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International: Indian life M&A: Ebb and flow

Forces for mergers and acquisitions (M&A)
The life insurance industry in India, like the rest of the financial services industry, is currently undergoing a structural change which is likely to continue as regulatory and legislative changes and economic recession alter traditional ways of doing business. In the last year, the life sector has received two big blows and two more are in the offing. These have certainly set the industry on its back foot, if not knocked it down completely.

1 Global economic recession.
The recession has caused the industry to shrink, although some insurers managed better than others. Growth in the top line until the middle of 2008 was remarkable, primarily due to high commission levels and policyholders being sold unit-linked policies via highly emotive sales pitches fuelled by greed and fear. This led to most insurers increasing their geographical footprint, assuming that agent productivity levels were sustainable at this rate and that their offices would break even sooner rather than later. This is now no longer the case.

2 Cap on unit-linked charges.
The regulator’s recent circular on capping of unit-linked policy charges will lead to reduction in either distributor payouts, shareholder margins or both. Reduction in shareholder margins will lead to a drop in valuations and reduction in distributor payouts will, presumably, have a negative impact on sales, which will further push back the break-even point.

3 Increase in taxation.
A draft tax code — effective April 2011—proposes a corporate tax rate of 25%. Many life insurers are still pricing their products using the 12.5% tax rate mentioned in the old tax code for the life insurance sector, even though the corporate tax code for other industries is 30%.

In addition, the maturity benefit from insurance contracts will be taxed with the exception of contracts where the sum assured is at least 20 times the annual premium, which is not true for most unit-linked contracts sold currently. The intention of the new legislative regime is to grant tax benefits only if the policy has meaningful protection and is not a savings instrument in the guise of an insurance contract. This legislation will possibly reduce the popularity of unit-linked contracts as an effective long-term savings instrument.

4 Abolition of commissions.
A consultation paper, ‘Minimum Common Standards for Financial Advisers and Financial Education’, issued by a committee constituted by the Government of India, has proposed abolition of entry and exit loads from all financial instruments, including insurance contracts. In addition, it proposes that, in order to curb misrepresentation at point of sale, commissions should be abolished effective April 2011 and a fee-based system, charging the customer directly, should be adopted as practised in countries like Australia. The recommendations, if accepted, would most probably have a negative impact on sales and would no doubt lead to some sort of consolidation in the industry.

All the factors listed above would suggest a strong likelihood of M&A in the life insurance industry in the coming years. However, one should avoid simplistic analysis which, in this case, would be to just look at top line, bottom line and the major changes occurring in the regulatory and legislative landscape.

Forces against M&A
Let us look at five compelling reasons that could prevent M&A activity in the Indian life insurance industry.
1 Creating sales momentum through guaranteed products.
With the equity bubble bursting for a second time this decade, some insurers have still managed to maintain market share or even enhance it by selling guaranteed unit-linked plans to overcome policyholders’ fear of volatile returns. Selling equity-based guaranteed products is a riskier proposition than the normal unit-linked products where most of the investment risk is passed on to the policyholder. Not surprisingly, many insurers have still maintained distance from guaranteed products, presumably because their shareholders do not want to take such risk on their balance sheets.

2 Margins.
There is a lot of uncertainty surrounding the operating models of many life insurers and new business margins (NBMs) are under pressure. However, the internal rate of return (IRR) on capital is still much higher than most other businesses and certainly of the foreign joint venture insurance partners. The expected growth rates for Indian life insurance companies are still better than the rest of the world.

Even if the NBMs decrease from around 18% to 12% — a significant 33% reduction — as a result of the cap on charges and increased taxation, it would still imply an IRR of around 30%, which would appear to be attractive by any reasonable standards.

3 Availability of capital.
Significant amounts of capital were required to fund expansion costs and solvency requirements. With the dawn of economic recession, all expansion plans were put on the back burner and the management teams of most insurers are under pressure to close expense overruns and demonstrate that their businesses can make profits. As such, capital requirements have reduced and raising capital through equity markets or private institutional placements using the India growth story should not be a problem for most shareholders, although the cost might be higher than before.

4 Regulatory approval.
M&A can only happen after regulatory approval. If two insurance companies merge, then they would end up having two Indian partners and two foreign partners as the owners of the combined entity. There is no such structure in place in India and it is not certain whether the regulator would be comfortable in approving such a move. In all likelihood, the trigger point for M&A is much more likely to emanate from two foreign partners merging at a global level. It is difficult to fathom a situation where there are multiple shareholders of which two are from foreign insurance companies and between them they hold a maximum of 26% shares, as allowed under the current regime.

5 Management.
The final and most important aspect is that of the management of the foreign partners who have been telling their boards about the growth stories of their Indian businesses and getting rewarded for the same. They would not be interested in offloading their equity unless and until some extreme event hits their business, which causes their free surplus to decline and forces them to focus on local markets. The Indian shareholder is still looking at attractive valuations when companies start to list and, until then, it is unlikely that they will offload their entire equity, although they can offload partial equity through private placements in case of capital constraints.

The future
Will the industry consolidate or will the varied socio-economic demographics of India still allow companies to grow at a healthy rate for many more years? Only time will tell but one thing is for sure — the industry will see tempered growth rates going forward and, in such case, what differentiates winners from losers is the quality of business. Let us hope there is no Satyam* (cited as India’s Madoff) or similar skeleton in the closet.

For such things not to occur, both the regulator and the boards of insurance companies have to cooperate. The regulator has to ensure that information on financial health, including financial statements of insurers, is in the public domain and there are on-site audits for things such as market conduct (e.g. sales illustration being signed by the policyholder). Boards have to ensure that management is incentivised not only by sales and profitability but also by qualitative aspects like policy persistency, compliance with regulations, market conduct of their intermediaries and risk management initiatives.

The world has witnessed in the current economic recession that management incentives are somewhat disjointed from company’s performance, and boards should structure management remuneration such that no similar anomalies exist. Even the International Actuarial Association in its July 2009 newsletter, ‘Global Financial Crisis—What Next?’, moots the idea that the regulators should increase the capital requirement for any market participant with remuneration incentives that focus excessively on short-term results.

The world has changed around us and companies need to respond nimbly and accept the change if they want to be here for the long haul. None of us knows what the future holds, but can we confidently say that we hold the future?

*The Satyam Scandal: http://news.bbc.co.uk/2/hi/business/7818220.stm

Sachin Saxena heads the product pricing team at Max New York Life Insurance in India. The views expressed here are of the author and not necessarily of his employer
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Readers’ comments
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’An interesting read and well summarised...’
Shobhna Sharma, Watson Wyatt, 29 Jan 2010