India Equity Research | Banking and Financial Services Sector Update

LIFE INSURANCE
IRDA plans to cap surrender charges; negative for margins, volumes

Since October 2009, the Insurance Regulatory and Development Authority (IRDA) has May 27, 2010
focused on rationalising charges, bringing broader uniformity in product features and
improving disclosures. After capping charges, fixing minimum policy terms and making
it compulsory to offer sum assured on products, IRDA now proposes to cap surrender
charges at 15% of fund value for 10-year policies and 12.5% for >10-year policies, Vivek Verma
declining to 0% in a stepped manner by the sixth policy year - lower than the +91-22-4040 7576
existing levels. As per our interpretation, these guidelines will apply to new business vivek.verma@edelcap.com
only (including the existing products, but not the existing in-force business).
Nilesh Parikh
+91-22-4063 5470
„ Our view: Current reported margins and volumes unsustainable nilesh.parikh@edelcap.com
In the ULIP business, since investment risk is borne by policyholders,
manufacturers were exposed only to persistency and operating risks. With higher Kunal Shah
surrender charges, a significant proportion of persistency risk was passed on to +91-22-4040 7579
policyholders. However, a cap on surrender charges will imply higher persistency Kunal.shah@edelcap.com
risk on life insurers’ balance sheet. We believe the impact will be felt on both
volumes and margins, as illustrated below:

• The biggest risk comes from the policyholder behaviour in response to drop in
surrender charges; due to lower penalty, persistency across sector may
drop, hitting margins adversely.

• Our analysis reveals that in products where life insurers have managed to
garner margins without surrender charges, they have done so by increasing
policy administration charges. However, with growing public clatter on high
allocation charges being used to pay commissions, it will be difficult to
frontload products. At the same time, if insurers sell only frontloaded
products, there will be a limit on choice offered to prospective policyholders.
Further, high frontloading may not fit into SEBI’s scheme of things. Hence,
impact on margins appears inevitable.

• This would require re-launch of products conforming to new standards, which

could consume significant sales effort and, hence, impact overall volumes.

• As per our understanding, these regulations do not apply to existing business,

hence, insurers will be able to realise profits out of Funds for Future
Appropriations (FFA) amassed over years.

„ Other highlights of draft guidelines

• Eliminating pitfalls in the treatment of lapsed funds, IRDA proposed four
options for policyholders: (1) revival; (2) continuation to the extent of risk
cover; (3) continuation of risk cover and remaining invested in a fund
(paying risk charges and FMC; this option is also set as default
option); and (4) withdrawal.

• Further, through the draft guidelines, IRDA has proposed uniformity on

parameters such as: (1) grace period; (2) lapsation; (3) policy revival period;
and (4) annual disclosures related to lapsation and surrenders.

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BFSI

Table 1: Valuation snapshot

Valuation (FY12E)
Appraisal
Embedded Structural Appraisal Appraisal Per share
value/
Company value value value value post contribution
Embedded
(INR bn) (INR bn) (INR bn) discount (INR)
value (x)
ICICI Pru 102 190 292 265 2.9 176
SBI 62 197 259 226 4.2 263
Reliance 32 66 99 90 3.1 366
HDFC Std 51 96 148 128 2.9 325
Kotak OM 20 35 55 48 2.7 102

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Life Insurance

Appendix I
Most products have surrender charges higher than the limit proposed by IRDA
Policy duration ICICI Pru SBI Reliance HDFC Std Kotak OM Birla SL Bajaj Allianz Max NYL
Year <10 years >10 years % of FV % of FV % of FV % of FV % of FV % of FYP % of FYP % of FYP
1 12.5 15 0-70 15-20 95-100 20-100 40-100 0-50 40
2 10 12.5 0-70 10-15 50 15-80 40-100 0-50 15-40
3 7.5 10 0-70 7.5-10 30-35 10-70 40-100 0-50 10-30
4 5 7.5 0-10 2-5 20 15 4-10 2-50 0-47 5-20
5 2.5 5 0-5 0-5 10 0-15 2-5 0-40 0-26 2.5-10
6 - 2.5 - 0-3 - - 0-2.5 0-10 - -
7th year
- - - - - - - 0-10 -
onwards
Source: IRDA, Company, Edelweiss research
Note: FV stands for fund value; FYP for First Year Premium

Appendix II
Companies can manage margins even without surrender charges by tweaking other charges (example enlisted
below of two products of ICICI Pru)
ACE Assure wealth
Premium allocation charges 0% Yr 1: 100%; Yr 2-5: 4%; Yr 6-7: 0-4%; Yr
8 onwards: 0%
Policy admin charges INR 60 p.m. Yr 2 onwards: INR 60 p.m.
FMC 0.75-1.35% 0.75-1.35%
Surrender value Yr1-3: 70%; Yr 4: 10%; Yr 5: 5%, Yr 6 No surrender charges
onwards: 0%
Remarks Zero premium allocation charge balanced Surrender charges are zero but recovery
by higher surrender charge done through 100% policy admin charges
in Year 1

