General insurance is simply the business of receiving premiums upfront and paying claims at a later date. This timing difference creates a negative working capital cycle and allows general insurers to deploy and earn investment income on the policyholders’ funds (float) in the interim period. A well-run general insurer is able to consistently raise float at a low cost and is able to retain the float for a long period of time. This unique business model of raising cash upfront (at possibly no cost) and earning income on it for extended periods of time makes a well-run general insurer an attractive business to own. In this context, we own ICICI Lombard (ILOM) in the Kings of Capital portfolio. ICICI Lombard is the largest private general insurer in India and has maintained its leadership position in the private sector since 2004. During FY08-FY20, ICICI Lombard has grown its PAT at a CAGR of 23% despite the Indian general insurance industry’s profit pool shrinking over that period! In this newsletter we explain how general insurance works and why we hold ICICI Lombard.

“Float is money we hold but don’t own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money. This pleasant activity typically carries with it a downside: The premiums that an insurer takes in usually do not cover the losses and expenses it eventually must pay. That leaves it running an “underwriting loss,” which is the cost of float. An insurance business has value if it’s cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if it’s cost of float is higher than market rates for money.”– Warren Buffett in the 2002 Berkshire Hathaway Shareholder Letter. Warren Buffet had first explained the merits of investing in a general insurer (GEICO) as a 21 year old in 1951 in a brokerage note titled ‘The Security I Like Best’ (click here to read).

Performance update of the live fund

The key objective of our “Kings of Capital” strategy is to own a portfolio of 10 to 14 high quality financial companies (banks, NBFCs, life insurers, general insurers, asset managers, brokers) that have good corporate governance, prudent capital allocation skills and high barriers to entry. By owning these high-quality financial companies, we intend to benefit from the consolidation in the lending sector and the financialization of household savings over the next decade. The latest performance of our PMS is shown in the chart below.

Under the TWRR method of calculating portfolio performance the initial performance looks optically lower in an upward trending market because of large inflows on a relatively small AUM. As on 16th March, the first customer of the Kings of Capital PMS had generated returns of 36.4% vs 57.4% for the Bank Nifty since inception.

ICICI Lombard is one of the four savings plays in the Kings of Capital portfolio. Given the complexity of the insurance sector, we have tried to first simplify the general insurance business and then explain why we hold ICICI Lombard in the portfolio.

General insurance industry profitability getting concentrated in favour of few large players

The Indian general insurance industry was a tariffed business i.e. the pricing for all products was fixed by IRDAI until 2007-08 when IRDAI de-tariffed all businesses except motor third party insurance. While the market share gain of private sector players continued post 2008, the pace of market share gains slowed down due to extreme price competition.

This extreme price-based competition led to the solvency ratios of the three large PSU insurers (United India, National India and Oriental) falling below the regulatory requirement. As a result, the sector’s profitability in FY20 was lower than that in FY08. However, PSU general insurers continue to have a ~40% market share in terms of premium income. Similar to the banking industry, the profitability of the general insurance industry has become polarized in the favour of few private insurers. The three largest private insurers (ICICI Lombard, Bajaj Allianz and HDFC Ergo) now account for two thirds of the sector’s profits.

General insurance: The only business which can potentially be run with negative cost of funds!

Like any other financial services business, the profitability of a general insurer is determined by three factors: (i) how much do the liabilities cost or what is the cost of funds; (ii) at what rate can the liabilities be deployed; and (iii) leverage. For a general insurer:

Cost of funds = underwriting profit or loss divided by the amount of float. General insurers which are able to earn an underwriting profit have a negative cost of funds i.e. they get paid to acquire float.
Rate at which liabilities are deployed = investment income divided by float. The investment yield is largely similar for most private players in India as most of the float is invested in fixed income instruments. ICICI Lombard though has the distinct record of not having seen a single write off on its investment book since its inception.
Leverage = Float divided by networth. Similar to lenders, higher the leverage, higher the ability of a well-run general insurer to deliver better RoEs. Leverage is a factor of the product mix as in businesses like third party motor insurance claims are settled over a long period of time which allow the insurer to retain float for a longer period of time.

High quality general insurers differentiate themselves on their ability to raise low cost of liabilities i.e. by sound underwriting practices. In this context, ICICI Lombard has improved its ability to raise low cost liabilities over FY16-20; the firm’s cost of funds stood at just 0.6% in FY20. Because ICICI Lombard is able to raise float at such a low cost in an economy like India where the risk-free rate is still 6%+, it is consistently able to earn a post-tax return on equity of 20%. The interplay between cost of float, earning investment income on the float and leverage to arrive at the RoE of ICICI Lombard is illustrated in Exhibit 3 below.

