'ULIP Products Have A Correlation With Markets By Design'

Sudhakar, what's your take on the equity markets right now? The house seems to be divided in terms of optimism and pessimism. Some believe that valuation indicators are already stretched, and the paucity of earnings growth poses a serious near-term risk…
Last five years realized earnings have been in the range of 5-6%. Q4 FY17 was an early sign of earning recovery against expectations. We are expecting earnings to be in mid-teens during FY18. It is expected that India's cost of capital will also progressively reduce especially as seen from bond yields. The consequent expansion in the ROCE-COC spread could be one of the drivers of the next leg of re-rating in Indian equities. Operating leverage will likely support earnings once India crosses its potential GDP growth, which will get more accentuated post FY17.

If we look at the Price to Book band of the equity market over the last 15 years it ranges between 2.1 to 6.4 and we are currently at about 3.6 times. With earnings bottoming out and the velocity of flows on the domestic side, there is no reason to believe that markets are rich and can give returns in line with earnings growth over the medium term, however with some volatility. Based on respective allocation strategies one can look at rebalancing since ultimately disciplined risk based allocations would provide better risk adjusted returns.

On the debt side, do you see more opportunity on the duration front, or should investors be buckling down and focusing on accruals? Inflation, of course, seems to be reined in for now. Do you see further scope for falling yields from the present ~6.5% levels?
RBI in its latest monetary policy has revised the first half FY18 headline inflation to 2%-3.5% in first half and 3.5%-4.5% in second half. Monsoon trends are encouraging at this stage and the government staying the course in effective food management will play a critical role. The risk of fiscal slippages at the state level has risen with the announcements of large farm loan waivers. Disbursements of allowances under the 7th Central Pay Commission have upside risks. The latest print of CPI has been below 2% and we believe inflation trajectory may undershoot RBI's expectation. Also, if we see from a real rates perspective, there is room for repo rate to be lower by 25-50 bps and hence benchmark yields could trend lower and get closer to the 6% levels. FII interest in Indian bonds is also reflecting this optimism. Dynamic Bond funds would be a good option since the fund manager would have an option to manage duration based on changing market fundamentals.

What is the size of the total asset base managed by you and your team right now? Does the low industry persistency number affect you in any way, as a CIO?
Kotak Life Insurances total AUM as on date is about Rs.22,000 crores. The ratio of Unit Linked to Traditional Funds is 55% to 45%. We hold about 14% equity in our traditional policyholder's funds and the same in Unit Linked is about 55%.

There is a marked improvement in persistency across the industry since there is a renewed focus on this aspect of the business. If we observe over the last few years there is a year over year improvement in persistency across buckets. Based on the IRDAI published data, Kotak Life Insurance is in the top quartile among industry's top 10 players in each of the buckets. Most insurers including us have a dedicated team focussed on this activity and action is being taken right from sourcing, selling, regular collections to maturity related services to ensure that the policyholder gets the benefit of remaining invested over the policy term. It goes without saying that, this better performance on persistency leads to retention of AUM.

How do you foresee GST impacting the broader markets in the short term and medium term?
The changes in tax rates appear to be neutral from a Consumer Price Inflation perspective. Though in the immediate term post implementation some increase in cost is expected based on formalization but within manageable limits. The impact of GST could be marginally disruptive in the near term as inventory destocking and restocking takes place, and GDP growth is likely to be adversely impacted to that extent in 1HFY18. Overall any adverse impact of GST implementation would be temporary in nature. We expect real GDP growth to be about 7% in FY18.

There could be some temporary earning disruption as well. Over time, the implementation of GST would improve tax compliance and with it the tax to GDP ratio of the country which would be positive from the perspective of fiscal consolidation. Markets are assuming no major disruption from the implementation in the medium to long term.

What's your take on 18% GST on the risk component of Life Insurance? Did you expect something different?
The new GST tax rate fixed at 18% for life insurance products is higher compared to the 15% service tax rate applicable earlier. The higher tax rate will have an impact on the life insurance industry and the cost of insurance products in general. With the elevation in the tax rate, the cost of buying insurance and keeping the policy active will increase albeit marginally. With the level of insurance penetration and need to cover more people a lower slab could have helped.

Broadly, what is Kotak Life's strategy on its ULIP funds? Do you foresee an uptick in ULIP inflows in the times to come?
For equity funds our philosophy is to construct a high conviction portfolio through bottom up approach to stock selection with top down awareness based on Business, Management and Valuation. Idea is to look for sustainable businesses with prudent management at reasonable valuations. Endeavor is to look for businesses which are scalable in terms of market potential and competitive intensity, predictable with low regulatory interventions and sustainable with respect to ROCE, ROE and Cash Flows. Management should have focus on corporate governance with fairness to minority shareholders, efficient capital deployment policy and focus on profitable growth. At the end of it all, it has to be growth at a reasonable price. For debt funds we place highest attention to credit quality and interest rate exposures across the yield curve, with prime importance given to duration management with a view on interest rates.

ULIP products have a correlation to markets by design. Financial savings on the back of real rates experienced over the last 3 years are in a sweet spot at this point of time. This has manifested through movement of savings from physical to financial, and hence more money is moving to financial assets instead of real estate and gold. The impact of this for Insurance is more money moving to ULIP's and with an inflation targeting mandate to RBI, there is no reason to believe that this shift will not continue into the future.

Post the 2010 reforms, have ULIP's come up to par with Mutual Funds in terms of Wealth Creation potential? Also, do you think traditional plans need to undergo structural changes in order to become more effective long-term savings solutions?
ULIP is a very good option for wealth creation. It provides by design a systematic way of investing over long tenures which is the recipe for meeting financial goals. It also offers asset allocation freedom with varying percentages for equity based on individuals risk appetite and also offers a self-rebalancing or switching for one asset class to other with no cost or tax implications. The cap on charges on ULIP products are at 3% up to 10 years and 2.25% beyond. If we do a simple math of total cost borne by a policyholder the same would be on par or lower than what is paid for other financial intermediation. Insurers have products, which are lower than the cap allowed by the regulator as well.

Traditional products while giving protection also give an option to the policyholder to either take a guaranteed product (Non Par) or participate in the experience of the fund (Par). The maturity proceeds are tax free based on the nature of the product offered and in line with requirements under tax laws. They are a good tool to save in a disciplined way. Structurally in addition to reducing cost for the business, there is scope to review the investment pattern to enhance funds return experience since 50% of the life fund has to be invested in Gsec and approved securities. If we compare banking industry's SLR & CRR requirements have come down from about 38% &10% respectively in 1998 to 20% & 4% as on date.

On a different note, how (if at all) is life different for the CIO of a leading Life Insurer, vis-à-vis a CIO at a leading Mutual Fund?
That's an interesting question. For Insurance company the nature of portfolios are varied in terms of ULIP and traditional funds. Within ULIP like a Mutual Fund there will be funds across the risk return spectrum like Money Market, Short Term Bond, Dynamic Bonds, Gilt, variety of balanced funds and pure equity funds. Typically insurers do not have arbitrage or gold funds. Within traditional insurers manage life and pension funds which can be largely categorised into Non Par, Par and shareholders' funds. Since these funds can have very long term liabilities as well as guarantees, liability driven investment philosophy and strategies become important. Also, the assets classes available are varied. In addition to bonds and listed equity, one can consider real estate, loans, private equity and alternate investment funds. Above all, the responsibility of allocation across asset classes is an important aspect in insurance.