Source: Company, Edelweiss research

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Appendix III
As per our understanding, these regulations do not apply to existing business, hence, insurers will be able to
realise profits out of Funds for Future Appropriations (FFA) amassed over years

Funds for future appropriations (FFA) FFA as % of AUM

8,000 3.5

6,400 2.8
(INR mn)

4,800 2.1

(%)
3,200 1.4

1,600 0.7

0 0.0
Reliance
Bajaj

Birla
ICICI

Kotak

SBI
HDFC

Max

Reliance
Bajaj

Birla
ICICI

Kotak

SBI
HDFC

Max
FY06 FY07 FY08 FY09 FY06 FY07 FY08 FY09
Source: IRDA, Company, Edelweiss research
Note: FFA (includes traditional and linked) implies the penalty to be obtained by insurer on premature surrenders; to be realized in P&L post
the revival period

Benefits as % of lagged AUM remains high in industry, reflecting significant

surrenders and partial withdrawals
70%
20.0

16.0

12.0
(%)

8.0

4.0

0.0
ICICI

Reliance

SBI
Bajaj

Kotak
HDFC
LIC

Max

FY06 FY07 FY08 FY09

Source: IRDA, Company, Edelweiss research

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Life Insurance

Appendix IV
Key recommendations of Exposure Draft on Standardisation of Terms and Conditions of ULIPs and measure for
Policyholders’ Protection Regulations
Parameter Recommendation
Grace Period Payment mode:
monthly 15 days
others 30 days
Lapsation Options to policyholders in case of lapsation:
a) revive
b) continue to extent of risk cover
c) continue risk cover and as a part of fund (default option)
d) withdrawal
if no fund option is selected by policyholder:
Lapsed fund to be invested in fixed income fund earning atleast savings
deposit rate
Interest on lapsed funds not available to shareholder
Minimum revival period 5 years

Surrender charges Policy term <10 >= 10

capped (% of FV) years years
1 year 12.5 15.0
2 year 10.0 12.5
3 year 7.5 10.0
4 year 5.0 7.5
5 year 2.5 5.0
6 year - 2.5
7 year - -
Treatment of proceeds Charges to be recovered by shareholder:
from lapsed policies

FMC
Risk charges
Proceeds to be refunded:
Not before three policy years
Compuslorily after the revival period
Disclosures Following to be shown as separate item in balance sheet:

a) Provision/funds for lapsed policies

b) Provision/funds for surrendered funds
Following to be shown as separate item in notes to accounts:
No. & % surrendered/lapsed during the year
No. & % surrendered out of lapsed policies during the year
No. & % of policies revived during the year
No. of policyholders opted for mortality and funds
Amount charged on account of surrendered and lapsed policies
Source: IRDA, Edelweiss research

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Appendix V
History:
Action Details Impact
Term Overall cap FMC capped Profitability capped
Oct-09 IRDA caps difference <= 10 years 300bps <=135bps Downward pressure on commissions
between gross and net Focus on improving persistency and
>10 years 225bps efficient cost management
yield on ULIP policies
Mortality charges, cost of guarantees kept out To maintain margins, new products
of the ambit carried:
Higher sum assured
Guarantees
No surrender charges allowed beyond 5th Freedom to fix surrender charges still
policy year allowed insurers to reduce persistency
No limit imposed by IRDA on surrender risk on their balance sheet during first
charges five policy years
Apr-10 Disclose commissions to As per media reports, IRDA has asked insurers To exhert downward pressure on
agents to disclose explicitly the commission in the (effective) distributor commissions
benefit illustration
May-10 Minimum policy term Individual policies to be of 5 year duration Renders regulator imposed long-term
fixed Group business to be on annually renewable nature to insurance contract; life
basis insurers cannot cater to demand for
short-term policies
Reduces persistency risk
No partial withdrawals in ULIPs during first five Makes product inflexible, hard to sell
policy years
No partial benefits on pension/annuity plans on
linked platform
At time of maturity and surrender 1/3rd value
can be commuted, rest need to be annuitised
in linked pension plans
Insurers to offer All pension/annuity plans to carry sum assured Restricts sale of pure savings/investment
guarantees on policy Top-ups to carry cover; to be treated as single products under umbrella of life insurance
benefits premium contract

No loans to be granted
on ULIPs
IRDA recommends Refer Appendix IV on details on caps on Since the caps recommended by IRDA
capping surrender surrender charges appear to be below what insurers are
charges on ULIPS charging currently, so a significant
persistency risk will now be borne by
insurer, even in first five policy years,
jeopardizing margins
Source: IRDA, media reports, Edelweiss research

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Life Insurance

Appendix VI- April WNRP

New business premium in individual new business segment remained strong in month of
April-10 with private insurers recording 38.3% WNRP (individual) growth Y-o-Y (against 27%
in March-10) while LIC continued to surprise positively growing 101% (against 58% in March
2010). Amongst large private insurers, in individual new business segment, ICICI Pru (187%),
HDFC (62%) and Tata AIG (41%) grew faster than private sector (38%). From volumes
point of view, April is a weak month contributing ~3% of annual new business premium.
Further, it is characterized by spillover from month of March which varies from company to
company.

