Insurance and Reinsurance sector- Truth is Beyond Time and Space

Stocks covered in this study: GIC RE and Cholamandalam financial holdings Ltd

Dear all, this study is mainly about the dynamics and factors affecting and governing the growth of insurance sector and not about any particular insurance stock. I have tried to list out the factors affecting the functioning and growth of this one of the most complex sector. But insurance sector (General insurance in particular) is going to see the huge growth for next 10-15 years in India and I feel this is going to be one of the sectors to produce future multibaggers. The growth and performance we have seen in Indian insurance sector up to now is nothing compared to the massive growth lies ahead. So I have tried to find out the most relevant factors which are going to shape this sector in the future and which stocks are going to be the major beneficiaries is just a matter of time and space and we will continue to find out more such stocks opportunities. As of now, I have selected GIC RE and Cholamandalam financial holdings Ltd (CFHL).

This study I have shared with the subscribers of this blog some 10 days back but due to some reason could not share the same here and in the meantime CFHL has witnessed good buying and has already touched 540 from 430 at that time. So not wasting any further time, I have decided to share the same here. The study is detailed spanning 42 pages so it will take some time in reading and understanding due to the complexity of the subject. I have also tried to cover issues related to valuation of businesses especially of financial firms. The second part of this study will be released soon covering the detailed study of stocks like GIC Re and CFHL. The full version of this study is available for the subscribers of this blog so I am sharing some samples from this study report here. Those who are interested in getting the full report please contact at oscillationss@yahoo.in

Sample study:

 

CONTENTS
Paragraph	Description	Page no.
(A)	Insurance- Role and impact on business and economy	4
1	Risk management in insurance and law of large numbers
2	Law of large numbers is everywhere
3	Concentration risk and Reinsurance
(B)	Insurance is complex but Reinsurance is even more complex	10
1	Law of large numbers and correlated or concentrated risk events
2	Reinsurance to manage concentrated/correlated risks
(C)	Time for Reinsurance is yet to arrive in India	16
1	General Insurance has a long way to go in India
(D)	Reinsurance to play big role in India for the growth of specialty insurance	20
1	Cyber Insurance and Catastrophic Insurance- The big game for Reinsurance
(E)	Cyber Insurance-The next big thing in insurance and Reinsurance	23
1	Valuation of Intangibles- where traditional accounting is useless
2	Valuation of data, information, and intangibles- a must in today’s world
3	Valuing the data assets- The starting point of cyber insurance
(F)	Crop insurance and Aircraft insurance- other Reinsurance heavy sectors	31
(G)	Something about Float and Investment Income in Insurance business	32
1	How life insurance industry adds value
2	Solvency Ratio
(H)	Government role is crucial in catastrophe insurance and GIC Re will be a key player for India	36
1	Catastrophe Bonds
(I)	Individual valuation of GIC RE (CMP 127)	40
1	Valuation of financial sector business- Book Value multiple or Earnings Multiple
(J)	Cholamandalam Financial Holdings Ltd (CMP 430, Market Cap. 8100 cr)	43

One friend once told me that he was fortunate to be born into his present religion as his life could have been useless had he been born into some other religion. But I told him that he was not that fortunate because truth is beyond space and time. Truth is absolute, ever-existing and ever-lasting. It is not affected, directed and objectified/represented by variations in time and space. I told him that he would have felt the same had he been born into some other religion. However my friend argued that still he felt good about his religion. But I told him that I was not denying that (feel good) but that which can be affected so much by time and space can’t be the reality. It can be whatever it is but it is not the TRUTH. You aren’t/can’t be defined by these temporal and spatial phenomena. I have seen people having a feeling of greatness, ego and class because of money. But I always tell them (wherever I can) that this is not the reality because this reality is bound by time and space. They could have born into a poor family and they absolutely have no control over this.

This misconception engulfs every sphere of life and Stock market does the same mistake when it thinks that quarterly numbers (time) and issues (often temporary) affecting industry (space) are the truth. As it focuses on time and space so it misses the truth. It sees bad quarterly numbers and reshuffling of Industry as an end of the game. But restructuring, reallocation and consolidation in any industry are indispensible for long term growth and sustainability of the Industry. This restructuring takes care of the misallocation of the resources in the industry and so the same is corrected through reallocation and consolidation. It is not the sign of a disease but it is a much needed surgery to cut off the cancer. So, quarterly results are not the truth (may be bad due to industry or company specific issues)…Industry problems are not the truth.

