How do equity market volatility, interest rate movement impact insurance companies?

The market mayhem over the past month has cost investors dearly. Insurance companies, too, have been caught in the market rout. A look at Capitaline data based on insurance companies’ holdings in listed companies suggests that insurers have lost close to ₹1.9-lakh crore in wealth between January 1 and April 8 (holdings of insurance companies in listed companies as of December 2019 has been considered).

How does the 27 per cent fall in the value of equity investments impact insurance companies?

In the bond market, too, while rates have fallen notably since January, there has also been heightened volatility in the past month. How do rate movements impact insurance companies?

In the case of life insurance companies, the erosion in equity investments immediately impacts unit linked insurance policies (ULIPs), where the market risk on investments is borne by the policyholder. In the case of traditional life policies, the chunk of the investments are in government securities and high rated corporate bonds, which do not have to be market-to-market. Here, the interest/dividend income and actual profit or loss booked on sale of investments are the key drivers of investment income.

However, the second order impact of market stock market volatility on ULIP business, softening interest rates and higher defaults do weigh on the profitability, return ratios and solvency margin of insurance players.

How it hits life insurers

There are broadly two types of life insurance policies — savings and protection. Savings products essentially comprise ULIPs, participating and non-participating policies. Protection products provide cover for life, disability, critical illness and accidental death.

In ULIPs, a portion of premium is invested in equity, debt or a combination of both based on risk appetite of the policyholder. Here, the market risk is passed on to the customer. Hence the recent stock market mayhem has impacted the NAV (net asset value) of ULIPs, which has fallen by a notable 20-30 per cent over the past two months.

For life insurance companies, it is the second order impact of market volatility that impacts their business. Since investors become cautious towards ULIPs, and the sale of such products takes a hit during market volatility. For instance, ICICI Pru Life had seen a 14 per cent fall in ULIP APE (annualised premium equivalent) in the nine months ended December 2019 (equity market volatility had persisted before January as well). There is also the impact on fund management charges that are linked to assets under management.

In the other types of life policies, the chunk of investments (equity is capped at 20-25 per cent) are in government securities and high rated bonds (AA and above).

In the case of SBI Life, of its total assets under management of ₹1,64,190 crore as of December 2019, 76 per cent is debt and 93 per cent of its debt investments are in AAA and sovereign bonds. In the case of HDFC Life, of its ₹1,36,500 crore AUM, 63 per cent is debt (96 per cent in AAA bonds and government securities) as of December 2019.

According to IRDAI regulations, debt securities are considered as ‘held to maturity’ and hence not marked-to-market. This implies that market fluctuations do not immediately impact the valuation of these investments. However, profit/loss on sale of investments impacts the income from investments, as also the interest/dividend income.

Also, the softening of interest rates and NPAs or downgrading of debt investments impacts insurers.

In the case of participating policies, 90 per cent of the profits are shared with the policyholder, 10 per cent accrue to the shareholders. Lower profits can hence impact the earnings of insurers and policyholders. Remember, interest rates have also softened over the past few months — the RBI’s 75 bps rate cut can impact returns from debt portfolio further. In the case of non-par policies that offer guaranteed returns with IRR (internal rate of return) of 4-6 per cent, there is the risk of reinvestment in a falling interest rate scenario. High guaranteed returns can pinch insurers, if not hedged appropriately or repriced when interest rates move.

Then there is the credit risk associated with bonds, which could become pronounced amid the Covid-led slowdown in the economy. Aside from the rise in defaults that impacts provisioning and earnings, life insurers take note of downgraded value of debt investments and make necessary provisions. A mark-down of these securities can also impact bonus payments for traditional policies.

During the period ended December 31, 2019, SBI Life had classified its investment in DHFL bonds as NPA. A provision of ₹157 crore under unit linked fund and ₹113 crore under shareholders funds was recognised.

Embedded value

Embedded value (EV) is a measure used to value a life insurance business. It is essentially the present value of shareholders’ interests in the earnings after sufficient allowance for aggregate risks. Listed life insurance companies give the sensitivity analysis of EV, highlighting the change in EV owing to change in equity value and interest rates, among other factors.

For instance, in the case of HDFC Life, a 10 per cent decrease in equity results in a 1.3 per cent fall in EV (as given in the December quarter presentation), while a 1 per cent decrease in reference rate leads to a 1.2 per cent increase in EV. In the case of Max Life, a 10 per cent fall in equity leads to a 1 per cent fall in EV while a 1 per cent fall in risk free rate results in 1 per cent increase in EV. A reduction in interest rate leads to an increase in the value of assets, which offsets the loss in the value of future profits.

Lower realised return

The economics of a non-life business principally rides on the concept of ‘float’, wherein insurance companies collect premiums upfront and pay claims afterwards. This creates a float or investable asset base that can be deployed to generate returns for shareholders. The investment income is dependent on the investment book and realised return. The realised return on investment book for many players has come down notably in the past year to about 6 per cent in 9M FY20 from around 9 per cent levels in FY19.

As interest rates soften further, realised return could moderate further.

Solvency ratio

Then there is the solvency ratio, which is a critical metric for an insurance company. Essentially it is the size of the insurance company’s capital in relation to the risk it takes — assets minus liabilities. Simply put, it measures how financially sound an insurer is, and its ability to settle claims.

Solvency ratio is derived out of the solvency margin (total available solvency margin/total required solvency margin). Insurers follow IRDAI’s guidelines for valuation of assets and liabilities to arrive at the solvency margin every quarter. Here, the sharp fall in equity investments could impact solvency ratio. But most players have a comfortable solvency ratio (above the mandated ratio of 1.5 by IRDAI).

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