FDI in Insurance – How important is it?

Baca Juga

At outset, let me declare that this post is a bit long so please bear with it. (And I just made it a bit longer by adding this disclaimer)

Increase in FDI cap to 49% from 26% had been under discussion for a long time. Chidambaram first discussed it several years back but it has finally been approved after almost a decade.

There are diverse views on the importance of FDI in any sector. In insurance, those who are in favor of FDI reasoned around high capital requirement in Life insurance, low density and penetration in the country etc to justify opening up the sector even further. Whereas those in opposition questioned the real need of the capital, how likely is it to be used for growth or would it just help domestic shareholder exits. Both the arguments have merit and we need to look at facts to understand how exactly FDI would help.

It is a well-known fact that Life Insurance is a capital intensive business and it generally takes more than 8-10 years for a life insurance company to achieve profitability (as long as it grows as reasonable rate; Yes! Life Insurance Company is likely to post losses for a longer period if it grows). Without going too deep into the profitability of life insurance Company, which we would discuss in detail at a later stage, let us now concentrate on FDI.

We often say that life insurance is a capital intensive business so let us first understand where all capital gets used. It is used primarily for three reasons as follows:

New business strain
Expense Overrun
Solvency Capital

New Business strain

New business strain is nothing but the acquisition cost over and above the premium collected. So when insurance company sells a policy, it collects premium which is an inflow. Whereas it incurs costs in the form of commission, overhead expenses (for Head office, sales cost etc) and it has to make provision for the reserves. In this transaction if outgoes are more than the inflow then the amount over and above inflow is called as ‘New business strain’.

New business strain = Outflows – Inflows at point of sale.

The overhead expense assumed in this calculation is steady state expense, meaning the expenses Company would incur once it reaches a desired scale.

This is an expected expense item, as in, it is not unusual in nature. It is priced into the product. This would keep occurring as long as company is acquiring new business.

Expense Overrun

When an insurance company starts, it has to incur costs in setting up the business and much of this cost is recurring in nature. However company does not reach scale to justify this cost for a long period. As a corollary we can say that company does not reach its full capacity utilization and productivity levels.

An insurance product is normally priced on Cost+ basis. All the cash-flows for future are projected and a profit margin or NBAP margin or ROC is targeted to arrive at premium. During the initial years company cannot load actual expenses for pricing the product, due to low capacity utilization. Or else product will not be competitive. The expenses over and above what is loaded on the product are called as ‘expense overrun.

For Eg: When company reaches a steady state say per policy expense would be Rs 500 but if we were to calculate it in initial stages then it could be as high as Rs 10,000. Company cannot load this whole expense on the product. Hence company charges only Rs 500 as overhead so as to keep product affordable and competitive. The rest of the 9,500 is the expense overrun and is funded by shareholders as business set-up expense.

The loss that company posts in any given year is due to expense overrun and new business strain.

Solvency Capital

Like Basel capital norms for banks, insurance companies have to adhere to solvency capital norms. For every policy on the company’s books company has to set-aside capital based on the reserves and sum assured called as 'solvency capital'. This capital is to be invested as per IRDA norms (Norms for investment of Life fund as solvency capital is a part of life fund).

Insurance company has to maintain a solvency capital ratio of 1.5; which means that actual shareholder capital (ASM) set aside has to be 1.5 times of required capital as per solvency calculation (RSM).

Do our life insurance companies need capital?

Based on the above analysis, it would not be wrong to say that company would need external capital if any one or more of the following is true:

Company is still posting losses in its shareholding account: This means that company is still incurring expense overrun and there is significant new business strain which needs to be funded.

Solvency capital ratio is less than 1.75: In that case company would soon breach the 1.5 ratio and would need capital to support the new and renewal business. If company is making profits then it can fund the capital requirement from internal capital else external infusion would be required. The likelihood of a company posting profits and yet be close to a solvency ratio of only 1.5 is rear.

Company is expanding its footprint aggressively: In that case company would need capital for expansion as new branches generally take 3- 5 years to become profitable.

Now let us see where most insurance companies stand on these parameters:

Companies	PAT (9M Dec 14)	Solvency ratio	Extra capital
Bajaj Allianz Life	317	7.78	5,639
ICICI prudential Life	427	3.70	3,325
Reliance Life	43	4.12	991
Birla SunLife	240	2.23	489
SBI Life	614	2.27	1,056
HDFC Life	574	1.87	432
Max Life	283	4.69	1,913
Kotak Life	38	2.35	381
Tata AIA Life	213	3.96	924
Exide Life	-36	2.69	320
Future Generali Life	3	2.86	120
MetLife	38	2.40	218
Aviva Life	-154	3.74	601
Bharati Axa Life	-139	1.67	17
IDBI Federel Life	-1	6.03	328
DHFL Pramerica Life	23	12.56	593
Shriram Life	12	5.18	296
Aegon Religare Life	-34	1.61	5
Edelweiss Tokio Life	-50	1.95	439
IndiaFirst Life	5	2.12	108
Star Union Dai-Ichi	8	2.30	56
All Figures are in INR Cr. Source: Public disclosures (Canara HSBC is not included as public disclosure link was not working)

It can be observed from above table that:

There are only 6 companies who have not posted any profit as of Dec 2014. This means that other companies would at-least not need to fund expense overrun and new business strain. It is getting funded from the cashflow generated within.

(Company could be incurring expense over-run even if it has posted profits. The level of profits in such cases would not be as priced since some part of profits go towards funding the expense overrun.)

There are only 2 companies whose solvency ratio is below 1.75 (we can take solvency ratio of 2 also for this analysis as companies try to maintain solvency at that level but wont change things much) and both are loss making. These companies will have to infuse capital sometime soon.

If were to do some broad calculation of excess capital lying in shareholder fund based on solvency capital requirement of 1.5. Then there are only 5 companies with extra capital of less than 200 Cr (no reason to take 200 cr but it gives good enough cushion). Out of these 5 only two are loss making.

“This means that unless companies revive their expansion strategy, there are only 2-5 companies which are starved for capital”.

In most other cases FDI would help unlock domestic shareholder value. Now the question remains how likely are companies to revive their growth plans? Answer to this would be a bit difficult. In the last 5 years insurance industry has shrunk significantly; companies have cut-down on costs. All this due to changes in regulations leading to reduced profitability. In this environment, there were companies which could afford to expand geographically but exactly opposite happened due to lack of sustainability.

In the last one year things have improved. Companies have begun to grow business and are again looking at investing however they may not go back to huge expansions. Growth this time would be cautious.

Hence use for FDI may not be as much for expansion as it would have been had this happened when the discussion started. Back then industry was booming, players were expanding aggressively and were truly capital starved. During these years situation seems to have changed.

Nevertheless FDI approval is a good thing for investor sentiments. This was the least controversial bill that government could have approved in parliament. It at-least shows the intent of the government. Whether this decision is good for country only time will tell.