Insurance Sector Divestment May Pave The Way For LIC Dominance

The first phase of financial sector reforms saw the banking sector tap the financial markets for capital. It is now the turn of the insurance sector to do so. The consolidation of the three general insurance companies – United India Insurance Company, National Insurance Company and the Oriental Insurance Company – announced in the Union Budget for 2018-19 was precisely intended to drive them into the financial markets for raising capital and helping government divest its stake.

A potential market entry by the consolidated behemoth though is still some distance away. But a divestment would essentially mean simultaneous buyback of government stake at a premium price and an initial public offering (IPO). The paid-up equity to the entities may or may not increase, though the share premium reserves will contribute to considerably bolstering the capital of the consolidated entity.

This is, however, not the first time that the public sector insurers are foraying into the financial markets. The maiden entry by the largest public sector general insurer in the country, New India Assurance Company Limited (NIACL), was at best a qualified success. The Rs 9,600 crore public issue in November last year by NIACL was supported by the Life Insurance Corporation (LIC) of India. The issue was priced at Rs 800 a share then. The largest chunk of bids for the issue came from the LIC. Four months after the IPO, the LIC held 7.15 crore shares of NIACL in its investment kitty, all picked up at the bid price band between Rs 770 and Rs 800 per share. Since then NIACL’s prices have sunk to Rs 650, meaning that the LIC’s investment has depreciated in value. It was the first time since 1972 that a general insurance company was entering the financial markets and being listed in the domestic stock exchange.

If solvency ratio was the criteria, then NIACL hardly required the funds. At the time of the public issue in November 2017, NIACL had a solvency ratio of 225 per cent. Solvency ratio is the excess of capital and value of assets over the insured liabilities. The regulatory prescription for solvency is 150 per cent. Besides, unlike the banking sector none of the insurance companies have seen infusion of capital from the government since nationalisation. The banking sector on the other hand has seen repeated capital infusions from the government in various forms.

Secondly, several analysts had given an “avoid call” to clients when the NIACL IPO hit the markets. But few Indian analysts or investment banks have experience in evaluating insurance stocks or even the business. Two of the standard matrices that are normally used for valuing insurance companies are the combined ratio and loss ratio. The combined ratio captures the total claims payout and the expenses over gross premium collections. So, low expenses and low claims payout mean high-retention premiums with the insurer, translating into profitability. The loss ratio, also called the claims ratio, on the other hand, looks at claims as a percentage of premiums collected. So if the claims payouts are in excess of the premiums collected, it means losses. If the criteria were applied then, despite the large underwriting losses in the motor third-party underwriting, on an aggregate level, insurance has not seen any major underwriting losses.

There is also however a third element as far as Indian insurers are concerned – investments. Indian insurers are mandated by the Insurance Act to keep invested 30 per cent of their funds in government securities. Of this, general insurers need to park 20 per cent of their funds in central government securities and 10 per cent in state government securities. The remaining 70 per cent are allowed to be parked in bonds and equities, though still regulated by the Insurance Regulatory and Development Authority of India (IRDA). This means that there is a non-core source of income for the insurers, through coupon or interest flows and through trading income. Trading income implies purchase and sale of investments.

But where analysts also misled investors on NIACL was in overlooking the hidden reserves. Insurers are presently sitting on investments that were acquired during the 1980s and 1990s, all at very low prices. In insurer balance sheets, these investments are valued at cost of acquisition, unlike in the case of bank balance sheets, where barring held to maturity categories (or permanent category). Clearly seen from the perspective NIACL’s stock shift to discount to below IPO price was neither based on market logic or on fundamentals. “The market is certainly a bitch,” a PSU insurer told this journalist.

So could a similar situation overwhelm the next round of insurance IPOs? That remains a fundamental question. A horizontal merger of the three insurers would mean an enlarged equity base of Rs 450 crore. (Source: annual reports of United India, Oriental and National).

However, based on the 2016-17 results, the combined entity would actually end up with a negative earnings per share of Rs 80, meaning pricing the scrip for disinvestment would be extremely challenging. On the flip side, the combined entity despite the losses would still have a book value of close to Rs 200 per share. But then the book value would be an undervaluation, in view of the large hidden reserves of the public sector insurers. After all the book value is a reflection of the cost of the assets as shown on the balance sheet. Some of the undervalued assets are financial that are valued on a historical costs basis. Again book value also does not include the real estate assets of insurers valued on the basis of historical costs. A shift in accounting to marked to market basis, fully or partly as in the case of the banking sector, would alter the fundamental values of insurers.

Moreover, insurance is a risk business. Underwriting losses are not unusual. It, therefore, means that large catastrophes could turn into underwriting losses and redline on insurer balance sheets. And 2016 was a year, when insurers had incurred losses on account of flood and fire related cases. So insurers make advance provisions in anticipation of claim events. It is these advance provisions that also show up as losses on the balance sheets. Besides Indian insurers seldom take all liabilities directly on their balance sheets, since the fundamental nature of the game is spreading the risk across as many players as possible.

Some risks are therefore passed on to reinsurers or syndicated to other insurers, especially in the case of high-value risks and some are foreign reinsurers, that include entities like Swiss Re, Munich Re or even Korean Re. The reliance on foreign insurance is also partly because Indian financiers particularly investments have inhibited the development of instruments like catastrophe bonds that would have contained foreign currency outflows as reinsurance premiums. Still, if insurers report losses as in the case of Oriental and United India in 2016-17, it was also because reinsurance settlements were still in pipeline and therefore likely to be carried over to the following year. As a result, using one-year results for pricing may not exactly be the right measure.

Finally, other major pricing retardants are management ratios. Post Independence, foreign insurance companies had used their entities in the country as vehicles for dividend stripping for capital repatriation. But amendments to the Insurance Act of the 1938 – in 1949 – had curtailed management expenses. Management expenses regulation also imply that the dividend payout to shareholders would stand capped. All other management ratios are subject to oversight by the IRDA. That was also incidentally one of the major factors, inhibiting government’s inability to seek high dividends for meeting fiscal shortfalls.

The fallout implies that insurance divestment is unlikely to realise any substantial revenues to the government from public or foreign interest. At best, the divestment could make the LIC, General Insurance Corporation (GIC) and the State Bank of India (SBI) as the largest institutional players in the sector. After all they are the largest stakeholders in NIACL. The next round could very well make them the largest stakeholders in the entire sector.