Calm After the Storm

A few years ago, fashion house Chanel signed up Brad Pitt to advertise their iconic fragrance No. 5. With so many things right — Chanel, Brad Pitt and No. 5, there was no chance anything could go wrong. But the campaign backfired badly as the audience just couldn’t connect the brand and Pitt spouting philosophical inanity. Best laid plans can end up as thickly laid sentimentality, or simply badly. Analjit Singh, the promoter of Max Financial Services (MFS) learnt it the hard way.

He, too, did what many promoters across the world do — pledge shares for a loan. On paper, all is well, even seems prudent, except when the stock falls. Then, the promoters have to pledge more to maintain the value of the collateral. That just leaves them vulnerable to the volatility of the market. The plan goes off the rails from there.

“They pledged shares to invest in hospitality business outside India and increase shareholding in other Max Group entities such as Max India and Max Ventures. But the stock price corrected after the IL&FS crisis, which led to increase in pledging of shares. As the stock plunged, they had to pledge more shares to maintain the same security cover,” says Nidhesh Jain, analyst, Investec India.

From an all-time high of Rs.683 in May 2017, the stock hit a 52-week low of Rs.344 in October 2018 (See: Staring into the abyss). Cancellation of the merger with HDFC Life Insurance in July 2017 followed by IL&FS default in September 2018 weakened investor sentiment. With the stock getting hammered, the promoter’s pledged shares went up from 52.6% (as a percentage of total holding) in March 2017 to 81.2% in December 2018. Despite the recovery in stock price to Rs.410, the pledged shares are still at 78.5% as of March 2019 (See: Staring into the abyss).

This, so far, does not sound like a happy story. Then, why narrate it?

It is because the financials of MFS’ only subsidary — Max Life Insurance — continue to be on an upward trajectory. In the previous fiscal, the insurance firm reported stellar set of numbers. Its embedded value (EV) — the assessment of future profit derived from the current business — grew 19% to Rs.89.4 billion in FY19. Annual premium equivalent (APE), which reflects sales (single and regular premium), rose by 21.6% to Rs.39.5 billion. The insurance giant is targeting 25% growth in EV, VNB (value of new business) and APE by FY22 (See: Steady performer). But can it maintain its robust growth? Let’s dive into the fundamentals of Max Life Insurance to answer that.  

Margin Protection

If you ask an insurance company to pick a favourite business vertical, it won’t be coy and say “all of them”. It will name the protection product business (plans that cover individuals and groups in the event of death, disability or disease). There is no return of premium on such products, so the profit margins on these are high. Hence, all listed insurance firms, including MFS, are eager to sell them.

It is a race and, over the past three years, Max Life Insurance has grabbed the second spot behind HDFC Life Insurance (16.7% of total APE) in protection plans. The share of protection in overall sales of Max Life Insurance grew by 220 basis points (bps) to 10.2% of total APE in FY19. Compared to this, SBI Life Insurance’s protection share went up by 143 bps to 6.8% and ICICI Prudential Life’s was at 9.3%, up by 538 bps.

This is a good business to be in, because Indians are living longer. “Indian companies are likely to see a significant rise in margins from increased protection sales. However, margin number in life insurance is just an assumption and hence, monitoring assumption movement each year is key. Given the improving persistency, mortality and morbidity rates, one should expect favourable outcome over next few years,” says Dhaval Gada, research analyst, DSP Investment Managers.

A pot of gold for sure, but the protection business is risky and demands more solvency. For instance, to get a basic life cover of Rs.10 million from Max Life Insurance, a customer has to pay a premium of Rs.563 per month. “When you take more risk, you get higher margins in our business. So, in a bid to increase the margins without taking undue risks, you have to be good at making actuarial assumptions. If mortality assumptions are correct, then the margins remain high, but if the outcome doesn’t match assumptions, then margins shrink,” says Prashant Tripathy, managing director and CEO, Max Life Insurance. Simply put, the actuary needs to be good at calculating the probability of the insured contracting illness or death.  

Tripathy is confident that they have the necessary skill. “We have the ability to take these risks because we have superior underwriting practices and we keep a constant watch on frauds,” he says. Therefore, they have been able to grow at a faster pace in this largely untapped vertical. According to an IRDA report, life insurance penetration — percentage of premium to GDP — was only 4.6% in FY09 and has been declining since then. As of FY17, the penetration of life insurance stood at 2.76%.

The general sentiment around life insurance products, especially unit-linked insurance plans (ULIP) have been lukewarm. It began when regulations were tightened. Distributors were mis-selling and misrepresenting these products, which offer life protection and a savings plan, and the regulator had to step in. IRDA formulated new norms in 2010. It capped the upfront commission, increased benefits and spread the payment of charges over five years. This meant consumers did not have to pay the ULIP charges all together at once. This made them more customer-friendly, but the withdrawing of incentives disheartened distributors and sales dropped. However, as the market was witnessing a broader rally, sales of ULIPs, which are equity-linked products, went up between FY16 and FY18 before turning tepid in FY19.

Currently, ULIPs account for 42% of Max Life Insurance’s total APE compared to 30% in FY17. Despite the increase in share of ULIPs over the past three years, the insurance company has pivoted towards a much more balanced product mix. The contribution of saving products such as participation (PAR) and non-participation policies (non-PAR) to Max Life Insurance’s sales stands at 40% and 9% respectively. 

