The Intelligent Quarterly from the publishers of The Insurance Insider

Autumn 2017

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Selling like hot cakes

Dan Ascher

If the insurance sector was a high street retail chain it would be a target for avaricious, asset-stripping vulture funds vying for the scraps of a wounded industry.

With rates in a steady decline and profitability dwindling, the prospects for insurers seem fairly bleak.

Generally, industries with the outlook of the property and casualty insurance sector would attract none but the hardiest of investors, those interested only in turning around distressed businesses bought at a significant discount.

But this sector has never abided by the norms of other industries - and that extends to its merger and acquisition activity.

In 2015, deal values for P&C companies in the US and Bermuda topped $50bn, rounding off what Deloitte referred to as a record-setting year for insurance transactions. However, 2015 also saw net income for US and Bermudian insurers trail behind the levels reported previously.

Yet that same year, valuations in the insurance sector were close to a six-year high, with the average price-to-book multiple standing at around 1.5x.

Oversupply
But of course insurers are not high street retailers - and they are hurting not from a dearth of demand but a glut in supply.

These complex financial institutions represent only a small portion of the wider macroeconomic environment in which they function, yet they are acutely sensitive to any changes in the global economic outlook.

The current rating environment, which has put pressure on profitability in recent decades, is itself a product of the global low interest rate - and that hampers earnings in two ways.

Firstly it puts pressure on the top line, as supply increases, with alternative capital pouring into the market in search of an uncorrelated investment offering profits that surpass the returns available from other channels.

And secondly, it compresses the investment income insurers used to depend on in order to smooth often lumpy quarterly underwriting results.

In recent years, those factors have worked in tandem to drive the M&A frenzy of 2015, when talk of low interest reached a crescendo as the rate languished at a more-than-three-decade low.

With investment floats effectively idle - struggling to earn a return and frequently even making a loss - insurers were sitting on significant capital that was just waiting to be deployed.

That combined with surplus capacity in the wider market putting pressure on rates - and thus on the denominator in the combined ratio calculation - set the stage for an M&A spectacular.

Bottom line
That combination of factors forced insurers to look elsewhere for measures to protect the bottom line.

One option is to rationalise the expense base and leverage the benefits of M&A to grow and gain economies of scale - and insurers did that in their droves.

But it would appear that even among the investment bankers that are often initiating and structuring these deals, there is some disagreement over what overarching market trends are causing this phenomenon.

John Hendrix, managing director of investment banking at Sandler O'Neill, thinks RenaissanceRe's $1.9bn deal to acquire fellow Bermudian Platinum in 2014 kicked off a busy period of M&A that has lasted more than two years.

Since then there has been a wave of deals including XL's purchase of Catlin, Ace's acquisition of Chubb and Italian investment house Exor's deal to take PartnerRe private.

Hendrix believes there were three key drivers behind the increase in deals.

"The industry still feels significantly overcapitalised," he says. "It is harder to grow the top line organically."

He adds that expenses continue to plague the smaller carriers - which at the same time are expecting to face significant technological pressure, although Hendrix expresses doubts as to whether that additional problem will materialise.

Building scale
Hendrix says all three factors have typically led small and medium-sized carriers to question whether it was better to remain independent or partner with a larger firm to leverage greater economies of scale.

He says companies were asking themselves: "Can I can I get paid today for what I'm going to be worth tomorrow?"

The executive adds: "The challenge for virtually all P&C companies right now is to grow their top line and to grow it in a safe and conservative way."

"A lot of them see the opportunity to acquire smaller competitors or a smaller company in a market sector that they're not in as a very sound and prudent way to build scale and to leverage their own capital base."

Hendrix says that, looking at some of the most recent deals, pricing multiples had hovered between 1.3x and 1.6x of Gaap book value. "Those are very healthy multiples and probably at the higher end of what we've seen," he explains.

"I think it is a rational price range, particularly when buyers are sitting on significant levels of excess capital that are earning very low rates of return."

The investment banker continues: "The opportunity cost of that capital has come down and it really enables buyers to pay fuller prices," adding that the debt markets have been "pretty accommodating".

"When you get to those meaningful premiums to Gaap book value that's when you start to see sellers who don't have to sell starting to look at the potential of a sale on the merits and what it does for their ownership base," Hendrix explains.

But he says the prices being paid are "fully justifiable" in terms of pro forma earnings and impact on earnings per share and book value per share.

