The Intelligent Quarterly from the publishers of The Insurance Insider

Spring 2012

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Click to enlarge The old adage about M&A activity in the London underwriting market asserts that it proliferates when capital is readily available in the marketplace and management wants to deploy the excess more adventurously.

In many cases, shareholders carry an equal appetite for such enterprise.

However, is this maxim a simplified version of a more complex picture? Are there other factors at play that are cultivating an increase in M&A activity?

Discourse over the past few years within London's insurance district has prompted a sense of inevitability with respect to M&A. As rates softened through a benign 2009 and remained stagnant through a potholed 2010 and first half of 2011, we have seen the focus on M&A increase.

A glance at the table below reinforces this standpoint, with a number of Lloyd's vehicles currently the subject of much discussion and conjecture - not to mention the various dealings in Bermuda and the US over the past 18 months.

Yet the list of targets and suitors is surprisingly varied and carries some clear themes, suggesting that the M&A picture is more complex than merely being a result of the increased availability of capital.

Those insurers that have been the subject of M&A activity can be split into two broad groups - those being approached by third parties and those put up for sale by current owners. Of the latter, the common theme appears to be modesty with respect to size, suggesting that the balance between size and economic viability has shifted.

Historically, would-be Lloyd's participants have enjoyed remarkably low barriers to entry in such a mature market, but various regulatory changes have significantly altered this over the past 20 years. The latest of these - Solvency II (SII) and RMS Version 11.0 - are now pushing the barriers to entry and the necessary economies of scale even higher.

Outgoing Lloyd's chairman Lord Levene commented earlier this year that the Lloyd's market would spend £300mn implementing SII. With the regulator rightly demanding the same standards across the market, this amount - split between just 55 managing agents - carries significant implications.

It is clear that for the smaller syndicates the cost of being SII compliant is disproportionately high, and could be the difference between a year-end profit and a loss.

Of additional interest is that Lloyd's has positioned itself ahead of the broader European insurance markets in readying for SII. The spike in M&A activity at the smaller end of the market may therefore be a precursor to similar developments across Europe as SII comes online.

Furthermore, the impact of SII is supported by the list of firms linked with acquisitions, with investors in a number of smaller syndicates (not yet ready themselves to sell) combing the market for buying opportunities of their own in order to achieve this new minimum scale. The future, it seems, is one of magnitude.

The significant loss events during the first half of 2011 have driven increased volatility in earnings for the global catastrophe market. This has left investors, many already managing low price-to-book ratios, struggling. Historically, this volatility has been smoothed by investment returns following large loss events and improvements in market rates, but none of these are currently supporting returns.

Click to enlarge And it is not just large cat events causing concerns; the motor book blowout cost the Lloyd's market more than £520mn in 2010 at a combined ratio of 151.4 percent. Fierce competition alongside a huge spike in claims farming effectively undermined a class of business that had long been regarded as safe and predictable. The upside for motor has been the reaction of market rates, but the volatility persists.

Volatility has of course been an unwelcome contributor to financial markets since 2008. However, a desire for a "smoother ride" has evidently pushed some investors into considering an exit route. This is especially so where the noise created by losses has proven disproportionately large at a consolidated group level. Furthermore, the dislike of volatility reinforces the argument that scale - particularly across diversified business lines - has become more important than ever.

Although volatility has led to the withdrawal of some investors, others see it as presenting opportunities. Indeed, volatility in reserving books and in relationships between management and shareholders can add further potential targets to the M&A market. However, it is this type of acquisition that carries the risk of additional and unanticipated reserving problems. It is therefore perhaps no surprise that transactions with these characteristics have searched for a protracted conclusion.

It is also interesting to note that there has been a lack of market participants with larger underwriting capacity. The table (left) shows a strong concentration of activity around the smaller and mid-cap London market, and it is apparent that the largest firms are holding back from making acquisitions. Whether this represents a preference to use capital to diversify away from London and protect against volatility, or a distrust of the outcomes of SII remains uncertain.

A number of the key players involved in M&A opportunities are private equity firms, including some with no prior insurance market pedigree. This trend has received much coverage in the insurance press already. One of the often-quoted reasons for this is the nature of the current value proposition available to acquirers due to historically low price-to-value ratios.

Buying capital at a "knockdown" rate sounds like a good deal, however excesses of capital are, by definition, not being deployed efficiently, and returns will be adversely impacted. Playing the waiting game for a turn in market pricing is a high-risk strategy - and is one that almost inevitably needs to absorb a large loss event first. Additionally, pure private equity buyouts, as opposed to merger transactions that result in consolidation, will not drive the hardening of rates.

But just how awash with capital is the market? Throughout the stagnant pricing environment, commentary has referred to a $50bn global loss event being needed to turn pricing. However, the combined (re)insurance losses to cat events since the start of 2010 have been estimated in some quarters at up to $115bn. This does not leave the supposed bargain low price to 2010 year-end book values looking quite as attractive as perhaps they once did.

Furthermore, there has been a growing voice of concern on the levels of reserve releases being made across the market. The relationship between $115bn of catastrophe losses and sub-90 percent combined ratios is challenging to rationalise. Throw in the much mentioned investment return environment and a significant level of capital being returned to shareholders over the last 12-months and the risk is that some firms are storing up trouble for the future.

Given the mixture of drivers for the current up-tick in London market M&A, some of the key themes - such as the impending imposition of SII and volatile market conditions - appear to be reasons to both buy and sell, depending on an investor's standpoint.

Added to this, the supposed queue of potential private equity suitors seems to have created something of a perfect storm for some fascinating transactions. Yet there are a number of potential hazards for the would-be investor to navigate, otherwise there exists the risk of casualties along the way - which may well work to turn the market in favour of those who have avoided the dangers.

Ultimately, the value proposition driving some M&A seems challenging. Any acquirer will have to be certain of what they are getting and may need a slice of luck in order to realise the bargains they hope to uncover.