The LIC IPO: Undervaluing India’s Crown Jewel – I

In the first of a three-part series on LIC, we examine how the process of valuing LIC is fraught with the serious risk of undervaluing the unique institution, among the biggest life insurers in the world.
The second part will examine how privatisation of LIC would change the character of this unique institution and sacrifice the interests of millions of policy holders.
The third and concluding part will examine the wider economic and social consequences of privatising LIC.

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IN a few days, the Narendra Modi government will reveal the value of India's most unique and valuable financial institution, the Life Insurance Corporation of India (LIC). The markets are abuzz as they await the valuation of the institution, which is expected to result in India's biggest-ever IPO (Initial Public Offer). But no matter how it is arrived at, and whatever the value attributed to it, it is bound to turn controversial, as has been the case with every instance of valuation that has resulted in privatisation in India.
The first step toward such a valuation was to calculate LIC's Embedded Value (EV). In late 2020, the government entrusted the task of computing the EV to Milliman Advisors India, the Indian arm of the US-based actuarial consultancy, Milliman. The EV is to form the basis for the entire IPO process, particularly in determining the price at which the LIC share would be issued in the IPO. This is significant, even though there are several imponderables.
Most significantly, the government has still not revealed how much of its stake in LIC would be sold to investors; however, what is clear is that at least 5% would be offloaded in the IPO. The size of the IPO itself is not a major issue yet. Instead, what is critical is the manner in which the EV would be determined. Based on Milliman's assessment of the EV, the government is likely to apply a multiplication factor to arrive at the price of the LIC share offered through the IPO.
Deloitte and SBI Caps have been appointed as pre-IPO transaction advisors. Ten merchant bankers, among them Goldman Sachs (India) Securities Pvt. Ltd, Citigroup Global Markets India Pvt. Ltd and Nomura Financial Advisory and Securities (India) Pvt Ltd, are to manage the issue.

Hurtling Toward the IPO

In the days ahead, the Department for Promotion of Industry and Internal Trade (DPIIT) will approach the Union Cabinet with a proposal to tweak Foreign Direct Investment (FDI) rules in order to enable foreign investor participation in the LIC IPO. Although current rules allow automatic FDI in insurance companies, these do not apply to LIC, which is governed by the provisions of the LIC Act.
The clearance is expected to be a formality because the world of Indian insurance was very different in 1956, when LIC was established. Since the Act does not make a specific reference to FDI, the thinking in the government must be that there is no need to amend the legislation to enable the IPO with foreign participation.
The next steps toward the IPO are to get a clearance from the Insurance Regulatory and Development Authority of India (IRDAI) and clearances from the capital markets regulator, the Securities and Exchange Board of India (SEBI). The EV calculation, which is of fundamental importance, has to available before these steps can be taken.
The government's open suggestion to SEBI that it expedite its clearance of the Draft Red Herring Prospectus (DHRP) is highly irregular. How proper is it for the government to openly hustle the capital markets regulator into fast-tracking the IPO's clearance?
Once these clearances are obtained, road shows need to be conducted overseas as well as in India to lure foreign as well as institutional investors. At the first stage "anchor" investors would be canvassed, after which a portion of the IPO would be offered to Qualified Institutional Bidders (QIB).
The LIC Act, as amended last year, does not allow any group of investors, acting alone or in concert, to hold more than 5% of the shares floating after the issue. That, given the conduct and attitude to privatisation, is likely to change at a later more opportune moment.
Voices in government are already talking of a Follow-on Public Offer (FPO) in 2023-24. Senior officials in the government have already confirmed that the IPO will happen before March 31 this year. The entire process starting from the determination of the EV and ending with the launch of the IPO is thus to be completed within about 50 days. This is an indicator of the extreme desperation of the government to complete the LIC IPO quickly. Most importantly, the headlong rush with which the government has proceeded with the valuation exercise is extremely significant.

