The increasing penetration of life insurance and the robust growth of private insurance companies in India in the past five years coincided with a stock market boom.

Insurance products, where the life assured bear the market risk on the investments made - viz. unit-- l inked products with a dominant focus on stock market investments - in expectation of higher returns, have naturally driven business growth in the above period.

The cumulative balances of unit linked investments, for instance, increased significantly from just under Rs.1700 crore in 2003-04 to as much as Rs.70,000 crore by March 2007. The share of investments of unit-linked business in the cumulative life business consequently went up from less than 0.5 per cent in March 2004 to as much as 11 per cent in March 2007. The share of the private sector in total life business correspondingly increased to as much as 20 per cent by March 2007 from under 10 per cent earlier, with the private players having a much higher market share of 25 per cent plus in fresh business (the first year premium). These trends were reinforced in FY 2008 with the private sector’s share rising to 35 per cent plus in first year premium.

But the severe losses in the Indian stock markets in 2008 have naturally affected investor (life assured) sentiments. Existing policy holders are consumed by doubts and apprehensions as to the soundness of their investment decisions and the probable long-term returns from their savings. There is a slide in sentiments among prospective insurance buyers too. Anecdotal reports talk of fresh premium accretions having decelerated during the course of the year.

How does or rather should the recent performance of the stock market affect the investors’ view of future returns? Will the insurance buyers’ preference for unit-linked insurance of the past few years prove beneficial to them in the long run? Should prospective insurance buyers continue to choose unit-linked policies as part of their portfolio? These are the key questions facing the life assured, prospective insurance buyers and the insurance industry at this juncture.

Focus on long term: stocks vs. bonds

In no other context and at no other time are these words -- in the long run-more appropriate than in the context of life insurance (in terms of risk cover, savings & investments). It may bear repetition that life insurance (other than pure term assurance) is a financial product which combines protective cover against some life cycle risks with a savings / investment component. Both these features make insurance a long-term product, whose utility and benefits have to be assessed only over a long time horizon - typically 10, 15 or 20 years.

These ‘long-term’ features are common to ULIPs too. Therefore, it may not be appropriate to assess the utility of and potential investment returns from an ULIP policy based on the stock market performance of a single year.

In this context, data regarding the overall stock market performance in the last 10 years are instructive (see Fig.1). We have taken the Nifty index of 50 stocks quoting on the National Stock Exchange for the purpose of this analysis. The data show that over the long term, stock markets have delivered a higher rate of return, relative to other investment products such as bank deposits, company fixed deposits or debentures.

The Nifty index has generated annual average returns (referred to as compounded annual average) of 13 per cent in the 10-year period from January 1999 to December 200, meaning that Rs.100 invested in the index in January 1999 would now be worth Rs.340.

Against this, the “above 5 year” bank deposit rate (the long-term deposit) ranged between 5.25 per cent and 10.50 per cent in the same 10 year period.

Government securities and quasi-government securities, which dominate the mandated investment portfolio of the traditional (non-unit linked) insurance products, too have not fared well in relation to stock market investments. Yields on benchmark government bonds were broadly in the 6.5 to 8 per cent range in the past 5 years. Calendar 2008 has seen a high level of volatility in government bonds, with yields rising to 9.50 per cent around July/August but now falling steeply to the 6 per cent levels.

Government securities, neverthe-less, can be a fairly strong candidate for inclusion in a unit-linked portfolio also given that they are an extremely liquid asset class (with some qualifications) in the Indian financial markets. They can, therefore, potentially generate high total returns (that is, both capital gains + interest). Positions in government bonds, in this environment, would naturally have generated substantial capital gains. A rough calculation shows that a position of Rs.20 crore in 10-year government bonds in the last 6 months would have generated capital gains of something like Rs.1/ 1.5 crore (and not merely mark-to-market upward adjustments which result in notional profits) on the back of the steep fall in 10 year yields.

But the key points to be noted about Government bonds is that historically, big yield movements tend to be concentrated and compressed into fairly short time periods. For a major portion of the time, prices/yields move gradually and in relatively narrow ranges though there could be a secular trend (up or down).

The all-time low in 10-year government bond yields (so far) has been 4.98 per cent in October-November 2003, when yields fell around 1.5 per cent in just three months from around 6.40 per cent in mid 2003. Yields bottomed out at this point and in the five years between November 2003 and now, have broadly moved between 6.50 per cent and 8 per cent.

We have now seen significant price moves again in the space of 4-5 months. Ten-year yields rose to a high of 9.50 per cent in July / August 2008 and have now, in December, hit 6 per cent.

Since big price / yield moves tend to be concentrated in short time buckets, the profit (loss) potential is also outsized during those time periods. Further, tradability and liquidity in government securities is highest in some five securities at any point in time.

Volatility in both stocks and ‘fixed income’ investments

Stock markets do experience a good degree of volatility. We will highlight how the fund/investment manager is better positioned to manage that volatility and produce more stable, risk-adjusted returns.

