Long before life insurance opened its doors to the private sector in 2000, state-owned Life Insurance Corporation of India (LIC) enjoyed a monopoly in managing householder’s money through insurance policies that doubled up as savings products.Twenty years later, despite facing stiff competition from the private sector, LIC still commands a lion’s share of the market—70% of first-year premium up to January 2020 was underwritten by the state-run life insurer. And the fact that it manages close to ₹31 trillion of the ₹40 trillion industry underlines the fact that LIC is much bigger than the 23 private sector life insurance companies put together.So, when the Union budget for FY21 announced a partial disinvestment—likely to be 10% —in LIC through the initial public offering (IPO) route by the end of the fiscal year, investors and analysts alike cheered the announcement. Given the size and strengths of the state-run life insurer, and the fact that it has consistently delivered profits to its majority shareholder (the government), it’s natural for anyone to want to own a slice of the company.And for analysts who have likened LIC to a black box on the back of poor disclosures, an IPO at least opens up the company to greater transparency. However, despite the nascent promise of profits, the path to the stock market is not going to be an easy ride for the behemoth. From structural changes with regards to shareholder’s capital to amending provisions of the LIC Act, 1956 (so that it can put more profits in the hands of the shareholders), the state-run life insurer has a lot of ground to cover.Currently, LIC pays only 5% of the profits to the shareholders and 95% go to the policyholders. This will need to change as more shareholders (apart from the government) come into the fold. They will after all be sizing up the stock against other listed insurers that promise a larger share of the profits. If LIC’s IPO doesn’t manage to meet the deadline, changes in law may be one of the primary reasons.LIC will also have to work on other metrics and improve its product mix and persistency ratios to arrive at a decent valuation. However, fears of government influence on the state-run life insurer may continue to loom over the valuation.The right valuationLife insurance is a long-term business. This means: you buy a policy today but continue to pay premiums for several years. It is from this future income that the insurers make profits. So, the value of a life insurance company is assessed by future profits that the current business is able to generate. This is captured by the embedded value, which represents the sum of present value of all future profits from the existing business and shareholders’ net worth.The state-run life insurer has so far not disclosed its embedded value, but as it prepares to go public, it will have to divulge this amount. The size and strengths of the company notwithstanding, the current dispensation of LIC—only 5% of the surplus goes to the shareholder—works to the disadvantage of the insurance giant and it is likely to get reflected in the form of a suppressed embedded value.It is important to understand how the profit sharing arrangement of LIC is unique compared to other life insurance firms and in order to understand that, an unpacking of the nature of life insurance products is necessary.Life insurance policies broadly fall into two buckets: participating plans and non-participating ones. A participating plan offers a baseline guarantee and pegs the investment returns from the profits that the participating fund makes. The profits from the participating fund get distributed between the policyholder and the shareholder in a 90:10 ratio. In other words, 90% of the profits go to the policyholders and are declared as bonuses that sit on top of the baseline guarantee. The balance 10% goes to the shareholders.The other type of life insurance policy is a non-participating plan, which comes with defined benefits or guaranteed returns. Here, the benefits are defined upfront and so this fund pool doesn’t participate in profit sharing. Term policies, unit linked insurance plans or traditional plans where the investment benefits are defined upfront are all non-participating in nature and, as such, the insurer can pocket the entire profits after provisioning for the guarantees.So, while private sector insurance firms essentially operate two separate pools: one a par fund—which pays 10% of the surpluses to the shareholders—and a non-par fund—that pays all the profits to the shareholders—LIC operates only one pool.Section 24 of the LIC Act has provisions for only one common account for all kinds of receipts and payments. This means even the non-participating business gets underwritten from this common pool of account and 95% of the profits are shared with the policyholders and only 5% is pocketed by the shareholder. This puts LIC at a serious disadvantage compared to its private sector peers and, therefore, these laws will need to be reviewed before the company taps the markets.It is important to note that the amendment to the LIC Act in 2011—which increased its paid-up capital from ₹5 crore to ₹100 crore—also brought the minimum profits payable to the policyholders to 90% from 95%, which is on a par with other insurance firms. However, LIC is yet to implement this. This is the reason why even though LIC surpasses all insurance firms in terms of its size, the dividend paid to the government doesn’t exceed the payouts by private sector insurers by the same margin.As per an insurance actuary, who spoke on condition of anonymity, amendments at this stage may not positively impact the embedded value immediately or significantly, as these changes will have to be prospective. “Embedded value looks at the future profits of the existing business. Given that currently shareholders only get 5% of that surplus, it’s unlikely that LIC will command a very high embedded value compared to its private peers,” he added.A Macquarie India research report pegs the embedded value of LIC at ₹25,000 crore, just about 11% more than SBI Life Insurance Co. Ltd that reported an embedded value of ₹22,400 crore in FY19 (the assets under management or AUM of LIC are 19 times more than SBI Life’s for the same period).The embedded value, in this case, is based only on the present value of 5% of surplus attributable to shareholders.As per the Macquarie India report, the actual embedded value will depend on many factors such as real estate holdings and investments, but the report does effectively underline the fact that getting the right valuation is going to be an uphill task for the government.The many unknownsThe other aspect that could impact LIC’s valuation is its book of business, which consists primarily of participating products, and has a significant chunk in the single-premium business. Single premium policies, as the name suggests, are one-time payment policies.