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18 October 2018 Alternative Risk Transfer

M&A: The perils of a shotgun wedding

They say opposites attract, and that a good marriage is greater than the sum of its parts. That is exactly what a number of insurers are gambling on in relation to commitments they have made of late in the form of an acquisition—they hope a complementary skillset will set them apart from the pack.

However, divorce in many countries now sits at record levels, and bringing together two large corporates can actually be infinitely harder than a marriage of two people. The break-ups are also more complex, if not more painful.

How much of a gamble are some of these companies making? And to what extent might they have felt pressured to walk down the aisle—not by parents and friends but by the corporate equivalent: investors.

“There is no doubt that some of these deals are driven by something akin to desperation. Companies are struggling to make decent returns and scrambling around for answers,” said one senior executive in a reinsurer, who preferred not to be named.

“They definitely see better access to alternative capital as part of the potential answer, yet many have never truly tested these markets or worked with them directly. Plus, of course, the irony is that alternative capital is exactly what is causing the squeeze on rates. Some of these deals will end in tears.”

Several rating agencies have already warned of this. Fitch, in a pre-conference season briefing, noted that companies that end up bidding to acquire a target run the risk of diluting their share price, especially if they fail to fully assess any risks around reserves and the potential complications of execution and integration.

Some of the acquirers have admitted to the risk involved. Jed Rhoads, president and chief underwriting officer, Markel Global Reinsurance, said that its move to acquire Nephila Capital, becoming the largest manager of funds in this sector in the process, was based on a “bet” of what the risk landscape would look like in 2025.

“We looked at what pieces of the puzzle we had and what we would need,” Rhoads said. “The market is changing; it is clear that insurance-linked securities (ILS) and alternative capital are here to stay and they would be heavily integrated into any future model of risk.

“On that basis, we did this deal. We have made an enormous bet in the ILS space but I am proud of what we have done.”

Meanwhile, just as Markel and Nephila, AXA and XL, AIG and Validus start to set up home together and move from pre-wedding courting to consecrating the post-nuptials, the market was given a somewhat unexpected insight into some of the pressures than can exist behind the scenes by TimesSquare Capital Management, a shareholder in RenaissanceRe since 2008.

A letter written on September 7, 2018 explicitly pressures the Bermuda reinsurer to explore the possibility of a sale. Describing action as imperative, it states that it believes that in order to maximise shareholder value, the reinsurer should explore the possibility of strategic alternatives immediately, including the exploration of a possible sale. It said it wants to engage in a dialogue around how the company can best unlock value for the benefit of shareholders.

How times have changed

What is really interesting is the logic behind TimesSquare’s conviction that a sale should be considered. In a nutshell, the investor is arguing that RenRe’s belief that as a standalone reinsurer it benefits from a “differentiated market position” is fine in theory, but in reality, this differentiation is not reflected in its share price.

The idea that standalone reinsurers may enjoy some benefits from this status is one that has been increasingly played on by PartnerRe since it was acquired by private Italian investment fund Exor. As more and more reinsurers end up part of large conglomerates offering insurance and reinsurance, the remaining specialists may benefit as cedants appreciate their focus and a lack of conflicts of interest—or so the logic goes.

It may well buy loyalty, and it certainly becomes important if there is any element of stealing of talent between the parties. As one chief executive of a global re/insurer told Intelligent Insurer in Monte Carlo: “We didn’t think it mattered until our insurance arm poached a high-profile team from our client. That made for some very strained meetings in Monte Carlo and we will almost certainly lose market share because of it.”

Yet this ethos does not seem to translate into higher premiums on deals or, as TimesSquare illustrates in its letter, a better share price. It notes that, despite rival companies being sold for escalating valuation multiples in recent acquisitions, RenRe’s share price has not reaped the rewards of this.

As TimesSquare says in its September 7 letter: “During the company’s July 25, 2018 earnings conference call, CEO Kevin O’Donnell pointed to the ‘increasingly differentiated market position’ that RenRe enjoys as a standalone reinsurer. We appreciate that core clients prefer to transact with reinsurance partners with whom they are not in direct competition and agree that this should foster an advantageous position for the company in accessing superior business.

