The Life Insurance Business: A structured Introduction

[Mas24]

Disclaimer: The posts in this thread reflect my personal view and do not reflect the views of my employer. The purpose of this thread is only to build collective understanding of life insurance business.

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Charter for Scope of discussion on this thread:
I would request everyone to please adhere to the following.

1. No comments on specifics for any life insurer. While I will not be able to stop anyone posting queries on any particular life insurer, please note that I cannot respond to any such post.
2. No pasting of data of any life insurer. I cannot respond to any such post.
3. No comments on management/strategy/ financials/etc. of any specific life insurer. In case anyone does that, I cannot respond to any such post.
4. No guidance on valuations for any life insurer. I cannot respond to any such post.
5. No forward looking statements on any life insurer. I cannot respond to any such post.

I would reiterate that the sole purpose of this thread is to build understanding on the key concepts of life insurance and the industry as a whole. Please note that this is not a thread to comment/post on any particular life insurer.

I would again urge everyone to please adhere to the above Charter for Scope of discussion on this thread.

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Post 1: How does a life insurer make money?

We can view this from different lenses – products, experience or release of reserves.

1. Product lens: There are four product categories and each one has a different source of profit.
   • Unit linked: Insurer invests customers’ money in funds of their choice and fund returns belong to customers. Insurer earns fee income to manage the funds (similar to mutual funds) and mortality charges.
   • Non-par savings: Insurer promises a guaranteed return to customers, collects premiums and invests. Insurer earns the yield difference between investment returns and policy guarantee (similar to FDs)
   • Participating savings: Insurer invests on behalf of customers and shares the profits earned (similar to certain hedge funds)
   • Protection: Insurer promises to pay on death of customer. Insurer earns the difference between the mortality charged to customer and actual death experience (similar to a markup on any other industry).
2. Experience lens: There are certain sources of profit for a life insurer and the profits emerge from experience being better than assumption. Key sources: investment income, mortality/ morbidity, persistency and expenses. Each source has a different sensitivity and significance based on the product category. More on this later.
3. Reserves lens: Given that life insurance products typically require customers to pay now and receive benefits later, insurers need to create reserves to ensure they have adequate money to pay these benefits later. Reserves are based on more prudent assumptions than expectations. Over time, as experience unfolds and if it is in line with expectation, the prudence in reserves is released as profits for the insurer.

Plan to follow up with additional posts covering various aspects of the business.

[Mas24]

Post 2: How does each source of profit (experience lens) impact different product categories?

Life insurance cashflows include:
• Inflows: Premium income, investment income, reinsurance payouts
• Outflows: Commissions, expenses, reinsurance ceded, benefit payouts

Now, let’s look at the impact of each source of profit for different product categories:

• Unit linked: Fee income depends on fund value, which will build only if customers continue to pay regular premiums and fund returns are good. So, persistency is very important. Also, given that charges are capped through reduction in yield, expense levels important. Mortality impact may be muted or higher depending on level of life cover.
• Non-par savings: Yield income depends on asset earnings less guaranteed payouts and other outgoes. So, investment income is a key lever, followed by expenses. Also, the product structure will determine if value is higher in case customer surrenders policy in say, year 5, or continues till maturity – so, persistency may or may not be as relevant.
• Par savings: It’s similar to non-par savings and the key difference is that company’s share is only 1/9th. So, if inflows are higher, gains are muted; and if outflows are higher, impact to company is again muted as compared to non-par.
• Protection: Mortality markup gains would depend on expected assumption vs. actual experience, adjusted for reinsurance cashflows. Mortality is the key source of profit. For long term policies, expense inflation (low ticket size) and investment income may be important as well.

[Mas24]

Post 3: What’s so different about life insurance financials?

A simplistic view of life insurance cashflows:

The blue bars represent the realistic cashflows wherein customers pay premiums, outgoes are deducted every year and a final lump sum payout is made at maturity. The initial year cashflow may marginally positive, later years maybe higher and the final year has a large negative cashflow.

Now, life insurers actually create reserves using assumptions which are more prudent than the realistic assumptions, from the start of the policy. The orange bars represent the cashflows adjusted for reserves. The cashflows are negative at the beginning due to reserves, the positives build up over time and the final cashflow is a large positive since the prudence in reserves is released when the policy terminates.