“LIC has traditionally been selling more of participating plans with a larger proportion of profit share with policyholders. This can therefore build lesser value for shareholders relative to the market,” said Joydeep Kumar Roy, partner and leader (insurance) at PwC India. “In recent years, LIC has built a large single-premium business which if difficult to get value out of through the years and difficult to grow as there is no renewal book of business.”What doesn’t work for the shareholders doesn’t necessarily work for policyholders either. Even as participating plans return 95% of the profits to the customers in the form of bonuses, the costs in the plan are unknown; the product is opaque resulting in sub-optimal returns; and exit costs are high. Even in the case of single-premium policies, a policyholder would end up paying upfront for a long-term plan that she may not need a few years down the line.Going forward, LIC will need a more balanced mix of products to get healthy margins. In fact, there’s more: persistency ratios and expense ratios also need to be looked at, as they can make their way to negatively impact the embedded value of the company. As per its public disclosures for FY19, the 13th month persistency ratio for LIC is the lowest—at 66%—compared to its listed peers, although its 61st month persistency ratio is second highest at 51%.Persistency measures the number of policies that come back with renewal premiums and is an essential metric in valuation given the long-term nature of the insurance business. Other than persistency ratios, factors like expense ratios can also impact the embedded value and LIC’s expenses (although in single digits) are not the lowest compared to its listed peers. For instance, in FY19, LIC reported an expense ratio of 9%. This ratio is defined by operating expenses related to the insurance business divided by the premium earned. A single-digit expense ratio is good, but two out of three listed insurers have expense ratio of less than 9%. Given the size of LIC, the costs should ideally be even lower.According to Rohit Jain, India head at global advisory, broking and solutions firm Willis Towers Watson: “The federal influence on LIC could also be a concern as the government will continue to be a majority stakeholder. Further, LIC’s role as the bailout entity of last resort may also not bode well unless LIC strictly follows investment discipline.”LIC may also have to undergo some structural changes vis-a-vis shareholder’s capital to meet solvency norms. “LIC will be incorporated as a company and so the solvency margin as prescribed by IRDAI will have to be followed. Currently assets required to maintain the solvency margin sit in the policyholder’s fund, but as per provisions of the law, assets required to maintain the solvency margin will need to sit in shareholder's fund. This is going to be a huge task for LIC,” said an insurance consultant who didn’t want to be quoted. “Now the government can’t take out more than 5% from the policyholder's fund so it remains to be seen how it will meet the solvency requirements,” he added.Due to a variety of such niggling unresolved legal and operational details, valuers believe the chances of an LIC IPO materializing in FY21 look low, according to the Macquarie India report. “Also, reportedly, neither the valuers nor the regulator have been kept in the loop with respect to the IPO as per industry players,” stated the report.What listing means for LICDespite the many challenges and uncertainties that lie ahead, there are also many positives. “A plethora of assets, vast customer base, million-plus agents, presence in rural India, large AUM, along with historical value of the equity and real estate holdings, and customer trust will contribute to a very large valuation during an IPO,” said Roy of PwC India.Distribution is key to the life insurance business and LIC stands unparalleled with nearly 1.2 million agents, compared to the 1.02 million agents for the private sector insurers put together for FY19. This is one of the reasons why private sector insurers have been competing to partner with banks, who can act as their distributors.The way the insurance behemoth is run may also change, for the better. “Financial metrics will become transparent and listing will be good for all shareholders. This also means that the federal influence will remain under check,” said Jain of Willis Towers Watson.In fact, according to Shyam Sekhar, chief ideator and founder of investment advisory firm ithought, the perception is only going to improve. “Crony banking and investments are now a thing of the past. LIC is bearing the brunt of M2M (mark-to-market) losses of the government companies it has stakes in, but with the government disinvestment target, the company too will be able to get rid of these firms from its portfolio,” he said. “So, while the valuation may be at a discount in the beginning, it will only improve for subsequent disinvestment.”So, even as there are many questions and doubts that hang over the embedded value of LIC, experts believe the company is bound to command a very high market valuation for two simple reasons: the life insurance business is trading at a multiple of at least 3 times its embedded value, implying a bullish outlook for the sector even when its Asian peers trade at a much lower multiple. Secondly, LIC being a household name is likely to find resonance with investors. And those are the twin hinges on which the government may hang much of its hope.