But, the large range in which the >5 year bank deposit rate has moved, as indicated above, shows that investors in such ‘safe fixed income’ products as bank deposits also face a fairly high degree of volatility and thereby will be exposed to considerable variation in their income flows. In our assessment, interest rates in India could likely experience the same level of volatility in the ensuing years as has been noticed in the past 10 years.

In this environment, therefore, stock markets need not be looked at negatively and more so based on just the performance of a single year. Any investor, more so a life assured, needs to have a good mix of stock market investments in his overall investments portfolio to average out the return variations which seem inevitable even in a purely ‘fixed income’ dominated portfolio.

Simple and compounded returns

Table 1 gives the annual returns on the Nifty index of 50 stocks in the period between January 1999 and December 2008. While compounded annual average returns of 13 per cent over a 10-year period appear quite healthy, investors obviously will be happier if they can obtain the higher 19 per cent rate of return shown in the table above. The compounded annual return is lower because of the fairly high degree of variability in the stock market’s year-to-year returns.

The key to producing higher annual average returns over the long term is to develop the ability to better time the entry and exit from the stock markets. That can minimise the adverse effect, on an investment portfolio, of the volatility of the overall stock market. In other words, while the investments can be broadly in a set of stocks mirroring the market index or barometer, the investment manager has to actively watch out for undervaluations and over valuations in the market, buying when stocks are undervalued and selling when they are overvalued, so as to produce higher and more stable long-term average returns.

Are Indian stocks undervalued now?
The important question then at this juncture, after Indian stocks have come through a harrowing 2008 losing some 55 per cent of their value, is: Are they undervalued and if so, is it time now to start buying again? And what does the potential undervaluation imply for the ULIP investor?

A study of the statistics relating to the Nifty index and its P/E ratio (a key valuation metric) of the past ten years (see Fig.2) shows that Indian stocks may indeed be potentially undervalued at the current juncture. Quoting currently at a P/E of around 11 or 12 after their steep falls in 2008, Indian stocks are now being valued at less than their long-term and sustainable average of between 15 and 20. Statistics show that the Nifty index has quoted at a PE between 18 and 25 times earnings for close to 35 per cent of the time in the past ten years. The PE was between 12 and 18 for another 55 per cent of the time in the same 10-year period. For the balance 10 per cent of the time it between 25 and 30.

Taken together, these statistics suggest that the long-term and sustainable average PE could be between 15 and 20. Fig 2 clearly shows that significant price falls have occurred in both the periods following the PE moving above the 25 level-once late in 1999/ early 2000 and now again in January 2008.

PEs above 25 should, therefore, be taken as a signal for exiting stocks and buying into other assets such as fixed income instruments so as to minimise or even avoid outright capital depreciation and overall returns volatility.

Much the same broad conclusion can be arrived at by considering the movements in the BSE Sensex and its PE of the last 18 years. The BSE Sensex has delivered compounded annual returns of around 11 per cent in the past 18 years. As for its PE multiple, it can be inferred from Fig.2 that its long term and sustainable average appears to be between 15 and 20. The early part of the period, from 1991 to 1993, is marked by considerable volatility (the market scam of 1992) in the PE as can be seen from the graph. But after the high of around 51 hit in early 1994, the PE ratio has corrected significantly downwards and by the first quarter of 1995 had settled down into the 10-20 range. As can be noted, post-1995 and for almost the entire period till 2008, the PE ratio has broadly been in the 10-20 range, more specifically in the upper part of the range between 15 and 20.

Again, there have been sharp downward corrections in prices and consequently in the ratio: on two occasions the ratio moved well beyond this range-in March/April 2000 and late 2007/January 2008. These corrections pulled the PE down back into a more sustainable range. The Sensex PE is now quoting just above 10 times earnings.

How important is the time horizon?

The key argument made above is that the long-term and sustainable average PE of Indian stocks is between 15 and 20 times earnings. This is based on statistics of the past 10 years in the case of the NSE Nifty and about 20 years in the case of the BSE Sensex. Indian stocks have fallen enough and therefore look undervalued by even this yardstick.

Therefore, the question of whether a shorter time horizon would indicate a higher (sustainable) average for the index PEs is not that important. (A higher average would mean that Indian stocks have fallen not only enough but in fact too much!). Indeed, there could be ardent believers in the emerging market economies (EMEs) story who will vouch that there have been some fundamental qualitative and quantitative changes in India which can support higher long-term PEs in its stock markets. (Incidentally, a shorter time horizon does produce a higher PE average).

The larger lesson for ULIP policy holders and prospective insurance buyers from the developments of 2008 is that this is not the time to shy away from stocks. Stocks continue to seem capable of producing attractive long-term returns, relative to other financial assets such as bonds. Extreme life assured (investor) negative response now to a single year’s stock market performance appears as unjustified as the overwhelming preference for only stock market-oriented ULIPs when the market was booming till early 2008. Now, as ever, is the time for building a portfolio with a good combination of stock market and fixed income investments.