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Another subdued quarter; future outlook remains strong

Star Health reported a weak set of numbers in Q3FY22, with a claim ratio of ~105%, a combined ratio of 135% and a net loss of Rs5.7bn. The numbers of Q3 reflect another imperfect quarter in a row due to a double whammy of Covid-19-led hospitalization along with an increased severity and a normalized frequency of non-Covid claims. With Omicron wave turning out to be relatively benign and the company’s action on product pricing and operating expenses, we expect the normalcy in the company’s numbers to come back in FY23. Notwithstanding recent turbulence, Star Health has built a strong moat in the highly attractive retail health market and is well poised to grow profitably over the medium to long term. We reiterate our Buy rating on the stock with a revised TP of Rs1,040.

* Double whammy of elevated Covid-19 claims and higher severity of non-Covid claims:

Poor Q3 numbers (Exhibit 8) were due to 1) the overall higher frequency of claims, with Covid-19 claims adding to more normalized non-Covid claims, and 2) higher severity of claims on account of Covid19 led precautionary measures in hospitals inflating the procedure costs in addition to medical inflation. However, on the 9MFY22 basis, Star Health’s claim ratio of 94% in Health was marginally better than that of some of the larger general insurance peers.

* Notwithstanding current turbulences, our conviction remains high on the stock:

Our highconviction Buy on Star Health is underpinned by three factors: 1) the health insurance industry is still in its infancy - we expect a heady growth rate of ~20% in the next decade; 2) Star Health’s dominant market share (>3x nearest competitor) in the sticky retail sector offers network effects – the trio of hospitals, customers and agents feed off each other in a virtuous cycle. Sub-scale competitors will struggle to outdo this moat; and 3) we expect margin gains with scale. The recent quarter abnormalities do not dent these factors beyond near-term impacts.

* Capital position comfortable:

Led by elevated loss levels, the required solvency margin (RSM) for Star Health has moved to the Net Claims factor in the last four quarters. In addition, the losses in Q3 reduced the available solvency margin (ASM). This reflects in a material decrease in the solvency margin (only 180% at Dec’21 despite Rs20bn capital raise). However, once claims normalize in FY23, we expect the RSM to move to the net premium-based factor and to improve to 188% in FY23 from 175% in FY22. Moreover, the option to utilize reinsurance and issue subordinated debt to shore up RSM gives enough levers before the company needs to look for an equity raise.

* Healthy medium-term trends in growth and profitability:

Star Health has the advantage of being present inthe health insurance industry is likely to grow at a ~20% rate in the next decade (led by volume and prices). Since the industry’s large public sector incumbents are growing at a much slower pace, we expect the private sector to clock a higher growth rate of over 25%. We expect STAR to grow its topline by ~23% over FY22-25. On profitability, we see the claim ratio returning to ~66-67% levels (slightly higher than pre-Covid year levels), leading to a ~95-96% combined ratio. Notably, the company’s claim ratio in 9MFY22 was not as bad as that of peers, and if there are any structural changes in claims cost trends beyond the temporary Covid-19-led spike, then the prices will adjust.

* Reiterate Buy; Revised TP of Rs1,040:

Factoring in the developments of Q3/9M, we change our FY22 estimates materially and reduce FY23-24 PAT estimates by ~10%. Based on the method of discounting future profits, we reduce our Mar’23 TP to Rs1,040, implying an FY25E P/E of ~46x and P/GWP of 2.8x. We reiterate our Buy rating on the stock.

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