M&A: The calm before the storm

In stark contrast to the plethora of mergers and acquisitions witnessed in 2015, which saw big deals such as the XL-Catlin merger and an influx of capital entering the market from Asian reinsurers looking to diversify, mergers and acquisitions (M&A) activity has gone relatively quiet—but many players are convinced that this trend is only temporary, and it will start to pick up as 2016 draws to a close.

Waiting to see how the big deals of last year pan out and the uncertainty surrounding the UK’s decision to leave the EU to die down have arguably both contributed towards the pause, but speaking to specialists in and around the recent Monte Carlo Rendez-Vous provides some reasons as to why this setback is only temporary.

BREXIT BLUES

In the lead-up to and aftermath of the UK’s vote to leave the EU, M&A activity had been somewhat stagnant, but Alex Finn, EMEA insurance leader of PwC, believes this to be an issue only in the short term.

“In the immediate post-Brexit aftermath there was a degree of drop-off, but do we see a reduction in M&A in the medium term? No we don’t,” Finn says.

“There is a variety of reasons—the consolidation of the industry continues. Some people have views about the extent of that. but there unquestionably will be further consolidation.”

Finn also suggests that there will be a lot of restructuring—not necessarily arising from the fallout of Brexit—but inevitably driven by the fundamental economics of the business.

“There are undoubtedly other factors: not everyone is too fussed by Brexit. Brexit is a sign of the political uncertainty, and that uncertainty affects everyone.

“Undoubtedly we are affected by the uncertainty—as a very general statement, our business tracks gross domestic product (GDP). So if there is uncertainty and GDP flattens out, that will have an impact on our business,” he says.

Finn says that PwC is also affected by deals volume, in that when M&A activity does pick up so will the work he does.

“When there’s change in movement, we’re a bit like the broking industry, that’s a buoyant environment for us as a firm,” Finn says.

Greg Carter, managing director of analytics for EMEA at AM Best, says that the Brexit vote might result in long-term turbulence in exchange rates, with sterling weakening and little prospect of this reversing in the short term.

However, he suggests the long-term impact of the vote remains uncertain, and the recent slowdown in M&A activity after the peak announcements in 2015 might now be the result of the market taking the time to digest these changes, and that further M&A activity is likely.

BANCASSURANCE

Patrick Maeder, another EMEA insurance leader at PwC, shares similar views to Finn’s, and cites other trends that will impact M&A activity, most notably through bancassurance—as banks, under pressure in other ways, look to diversify into insurance.

As banks come under pressure, Maeder sees potential M&A activity as a major incentive to increase their capital base, based on the current low rates situation.

“As you know the banking market is under quite some pressure—the rates are low, probably more so than the insurance market right now. Therefore many of them are thinking about revising their strategies,” he says.

Maeder cites examples in southern and eastern Europe that have seen a lot of bancassurance, with banks owning quite significant insurance companies.

A significant deal earlier in the year was private equity firm Apollo Global Management’s acquisition of Companhia de Seguros Açoreana, which offers life and non-life insurance services.

“Over the last year we’ve seen companies in Portugal, Spain and Italy, start to separate the insurance carriers from the banks,” he continues.

“As a result, we assume we might see even more activities as the banks are coming under continued pressure and strengthening their capital base.”

Although capital was considered the main driver on this deal, Maeder says another incentive would be for a bank to find an insurance company for a potential buyer, using them to diversify its channels.

“They could use the insurance company even as a sales channel, which would then be a win-win situation for them.

“That’s a trend that will continue. We might also see accelerated consolidation on the bancassurance market, which will impact the overall M&A market.”

WAIT AND SEE

Arthur Wightman, leader of PwC Bermuda, said that while there won’t be any mega deals like those seen in 2015, the industry is very fragmented and he too anticipates more activity going forward.

“If you are a big player or a niche player you are OK, but the middle tier players will be exposed to potential consolidation,” Wightman says.

Wightman believes the pause in M&A activity is largely due to the fact the industry has still been digesting some of the previous mega deals and watching to see how the pairings work out.

Valuations are being hindered by the industry’s lower profitability—especially if potential cat events are added in—but they will not prevent deals happening on that basis alone, he says.

“The main thing slowing consolidation is simply the fact that people are focused on trying to find the right partner,” says Wightman.

“We have seen some very good deals such as ACE-Chubb where the companies have great synergies. People need to feel confident they have found the right strategic partner.”

SOLVENCY II AND RUN-OFF

Another driver in the projected increase in M&A activity is the Solvency II environment and re/insurers in run-off, Maeder believes.