The Risky Business of Determining LIC's Worth

The way in which LIC's worth is determined is vitally important for two reasons. The first pertains to the fact that the EV, itself a recently developed quantitative tool for assessing the worth of an insurance company, offers by no means a conclusive estimate of the actual worth of an insurance company.
Second, the valuation of a unique institution — given the fact that LIC is sui generis in the world of finance, and nothing like it exists anywhere in the world — is fraught with not just the serious risk of undervaluation but abandoning the interests of millions of policy holders who have built its asset base.
It is important to emphasise that LIC has never made an estimate of the actual market value of its vast assets. Instead, it has only taken them at book value. The logic for this was that a conservative estimate of its assets' worth provided an insurance against the risk of unforeseen liabilities; this was particularly important in the context of long-term contracts that are typically characteristic of life insurance products.
Given the fact that a large part of its assets were in government securities and other gilts, as well as the fact that LIC is perhaps India's largest realtor, owning properties in prime locations across cities and towns in the country, implies that the valuation exercise is fraught with serious risks. The mind boggles at the thought that Milliman and its associates would have been able actually estimate the market value of each of these real estate assets during the pandemic.
Limitations of Embedded Value as a Measure
But there are even more fundamental problems with using just the EV as a means of evaluating the worth of an insurance company like LIC. Contrary to a simpleton's notion that this one summary estimate is the best measure of the real worth of an insurance company, the literature reveals that the use of EV assumed wider usage only in the past two decades, particularly after the collapse of insurance companies, most notably after the Great Financial Crisis in 2008.
The greater use of this summary measure was particularly driven by the spate of mergers and acquisitions in the insurance business after the Great Crash. That is, the measure was obviously driven by the interests of companies valuing their targets that had collapsed or on the verge of collapse. The fact that EV tries to estimate the potential returns to shareholders, reflects the limited purpose for which the concept was adopted.
In India, the three important floats of private life insurers — ICICI Prudential Life (2016), HDFC Life (2017) and SBI Life (2017) — were all meant to enable the original promoters to dilute a part of their holdings through an IPO. Incidentally, Milliman estimated the EV of two of these private life insurers, ICICI Prudential Life and HDFC Life.
What makes the LIC float very different is not just the fact that it is much bigger, with the insurer enjoying a much bigger market share, but that it has an asset base that is far, far bigger. Also, given the fact that the government is obviously desperate to relinquish a portion of its stake makes the risk of undervaluation result in far reaching consequences to not just the government but to millions of policyholders.
Now, let us get around to breaking down what the EV is and what it is not. Although the world of actuaries, auditors and chartered accountants would have us believe that such a summary figure is an objective estimation of the real worth of an institution and its business, this is clearly not true. A paper published by Frédéric Tremblay, a Canadian actuary in 2006, observed that "the embedded value is only a best estimate. This is only one vision of the future."
"It is important to keep in mind that the embedded value must be used carefully, always having in mind the assumptions underlying the calculation," Tremblay warned. "With its advantages and disadvantages, the embedded value is a portion of a whole and it must be taken this way."
Basically, the EV consists of two components: first, the net present value of the profit streams of the company accruing to shareholders, and second, the net asset value of the company's capital and surplus. Specifically, in the case of a life insurance company, the value of the first component arises from the profits accruing from in-force policies after accounting for probable claims (death of the policy holder, for instance) and expenses undertaken by the insurer to maintain the policies during their lifetime. Note that conceptually, the net asset value arises from the value of assets and capital that have been accumulated historically from the past, for which, in the case of LIC, the shareholder may have contributed nothing. This is of critical significance in the LIC case, an issue we will come to a little later in greater detail.
But even more critically, especially in the case of LIC, which has pioneered life insurance in India in the past six decades, it is important to recognise what EV estimates do not capture. First, EV does not take into account the future growth of business — that is, in the case of LIC, which has had a long track record, it does not incorporate its potential for growth in the future.
Second, even more importantly, it does not attribute any value to the goodwill that the company enjoys, which is a function of its past performance. This is a serious omission insofar as LIC is concerned. Since life insurance policies are long-term contracts extending over two or three decades, the track record of the insurer in terms of settling claims and servicing policies during the life of the policies, is completely missed in the computation of EV.
It is not enough to rely on a measure, simply because it is sanctified as a trustworthy measure of a life insurance company's value in a very different context and in a world that is vastly different from the one in which LIC operates. According to a recent report by UK-based Brand Finance, LIC is the most valued brand in India; its brand value is estimated at $8.66 billion (about Rs. 65,000 crore).
Missing the value of the brand or the value of "goodwill" is a very significant omission in the case of a life insurance company because the potential customer base values the reputation of the insurer while deciding on a long-term contract. A customer wants to know whether the insurer would be around when the adverse event, death in this case, actually happens. To leave this out of the computation, simply because it does not fit the valuation "formula" would result in significant undervaluation, particularly of an entity such as LIC.