Insurance cashflows are peculiar in two respects:

1. The time horizon from inception to termination of a policy is spread over a number of years
2. Reserves delay the release of positive cashflows

Hence, a single year view of the financial statements does not capture the complete picture of the health of the business. In fact, it leads to counterintuitive outcomes, for example:
• Higher new business is good, but leads to negative cashflows and reduces current year profits
• Current year profits do not provide any indication of profitability of the new business written as the positive cashflows will emerge after many years
• Given that we need to estimate profits based on future cashflows, the underlying assumptions are important and it’s difficult to understand this from the financial statements

While eventually the financial statements will reflect the true and fair picture, in the short/medium term it may not address all the queries on may have on the health of the business. Hence, life insurers came up with a different set of metrics to address these issues. The two key ones are VNB and Embedded Value.

[Mas24]

Post 4: What’s VNB and EV?

VNB (Value of new business) is the present value of expected future profits. In this market-consistent framework used in India, all cashflows are developed for all future years and then discounted to current period at risk-free rates. The risks in the business are separately assessed and explicitly allowed. VNB is similar to P&L.

VNB margin is VNB divided by Annualized Premium Equivalent (APE) – it’s similar to profit margin; but one can always debate on whether APE is the appropriate denominator.

Embedded Value (EV) is the intrinsic value of the existing book. It’s split in to two key components: Value of in-force (VIF) and Adjusted net worth (ANW). VIF is nothing but development of VNB over time – for example, for a policy in year 2, it’s the present value of future profits as calculated at that point in time. Adjusted net worth is essentially the shareholder funds in excess of that required to meet policyholders’ liabilities. Again, the risks are evaluated separately and explicitly allowed for. EV is similar to Balance sheet.

A good lens to look at EV is to split it in to sources of EV:
• VNB: This is the product of APE and VNB margin. Companies can improve their sales or their margins to increase VNB.
• Unwind of book: This is just the existing book brought forward by one year. The expected rate is an assumption here but usually in line with actuals.
• Operating variance: This informs us whether the company has performed better, in-line or worse than its assumptions over the one one-year period.
• Operating assumptions: This updates us on whether the company is tightening or easing out on earlier assumptions. Difficult to say what’s better (positive or negative) without doing a deep dive.
• Economic variance: This gives us the impact of interest rates and equity market – it’s the difference between the expected values and actual performance

So, VNB and EV provide us with additional information to evaluate the business of a life insurer.

[rupeshtatiya]

Hi @Mas24,

Thanks for engaging and providing us opportunity to pick insider’s brain.

The most important aspect of any financial company is risk management.

The life insurance companies are different than say lenders because of one fundamental difference - lending is a cost plus business where you know cost of your input/money upfront and then you add margins and sell. Most of the products now have variable interest rates which further reduces the risk. Life insurance is reverse - where your output cost is decided upfront and then you have to manage your input costs.

The second difference is in terms of tenures - e.g. maximum loan tenure in India for Home loans is 20 years but a large number of products have far smaller tenure (e.g. car loan, consumer durable loan etc.). The policy tenures of Life insurance products tend to be higher - Protection, Annuity, Pension etc. can to have tenures of 20-30-40 years. So asset liability mismatch risks and counter party risks - are far higher than lending business.

The other difference is that - many lenders have developed many robust streams of other income (fee income, distribution income etc.) which also helps financial companies manage risks and stay afloat in down cycle.

With that context, can you please help us develop a framework/checklist to asses risk and probably some softer aspects that one should look at while analyzing life insurance companies?
E.g. in financial companies, ability to scale back a line of business when risk goes up is an important risk assessment parameter. Getting better pricing for risk you are taking is another important parameter to look at.

I will come back with more specific questions on risk management and other aspects as we go along.

[Mas24]

@rupeshtatiya, thank you for mentioning quite a few pertinent points.

Let me try to address these below:

Interest rate risk
Interest rate is a key risk for life insurers. However, this risk is more pronounced in non-par savings (life, annuity, pension - wherever there is an absolute guarantee) as compared to other product categories.