Truth is something else. Consciousness is the truth as consciousness exits beyond time and space. Businesses/Firms have their own consciousness which has the ability to create a superior product with scale with high entry barriers. This consciousness can travel beyond time and space. Promoters/management is just one of the part of business consciousness which comprises technical capabilities, superior R&D abilities and focus, Networking effects, superior and vast supply chain etc. Businesses are not alive beings still we can feel they have their own consciousness…they have their own aura…employees feel it (different feeling with different employers), other stakeholders feel it. The legacy of a business, work culture, integrity and focus attract, nurture and develop like-minded people...just like the ones who have created the original legacy (Like Tata, I feel even when Ratan Tata is gone the legacy and style of Tatas will prevail and this shows that business consciousness is real and shape all and everything around it).

Brilliance is not the rarity but the opportunity and expression of it is. So Steve jobs, Gates and Ratan Tata are not the exceptions…they will keep coming. They will keep coming into Microsoft and Tata attracted by their business consciousness. Strong businesses are not one product wonders but they are because they create and develop a work culture (consciousness) which automates the generation of new ideas, innovation, expression and resilience. This is the real strength of a company…its soul…its most important asset. This is what makes companies to fight at the face of adversity and lead to their resurrection. A business becomes more resilient to outside threats (competition and existential) when it has technical expertise, high entry barriers due to business model and complex supply chain. A great warrior is not who can hit others hard with his power but he should have the will power to withstand the hard blows of opponents…only then he can win fights and be a great warrior. So, strong business model and technical expertise are not enough. A business has to be resilient…it should have the strength and will power to withstand tough periods…periods of droughts.

Future growth is extremely uncertain as it is impacted by thousands of variables…more so now because the world has become a big single market (and it may stay so). I don’t think it is possible to assess the impact of these vast numbers of variables into the distant future with a high degree of certainty and then assigning a value for this assessment (growth rate). This assessment or guesswork becomes increasingly difficult and complex for an emerging line of business or when there are structural shifts happening in an economy. But it is possible to assess the technical expertise, strength and resilience of a business. The chances of a traveller crossing a tough terrain are not determined by the risk of dangers which may come during the travel but more by his strength and resilience. He can defeat those dangers. So rather than focusing alone on assessing the future dangers (guesswork) the better approach is to assess the strength of the traveller. Same is also true for a business. Future growth is not determined by the external threats but by the capability of a business to fight of those threats.

But I have seen business analysts putting all efforts to declare a growth figure. I always wonder how they calculate the growth rates i.e. at CAGR of 15% or 20% because 90% of the times these estimates are wrong. But if I am a great analyst charging hefty fees then I have to give a figure otherwise I can’t claim to be a God…I need to demonstrate. I am not saying that all such efforts are futile and misdirected but that they should not be the sole basis for assessing the worthiness of a business. The value of a business should not be determined by these estimates. I always feel that the major portion of the value of a business is determined by the individual capability to fight and survive. Financial ratios are linear but consciousness (strategy) is multi-dimensional.

Last year I have written a detailed post on Homeschooling explaining the pain points of our education system. One school principal asked me that day what I think is the major limitation of our study books and teaching. I told him that our books lose the purpose when they declare, present and demonstrate that they know everything and what they know is unquestionable and absolute. I always feel that schools should not only teach what we know but also what we don’t know. Science books should also have strong focus on what we don’t know as of now. This will create more Einsteins…more children will feel interested and motivated. Similarly, I think we need to understand that we can’t assess thousands of variables projecting their future behavior in an excel sheet…rather than giving inconclusive and raw figures it is better to declare that this we can’t assess or can assess with lower degree of certainty.

GIC RE- Its recent business performance is not the TRUTH

 GIC RE has been hit badly in last one year and trading at extremely lower valuations. But the truth is completely different from its recent quarterly numbers. In the coming paragraphs we will try to capture the truth.

