Rating agencies could thwart M&A strategies

The unsolicited offer made yesterday (Monday) by Endurance Speciality for Aspen Insurance would have been no surprise for many in the industry who have been forecasting that the many competitive pressures in the industry could trigger more mergers & acquisitions for some time.

But while the logic of such a strategy can appear sensible for some companies – especially smaller and mid-tier reinsurers – 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 some 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.

He 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 said.