• Unit linked is a fee income based product and does not offer any guarantee.
• Par savings offers a base guarantee with the opportunity of upside through regular bonuses. Now, this is similar to variable interest rate products as the bonuses can be adjusted every year in line with yields
• Protection carries some interest rate risk but is not as significant as non-par savings.

So, for non-par the key risk mitigation strategies include duration matching, cashflow matching, natural hedges within other product lines (eg: credit life or annuity), derivatives and partially paid bonds. Insurers do have robust ALM frameworks to manage this risk though it’s difficult to eliminate as complete cashflow matching may not be practically possible.

Perspective on risk

The way I would look at risk is as follows:

1. Understand the sources of earnings for life insurers. Since each source is based on assumptions which flow in to cashflows, there is a risk that experience will be adverse compared to expectations.
2. Understand the impact of divergence in experience for each source on the cashflows (will put up a post on this later)
3. Track year-on-year variance to get to the trends and then evaluate performance

Risk framework

This would include financial and operational risk aspects, some key ones have been mentioned by you. The framework needs to be simple and derived from publicly available information to make it work. Let me give this a thought and come back.

[rupeshtatiya]

The next BIG question is LIC.

LIC is a formidable competitor to private companies - with strong brand, largest network of distributors/agents and trust reposed in it due government as promoter.
LIC stopped doing Unit Linked business in ~2013 and it only focuses on non-traditional insurance products. Unit linked business has low margins compared to other traditional products.

• Despite having 28L Cr AUM and very high vintage book, the profits reported by LIC have been ~3000Cr for FY19. That is like 0.1% return on assets. As vintage of the book grows and back-book becomes far bigger than new business, unwind should overpower the new business strain and should reflect into profitability. Above PAT number is disappointing and frankly quite scary. That LIC does not have low margin ULIP business makes above PAT number very abysmal.
  Why is this the case, can you please provide your perspective?
  What things do we look for so that our investee companies do not suffer this outcome? (I do not believe public vs. private ownership argument in financial companies based on recent experience in Yes Bank, RBL Bank).
  Can you please do insider’s take on SWOT analysis of LIC?

• On a broader context, LIC’s size represents an aspiration to existing private players i.e. what future can look like. Largest private life insurers are at ~1.5L cr AUM and if one removes ULIP AUM, that number is closer to ~1L cr. So there is an opportunity to grow 28x theoretically and due to under penetration, there is inherent growth in the industry.
  With that opportunity landscape, what characteristics does private insurer need to have to gain market share?
  Can LIC fight back with either pricing or on the back of large agent network? How do insider’s view LIC as competition?
  Listing of LIC (if it happens) will probably make it more market aware and probably make it more focused?
  If you have some thoughts on listing of LIC, can you please pen those as well?

Best Regards,
Rupesh

[Mas24]

Post 5: How do we understand some of the key risks and opportunities in EV and VNB?

Disclaimer: The numbers used below are for illustrative purposes to build understanding on the subject and not a comment on any life insurance company.

Life insurers provide sensitivities to their VNB and EV and these can help understand both risk and opportunity of the business.

Let’s look at the illustrative table below:

1. Reference rate: This given the sensitivity of a parallel shift in yield curve. It does not allow for shape change of the curve.
   • VNB: This is primarily a function of new business product mix. Higher non-par savings would result in higher sensitivity.
   • EV: It gives a sense of how well are the assets and liabilities matched on dollar duration. For example, a positive change on decrease in interest rates would mean that asset duration is higher than liability duration. A key point to note is that generally, higher interest rates are better for life insurers and these sensitivities don’t reflect it.
2. Equity movement: This reflects primarily the following:
   • Impact of lower/ higher charges than insurers can deduct depending on drop/increase in fund values of unit linked fund
   • Mark-to-market impact of any equity investment in the general account (non- unit linked funds)
3. Persistency: This gives the impact of a multiplicative change in persistency. However, this impact significantly depends on the product mix. A good way to use this is to compare the change in persistency over the years with the change in VNB/EV, if the insurer has provided a break up of persistency variance. Also, it can be used to evaluate both opportunity and risk going forward, depending on whether one expects persistency to improve or reduce over time.
4. Maintenance expense: Regulations require insurers to use actual expenses and allow for inflation in future years. Given that one may expect further economies to scale to build over time, this can give a good sense of operating leverage available to the insurer.
5. Acquisition expense: This impacts VNB and again, the operating leverage point applies here as well.
6. Mortality/Morbidity: This sensitivity again depends on the level of protection in the product mix and reinsurance arrangements of the insurer. Generally, improving experience will give a positive uplift and most insurers would be working towards better underwriting analytics, improving claims management, reducing frauds, etc.