Why has ICICI Lombard been able to raise float at a low cost?
We believe that ICICI Lombard has been able to raise float at a low cost because of the following factors:

A. DNA of choosing profitability and RoE over growth in premium income

ICICI Lombard has grown its premium income at a CAGR of 12% during FY08-FY20 vs. an industry growth rate of 16.8% during the period. However, ICICI Lombard’s PAT has grown at a CAGR of 23% during this period vs. negative growth for the industry thus highlighting ILOM’s focus on profitability. Historically, ICICI Lombard has made a conscious choice of staying away from segments which are likely to see high loss ratios and aggressively growing in segments where loss ratios are likely to be lower. For example, in the past two years it has aggressively grown in the fire insurance segment while it has completely exited the crop insurance business even though it used to form 17% of the product portfolio in FY19.

B. Ability to change business mix at will in a regulated industry

While other insurers might also have the will to choose profitability and RoE over volumes, they might not have the ability to change business mix at will. Because ILOM has been the leading private general insurer since FY04, it has been able to setup deep distribution networks across all major segments. As illustrated in Exhibit 4 below, ILOM has consistently been the leading player across all major segments which enables it to change business mix depending on regulations, competitive intensity and expected loss ratios. Even within each of these segments, ILOM has chosen to operate in verticals with higher profitability. For eg. ILOM’s motor insurance book is more tilted towards private cars and 4 wheelers rather than commercial vehicles and its health insurance book has a low share of mass government health policies.

C. High quality underwriting

As in the case of banks and NBFCs – where asset underwriting is key to building a high-quality loan book – high quality liability underwriting is key to build a high-quality insurance book.

Understanding underwriting quality from reserving triangles: ICICI Lombard’s underwriting skills are evident in the reserving triangles disclosed by the company in their annual report. The reserving triangles provide a sense of initial loss estimate and ultimate realized loss experience over a long period of time. For eg. in AY11 initial loss estimate was Rs. 20.66bn. At the end of the next year, the estimate for losses pertaining to AY11 got revised to Rs. 20.44 bn. The initially estimated loss for policies written in AY11 was Rs. 20.66bn which even nine years later is Rs. 20.61bn. Similarly, loss estimates have been conservative in the years post AY11 as well which is illustrated by the redundancy % in the last column of the table below. Not only does it show surplus provision release but also the fact that it has been able to price risk well consistently over the years. These disclosures by ICICI Lombard gives us confidence on its prudent reserving and accounting practices as well as its ability to price risk. (Note: AY refers to Accident Year)

The underwriting quality of ICICI Lombard can be further understood from the fact that its share of losses in catastrophic events has been consistently lower than its market share as illustrated in the exhibit below.

Financials of Indian general insurers understate true profitability

The profitability of Indian general insurers is understated because of primarily two reasons:

Frontloading of customer acquisition expenses: Indian insurers are not allowed to amortise the expenses incurred to acquire the customer over the life of the insurance policy. As a result, while the premium income is earned over a period of time, the customer acquisition expenses are debited to the P&L in the year of acquisition itself.
Discounting of reserves not allowed: Indian general insurers are not allowed to discount reserves which implies that insurers have to estimate inflation for future time periods and create reserves based on loss estimates without any discounting.

We believe that the profitability of ICICI Lombard is understated by ~20%-25% because of the above two factors. As a result, ILOM’s P/E multiples also look optically higher.

In addition to being a high-quality general insurer, global experience suggests ICICI Lombard is likely to have a low correlation with the lenders in the Kings of Capital Portfolio

While insurers do not have a long history of being listed in India, we compared the share price performance and fundamental performance of global insurers with that of global lenders during the global financial crisis. We observed that unlike the banks, the return on equity of general insurers did not see a substantial deterioration post the crisis and the general insurers also saw a drawdown which was much lower than the large banks.

Similarly, the correlation of share price returns between Wells Fargo and JP Morgan during the global financial crisis was as high as 86% but it was much lower among the banks and insurers i.e. Wells Fargo with the two insurers and JP Morgan with the two insurers.

Note: ICICI Lombard is a part of many Marcellus portfolios.

Regards
Team Marcellus