Rate reversal
Discussing the relatively lofty public market multiples relative to the challenged P&C rating environment, Peter Babej, Citi's global head of financial institutions in its investment banking group, says there is a perception that the downward trend in pricing will reverse eventually.

"Historically, if you look over the cycle, whether it's because there's a large insured catastrophe or some other event in the market that depletes capital, rates tend to revert over time."

He adds: "People are also expecting interest rates to come up.

"While profitability near-term may not be at the level that you would like longer-term, interest rates look like they may recover, and while you can't predict the timing, at some point P&C pricing also will recover."

Babej says that while rates have continued to broadly decline across commercial, personal and specialty P&C lines, specialty areas such as some excess and surplus business have been relatively sheltered from pricing decreases.

"So you see some of those specialty players still trading at pretty healthy multiples because they're not subject to the same rate pressure as, for example, a property-catastrophe reinsurer."

He adds that the strong bid speculation in the sector has also had the effect of driving up valuations.

"You have to pick your spots," he says.

Dual wave thesis
Meanwhile, Deutsche Bank's chairman of insurance Paul Puleo thinks the swathe of M&A activity that has grabbed headlines in recent years falls into two distinct categories.

The first, he says, could be characterised as "cross-border acquisitions" where foreign buyers diversify away from their home market to balance currency risks and look to jurisdictions where higher returns are available.

The second, Puleo explains, are more strategic acquisitions where domestic trade buyers attempt to gain scale and leverage both capital and cost efficiencies through acquisition growth.

"I would say there's this dual thesis," the investment banker says.

"When you look at it all together it looks like an incredible wave, but it's a very different sort of a wave when you separate it."

Celeste Guth, Puleo's colleague and co-head of the German bank's financial institutions group, says US life insurance companies have been of particular interest to Asian buyers.

She says the investable assets relative to capital that insurance assets provide are attractive to buyers coming from countries with low domestic growth or with a high concentration of volatility.

Citi's Babej thinks the inbound interest from Asia has made a major change in the M&A landscape in recent years, which has seen Tokio Marine acquire Philadelphia Consolidated, Kiln and Delphi; Mitsui Sumitomo buy Amlin; and Sompo take on Endurance.

Babej says he expects further geographic diversification from the Japanese carriers, though there is unlikely to be a rapid succession of deals.

He says that low yields in Japan were a further factor behind their interest.

"Obviously, investment returns are a big part of the insurance business, and the fact that yields in Japan are so low is another impetus for looking overseas," he explains

"And [in] our market, even though we think our yields are low by historical standards - and they are - they're still relatively high compared to Japan."

Specialty interest
Guth says another area where Deutsche Bank has heard a lot of interest on the P&C side is specialty business.

"But I think when you look at it there are relatively few targets out there, and for the most part I think many of them are not considered actionable," the investment banker warns.

She says there has been a "huge" amount of activity that had whittled down the number of potential targets where the board or management team would be amenable to selling.

"The board can always say no if they feel they can build a lot of value just by keeping the company independent and executing the business plan," she explains.

"Often times you will see that, where boards want to remain independent," the executive continues. "They feel good about the prospects that the company has on an independent basis and they don't necessarily want to take a 20-30 percent premium and get cashed out because they feel like there's more upside in the stock."

And the scarcity of available businesses has driven up the prices being demanded. Babej says one of the main obstacles to getting a deal over the line is balancing the pricing expectations of sellers and buyers.

"That's been heightened a little bit by the fact that we've seen certain trades at pretty high multiples," Babej explains.

He warns: "Different buyers are situated differently and willing to pay different types of prices, so it just depends on who's actually out there willing to do a deal, and whether you're going to have a match from a valuation perspective."

Specialty interest
And the challenges don't end once a deal has finally been agreed.

Andy Wallin, group commercial director for Ed, has bought and integrated many broking businesses, but he admits: "I'd struggle to name you any businesses that have been perfectly integrated, given the constant change in all businesses."

He says the conversations acquirers should be having would go something like: "We are going to integrate your IT, your finance, your HR, your risk, your compliance, your legal and probably your premises and we're probably going to take your brand away.

"If you can deal with all of that, then we can have a conversation."

However, he adds, the dynamic is slightly different for portfolio businesses: "You want the assets, you want the portfolios [and] the people, and you want the renewal rights."

Integration is set to take centre stage in the months and years to come because, while there is little agreement as to exactly what is driving the increase in deals, the consensus view is that it will certainly continue.

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This article was published as part of issue Spring 2017

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