A good exercise to understand the impact of these levers is to look at the past 3-4 years performance of an insurer on each, apply these sensitivities to each element and check whether one can get a number on VNB/EV which is in line with the published results.

If one gets a close correlation, it can:
• Improve understanding on the key levers for value
• Use these as building blocks to help understand possible opportunities and risks going forward

[Mas24]

@rupeshtatiya, No comments, please refer to the Charter on post 1.

Also, would like to a pit-stop here and check with everyone on whether these posts are helpful or no? Would you want me to continue or is this too basic/ theoretical? I had the weekend free so was able to write but as the week begins, it will make sense to create posts only if they serve a purpose. Any feedback is welcome - am happy to stop now, or write more posts, or respond to queries only…

[Donald]

Hi @Mas24

Please continue building up on the posts, as you deem fit.
I can speak for myself (as someone who had not taken much interest in Insurers - finding it tough ti get to grips with), this is proving very useful for someone like me.

I am soaking it all in, so I don’t/won’t have well-formed comments/questions at the moment.
I know some others are waiting for a proper build-up, and looking to ask their own questions(they have been pondering on, or triggered by the posts) once this has an established flow.

Guys - Time for some initial reactions and suggestions (if any).

[rupeshtatiya]

Hi @Mas24,

I enjoyed reading your posts - they are crisp, to the point but also reflect the command one has over the subject. They are definitely very helpful.

I could think of so many broad as well as pointed questions on several aspects after reading these posts. Please continue writing/responding as you deem fit.

Look forward to more detailed interaction.

[Mas24]

Thanks @Donald and @rupeshtatiya. Encouragement always helps, will continue to write more posts for now and check again after some days.

Post 6: How may a shareholder view the life insurance business over time?

From a shareholder lens, a typical life cycle of the life insurance business evolves over the following stages:

1. Capital infusion phase: At inception of a life insurance business shareholders put in capital and the initial requirement is to grow the business. There will be new business strain as the company increases sales and may need a continuous infusion of growth capital – this leads to losses on the P&L.

2. Self-sufficiency phase: After initial years, shareholders would want the business to grow without any additional capital calls. This would mean that insurer has to become profitable on a sustainable basis and ensure solvency is above the required threshold.

3. Value generation phase: Now that the business is set up well as a going concern, the insurer needs to create value for shareholders (VNB, EV) and continue to scale up the business. Every lever that impacts value becomes important and there would be a large number of parameters that need to tracked. Profits would still be muted due to new business strain.

4. Dividend income phase: This is the steady state phase when the business has matured. Sales growth would come down and the business would start generating significant profits from the existing book.

One way to look at the life insurance industry in India is that 2001-2008 was phase 1, 2008-2015 was phase 2 and since then, we are in phase 3. One hopes that it may continue for another decade or so, given the GDP growth projections, increasing levels of disposable income, benefits of demographic dividend, etc. in India.

So, at the current level of maturity of the industry, one needs to track many parameters for a life insurer and monitor if the company is focused on value creation. This can be confusing and make the business look more complicated that it should be. We will continue to try to peel off the various layers to simplify the business.

However, in the long run, probably the most important parameters are solvency and dividend distribution. The first one ensures that the insurer will remain in business and second one would provide a steady income stream to the shareholder.

[Mas24]

Post 7: What’s a good strategy for a life insurer in the current phase of evolution of the industry?

• Growth: In the long run, the key determinants of success for a company in any industry is predicated on it either being in the top cohort or developing a specific niche. In insurance, growth can either create value or destroy it. So, scale helps only if it comes with value creation.

• Value: This one is a no-brainer. If a company intends to create value and executes well, it’s probably a good one. In this case, the only thing one needs to validate is whether the assumptions are panning out over time.