Under the first category, bonus or dividends are paid to policyholders on a monthly or annual basis along with a fixed guaranteed amount and, under the second, a fixed amount is paid to a policyholder after the maturity without any bonus or dividend.

The share of PAR products was higher at 54% in FY17, but the management has strategically shifted its product focus (See: Perfect mix). And it wants to take the share of protection above 10% over the next few years. “We have continued to launch new products in the segment with flexible design and option of shorter premium paying term,” says Tripathy. The company’s VNB margin expanded to 21.7% in FY19 compared to 18.8% in FY17. “The margin has been expanding because of an increase in the percentage of protection in our product mix and strong new business growth of 22-25%,” says Tripathy.

Channelling growth

Along with recalibrating its product focus, the fourth largest life insurance firm in India is working on its distribution channel. It is investing heavily — Rs.900 million — in its  proprietary channel. It opened 120 branches in FY19 and plans to add another 60 this financial year. The plan is to increase share of sales through this channel to 40% by FY21, from 30% in FY19.

HDFC Life Insurance and SBI Life Insurance’s proprietary channels contribute 26% and 21% to sales, whereas bank channels contribute 49% and 64%, respectively.

According to analysts, the expansion of proprietary channel gives Max Life the power to maintain the product mix and reduces its dependence on bancassurance (sales through banks) channel. “The company may guide a bank to sell a particular product, but the bancassurance channel is not completely in its hand. Max Life Insurance’s proprietary channel is very focused on selling term plans (protection product), and this is reflected in its numbers,” says Madhukar Ladha, analyst, institutional equities, HDFC Securities. The protection sales mix is about 14% in proprietary channels whereas it’s 2% in the bancassurance channel. 

Jain adds that overdependence on bancassurance channel is not good for any insurance firm since the partner bank can command very high negotiating power. The bancassurance channel contributes 70% of Max Life Insurance’s sales, out of which Axis Bank accounts for 40%.

Building your proprietary channel means spending money — think air-conditioned offices, staff and coffee machines, but Max Life Insurance has it covered because of its sensible product mix. “We invest in our proprietary channels and then recover that investment with the help of higher margins. We do that by driving protection business and higher case size (covered amount) by focusing on the sum assured,” says Tripathy. In fact, the management stated in the latest analyst conference call that the “ability to absorb overheads and fixed costs are enhancing with expansion of proprietary channels”. The more they sell through this channel, the more money they make. Impressive, but is it true?

Looks like it, say analysts. They see further scope for improvement in margins. “Max Life’s proprietary channel has achieved economies of scale, and as it continues to sell more policies through this channel, margins are set to expand further. The company will be adding relatively fewer branches this year, boosting margins even more as expenses will be lower compared to FY19,” says Madhukar. 

Factored in 

In all, FY19 has been a good year. But the stock has been under pressure for reasons mentioned earlier. Besides high level of pledged shares, investors are also wary of Axis Bank’s decision to sever exclusive ties with Max Life Insurance. There is a belief that the company’s share of sales from Axis Bank’s channel might drop after the lender decided to ink a similar pact with LIC.

However, Max Life Insurance still has an agreement with Axis Bank till FY21, to sell products via the bancassurance channel. And it has also tied up with other lenders such as Yes Bank.

“Big banks such as Kotak Mahindra Bank, HDFC Bank and ICICI Bank have a life insurance arm. Axis Bank doesn’t, and it might want to have one,” says an analyst, requesting anonymity. However, he also adds that Axis Bank might want to buy a majority stake in Max Life Insurance since it’s already selling its products and the deal would be beneficial for both. 

Analysts believe the impact of the deal would depend on the valuation at which Axis Bank buys the stake. “Overall it will end the uncertainty or overhang on the stock of Max Financial Services. Once Axis Bank becomes an equity partner in Max Life, it will provide certainty to investors that Axis Bank is now a perpetual bancassurance distributor,” says Jain.

Max Life Insurance is in talks with Axis Bank to continue its partnership beyond FY21. But it hasn’t quelled the concerns of investors. Brokerage firm Nomura states that the headwind emanating from the uncertainty has been factored into the stock. “Our sensitivity analysis indicates the stock is pricing in a 70% VNB drop post FY21. Assuming a 50% drop in APE and 10-18% VNB margins, in case Axis does exit, we derive a fair value range of Rs.407-503/share,” states the Nomura report. 

The promoter, in an earlier press release, has also assured that steps have been taken to reduce the level of pledged shares. “We have a clear plan to reduce this within the next few months by selling a couple of privately held real estate assets, diluting 5% stake in the anticipated merged Max Healthcare-KKR-Radiant entity. We may also sell a small percentage stake in Max Financial if the need arises,” said Analjit Singh, founder and chairman of Max Group and the non-executive chairman of MFS.

With all the concerns weighed into the stock, MFS is trading at price-to-embedded value (P/EV) of 1.2x for FY21, compared to its listed peers ICICI Prudential (2.1x), SBI Life Insurance (2.1x) and HDFC Life Insurance (3.4x).

Analysts believe it’s a strong bet for those looking to stay for the long haul. “Current valuation has priced in all the negatives,” says Jain. He also adds that the brand has evolved and the high quality management at the helm has built a strong franchise despite the limitations. “There is very less volatility in growth and profitability,” he opines.

With robust performance driven by strong growth in the protection business, coupled with strengthening of proprietary channel, investors should be insured against the downside. When the fundamentals are sound, like with Chanel, you eventually get your oomph back.