LIC IPO: The embedded value of a life insurance company is the present value of future profits plus adjusted net asset value.
Life Insurance Corporation (LIC) in its draft red herring prospectus (DRHP) filed with the market regulator SEBI said its Indian Embedded Value (EV) as of September 30, 2021, stood at Rs 539,686 crore. The embedded value of a life insurance company is the present value of future profits plus adjusted net asset value. The metric is popularly used to value insurance firms across the world.
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Net Asset Value
In valuing a company, normally three methods are employed. Net Asset Value (NAV), future earnings per share and market value of its assets. NAV is the book value of its assets less its liabilities and hence there for everyone to see but is historical and not futuristic whereas future earnings computation involves a lot of assumptions often with a degree of exaggeration or discount depending on the purpose of valuation. Market price of a company is its liquidation value. Some prudent valuers assign weights to all three criteria and arrive at a Goldilocks solution to this admittedly vexed issue. What LIC valuers have done is to adopt just two criteria namely NAV and the discounted value of future profits.
Why discount the future profits
NAV is here and now whereas future profits, as the name suggests, are in the realm of the distant and unpredictable future thus necessitating guesswork ranging from the informed to the wild. Bird in hand is worth two in the bush is an old adage that resonates in the world of finance. In other words, a rupee earned today is worth Re 1 but the same rupee to be earned one year hence would be valued at 0.90 paise if the average cost of capital to the company is 10 percent and so on. One can very well understand why the same rupee that is going to be received ten years hence would be having a very low present value. Compounded discounting does it.
Issues unique to life insurers
Life insurance business is a different kettle of fish, intrinsically enmeshed in future unlike general insurance. When you insure your car, the premium usually is for a year and if during the year there is no claim made by you, the entire premium is the insurer’s profit. Not so in the case of life insurance. When you pay say Rs 5000 as the annual premium on a money-back policy expiring after 15 years with the amount assured being say Rs 1 lakh, the insurer has to wait patiently for 15 years before computing his profit or loss from the transaction. If unfortunately, the insured dies immediately after paying the first premium, it is a straight loss of Rs 95,000. But more often than not that rarely happens, leaving the insurer in a fix. How to calculate his profits? In view of the innate uncertainties, life insurers resort to acturial valuations. An actuary is an expert in mathematics and values a life insurance business on the basis of a complex matrix of factors namely age of the insured, likely rate of inflation during the currency of the policy, the longevity of people and so forth. Embedded value, therefore, strikes the golden mean between NAV and future discounted profits acturially computed. The result is EV.
Issues unique to LIC
LIC virtually enjoyed monopoly from its inception in 1956 when it was formed by nationalisation of some 245 Indian and foreign life insurers operating in India. But the liberalisation of the economy in the last decade of the century gone by saw the insurance sector being opened up to the competition. Be that as it may, in its monopolistic days, LIC had wisely invested a substantial part of its liquidity in real estate so much so that one cannot gloss over the value of the hot properties it is sitting on. Yet it has chosen not to value them at their current market prices but only at their book value. It also has a substantial presence in the share market with successive governments using its phenomenal cash treasure to bail out disinvestment programs of public sector companies.
The likely IPO price
What will be the issue price? A Bloomberg report has computed the market capitalisation (number of outstanding shares of a company multiplied by the market rate on a given date) multiple in relation to their EV of three listed Indian life insurers namely SBI Life, HDFC Life and ICICI Prudential Life and struck the average which comes to 3.4 times. Employing the same methodology to LIC, it has arrived at a price range of Rs 1,706 to Rs 3,413 per share based on the most pessimistic EV-market cap multiple of 2 to the most optimistic multiple of 4 times.
But the government is likely to pitch for a reasonable price given the inevitable market suspicion of government interference in the functioning of LIC. Even at a conservative issue price, it can hope to garner close to Rs 60,000 crore which by far would be the highest mobilisation from disinvestment by the government.