We had an overweight position in Life Insurance (upto ~20% allocations in some accounts). We find this to be a very attractive industry and found valuations strongly in favor when it was hard to find value elsewhere. However, the industry has seen two regulatory actions in the last 24 months on tax saving products. There are concerns of some pending regulatory actions in Life Insurance (discussed below) the timing and scale of which are unclear at present, but which could have material impact on stock prices. Considering we take rolling 5 year (and not decadal views), we considered it prudent to reduce our position size.
The Life Insurance sector is well positioned to grow long term due to under-penetration in Term Insurance and Retirement products. Less than 10% of Indians who file tax returns own Term Insurance. Leading private insurers could grow premiums at 15%+ CAGR for long periods as they enjoy strong moats (brands that can be trusted/distribution through bank branches). Risk of technology disruption risk is low.
Complicated accounting (mismatch between revenue and costs) means true PAT and ROE of the business is hard to gauge. We believe for sector leaders (SBI life/HDFC life), true ROE will be ~17-20%. Businesses that require regulatory capital need to raise equity if growth> ROE. SBI Life has not raised equity since 2008 and has grown net-worth by ~18% CAGR and net written premium by ~18% CAGR in the last 15 years respectively, and still maintains high solvency levels despite paying regular dividends over time. This is a very attractive business to own from a permanent ownership mindset.
Some of the pending regulatory concerns are as follows:
- Life insurance has low corporate tax rates today (~14.5%) which could normalize over time.
- Some products are mis-sold while also having high surrender penalties. These could attract regulatory scrutiny (the Finance Ministry issued a circular to PSU Banks to curb mis-selling in Dec 2022)
- The regulator is trying to discourage Life Insurers from selling saving products.
Our view on these issues is as follows:
- Preferential corporate tax rates for the sector cannot continue indefinitely. However, we believe these may not increase in the short term and are a medium-long term risk. Having recently IPOd LIC, the Govt would send the wrong message to investors by changing tax policy so soon. Normalizing tax rates wouldn’t be very tax accretive for the Govt as the PBT of the private players (ex LIC) in aggregate is ~6,600crs in FY23 which would imply ~1000 Cr additional tax collections from private players. LIC is ~85% of overall Life Insurance profit pool and any increase in tax rates would impact valuations at which the Govts would further reduce its stake (96.5% at present).
- Some mis-selling does exist and customers suffer from high surrender penalties for some products. One of our colleagues house-help who earns ~2.5 Lacs a year was sold a policy with an annual premium of ~60000. ICICI Bank does not distribute guaranteed return products of ICICI Pru Life for this reason. However, not all sales in guaranteed return products can be attributed to mis-selling as some customers appreciate the ability to lock in interest rates for long periods. However, for leading players, mis-selling has reduced over time (persistency rates have climbed higher).
- Some surrender penalties are justified – customer acquisition costs are paid upfront.
- We do not believe the regulator is discouraging sale of savings products. Changes in regulations in the Life Insurance sector have been brought about to close tax loops for the super-rich, not to discourage long term savings. (Capital gains tax exemption under Sec 10 (10D) for ULIP < 2.5 lacs p.a. and < 5 lacs p.a. for other savings products still exist). The country needs long term locked in savings to fund long gestation infrastructure projects.
- Insurance is not bought primarily to save tax as the 1.5 Lac limit is already exhausted by other products such as PPF, MF tax saving investments, principal repayment on housing loans etc.
- Finally, Life Insurance companies are already preparing for the new era by focusing on lower ticket size policies and revamping product mix towards product segments with lower surrender charges.
None the less, regulatory risks are binary. Just because something should not happen, does not mean it will not happen. And unlike AMFI, which as an industry promoted the “Mutual Fund Sahi Hai” campaign, the Life Insurance industry as an industry forum is not moving with enough intensity and purpose to promote Term Insurance. Any regulatory action on surrender penalties and taxation together could have a meaningful impact on stock prices.
While we don’t believe this action is imminent, we believe it is prudent to reduce the sectoral position size to something more palatable today and wait for regulatory head winds to pass before increasing stake.