“That said, the benefit of this premier positioning has not resulted in investors ascribing an improved valuation for the company, even as acquisitions of peer companies have been generally consummated at escalating valuation multiples over the past two years.”

The letter then details the last five big mergers and acquisitions (M&A) to have occurred in the industry and shows a deal’s value as a premium of the target’s unaffected share price and as a multiple of the target’s book value and tangible book value. The latter ranges from 1.96x in the case of the XL-AXA deal to 1.45x in the case of Ironshore-Liberty Mutual; the average of all five deals was 1.65x. It then stresses that the valuation of RenRe as of September 7 was 1.28x.

The letter also reflects on the way the growing influence of alternative capital has reshaped the industry and made it more difficult for reinsurers to benefit from healthy price rises in the aftermath of losses.

“Over the period of our ownership, we have witnessed a structural transformation of RenRe’s core property catastrophe reinsurance business, driven by the growing participation of alternative capital.

“In our view, this has had an adverse impact on the long-term risk-adjusted returns achievable in this business. Importantly, the degree of pricing response following large loss events over the past decade has been dampened relative to history and the duration of pricing gains has been ephemeral,” the letter states.

The letter ends: “Further, as the industry environment evolves, we have diminished conviction that RenRe’s share price will appropriately reflect intrinsic value. In our view, however, there is a way for RenRe to better realise its intrinsic value: through a review of strategic alternatives, including a possible sale of the company.

“We believe there are a number of potential acquirers that would covet RenRe’s dominant and unique position in third party capital management, as well as the company’s proven track record of superior underwriting, risk management and tangible book value per share growth.

“Our opinion is that an active competitive sale process for the company should be launched, which would likely yield a significant control premium over the current share price.

“To this end, we are requesting that the board immediately commences a review of strategic alternatives, including an exploration of the sale of the company, in order to maximise value for shareholders.”

Open communication

By way of response, RenRe has acknowledged the letter, without giving much away in terms of whether it will act on its advice or not.
Its response says: “RenaissanceRe welcomes open and constructive communications with all shareholders and values their input. In this regard, members of our senior management team have held numerous meetings with TimesSquare over the past few years.

“In particular, both our chairman of the board and our chief executive officer have separately met with TimesSquare in recent months.

“We have considered fully TimesSquare’s views and have shared them with our board. Our board understands, and is committed to, its fiduciary duties to act in the best interests of all shareholders. Our board and management team continuously focus on enhancing shareholder value through execution of the company’s strategic plan. We will maintain an open and active dialogue with all of our shareholders as we continue to work to enhance shareholder value.”

If you can’t beat ‘em

TimesSquare is effectively acknowledging that the best way forward for RenRe may well be to join a larger insurance conglomerate, much in the same way that other recent acquisitions—of XL Group by AXA and Validus by AIG—have demonstrated a fundamental change in the philosophy of large global insurers.

TimesSquare certainly believes RenRe would be attractive to such a player—especially because of its access to alternative capital.

This has been reflected in the rhetoric of the acquirers in recent deals. For AXA, the deal with XL shifts its business profile from life & savings business to property & casualty (P&C) business. The deal enables the group to become the biggest global P&C commercial lines insurer based on gross written premiums, according to a company statement.

One of AXA’s clear motives in buying XL Group is the reinsurance portfolio it comes with, which will offer further diversification, and also the access to the capital markets that now comes hand-in-hand with this.

That was according to AXA CEO Thomas Buberl speaking during a March 5 presentation on the deal. He said AXA wants to retain the reinsurance business not least because of the access to financial markets it enables.

Greg Hendrick, then chief operating officer of XL, added at the time that XL Group wants to “bridge the gap between traditional reinsurance and insurance market into that alternative capital space”.

For AIG, there is similar logic. The insurer says it is taking over Validus in order to diversify the business into reinsurance and to add a Lloyd’s syndicate, management suggested in a January 22 conference call discussing the deal.

But it also took on ILS fund AlphaCat, which manages $3.2 billion on behalf of clients by investing in ILS products, and it seems the possibility of ILS has increasingly come to the fore for AIG boss Brian Duperreault.