GIC Re is India’s biggest reinsurer with around 60% market share. Insurance business is one of the most complex businesses and reinsurance is even more complex. So no wonder people are trying to assess the fourth dimension with 3D tools.

Sample 1:

 Insurance- Role and impact on business and economy

Insurance is basically a process by which risk is spread among vast number of people across geographies. As I have shared earlier, future is extremely uncertain and there are existential threats for all whether for an individual or a business. So the focus was always on as to how to eliminate these existential risks. Insurance tried to fill this void with its innovative business model.

To understand the model, let’s assume a small town with some 1000 families. As there is a risk of untimely death due to accident or disease so every resident is worried about the safety and future of his family. The best way for him is to build an emergency fund for his family. As per his estimates, the fund he needs is Rs. 1 crore and so saves this much money. But this threat is for every family hence every family is focusing on saving around 50 lacs to 1 cr in order to ensure the safety of their families. This means that people will try to save 500-1000 cr in this small town and the same will be parked in safe instruments like FD. But the savings of this huge sum also means that people will spend less and take very less risk for staring new ventures. And this will certainly hit the growth of the town very badly and the question will come as to how they will save this much money in the presence of low economic growth. Interest rates will be low but still even at lower rates there won’t be much takers of credit as everybody has become risk averse.

But then, a smart guy comes into the town. He does his homework and finds that on an average every year some 10 people die of accidents. So he understands that there is no need for everyone to create emergency fund. In fact, he can create a fund sufficient to pay Rs. 50 lac to 1 crore to the family of each deceased fellow which will be around 5-10 cr and for that he can charge a small amount as premium from each family in the town. The premium he will decide based on his cost of capital, administration and other charges. So if everything goes according to his estimates (of 10 deaths) then he will make money from this business. Most importantly, people will be very happy to pay small annual insurance premium (say Rs. 20-30K) to safeguard the future of their families and avoiding the need to save huge money for emergency fund.

So we can see this arrangement is a win-win situation for everyone but most importantly this will ensure the good growth of the economy as a whole as people will feel comfortable to spend and to take risks for new ventures. So we can see the big role being played by Insurance for the growth of economy also not just ensuring the safety of the people alone.

But the major factor here is to cover large population under insurance because only then law of averages will come into play and this will further reduce the insurance premiums. Insurance is mainly about vast coverage because if in the small town in our example only 100 people opt for insurance then there are high chances that out of these hundred 7 people die of accident resulting in high claim payouts for insurance company which is not a viable model. So the expertise of Insurance firm here is to assess the mortality rate accurately and increase the insurance coverage to large number of population. Hence, Insurance is basically a risk management mechanism where the insured manage his risk by transferring the same to the Insurer while the Insurer manages his risk by accumulating/pooling the risks of similar large number of individuals.

Non-life insurance (General insurance) follows the similar model and just like the life insurance it has to assess the risk events accurately like motor accident rates, Fire and catastrophe risks. But the focus here also is to cover the large geographical area in order to spread the risks. Like in our small town case, effectively 1000 people are taking care of the families of 10 people expected to die of accidents in the current year because instead of each family taking care of themselves 1000 families are taking care by pooling money for an adequate fund. So the core competency of insurance business is to spread risk because the risks associated with different policies are not perfectly correlated so the total risk of a portfolio of policies is smaller than the sum of the policies’ risks- for example, 100 policies having insured value of 100 cr…now the risk of each policy is 1 cr but total risk of 100 policies is not 100 cr due to nonlinear correlation between all the policies.

Insurance is a unique business and a very complex one because unlike other businesses where they sell goods or services but in insurance they sell promises…a promise to indemnify the other in case risk/loss event happens in the future. So the indemnity event is also contingent upon the loss event happening in the future which may or may not happen. So, Insurance companies are required to keep adequate liquidity and capital to meet out their future obligations in the form of insurance claims. Insurance companies are required to maintain a solvency ratio of 150% in India (will touch this in the coming paragraphs).

