The Budget has two proposals that can potentially affect the growth and profitability of life insurance companies. They are withdrawal of Section 80C deduction for assessees who opt for the new tax regime and secondly, withdrawal of dividend distribution tax (DDT) and transferring the tax liability of dividend income to investors. While the former one will impact new business volumes, we expect the impact to be limited due to relatively reducing relevance of Section 80C deduction.
Withdrawal of DDT will increase the tax liability of life insurance companies, though the same may be partially managed by setting off dividend paid to its shareholders.
Impact of removal of Section 80C
A tax assessee opting for the new tax regime will not be eligible for tax benefits on insurance premium paid during a year (under Section 80C). Currently, there are multiple reductions under Section 80C aggregating to overall cap of `1.5 lakh; these include life insurance premium payment, deduction on home loan repayments and investments in PF, PPF, ELSS, five-year bank deposit, NSC, etc. The removal of Section 80C benefit may hence pose risk to new business volumes of life insurance companies.
We, however, believe that the section has increasingly become less relevant as a sales pitch by insurance agents. The limit of Section 80C was stable at `1 lakh between FY2005-13 and increased to `1.4 lakh in FY2014, not keeping pace with rising income levels. Insurance firms, on the other hand, have seen a gradual increase in average ticket size likely reflecting increase in income levels. As such, the relevance of the benefit has been incrementally lower. This is also reflected in the fact that the overall business booked by insurance companies in 4Q (the quarter in which typically the ‘tax benefit’ sales pitch may be most pronounced) is down to 35% in FY2019 from 50% in FY2005.
We are revising our EV estimates to reflect marginally lower growth and transition to higher effective tax rate, the latter will affect value of in-force (VIF) and value of new business margins (VNB). ICICI Prudential Life is most impacted with about 5% haircut to VIF and 150 bps lower VNB margins.
DDT removal to affect VNB margin
Insurance companies have enjoyed tax exemptions on dividend income and as such their effective tax rates have been lower than their nominal tax rate of 14.5%. Three of the four large insurance companies (HDFC Life, ICICI Prudential Life and Max Life) have reported their margins on effective (lower) tax rate. SBI has reported margins under both effective and nominal (14.5%) tax rates; the nominal (higher) being considered in our valuation models.
The Budget proposes to shift the tax liability on dividend income to the investor versus DDT paid by the issuer earlier. Thus, insurance companies may not be able to enjoy this tax benefit (of 0% on dividend income) and hence their effective tax rate will increase, affecting their earnings and VNB margins. It is challenging to estimate the impact of this aforesaid migration to its VNB margins. Apart from the historic trends, the expectation of earnings growth, dividend payouts will drive the impact.
Set off of dividend income
The Union Budget also proposes that income from dividend from a domestic company can be set off by dividend paid to shareholders. Assuming that the same is applicable to insurance companies, their effective tax rate will likely remain low.