Timing of valuation and Underlying Assumptions

More importantly, the timing of EV computation can itself make a huge difference to the valuation exercise. For instance, since the Value of New Business (VoNB) figures explicitly in the estimation of the EV, the fact that such an exercise is being carried out in the midst of the pandemic, when not just the Indian insurance industry but the global life insurance business has slid sharply, would result in undervaluation of an insurance company. According to IRDAI, the pace of premium income growth slowed down significantly in 2020-21.
Most importantly, LIC's first-year premium income, a measure of new insurance policies issued, declined by about 41% in 2020-21 (this does not include single premium policies, whose growth increased significantly in 2020-21). The fact that LIC is India's only mass-based life insurer is captured by the fact that the average "ticket size" of its policies is about Rs. 16,000, compared with about Rs. 89,000 for private life insurers. This points to the fact that its popular client base, hit hard in the pandemic, have forgone insurance cover in the crisis. To evaluate LIC's worth by incorporating the VoNB at such a time thus runs the risk of significantly undervaluing its worth.
There are yet more problems. All EV computations are based on assumptions and are sensitive to the methodologies adopted. This requires "economic" assumptions, such as interest rates, inflation and several other variables to be factored in. In fact, if Milliman had started the exercise soon after it took charge of its assignment in early 2021, its forecast of interest rates would have been very different from an exercise taken up now. The fact that interest rates are now headed higher, following the US Federal Reserve's commitment to hike interest rates from March, is an example of how economic uncertainties can influence the valuation of LIC. You could thus arrive at an EV this year and find it very different next year. To value an institution such as LIC in order to sell a part of it to "investors" in this manner is thus risk-laden.

Policy Holders Shortchanged

This brings us to the second critical problem in evaluating LIC's worth, given its completely unique character.  LIC is only one if its kind in the world because it is the only life insurer that places policy holders on a higher pedestal than its shareholder, the Indian government.
The widely respected actuary, R. Ramakrishnan, former Chief Actuary at LIC, who passed away recently, pointed out in 2019 that the LIC Act was unique in that "participating policy holders are treated as shareholders and get a higher percentage of the surplus than the actual shareholders."
The LIC Act, until it was amended last year through the Finance Act of 2021, assured policyholders that 95% of the surplus generated every year would be paid back to them as bonuses, while the government was only assured 5%. The amendments now imply that policyholders would receive a smaller fraction of the annual surplus, although LIC has still not implemented it.
Moreover, Ramakrishnan, by no means an opponent of disinvestment — in fact, he served as a member of the Malhotra Committee, which, in 1994, recommended reforms in the insurance sector — pointed out that the entire solvency reserve of LIC, which is typically provided by promoters, was built on policy holders contributions.
The fact that the government made no contribution to the capital base of the LIC, apart from the initial equity capital of Rs. 5 crore between  1956 and 2011, when the equity base was expanded to Rs. 100 crore, raises serious questions about who the true owners of LIC's huge asset base are. In order to facilitate the IPO the government recently expanded the equity base to Rs. 6,325 crore, consisting of 632.50 crore equity shares with a face value of Rs. 10. This expansion was facilitated in part by the dividend that was payable from LIC for the last two years (which the government had asked LIC to retain with itself). 
The crucial question that hangs in the air is this: how can the asset base of a company, evaluated by a methodology that systematically excludes those who have built LIC, be fair? A related question is: how can the interests of policy holders, who have provided the entire solvency reserve of LIC all these years, which has backed the vast expansion of its asset base, be deprived of the valuation now? Valuation thus lies in the eyes of the beholder. While the government, swayed by its ideological predilections, may value the institution in a particular manner, policy holders may perceive the value very differently. 
Those feeding the ongoing buzz about the LIC IPO have pointed to the benefits that would accrue to policyholders. In particular, they refer to the fact that about 10% of the retail portion of the IPO would be reserved for policyholders. This is not even clever, it is positively evil, for the simple reason that the universe of policy holders is far bigger than the universe of potential shareholders who may be successful in getting an allotment in the IPO.
Currently, LIC has 286 million individual policies, apart from 93 million group insurance policies. Even if one adopts a discount factor of 20% for multiple policies by individuals, this implies that more than one-fifth of all Indians are covered by an insurance policy issued by LIC. The simple point that emerges from this is that policy holders as a class would stand to lose far more than what a few, wealthier policy holders, may gain by becoming shareholders after the IPO. In other words, the 10% reservations, even at a possible discount, is nothing but a bribe to get their support for the IPO.