 A strong and efficient insurance industry is vital for the growth of an economy because in the absence of insurance support businessmen won’t be able to take the risk of setting up new factories/projects. Take the case of a setting up of a power plant costing Rs. 5000 cr which is exposed to the natural catastrophic risks like earthquake, hurricanes or other risks like war and terrorist attacks. In the absence of strong and solvent Insurance industry it is not possible for any businessman to invest such a huge amount. Banks can’t provide credit to businesses in the absence of Insurance.....

Sample 2:

Concentration Risk and Reinsurance

This is what insurance business is all about and the most important strategic decision for any insurance company. The holy grail of Insurance business is to avoid concentration risk. This is the most important factor which affects the demand and profitability of insurance business however surprisingly there is not much information about this in any of the coverage reports on Insurance business. They only talk about regulatory and mass retail Motor insurance, health or fire which are required by law and are non-discretionary. But due to easy money there is high competition in these sectors.

The major risk for an insurance company is to have high number of claims as compared to expected claims upon which they have built and priced their insurance policies. Now this high claim risk can be due to two factors- first, their assessment was wrong and their data collection and analysis models were wrong or outdated; second they have accumulated/distributed insurance policies in such a way that it has concentrated the risk for them……..

Sample 3:

Insurance is complex but Reinsurance is even more complex

I have not seen a business as complex as Insurance where growth and demand dynamics are extremely difficult to assess. But I have seen people treating both insurance and Reinsurance on the similar lines…analysts predicts linear relationship between insurance and reinsurance business and growth in retail insurance will result in the same degree of growth in reinsurance. But this is not the case. Both have distinct demand and growth dynamics.

Once one analyst associated with large broker house was telling me that their analysis about reinsurance is that with the growth in Motor, health insurance in India more business will come to Reinsurers. But I told him that I did not feel the same and instead as far as I can see growth catalysts are very different for Reinsurers. Actually here things are very complex- risks associated with Motor and Health insurance are not co-related…means one car accident does not create the chances of another car accident. In other words, if one car insured by insurance company X gets into an accident in area A then it does not affect the possibility of another car accident in area B nor it creates a chain where another car accident may take place due to one car accident in area A…means each risk event is different and independent and does not even out the other risk event. Car accidents are not mutually occurring and each car accident is a mutually exclusive event and independent of other car accident unlike catastrophes like hurricane where one hurricane can do big damage in multiple and correlated risk events in a particular area and further you can’t pin point the area in advance……

Sample 4:

General Insurance has a long way to go in India

However, Indian general Insurance industry as of now is very backward and needs huge resources and innovation to start the new growth path. To have an assessment as to where India stands now, two ratios are used across the globe to measure the development of insurance industry. First is Insurance penetration which measure the development of insurance sector i.e. circulation rate of the insurance products in an economy and second one is Insurance density which is the ratio of total insurance premiums earned in a given year to the total population.

Insurance penetration rate is measured as the ratio of premium underwritten in a particular year to the GDP. India’s insurance penetration was 2.71% in 2001, when the world average was 7.83%. The same in 2016-17 was at 3.49% (2.72% Life and a mere .77% for non-life). The same now stands at 3.7% against global average of 6.8% which shows that we have too much to cover as of now.

But i don’t like this ratio much and don’t think that this ratio is expressing the status which is desired because:

(1) If we can see then this ratio attempts to show the relation between premiums and GDP. But I think the focus of Insurance is not on protecting GDP DIRECTLY.

(2) In fact, Insurance aims to protect the GDP generating assets not the GDP.  So I think the focus should be on to check how much of the income generating assets (Like factories/power plants) are insured.

(3) Also, insurance premiums are affected by competition and interest rate in an economy (because insurers can set low premiums to attract more business to invest the premiums in high interest generating assets like Bonds).

(4) So I feel instead of focusing on insurance premiums received in a year the better way is to focus on the value of income generating assets insured as a percentage of total income generating assets in an economy. I mean focus should be on sum insured not on premiums paid. For example, if an economy has Rs. 10 lac cr worth of assets then the penetration should be measured as how much of these assets have been insured not the premium paid for ensuring these…….