• Profits: In the current phase, it may be more appropriate to give less significance to this parameter. In fact, one is better off with a lower profit due to higher new business strain as long as the sales growth generates value.

• Capital: One can never ignore this parameter– shareholders have entrusted the management with capital and it is the management’s job to ensure that this capital is optimally employed while the company remains solvent.

So, how do we define a good strategy for a life insurer? Well, its depends on many factors, including:
• What are the intrinsic strengths of a life insurer and is the strategy aligned to this?
• How well has the insurer done on execution of strategy?
• How well is the insurer balancing amongst these competing priorities? – this is the key one for me.

Note: Posts 6 and 7 are more strategic in nature and let’s see where it goes since it’s evolving. Will probably write 1 or 2 more such posts and then come back to the nuts and bolts.

[zygo23554]

@Mas24

Also, would like to a pit-stop here and check with everyone on whether these posts are helpful or no? Would you want me to continue or is this too basic/ theoretical? I had the weekend free so was able to write but as the week begins, it will make sense to create posts only if they serve a purpose. Any feedback is welcome - am happy to stop now, or write more posts, or respond to queries only…

@Mas24 - On the right track and very helpful

We investors sometimes have the tendency to reduce any business to a set of numbers - growth rates, capital efficiency, expected return etc. While this approach by itself is not wrong, it is what separates good investors from really good investors. Really good investors get under the skin of the management running the business, have a good appreciation of what it takes to run and scale the business. In the medium term this is what builds conviction in a business, the ability to not just make sense of the past but also to have an independent, well grounded view on how the business could evolve over time as it responds to regulatory, competitive & economic forces.

I am keenly following your series of posts and will have some queries soon.

Request you to also cover the following at the appropriate time -

1. How does the evolution of the Indian life insurance industry stack up against other developed countries who have gone through this process? Are there any common errors that life insurance companies in the growth phase appear to make?

2. Are we yet at a stage where we have life insurers starting to diverge in their customer focus? Are we seeing companies focus on niches or are we still in a “capture market share through better sales & marketing till the growth slows down”?

[rupeshtatiya]

@Mas24

A key point to note is that generally, higher interest rates are better for life insurers and these sensitivities don’t reflect it.

Hi @Mas24,

As you mentioned above, understanding impact of interest rates is so important to understand the life insurance business. I have two specific questions in this matter.

First one is risk-free interest rate assumptions in either coming to actuarial liability or in EV/VNB calculation.

The way I read above table is - projected cash flow that will be generated in year 20 will be reverse discounted at 7% whereas potential cash flow generated in year 2 will be reverse discounted by 5.69% as of Mar 31, 2020. So this is like weighted reverse discounting using a curve instead of a fixed rate. Is this correct?

If above understanding is correct, then this sounds very risky to me. E.g. take a case of calculating current liability in case of protection where sum assured will be paid after 30 years. The liability at 29th year will be x/(1.07).
In reality, risk free interest rate in year 29 from today might be 4% or even 2%. So aren’t liabilities vastly understated?

I do understand that this curve is a technical curve that is used by everybody but what stops companies from using their own estimate of the curve?

If above understanding is incorrect, can you please give us a texture with an example - e.g. can we calculate current liability sitting in balance sheet or P&L for a protection policy of 1Cr and tenure of 30 years? We can ignore mortality angle if required.

[Mas24]

@zygo23554: Thanks for your comments. No comments on your specific queries.

In my personal view on the evolution of the industry, Indian life insurers have benefited from certain structural advantages:

• Many have been set up as JVs with foreign insurers where their global expertise can be leveraged
• Regulator has been very supportive, proactive, well informed and prudent over the past two decades
• Initial senior leadership came from financial services, global insurers, Indian insurer- this helped having the appropriate experience to run the business.
• the opportunity landscape in India was and continues to have significant potential

Insurers have experimented under various time periods, but in most cases have operated within their risk appetite. So, experiment but ‘fail the failure fast’ has been a recurring theme.

[Mas24]

@rupeshtatiya: No comments on the data posted by you. Please refer to the Charter on post 1.