“Over the last year I think the UK and US have already solved the environment on the life side,” he says.

Maeder says he believes there may some more transactions coming up in the future as a result of this.

He suggests that while consolidation is one potential driver towards increased M&A activity, there is also more drive from forced run-off on the other side, prevalent within continental European markets, like Germany, France and Italy.

This is supported by PwC’s 10th annual Survey of Discontinued Insurance Business in Europe, in which 77 percent of respondents expect to engage in exit or restructuring activity by 2019.

“Europe’s run-off market has had an exceptionally busy year and the transaction environment continues to thrive,” says Andrew Ward, director in PwC’s Solutions for Discontinued Insurance Business team.

“Board-level engagement on legacy business is still a challenge for Continental European insurers in particular, but the volume of deals we have seen in the UK and to some extent on the Continent shows that legacy is in the spotlight for many re/insurers.

“Solvency II has really focused attention on the most effective use of capital and is increasingly generating opportunities for acquirers of run-off. Insurers with legacy business are beginning to make decisions around the capital benefits associated with disposing of discontinued books.

“We expect to see this trend continue for some time as Solvency II becomes embedded within middle tier and more niche re/insurers,” says Ward.

STRENGTH IN SIZE

Looking to the future, the overall reinsurance environment will become more challenging and cedants will get larger throughout this cycle, says James Slaughter, senior vice president and director global reinsurance strategy at Liberty Mutual Group.

“Large cedants will continue to grow and we’ll see more M&A activity, which will drive fewer buyers into the market. The companies will then get bigger so they buy less, and you can see that spiralling,” says Slaughter.

Furthermore, Slaughter believes the reinsurance industry will then become less relevant to the larger cedants, and more relevant to the smaller, niche and regional cedants.

According to Paul Schultz, CEO of Aon Securities, the industry will have to find new ways to grow, such as new types of businesses and finding ways to help primary companies to move into parts of the world that are under-penetrated in terms of insurance.

With regard to buyers, Anthony Day, chief executive of insurance at Suncorp suggests that combined reinsurers are usually stronger.

“It is hard to imagine that the M&A activity is finished, given the current pressures on pricing and capital returns,” Day says.

Looking forward, Martyn Street, co-head of reinsurance at Fitch Ratings, says that while M&A may seem like an appealing prospect for reinsurers looking to expand to grapple with challenging market conditions, credit analysts are often more interested in the rationale of M&A activity than the scope.

REGULATORY BURDEN FORCES INSURERS TO RETHINK

One of the outcomes of the increased regulatory burden that has been imposed on insurers in recent years, exacerbated by Solvency II, has been the forcing of smaller insurers to consider either converting into agencies, thus avoiding a big part of the burden, or selling out to bigger players.

That is what Martin Davies, chief executive of AHJ Capital Markets, says he has been seeing in the market in the past year.

“If an insurer converts into an agency, it no longer has to worry about managing a regulated balance sheet, only about underwriting. On the flipside, the bigger carriers get better distribution, which is another driving force in the market at the moment,” Davies says.

He adds that Solvency II has driven companies to raise more capital whether that be through debt, equity or reinsurance arrangements. AHJ Capital Markets, which specialises in corporate finance for the insurance sector, is seeing more interest as a result of this trend.

The other factor driving the activity is bigger players, struggling for growth in other markets, looking to achieve it by extending their distribution. Often, acquiring a smaller player or agency achieves this.

“The big players need distribution and the smaller players need the financial strength and the balance sheet,” he says. “It is a good time for managing general agents (MGAs) at the moment.”

Davies adds that advances in technology have also made it much easier for individuals to start small, niche agencies with minimal frictional costs.

“We are seeing individuals start insurers who before might not have. They are creating new entities, which need capital and also an exit strategy,” he says.

Last year, Davies said he was seeing more third party capital taking an interest in moving into the MGA space. He says this trend has continued, with investors prepared to back the right management team with the right idea with anything from debt through to start-up funding.

“MGAs are a very attractive sector at the moment. It is a challenge and getting access to paper is critical, but for those that succeed, it is a good time.”

One of the few factors muting the sector is the continuing soft market but he stresses that rates are not necessarily soft in all areas, with niche sectors in particular weathering the downturn.

“The fact is an MGA will be successful only if it is profitable,” he says. “There are cycles within cycles and much of the rhetoric about cat rates does not affect the type of business most MGAs write. That said, the margin for error can also be fine.”