e. lower surrender charges. We believe
companies are therefore planning to focus on single-premium products, link commissions
to persistency and even changed policies to annual payment vs. quarterly to reduce lapses.
Some companies plan to sell more SP to avoid persistency issues
Premium income can be received by insurance companies in any of the following three
forms:
Single-premium product – the premium is received upfront.
Limited pay product – the premium is received over a couple of years.
Regular premium product – typically quarterly/half-yearly or annual premium
received over 5-15 years (till recently products were sold for a minimum period of
three years, and generally most policy sales were skewed towards the three-year
product with very little coming in a longer tenure).
Till now most private companies were focused on regular premium products – likely given
higher profitability and likely low success ratio in selling single-premium products.
However, given changes in regulations and concerns relating to the higher lapse ratio,
most private companies now seem to indicate a preference for single-premium products.
Additionally, the commission structure too is better for the distributors on single-premium
products encouraging in a shift to these products. The two companies that have managed
to sell single-premium products are LIC and SBI Life.
Despite persistency issues, ULIP remains preferred choice
Unlike other parts of Asia, the Indian market is largely driven by ULIPs. Higher returns
(given investments in equities) and transparency have been key reasons for the product
finding a strong demand. Even companies have preferred this product given the relatively
higher margin on ULIPs vs. traditional products. In India, companies have to share 90% of
the profit earned on traditional products with policyholders (vs. 70% in China). In addition,
65% of the funds under traditional products have to be invested in government bonds,
where yields/returns are low relative to equity, making this a less attractive investment.
Nearly 70% of incremental sales (even post the new regulations) is driven by ULIPs, with an
estimated 65%-75% of the funds flowing to equity-linked funds.
Fluctuating market share and ranking
Over the last ten years, LIC has lost market share to private players (down to 43% in FY09)
as the latter started expanding the market. However, post the financial crises and recent
regulations, LIC regained some of its lost share given government ownership with a strong
franchise and reach (52.8% ytd). Despite the loss of market share over the last three years,
ICICI Prudential Life Insurance has retained its number one position (8.1% share) amongst
private companies. It now has a 200 bps gap over SBI Life (6% market share), which over
the last two years, has gained significant share. The market share of other players has
moved around significantly.
We think the key reason for the changing market share and ranking of participants has
been the inconsistent strategies and investments made by promoters in the business.
Given the advantage of strong brand, franchise, distribution strength and strategy, we
expect ICICI Prudential Life and SBI to remain the top two players. A large part of the loss
in market share and ranking at Bajaj Allianz Life we believe was driven by a strategy of
cleaning the portfolio and focusing on quality of product sales. Other strong players in the
market are HDFC SL and Max New York Life, while Kotak Life remains a niche, profitable
company.
Distribution models: Advantage banks
Insurance companies distribute products through their own agency force, banks, direct
sales and brokers (the internet/mobile phones etc have had a limited impact to date). On
average, 50% of products sold by private insurance companies in India are through the
agency channel and 25% through the banking channel. Till 2008, we saw insurance
companies expand their network aggressively. However, over the last two years we have
seen a sharp reduction in the size of agency forces and number of branches and employees
at these companies. Volume pressure post crises and regulatory changes in the recent past
are two key reasons for the shift in strategy from being in every nook and corner to
focusing on key markets.
Bancassurance turning out to be an advantage
Indian banks have been selling both traditional and ULIP products through their
branches(most banks sell ULIPs, though there are few exceptions like Axis Bank for which
90% of sales are traditional products). Given that India follows a closed architecture, i.e.
Indian banks can sell only one insurance company product, the banks have been charging
higher rates of commission for distribution vs. the agency channel. In addition, banks may
discontinue their tie-ups beyond the contract period, which is typically for three years.
There have been expectations that the regulator may allow banks to distribute three
insurance companies’ products vs. one now. Manufacturers with their own bank stand to
have a clear advantage, i.e. a low cost of distribution. With most part-time agents falling by
the way-side/exiting the industry (given low commissions on the back of new regulations),
dependence on the banking sector will increase.
Issues/challenges in this model are: mis-selling, low profitability for manufacturers – as
bankers claim the high commissions, product development (as products are made more for
bankers rather than for investors/insurers), single-premium or short-term products sold
with less focus on persistency.
Reserving and expenses, comparison across countries difficult
Accounts/profits across Asia are not comparable, given different expensing and reserving
policies followed by companies. For example:
Expenses are written-off upfront in India, Japan, Taiwan, and China, whereas in Korea
this is deferred evenly over seven years. This issue will be resolved as India moves to
implement IFRS in April 2012.
Besides regulations, expense ratios across countries and companies will also be
influenced by the maturity of the business, and the growth trajectory. For example, in a
country like India the expense to total income ratio is higher than peers in other
markets given a higher growth trajectory and the cost of building the business. Within
companies as well, this ratio varies significantly depending on the scale of their
operations and strategy adopted. Additionally, companies in India had built bloated
cost structures given higher surrender/lapsing charges that were used to offset these
costs.
Earnings and RoE likely to emerge despite lower margins
Insurance companies have been reporting huge losses since inception. This reflects factors
such as: faulty business models – high cost structures, aggressive network expansion, low
productivity levels; strong growth in volumes; and upfront write-off costs. Most companies,
therefore, are still sitting on huge accumulated losses. We believe this is now likely to
change, as companies have effected significant cost-cutting measures and have seen
moderation in volume growth – most of which have been forced by market changes
(regulations and volatile equity markets). In the near term, the surrender charges booked
by companies on old policies will also support income. After that, profit will have to be
driven by reducing the cost of operations, as surrender charges fall to a minimal level as
per new regulations and may provide a real test of the models now being built by the
various companies
Solvency ratios not an issue for Indian companies
Private sector insurance companies have invested over Rs200bn in capital in the insurance
space since 2000. We believe the amount of capital investments will now reduce as
companies have moderated growth, and see lower losses on cost-cutting. Based on the
IRDA data, all insurers are well capitalized. Analysis of the capital invested vs. AUMs, total
premium income generated and market share shows that SBI Life, Kotak and Bajaj have
been most efficient users of capital – likely due, we think, to lower expense ratios (SBI Life)
and in some cases (Bajaj and Kotak) higher upfront charges on products to recover higher
costs.
General insurance: Structurally a low-profitability business
Low level of penetration: In India, the non-life insurance business is less penetrated vs.
life, with a premium income to GDP ratio at 0.6% vs. the international range of 2.9% to
4.5% (see Exhibit 134 in Appendix 1). The non-life insurance business/premium income is
driven largely by motor and health insurance, both of which account for 64.6% of the policy
premium income. We expect the motor insurance business to grow in line with the auto
market at around 10% to 15%, while we estimate the health insurance business could grow
at faster pace of 15% to 20% given lower penetration levels.
Few private players and four PSU companies dominate: Bajaj Allianz, ICICI Lombard
and Reliance General Insurance dominate this space amongst private companies with 21%
share, with the largest piece of the pie still with the public sector entities which enjoy 61%
market share.
Low profitability on high competition, PSU dynamics: As is the case with life, the
retail business is the more profitable business, with significant competition in the group.
Even within retail, non-life products are priced competitively given the strong presence of
PSU entities, which have resorted to mis-pricing. They managed to do so due to high
investment income driven from past investments made at low valuations. Within the
private insurers, Bajaj Allianz General Insurance is the best run and most profitable
company, generating RoEs of 15% vs. 8% for ICICI Lombard
No comments:
Post a Comment