Sample 5:

Cyber Insurance-the next big thing in Insurance and Reinsurance

Data is God. As you all know I am a firm believer of this. And as things are changing in the structure, growth factors and catalysts of economies across the globe the same is going to be recognized by all the businesses and insurance providers. The world, economies and businesses as we know today are defined by one factor- DATA. Just see the top companies of the world- Google, Facebook, Alphabet, Apple, Amazon, Microsoft, UBER, Netflix, Linkedin. They are not our conventional companies selling physical goods but they are the ones selling information, digital goods and services. For these firms, Data is all and everything. Companies selling and dealing in physical goods are no longer the global giants. Goods are replaced by DATA.

This Data orientation of the businesses has fundamentally changed the risks associated with the businesses. Two-three decades ago, businesses were about investments in machines, plants, infrastructure and raw materials. Business meant physical assets but now is the time of intangible assets……

Sample 6:

Valuation of Intangibles- where traditional accounting is useless

Once I was sitting among the group of stock market enthusiastic and CAs when one passionate investor told me that my being a qualified CA helps me a lot in analyzing the stocks. But I disagreed with him. I have seen CAs considering themselves as depositories of accounting laws and fundamentals so they have a feeling that they can value stocks and businesses. But I usually tell them that this is not the case because stock analysis starts where traditional CA ends. In mergers and acquisitions, intangibles are accounted for some 70% of the business valuations with traditional assets in books accounting only for some 30%. The problem with the traditional accounting is that it has no tools to evaluate intangible assets. Our so called balance sheets comprise of just physical and financial assets and liabilities and accounting says that the difference of the assets and liabilities is the net worth which is the value of the business as per accounting. But we all know that net worth in fact is the minimum value as businesses get maximum value from the intangibles like brands, technology, Patents, customer loyalty, information and data which is not assigned any value in the balance sheets by traditional accounting. So we can feel the uselessness of our accounting systems. The uselessness of our accounting is more pronounced at present with the onslaught of digital economy as more and more resources are invested in the formation of digital and intangible assets…..

Sample 7:

But in the absence of capitalization of intangibles or valuation of Data assets in the balance sheets have rendered the books of accounts and return ratios meaningless in today’s world because as pointed out earlier it is very much possible (it happens always) that the revenue earned today is due to R&D expensed out 5 years ago so this revenue will distort the return ratios/metrics big time and investors/analysts will have a false interpretation of high return ratios when the fact is that the most of the related expenditure is charged off 5 years ago. Further, the timing of R&D expenditure may impact the results big time and people may arrive at wrong conclusions when the fact may be that in a particular year with lower profits the firm actually has invested much higher in R&D for a new breakthrough product. For instance, take the case of Pharma biggies like Gilead and Pfizer, aviation giants like Boeing planning a new aeroplane…all these new products require massive investments in R&D the benefit of which will be realized in the foreseeable future. So the books of accounts we are seeing and analyzing today (especially of a tech heavy and R&D heavy firms like Pharma) are just superficial. If you ask me, Indian analysts have very low expertise in recognizing and valuing intangibles (Biocon was never valued much in 2013-14 when it was spending big in R&D and I saw many analysts questioning its return ratios at that time. But I picked it at that time and it is now a 12 bagger). The main reason for this is that Indian companies are very backward in investing in R&D so in India these analysts have the liberty to ignore or deficient in valuing intangibles but still be regarded as great analysts…..

Sample 8:

How life insurance industry adds value

 If we can see, life insurance industry sells the true interest rate sensitive products or policies. Almost entire profits of a life insurance provider arise from the difference in the interest rates they are earning on their assets and the interest rates they have promised to their policyholders. So falling interest rates negatively affects the future value of its assets which it needs to payout its liabilities in the future which are at much higher interest rates. So this can result in the asset liability mismatch and even can threaten the insolvency of the insurance firms. That’s why prediction of long term interest rates is more relevant and imperative for life insurance firms than non-life firms.

So the most important thing for the life insurance firms is their ability to predict the behavior of interest rates over a period of 20-30 years…..

(Views are personal and should not be taken as a recommendation for buying or selling a stock. Stock markets are inherently risky so kindly do your own Due Diligence before investing. I am not a certified Sebi Analyst and holding the shares discussed in this Post. Reach me at oscillationss@yahoo.in).