How the rating agencies are responding to M&A

Against a backdrop of continued consolidation in the industry, Stuart Shipperlee, managing director, and Karin Clemens, senior consultant, at Litmus Analysis, consider what the rating agencies focus on in a merger or acquisition, and why.

“Cost efficiencies will be seen as positive in theory but these have to be pretty dramatic (and clearly sustainable) to make a big enough difference for a positive rating action.”

The rating agencies’ negative outlooks on the reinsurance sector reflect the  pricing environment. Yet—despite these having been in place for a while—we have seen very little negative rating activity as a direct consequence.

However, to the extent that market conditions are driving mergers and acquisitions (M&A) activity, then pricing is certainly impacting ratings.

So, what do the agencies focus on in a reinsurer merger or acquisition, and why?

For a rated acquiring group three aspects of its expected post-M&A profile are key: (prospective) capital, future business profile & strategic fit, and future risk appetite. Plus execution/integration risk.

Agency reactions to the post-acquisition capital position should be reasonably predictable.

AM Best, Fitch and S&P all have capital models into which the pro-forma future group position can be ‘plugged’. The agencies vary on exactly how they then use the capital model outcome but a negative ratings surprise due to capital should not be on the cards assuming the group has worked proactively with the agencies that rate it.

However a negative outcome is still possible; how the deal is financed can fundamentally change the capital model result, and ‘goodwill’ is basically discounted as an asset in the main agency models. Conversely, material gains in scale and diversification will be positives.

Prospective capital and its management for the enlarged group is also crucial. Again these can be evaluated via the agency capital models and criteria.

The business logic is critical

Strategic logic and future business profile is usually the heart of a transaction rationale. While shareholders and equity analysts may judge this somewhat differently to credit analysts, there will be quite a lot of overlap.

Unless the operating performance of the acquired group is seen as a material drag (current and prospective) on its acquirer, an enhanced business profile is the most likely source of positive M&A impact, although the agencies will often wait a year or two as they see it play out (and moves into new markets or products will be a particular focus of attention).

Enhanced scale is positive if it appears to significantly support the group’s market position and hence pricing power (with cedants, brokers and reinsurers) and/or if it materially enhances earnings diversification. Cost efficiencies will be seen as positive in theory but these have to be pretty dramatic (and clearly sustainable) to make a big enough difference for a positive rating action.

While this is more qualitative than the capital-related analysis, a group should again be able to reasonably assess the likely rating reaction ahead of time—especially with S&P ratings (given the agency’s explicit and detailed ‘Business Risk Profile’ criteria)—and, as with the capital position, an acquiring group should have engaged with the agencies on this as early as possible.

Agency views on the future business profile and strategy will also be subject to both the post-merger risk appetite and to the perceived execution/integration risk.

Any material increase in group risk appetite is inevitably seen as a potential rating negative, not least because of the related concern that the group’s leadership is under pressure to justify the acquisition to shareholders with further growth and/or increased return on equity (RoE).

This can be a particular feature when an existing rated group or sub-group is acquired by an investing organisation rather than another industry participant. Even if the investing organisation intends to be at arm’s length and no risk appetite change is expected or desired, it may not have the relationship and/or the experience to effectively address this concern with the agency before the event.

Finally ‘execution/integration risk’ is always a concern for anything greater than ‘bolt-on’ scale, especially for contested acquisitions. The loss of key personnel can be a negative rating factor; there will be concerns around cedant retention and inevitably there will be challenges in systems integration (which in turn can make both the prior risks that much greater).

Arguably the biggest concern is leadership focus, especially around underwriting and other risk control. The mood music around acquisitions can too easily sound like ‘over-reaching ambition’ is in vogue and ‘due caution’ is not. A robust, through the cycle, long-term rationale for the acquisition is what the agencies need to hear.