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Surrendering to uncertainty

Private sector life insurance stocks have sold off 4-7% in the past two days. Unconfirmed media sources (link) suggest that IRDA is proposing to revisit surrender penalties for traditional policies. Based on details available in the media, it appears that the impact on surrender income may be significant, exerting pressure on VNB margins. More than the eventual impact, the uncertainty around the regulatory framework is making it challenging for investors to take a constructive call on the sector. We await final guidelines and product strategies of insurance companies to revisit forecasts.

Surrender value may increase

According to unconfirmed media sources, IRDA is proposing to increase the special surrender value (SSV). Insurers will have to ensure that the SSV is at least equal to the expected present value of paid-up sum assured and paid-up future benefits. The rate of interest to calculate expected present value share should not be more than 10-year G-sec.

Exhibit 1 compares the impact of surrender penalty guidelines—draft guidelines released in December 2023, final guidelines released in March 2024 and current proposed draft (according to media reports). The math suggests that the impact according to the current draft is broadly similar to the December 2023 draft, with higher impact for higher IIR or shorter-duration products. It is unclear if terminal bonuses/additions will be considered in the above calculation; this can swing the impact significantly. The above is a representative calculation, and we await final guidelines and changes in product structures to assess the eventual impact on stocks under coverage. Current forecasts anyway build in depressed margins, though the same may need to be revisited.

Changes in regulations make the investment thesis challenging

IRDA’s final surrender penalty guidelines released in March 2024 were less punitive for insurance companies than the draft released in December 2023. The current proposal for an increase in the SSV (according to media reports) once again reduces surrender penalties. The eventual impact on margins will be an interplay of final guidelines and consequent product strategies of listed players. Apart from the eventual impact, our interaction with investors suggests that frequent regulatory changes make it challenging to make an investment case in the sector, even as long-term growth prospects remain bright with valuation undemanding.

Sharing the burden with other stakeholders—distributors and policyholders

The insurance sector has three primary stakeholders, viz., companies (shareholders), distributors and policyholders. The impact of any business or regulatory change may be shared between the three in varying proportions. In this case, while exiting policyholders’ benefit, the impact will be borne by shareholders, but can be shared with distributors and continuing policyholders (in terms of lower IRRs). This may help offset some of the impact on the company’s margins.

Change in commission structure may also help

Another option is to change commission structures with higher trails, which is currently largely front-ended. It is unclear if the industry is ready for deferment. However, revising the compensation structure may be crucial to reduce mis-selling. This (revision of structure) may be the first step to the insurance industry’s eventual migration to a full trail model, on the lines of the mutual fund industry. Notably, ICICI Prudential Life launched an annuity product, with deferred commission payouts last quarter.

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