Preparing to leap

Many in the industry are forecasting a spell of consolidation. But how and when this may come to pass divides opinion, as Intelligent Insurer discovers.

The long-running and ultimately failed acquisition attempt by Endurance Specialty on Aspen Insurance this year crystallised a trend that many industry commentators had predicted for some time: the industry is overdue some serious consolidation.

“Lloyd’s businesses continue to be attractive acquisition targets and a popular route for gaining a presence in the market, although the number of ‘available’ businesses is now limited.” Aon Benfield report

2013 proved to be a weak year for deal flow in the insurance industry with transaction numbers down 6.7 percent compared with 2012 and the aggregate deal values down 55.3 percent, according to a study by Conning. But most now expected this trend to reverse.
In a poll conducted at the International Insurance Society’s (IIS) annual conference, held in London in June, 90 percent of delegates said they expect a period of consolidation for the reinsurance industry.

Some 35 percent of attendees anticipate substantial consolidation while 53 percent said they expect some consolidation. Only 12 percent said they do not expect much mergers and acquisition activity going forward.

Many commentators have been predicting more M&A for some time, driven by a number of fundamental changes in the reinsurance markets. One of these is the unprecedented levels of new capacity entering the markets, creating intense competition in some areas and driving down rates. As more traditional reinsurance seek diversification into new lines of business, acquisition will become a natural strategic move for some.

Second, driven partly by regulatory requirements and resulting changes to the way they manage their capital and partly by the growing availability of fully collateralised coverage, some of the world’s larger buyers of reinsurance have been rationalising their approach.

Many are choosing to work with a smaller number of highly-rated reinsurers, which can work with them on a global basis and complement rather than compete for the growing percentage of business they are placing into the insurance-linked securities (ILS) markets or other alternative markets that offer fully collateralised coverage.

But this shift has the potential to leave many mid-tier reinsurers, which would have previously enjoyed small but lucrative parts of these programmes, high and dry. One solution is simply to pursue an M&A strategy to achieve high ratings and a bigger presence in the market.

This exact point was made by Joerg Schneider, the chief financial officer of Munich Re, in a widely reported interview with German newspaper Boersen Zeitung earlier this year. He said that a period of consolidation may be ahead for smaller reinsurers pressured by pricing and other factors including the continued low interest rate environment and increasingly stringent regulation.

He pointed out that smaller to mid-tier reinsurers, as well as property-catastrophe focused players, are increasingly being squeezed between the large global reinsurers and alternative capital.

An attractive option

The Lloyd’s market has seen its fair share of deals in recent years. At that same IIS event in London, Vincent Vandendael, director of international markets at Lloyd’s, noted that some 20 percent of the capacity in Lloyd’s has changed hands in some shape or form in recent years and he expects this to continue.

This is backed up by a report by Aon Benfield published earlier this year. The broker notes that four transactions have occurred so far in 2014 and suggests the strength and attraction of the Lloyd’s franchise is largely driving activity in this part of the market.

“Lloyd’s businesses continue to be attractive acquisition targets and a popular route for gaining a presence in the market, although the number of ‘available’ businesses is now limited,” the broker said.

A number of senior executives commented on this topic at the Standard & Poor’s Ratings Services’ 30th Annual Insurance Conference held in New York earlier in the year.

Among the forces driving this trend were competitive pressures including weakening profitability, steadily flowing alternative capital, pricing pressure, and persistently low investment yields.

One of the commentators on M&A at that forum was John Charman, chief executive of Endurance Specialty, which at the time was still in the process of attempting to execute its own $3.2 billion high-profile acquisition bid for Aspen.

Charman said there are two views of M&A. “One is positive in that it’s seen as the best use of capital to strategically deploy to create a more relevant, stronger business, but much better prepared and able to deliver the profitability that shareholders require,” he said.

But on the flip side, he noted: “As an industry, I’m horrified. My view is that I’d rather deploy capital in a strategic way and be well prepared for a change in the marketplace on both sides of the balance sheet.”

A conference survey of delegates revealed that 51 percent of attendees believe there’ll be active M&A in the next year, with as many as five major transactions.

Charman’s comments backed up the rhetoric he had used in relation to the Aspen deal. In one of many statements he made around the merits of the deal, he said the deal would create a stronger, more profitable company.

“The specialised businesses of Endurance and Aspen, such as Endurance’s market-leading agriculture insurance business and Aspen’s Lloyd’s operations, are highly complementary, and together we will create a company with increased scale, an attractive diversified platform across products and geographies, and greater market presence and relevance,” Charman said.

Look before you leap

There are some detractors from the M&A argument. Denis Kessler, chief executive of SCOR, while firmly believing there will consolidation, does not foresee the biggest players being involved. He also stresses the cautious nature of boards these days. “Almost all boards are more cautious than they have ever been, but I still expect a number of deals,” he says.

The other factor that could slow such activity will be the perspective of the rating agencies. There are some who point out that the rating agencies may not be so easily convinced, which could mean that some deals are not ultimately as advantageous as players may believe.

In a research note on this subject, Stuart Shipperlee, analytical partner at ratings consultancy Litmus Analysis, points out that there are several good reasons for companies to consider M&A as a strategy.

One is simply to increase market power, thus potentially allowing a reinsurer to negotiate better deals. A second reason would be cost efficiencies. A third would be a play around the cost of capital. Essentially, achieving greater diversification by buying a well-established book is generally seen as less risky—reserve adequacy permitting—than organic diversification due to the avoidance of the anti-selection risk faced by new market entrants, Shipperlee notes.

The ultimate goal of all these strategies, however, would simply be to find more return against a backdrop of insufficient pricing.

But rating agencies will not easily be convinced that M&A is the best way to achieve this, he believes.

“For now at least, the mantra for many is ‘find more return’; either by consolidation, or pursuing more aggressive ‘hedge fund type’ investment strategies. Neither will be easily sold to the rating agencies.

“Reinsurer M&A in a softening market has not always been a runaway success to put it mildly; the business case will not be easily made to the agency,” he says.

Shipperlee notes that increased market power can be a plus but it takes real scale in the reinsurance market for this to be much better than a neutral factor for a rating.

Cost efficiencies are a positive, he notes, but few reinsurer ratings are heavily influenced by this because reinsurance is a volatility-based business and it is the management of that volatility that primarily drives the credit risk profile.

While buying diversification has many merits, he notes that if, one way or another, the plan involves a more aggressive use of the post-acquisition combined capital than that of the pre-acquisition acquirer, the conversation with the agency may not be straightforward.

“Add to that the agencies’ inevitable concerns about execution risk and whether the acquired reserves are indeed adequate, and reinsurers will need some very persuasive logic to support the acquirer’s rating,” Shipperlee says.