How LIC embedded value jumped 5-fold in 6 months
If you go through the draft red herring prospectus (DRHP) filed for the LIC IPO, you will find a separate section showing the embedded value calculation for LIC. The embedded is also called the actuarial valuation and is the basis for valuing any insurance company. It is a combination of parameters that captures the cash flow power of the insurer for the present and also into the future. But why exactly is this Embedded value so critical?
When the LIC IPO was first announced about 2 years ago, the first thing the LIC did was to appoint Milliman Advisors to work out the embedded valuation of LIC. Normally, the eventual IPO valuation is based on this embedded value. The global benchmark to value an insurance firm is for the actual stock market valuation of an insurance company to be pegged at between 2.6 times and 4.1 times the embedded value of the insurer.
What explains the spike in embedded value in 2021?
The detailed comprehensive note from Milliman Advisors, which is part of the DRHP filed with SEBI, explains how they arrived at the embedded value of LIC as part of the exercise to help LIC determine the issue price. It has been explained in detail in the DRHP as to how Milliman arrived at the embedded value for LIC, which has been pegged at a level of Rs.539,686 crore. This is the figure arrived at as of the end of September 2021.
However, it is more interesting to understand how the embedded value changed in a short span of 6 months. As of March 2021, the embedded value of LIC stood at just about Rs.95,605 crore. In a span of just six months, the embedded value of LIC shot up from Rs.95,605 crore to Rs.539,686 crore. That is a 6-month appreciation in EV to the tune of 5.96 times or you can even call it an appreciation of 496% in a span of just six months.
The reason behind this sharp spike in the embedded value was a small step that LIC took in January of changing the way it holds and distributes its surplus (which is the insurance equivalent of profits). Formerly, LIC held its policyholder funds and shareholder funds under one consolidated head. Last year, LIC bifurcated this consolidated fund into participatory and non-participatory funds, which boosted EV in the process.
LIC’s Consolidated Life Fund stood at Rs.34.33 trillion in Mar-21. Post the amendment, LIC now held 2 separate funds for surpluses generated from participatory and non-participatory policies. Now shareholders could get 100% of non-participatory surplus and up to 10% of participatory surplus. As a result, by Sep-21, LIC had a participatory fund of Rs.24.57 trillion and non-participatory fund of Rs.11.37 trillion.
In the previous scenario of a consolidated Life Fund, value of non-participatory surplus was a small fraction. With the bifurcation, the non-participatory surplus goes entirely to shareholders. This was reflected in the Embedded Value that is distributable to shareholders. Due to more profits being distributable to shareholders, the value of the in-force business gets enhanced and automatically embedded value is also boosted.
This shift best explains why the embedded value of LIC got boosted nearly 6-fold between March 2021 and September 2021. The net impact was a much higher valuation for LIC by just tweaking the way its surplus was accounted for.