Demystifying RoEs

Our analysis suggests that the motor TP business (with ~50%+ segmental RoE) remains the single-largest driver for high-teen RoEs of large non-life insurance companies; we find little change in 1QFY24, i.e. post implementation of EoM guidelines. Motor OD remains weak (with negative to single-digit RoEs); the competitive intensity remains strong with mixed impact of EoM guidelines. Commercial lines, to some extent, augment profitability of ICICI Lombard. We retain REDUCE on ICICI Lombard and ADD on Bajaj Finserv.

Motor TP seems to be key profitability driver 

In this report, we calculate segmental RoE of select non-life companies, extrapolating from reported underwriting results, making notional calculation of segmental net worth and float. The detailed methodology is discussed later.

Key takeaways. (1) The motor TP business has seen increase in RoE post Covid to 54-60% from 27-38% earlier. (2) Competitive intensity in the motor OD business remains high, driving -20% to +0% RoE during the past two years; profitability has improved a bit (no major change) for select players in 1QFY24. (3) Motor (OD+TP) RoEs of ICICI Lombard and Bajaj Allianz were similar at ~30%. (4) The impact of EoM guidelines is mixed—there is no major difference in segmental profitability post implementation of EoM guidelines from 1QFY24; some companies (HDFC Life and SBI GI) have slowed down in motor during the past few months but aggressive ones (Go Digit and HDFC AIA) have not. (5) Health remains a low RoE segment with -2% to +2% RoEs in FY2023 for ICICI Lombard and Bajaj Allianz. (6) ICICI Lombard fares well on commercial lines with 11-64% RoEs in FY2023, these lines (fire, marine, aviation and engineering) contribute 22% of premium and 38% of profit.

Implications. It is unlikely that motor TP tariffs will increase in the near future, given current high inherent profitability. This will keep up competitive intensity in motor OD as well. While industry players expect competitive intensity to reduce post implementation of EoM guidelines, recent trends don’t suggest the same. The health business continues to have low (single-digit) RoEs likely due to the focus on the less-profitable group business and investments in retail—the business is not making meaningful contribution to earnings as of now. Commercial lines are somewhat value-accretive for ICICI Lombard, driving 38% of PAT in FY2023—this will likely remain profitability pillar for the company.

Retain REDUCE on ICICI Lombard, ADD on Bajaj Finserv

The non-life insurance sector is looked upon by the Street as a multi-segment sector that can sustain high multi-year growth. The above analysis suggests that motor TP and commercial lines are driving earnings with no meaningful contribution of other segments to PAT. This raises question on any premium for diversification that can be assigned in valuing non-life companies. We retain REDUCE rating on ICICI Lombard (FV Rs1,265) and ADD on Bajaj Finserv (FV Rs1,630).

Methodology

General Insurance companies disclose underwriting profits for each segment. We allocate investment income and other expenses to build segmental PAT. We estimate investment float for each segment using outstanding claims, advance premium and unexpired risk reserve, apart from notional net worth. We allocate policyholders’ investment income in the ratio of aforesaid segment-wise float to calculate segmental investment income. We allocate net worth to each segment in the ratio of required solvency margin (RSM). Other expenses were allocated in the ratio of operating expenses. Tax rate was assumed to be similar for all segments.

Motor TP and commercial lines drive earnings

Overall RoE of general insurers such as ICICI Lombard (down to 18% in FY2023 from 22% from FY2021) and Bajaj Allianz (down to 15% from 20%) has been under pressure (see Exhibits 1-2). Pricing pressure in motor OD has led to drag in profitability in the segment. High medical inflation and Covid-related claims inflation led to subpar profitability in the health business, especially in the group health segment.

Except for certain commercial lines, most lines of business have combined ratio >100% (see Exhibits 3-4). The investment income generated from the float and shareholders funds offsets the underwriting losses generated in these businesses.

4 Motor TP has 70% float, hugely profitable to subsidize motor OD. The Motor OD business remains under competitive pressure, subsidized by high RoE in motor TP. The long tail of claims and advance premium results in higher float in the motor TP business (~70% of overall float is driven by motor TP segment, as per our calculations).

4 ICICI Lombard fares well in commercial lines. While the commercial segments may appear to have low barriers to entry, ICICI Lombard is able to run the businesses profitably. Better risk management, long-term relationships and reinsurance capacities are the likely reasons for better performance of ICICI Lombard.

