5 metrics to evaluate life insurance business


Till now you have interacted with life insurance companies as a customer, and so you needed to understand the different products they sold, embedded costs, performance record of the insurer and processes of making a claim. But last year, with ICICI Prudential Life Insurance Co. Ltd going public, followed by two other insurers this year namely SBI Life Insurance Co. Ltd in October  and HDFC Standard Life Insurance Co. Ltd in November, you would also be interacting with the insurers as a shareholder. Listing brings greater disclosure and as an investor you will come across financial metrics unique to the life insurance industry. We explain five such key financial parameters that you need to understand in order to analyse the value of a life insurance company.

Embedded value

Insurance is a long-term business. This means, you buy a policy today but continue to pay premiums for several years. It is from this future income that the insurers make profits. So the value of a life insurance company is assessed by future profits that the current business is able to generate. This is captured by the embedded value (EV) that represents the sum of present value of all future profits from the existing business and shareholders’ net worth. “Embedded value simply represents the value generated from the business sold by the company, if it were to stop writing anymore business,” said Shashwat Sharma, partner and head of insurance, KPMG India. “The more business a company generates, the larger will be the embedded value assuming all other metrics like persistency ratio and costs remain the same,” he added.

Analysts look at EV to analyse valuations. For example, an insurer X may have market capitalization of Rs1,000 crore whereas its EV could be Rs250 crore. This would imply that investors are willing to pay four times the company’s EV, indicating a bullish outlook. And this has been the case for life insurance companies in India so far. All the three companies that were listed have been valued at multiple of at least 3 times the EV.

Click here for enlarge

But zoom out and compare the metrics with regional peers and the valuations could begin to look a bit stretched. “When compared to Asian markets that have higher growth rates and operate at far superior profit margins, the valuations of life insurance companies in India seem out of line. This is because the companies in Asian markets are valued at a multiple in the range of 0.4 to 2 times the embedded value whereas in India the multiple is upwards of three times the EV,” said a life insurance business analyst who didn’t want to be named for the story. This implies a bullish outlook for the life insurance sector to grow in the future. “About 80% of the total value is based on growth and profits from the future rather than current intrinsic factors. The outlook is that insurance companies are expected to generate great profits on the back of better product mix, higher margins and customer profile. The valuations, in a sense, are a bet on the future,” added Sharma.

According to K.S. Gopalakrishnan, chief executive officer, Reinsurance Group of America Inc., you also need to track the EV year-on-year as that tells a story. “A consistent performance in the growth of EV indicates stability. Companies that see huge spikes or dips will need to be tracked closely—as changes in product strategy, distribution model, expense performance, persistency all get reflected in the EV,” he added.

Value of new business

If EV tells you the value of the company on the basis of its historical book, the value of new business (VNB) tells you the value of an insurer on the basis of the new business it wrote in the last year. “VNB is also termed as embedded value of new business measured at point of sale,” explained Gopalakrishnan.

In fact, looking at valuations as an implied multiple of VNB is also crucial in understanding fair valuations. “This multiple indicates the number of future years the insurer has to underwrite at least the same amount of business as last year and with the same level of profitability to justify the valuation,” said the analyst. “This is calculated by subtracting the embedded value from the valuation of the company and then dividing it by the VNB,” he added.

Value of new business margin

The other important metric to track is the VNB margin. VNB margin is calculated by dividing the value of new business by 1 year’s annualised premium and it indicates the profit margins of a company. “Simply put, a VNB margin of 20% would mean that if the insurer underwrote new business premium for a particular mix of products of Rs100 in a year, the expected profit over the lifetime of that business is Rs20,” said Sharma. Obviously, companies with high VNB margins are better off from a profitability point of view.

According to Gopalakrishnan, VNB margins tell you the product that mix a company has. “It indicates the product mix of a company. Protection plans have the highest vnb margins followed by Ulips (unit-linked insurance plans). traditional investment products have similar margins. So a company that wants to improve its margins will start focussing on the protection business more and that is what we see happening currently,” he said.

Expense ratio 

Expense ratio is yet another number that you need to track. The expense ratio of an insurance company is described as the expense of management divided by the gross premium. Expenses of management are costs that an insurer can deduct from your money, and which include commissions, and operational and administrative expenses. As per Sharma, a high expense ratio can hurt the policyholders as high costs can impact investment returns especially in the case of traditional products. In India, expense ratios of life insurance companies are in double digits and for some companies they are in the range of 35-50%. According to Sanket Kawatkar, principal and consulting actuary- life insurance, India, Milliman India Pvt. Ltd, companies should aim to bring their expense ratios to single digits. “Expense ratios depend on the type of business sold by a company. For a company that largely has single-premium business, the expense ratio will be much lower. But given the type of business generally sold by insurers in India, companies should be aiming to achieve a very low double digit or close to single-digit expense ratio in order to achieve expense efficiencies and eliminate expense overruns,” he said.

Persistency ratio 

If you are a reader of Mint Money you would know what persistency means in life insurance. Simply put, it measures how long customers persist with their policies. This is an important metric to track as persistency is a key driver of profitability for an insurer. Read here for more: bit.ly/2qhNFvV. A persistent book—where customers pay renewal premiums every year—also helps insurers reduce costs through economies of scale. The insurance regulator reports persistency ratios of all companies by the number of policies and you can benchmark this ratio against the global average. For instance, global average of 13th month persistency (policies that renew after a year) is close to  90% whereas the 61st month persistency (policies that renew after 5 years) is about 65%. Persistency is an important metric to consider while buying stocks of a life insurance company. While evaluating it, compare it with global benchmarks.

Of course, these are not the only metrics you look at as an investor. There are many others that you need to take into account, including some of the softer parameters such as the brand, which too determines the valuations.

However, make sure to take a comprehensive view. All the metrics mentioned above should be an important factor in evaluating the fundamentals of a life insurance company.