I will address the queries related to the concepts on life insurance:

The yield curve used to discount both assets and liabilities on the market consistent EV framework. Companies use external curves from established publishers and this is usually reviewed by external consultants. Also, insurers can re-price products in line with falling yields. In order to mitigate the reinvestment risk of future cashflows, companies have been using various internal and external hedges. Also, EV/ VNB numbers are adjusted for asymmetric and non-hedgeable risks are separately. Will cover more on this when we discuss risks to the business.

Reserves work differently - they operate under a separate guidance which requires extra prudence (Refer Posts 1, 3) on all assumptions. Specifically, on technical discount rates used by insurers, they do publish these in the detailed financial statements - though most give a range.

Calculation of liabilities using financial statements: This is difficult to estimate without having a certain level of actuarial knowledge and granular understanding of assumptions/ impact of each lever. Any broad-brush exercise may be futile.I will try to share an illustrative example of how provisions work later- it will help to understand the concept but won’t answer the specific query. Also, I can say that in my view, provisions are usually prudent and reasonably adequate to address the liabilities in future years.

[Mas24]

Post 8: What are the sources of competitive advantage for life insurers?

They are and can be various sources of competitive advantage:

• Distribution strength: The traditional way to sell life insurance has been through a partner who has an existing relationship with potential customers. Access to large customer segments, geographies, income profiles, etc. is a key differentiator if it can be efficiently leveraged. Most insurers have well defined channels to solicit new business and service customers. While strategies for each channel may evolve over time, being able to access a large distribution network will remain a source of strategic advantage.

• Products: This is more nuanced. Product structures are similar across life insurers and any innovation can be competed away quickly. Yet, life insurers may adopt different product strategies based on their customer base, risk appetite, economics and nature of distribution network. There is no correct or best answer here, except maybe agility to adapt.

• People: Building and retaining a strong talent pool would remain a source of competitive advantage for any service related industry, including life insurance.

• Digital adoption: This can be on either customer onboarding/partner integration or internal processes. Different companies will be at different stages of evolution and technologies will continue to change at pace. Covid-19 has probably given a strong impetus to digital and one needs to watch out for how life insurers will adapt. It may be important to monitor the pace at which insurers keep evolving on digital.

• Expenses: This can improve the ability of a life insurer to compete. However, it may play out only over the long term. One needs to keep in mind that efficiency by itself is only one parameter and its effectiveness as a differentiator depends on many other parameters.

• Operating leverage: If one wants to look at the future, one may evaluate the runway on operating leverage available and the impact it can have on financial parameters.

• Risk management: This is a difficult one to evaluate with an external lens. I will cover risks in a separate post and one can make a risk checklist to keep a track.

A final note: I have listed only some of the sources of competitive advantage and there can be others as well. I may well have missed out some in the past half hour as I typed this post.

[rupeshtatiya]

@Mas24

So, for non-par the key risk mitigation strategies include duration matching, cashflow matching, natural hedges within other product lines (eg: credit life or annuity), derivatives and partially paid bonds.

@Mas24

• Risk management: This is a difficult one to evaluate with an external lens. I will cover risks in a separate post and one can make a risk checklist to keep a track.

Hi @Mas24,

While you work on laying down the risk management framework, let me set start on it by following questions.

• Firstly, can you please expand on duration matching, cashflow matching, natural hedges with examples. I/We have some broad level understanding of it but it would be great to deepen it.

• Can you please talk about risk management at product level and at portfolio level? How important is it to have balanced product mix? Can you please talk about how different products can be hedges to each other along different axes of mortality, cash flow, interest rates etc.

• Can you please explain the difference between parallel shifts and non-parallel shifts in yield curve? And also convexity?

• Can you talk about return of premium products in terms of pricing, margins and risks (interest rate, reinvestment risks in particular)? Can you please talk about ROPP products in protection as well as non-par savings business?

• Can you please bring out the risks as well as any advantages that deferred annuity products have? Deferred annuity products seems like a good way to catch the customer early and get a commitment. But large deferment period will force to take risks on interest rates as well as reinvestment risks. Already finding long term assets with high yields is a challenge and deferred products seem to aggravate this problem.

I will do another post on product specific questions.

Thanks again!