WNRP- April 2010

Y-o-Y Market WNRP Y-o-Y Market WNRP Y-o-Y Market
WNRP growth share (indl) growth share (group) growth share
(INR mn) (%) (Private) INR mn (%) (Private) INR mn (%) (Private)
ICICI Pru 2,935 162.7 20.5 2,665 187.4 21.7 269 41.9 12.9
SBI 1,643 (62.5) 11.5 893 (18.7) 7.3 750 (77.2) 36.0
HDFC Std 1,586 112.5 11.1 1,175 61.9 9.6 412 1,858.1 19.8
Bajaj Allianz 1,357 (14.0) 9.5 1,206 37.2 9.8 152 (78.3) 7.3
Max NYL 1,260 (1.6) 8.8 1,205 (4.8) 9.8 55 262.2 2.6
Reliance 1,235 31.9 8.6 1,116 26.5 9.1 119 122.7 5.7
Birla Sun 835 5.3 5.8 709 14.1 5.8 126 (26.7) 6.0
Tata AIG 631 36.7 4.4 617 41.3 5.0 14 (44.8) 0.7
Canara HSBC OBC 534 17.2 3.7 532 17.0 4.3 1 0.0
Kotak OM 413 45.8 2.9 327 30.4 2.7 86 164.1 4.1
IndiaFirst 296 2.1 296 2.4
ING Vysya 290 (21.4) 2.0 289 (21.4) 2.4 1 (37.2) 0.0
Aviva 260 (6.2) 1.8 235 (3.5) 1.9 25 (25.6) 1.2
Met 240 51.9 1.7 198 34.4 1.6 42 297.1 2.0
Bharti Axa 203 21.2 1.4 201 21.4 1.6 1 (0.7) 0.1
Future Generali 152 41.2 1.1 131 81.1 1.1 21 (41.2) 1.0
Shriram 141 0.2 1.0 140 (1.1) 1.1 2 0.1
IDBI Fortis 128 23.3 0.9 128 23.0 1.0 0 0.0
Aegon Religare 63 234.0 0.4 63 233.8 0.5 0 0.0
Star Union Dai-ichi 59 108.7 0.4 52 82.4 0.4 7 0.4
DLF Pamarica 55 433.7 0.4 55 433.7 0.4 - -
Sahara 21 (45.4) 0.1 21 (5.9) 0.2 - -
Private 14,339 6.5 44.5 12,256 38.3 43.3 2,083 (54.7) 53.1
LIC 17,908 100.7 55.5 16,071 101.1 56.7 1,837 97.6 46.9
Total 32,247 44.1 - 28,327 68.0 - 3,920 (29.1) -
Source: IRDA, Edelweiss research

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Board: (91-22) 2286 4400, Email: research@edelcap.com

Vikas Khemani Head Institutional Equities vikas.khemani@edelcap.com +91 22 2286 4206

Nischal Maheshwari Head Research nischal.maheshwari@edelcap.com +91 22 6623 3411

Coverage group(s) of stocks by primary analyst(s): Banking

Axis Bank, Federal Bank, HDFC Bank, ICICI Bank, IOB, Karnataka Bank, Kotak Mahindra Bank, OBC, SBI, Yes Bank, IDFC, HDFC, LIC
Housing Finance, PNB, Power Finance Corporation, Reliance Capital, SREI Infrastructure Finance, Syndicate Bank and Union Bank.

EW Indices Recent Research

1,600

1,400
Date Company Title Price (INR) Recos

1,200 17-May-10 Federal Healthy core to offset 293 Buy

Bank asset quality pressures;
Result Update
1,000
14-May-10 SBI Look beyond the 2,224 Buy
800 headlines; Result Update

21-May-09 21-Nov-09 21-May-10 12-May-10 Manappuram Growth momentum 77 Buy

Finance continues; Result Update
EW Banks and Financial Services Index Nifty
12-May-10 Kotak Financing businesses 768 Buy
Mah. Bank surprise positively; securities
and AMC disappoints; Result Update

Distribution of Ratings / Market Cap

Edelweiss Research Coverage Universe Rating Interpretation

Buy Hold Reduce Total Rating Expected to

Rating Distribution* 101 56 9 169 Buy appreciate more than 15% over a 12-month period

* 3 stocks under review

Hold appreciate up to 15% over a 12-month period
> 50bn Between 10bn and 50 bn < 10bn
Reduce depreciate more than 5% over a 12-month period
Market Cap (INR) 103 53 13

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