The LIC valuation

Now, to what the IPO may be like. With all the speculation about the EV flying around, there may be an element of guesswork, but let us give it a try anyway. According to one of the earliest estimate, made in November 2021, LIC's EV was reportedly $150 billion (Rs. 11.25 lakh crore). Still later, these were pared down to a significantly lower Rs. 5 lakh crore.

Assumptions:
1.    The face value of the shares remain unchanged
2.    5 per cent stake is sold through IPO without fresh issue of shares
3.    The government offloads 31.625 crore shares, accounting for 5 per cent of the equity base of 632.50 crore shares.
4.    No discounts for policy holders and LIC employees have been factored in.
Assuming that there is no stock split — that is the face value of the shares remains Rs. 10 — and assuming no multiplication factor is applied to the EV, the price of the share would range from Rs. 792/share at the lower bound to Rs. 1,779/share at the higher estimate of EV for the sale of 5% stake in LIC.
In the first case, the government would realise Rs 25,050 crore and if the share is priced at the higher end of the EV it would realise Rs. 56,250 crore from the IPO. Assuming a conservative multiple of about 3, in line with the private life insurer floats cited earlier, at the lower bound, the government can realise a little over Rs. 75,000 crore. 
The Modi's government is also likely to split the face value of the share in order to price it lower so that it appears even more attractive to retail investors. In doing so, it will be essentially traveling along the road of "popular capitalism" coined by former British Prime Minister Margaret Thatcher, the results of which are there for everybody to see.
It is quite possible that the Modi government would sweeten the deal by keeping either the EV low or the EV multiple low or by keeping both low in order to provide a mood elevator to the stock markets that have been on a rollercoaster in recent days. The fact that at the issue price of LIC's market capitalisation would take it within touching distance of Reliance Industries, would then be paraded by the Modi government as an indicator of the "success" of its disinvestment drive. The fact that this "success" would leave millions of policy holders shortchanged is just an indicator of the priorities of the regime. 
It is important to appreciate that LIC's IPO would not only set the valuation low for now but will have implications for later issues of shares. Subsequent issues would depend on a multiplication factor that hinges on the price of the share. And, since only 5% of the shares would be floating, the price of the subsequent issue would be determined by the price at which it would be selling then. It would then be like a small tail wagging a giant dog. The current valuation would then be seen as the original sin.
But whatever the Modi government does, and however it does, LIC's dubious valuation would result in substantial benefit for a few, at the expense of the many. In the annals of privatisation, the LIC sale would be the first to directly and immediately result in losses to millions of people.
(To Be Continued)
The writer is former associate editor, 'Frontline', and has worked for The Hindu Group for over three decades. He is a member of the People's Commission on Public Sector and Public Services. The views are personal.
First published by Newsclick.