Motor TP business has seen significant improvement in profitability in past two years

Motor TP combined ratio and RoE of Bajaj Allianz are better at 90-92% and 54-60%; this compares with 103-107% and 54-57% for ICICI Lombard. Nevertheless, motor TP is a highly profitable business with 40-60% RoEs due to (1) sharp hikes in motor TP tariffs by the government prior to Covid, (2) mandatory 3-5-year TP insurance attached to new vehicle sales. A large part of the income is driven by high float in this business. Yoy earnings/profitability may not accurate representation of the business due to subjectivity in reserving policies; as such, we would compare the trend across players over a multi-year period.

Motor OD business continues to bleed

Entry of new-age players backed by private capital led to heightened competition in motor insurance since FY2020. The intense price competition in the motor OD segment has resulted in significant underperformance of ICICI Lombard (-20% to +1% RoE during FY2018-23). Bajaj Allianz General has fared better, reporting lower losses in the motor OD segment (-1% to +8% RoE during FY2022-23). ICICI Lombard’s combined ratio improved a bit to 104% in 1QFY24 from 105% in FY2023 and 104% in 1QFY23.

Health business remains weak with -21% to +2% RoE

Covid-related claims inflation led to losses during FY2021-22 (-2% to -21% RoE during this period). While Covid-related claims declined in FY2023, sharp medical inflation likely led to subpar profitability of -2% to +2% for Bajaj Allianz General and ICICI Lombard. The latter has been investing in the retail franchise, which may have added to earnings drag. Star Health reported 12% RoE in FY2023, this may likely be due to the fact that retail health (group health is the larger segment for ICICI Lombard and Bajaj Allianz) has higher profitability.

ICICI Lombard fares better that Bajaj in commercial lines

While commercial lines account for only 22% of ICICI Lombard’s GDPI, they contribute 38% of profits (see Exhibits 5-6) in FY2023. Bajaj Allianz’s commercial business is less profitable contributing 19% of GDPI and only 14% of profits. ICICI Lombard has reported 11-64% RoE in these lines of businesses as compared to -2% to +18% by Bajaj Allianz.

Segmental profitability trends are broadly similar across players

Fire remains highly profitable. Fire and other commercial lines are more profitable, especially for the larger players likely due to pricing discipline enforced by reinsurers. Profitability has improved in FY2023 for major players such as Bajaj Allianz, HDFC Ergo and ICICI Lombard. Quarterly trends vary widely due to differences in reserving and timing of reinsurance contracts.

Motor OD profitability under pressure. Motor OD combined ratio has increased for most players in FY2023. The pricing pressure in the segment has not waned and in 1QFY24 as well, the trends are mixed. While all players are operating at >100% combined ratio, HDFC Ergo and Bajaj Allianz are faring better than the rest with a combined ratio of ~110% compared to 123-200% for others.

Motor TP profitability has improved. Motor TP combined ratio is lower than the OD segment for most players in FY2023. Motor TP combined ratio has dropped during FY2018-20 due to hike in TP tariffs. Profitability during FY2021-22 was boosted by lower travel and traffic due to Covid-related lockdowns. Despite the pricing being regulated, the combined ratio varies from 93-148% across players.

Health combined ratio moderating from peak in FY2022. Combined ratio has moderated to 92-156% in FY2023 across players likely to due to pricing action taken by most insurers. The impact of Covid-related claims inflation followed by high medical inflation led to gradual increase in combined ratio (up to 113-233% in FY2022 from 54-187% in FY2019).

EOM guidelines—no major impact

No impact on overall profitability. EoM guidelines, implemented from April 2023, provide leeway to insurance company to compensate the distributor/agent. There may be concerns in the past that distribution commission and incentives were not accurately represented across LOB. As such, 1QFY24 likely reflects true LOB-wise profitability. However, 1Q performance does not seems to suggest any major change in overall segmental profitability for motor OD or TP businesses.

What do EoM guidelines imply? EoM guidelines cap overall expenses (operating expenses and commissions) to 30% of gross written premium and requires insurers that exceed this ratio to have a board-approved plan to bring down the ratio to 30%. Insurance companies that exceed the EoM limit of the board-approved plan by 10% are restricted from paying variable compensation to their KMP. In addition, IRDA may restrict the insurer violating EoM limits from (1) opening new places of business, (2) launching new products, (3) entering new segments, and (4) levying other penalties under Insurance Act.

No visible change in competitive intensity. Exhibit 8 shows EoM reported by select players. Exhibit 9 shows growth in motor business of select players. It appears that Chola MS, HDFC Ergo, and SBI GI have slowed down in the motor business in the past few months with expense ratio of 23-38% in FY2023 and 20-27% in 1QFY24. Go Digit continues to grow aggressively despite high expense ratio of 38%, so does Tata AIA (36%). Thus, it is not very clear if EoM guidelines are prompting pricing discipline in the motor industry.