He has stated that he is in the process of reducing volatility of the company’s portfolio, and ILS capabilities acquired through the Validus takeover are expected to help to reach this goal.

“There is huge potential for the whole ILS market within our portfolio,” Duperreault said during the KBW 2018 Insurance Conference.
Underwriting is, in its essence, looking at risk and matching it with capital and AlphaCat gives AIG another capital to use and match risks, Duperreault explained.

“We’re a risk originator,” he said. “There should be ways where we can actually construct business, which would be immediately matched with the ILS market,” he added.

Duperreault also expects to be able to reduce the cost of capital by matching risk with capital markets. “This can be quite a useful tool,” he said. “It does reduce volatility, and it gives you much more flexibility.”

He predicted that there will be more use of ILS at AIG and elsewhere in the market. At the same time, AIG is still looking at how to reorganise its reinsurance programme. “There is still more work to be done,” he said.

In order to reduce the volatility of its portfolio AIG is adapting rate levels where needed, reducing limits and looking to define the right attachment points for the risk. “All that is work in progress. But we’re getting there,” he said.

“Last year we had $4 billion worth of cats and basically no recovery. So now I go out and buy. We are buying reinsurance of significance.”

An attractive space

Markel’s Rhoads expressed a similar logic in its acquisition of Nephila. The deal will complement its existing ILS offering from Markel CATCo, which it acquired in 2015. He notes the deal is also significant against a backdrop whereby the ILS sector is growing faster than the traditional reinsurance sector; Markel is now in a pre-eminent position to benefit from its potential. “This puts Markel in a really good position within the ILS market,” Rhoads said.

Richard Whitt, co-CEO, added that company expects this trend to continue. “We believe that the ILS growth trajectory will be higher than traditional for at least the next several years,” he said. “It is going to become a bigger part of the market.”

Pension funds and endowments are increasingly adding uncorrelated risk to their portfolios and are bringing new capital to insurance products, Whitt explained. “The interest is there on behalf of capital providers,” he said.

Rhoads added that on the customer side, ILS funds’ lower cost of capital enables a lower return profile for investors, and there are many stakeholders interested in diversifying into types of risk other than cat. “ILS funds are lean operators,” he said.

Some of the bigger guns in the reinsurance space are also observing what is going on with close interest. Torsten Jeworrek, member of Munich Re’s Board of Management, notes that the recent new wave of consolidation has shown a further trend towards more companies operating ‘hybrid’ business models, whereby they write both insurance and reinsurance.

He says that such a model can generate useful synergies, but it is also one of many factors driving consolidation, but he also stresses that it is rare for a business model to prioritise both equally.

“Most companies with hybrid underwriter models focus more on either insurance or reinsurance. Quite often, profitability stems predominantly from the key focus area, and is not shared equally between the two business segments,” he says.

“Insurance risk and market-cycle diversification will be improved if hybrid underwriter models are established at the holding level of companies. Synergies in terms of technology and know-how transfer are also possible.”

He adds that there are much deeper forces at work driving M&A activity, which is occurring despite price levels remaining high.

“We are witnessing investments for an increasingly diverse set of reasons, from further diversification of business models to larger deals aiming for additional scale. At the same time, we also see companies re-focusing their businesses, divesting non-strategic assets or areas with larger loss situations,” Jeworrek says.

“Other drivers of transactions are global, political and economic changes such as reactions to the Brexit referendum and US tax reform impacting on Bermudian markets. Increasingly, M&A transactions are also taking place to gain access to technology know-how.

“I believe that mounting political and economic changes will continue to drive M&A, in line with further pressure towards consolidation and access to new technologies.

“In the reinsurance sector, consolidation is taking place among the smaller companies, so there will be stronger market players in the future.”

Only time will tell just how many of the marriages the industry is seeing at the moment are truly forced—and how many are driven by real synergies that will stand the test of time. But, as the letter from TimesSquare proves, the pressure on boards to seriously consider consolidation is very real—and it seems inevitable that not all marriages will stand the test of time based on such motivations.

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