Only the strong will survive

So far, 2015 is shaping up as the year of the mergers across many industries. According to Dealogic, US targeted mergers and acquisitions (M&A) reached a half-year record high of more than $1 trillion in the first half of 2015, the first time on record any nation has broken the $1 trillion mark in a half-year period.

The global reinsurance sector is no exception and has jumped on the M&A bandwagon as management teams and their respective boards of directors are placing renewed attention on growth and responding to cedants’ changing demands for greater scale. Because organic growth is hard to come by, M&A is a natural strategic option for top-line growth and excess capital deployment.

During the past nine months, the re/insurance sector has been very active, with nine major M&A deals that totalled approximately $57 billion (see Table 1). On average, buyers have paid 24 percent more than market value. The highest premium of 38 percent was offered by Tokio Marine & Nichido Fire Insurance for its proposed acquisition of HCC Insurance Holdings. About half of these acquisitions were all-cash transactions and the rest were a blend of cash, stock, and debt.

Major M&A deals announced during the past three quarters are reshaping the reinsurance sector in a consolidation wave that Standard & Poor’s Ratings Services anticipated. This trend confirms the challenges that global reinsurers’ management teams face in the current soft market, including an ongoing downtrend in pricing and underwriting conditions exacerbated by an influx of third-party capital that poses an additional threat to traditional reinsurance players. Against this backdrop, reinsurers are increasingly seeking M&A transactions to alleviate some competitive market pressure and achieve profitable growth, cost savings, and capital efficiencies.

We believe competitive pressures will remain elevated in reinsurance for the next 12 to 24 months, and we don’t see the recent spate of consolidation as a panacea to alleviate that burden. In fact, we believe the trend toward greater scale highlights how hard it will be for management teams to defend their market positions. Few of these competitive pressures will abate as long as capital remains at or near all-time highs.

Strategic or defensive moves?

On the surface, it seems that the barriers to entry for the reinsurance sector are low. However, it takes more than just capital to build a successful franchise with a defendable and sustainable competitive position to weather the vagaries of the underwriting cycles. Newcomers need to have a credible management team, a robust and diversified business model, established broker and client relationships, financial security, increasingly larger balance sheets, and a solid track record that takes time to develop.

Cedants want to be sure that their reinsurers will be around to pay claims, and increasingly to be able to offer large reinsurance capacity and solutions to complex risks. The recent consolidation of small and midsize reinsurers to strengthen their competitive positions, bolster their balance sheets, and establish themselves as viable long-term players underscores the difficulty reinsurers have in ensuring that longevity. The recent spate of consolidation is reducing the number of players and raising the price of admission for reinsurers that seek to demonstrate their larger scale, scope, relevance, and staying power to increasingly sophisticated clients.

With the announcement of its $1.9 billion takeover of Platinum Underwriters in November 2014, RenaissanceRe kick-started the consolidation wave. In addition, after its failed attempts to acquire Aspen in 2014, Endurance completed its $1.8 billion buyout of Montpelier Re in July 2015. RenaissanceRe’s and Endurance’s acquisitions of Platinum and Montpelier, respectively, are strategic and enhance their value proposition and market footprint. But these deals are also defensive in nature as both acquirers are seeking scale and breadth to differentiate their offerings from amore-commoditised reinsurance capacity.

Reinsurers who are involved in this wave of M&A have listed a number of benefits to the proposed deals to justify the cost: increased scale, product diversification, cost synergies, and capital efficiency. We see some potential benefits to each of the individual deals, if executed correctly. However, we would classify all of these transactions as primarily defensive in nature, as the management teams have taken the view that combining forces with another player will make their companies more viable to compete in the coming years.

Emulating the Berkshire Hathaway business model

Lately, we have seen an increased interest by investors to emulate the Berkshire Hathaway (BRK) business model.

Through their investment holding companies, they are acquiring re/insurers with strong operating cash flows that ultimately will be upstreamed to the parent company. Re/insurers receive premiums up front and pay claims later. This collect now and pay later re/insurance model generates cash flows or ‘float’ that these BKR copycats invest. Through this scheme, these investment holding companies gain access to capital with minimal cost.

The BRK business model is hard to duplicate and it is becoming a crowded trade in an already saturated reinsurance market. We expect more similar deals to come to the market during the next 12 months, which will likely continue to put pressure on reinsurance pricing given these holding companies’ lower cost of capital relative to that of standalone, publicly traded reinsurers.

The Chinese and Italian acquirers—Fosun International, China Minsheng Investment Corp, and EXOR—who are newcomers to the reinsurance market are following suit. In May 2015, Fosun announced the acquisition of the remaining interest in Ironshore that it does not already own (about 80 percent) in a $1.8 billion transaction. Fosun paid about $464 million for the initial 20 percent back in August 2014. In July 2015, China Minsheng Investment reached a definitive agreement with White Mountains to buy Sirius for about $2.2 billion. Finally, after many attempts, on August 3, 2015, EXOR clinched an agreement to acquire PartnerRe for $6.9 billion.

None of these three transactions has closed yet. Therefore, it is still unclear how these to-be-acquired entities will operate under the new ownership. We could take negative rating actions on these reinsurers if we believe the change of ownership will weaken their business or financial risk profiles. There is still uncertainty surrounding how, under the new ownership, their investment strategies could be altered and potentially become more aggressive, or their competitive position could be undermined by a significant strategic shift in their business mix to lines or regions in which they don’t already have expertise and relationships.

Reinsurers aren’t the only ones

Insurance M&A has been rampant outside the reinsurance market as well, with large deals announced in recent months in the US healthcare market and the global multiline insurance (GMI) arena. The consolidation among GMIs will have a direct effect on competition in the reinsurance market. We believe this will exacerbate the reduced reinsurance purchasing from GMIs that we’ve observed in recent years. Expense savings and lower cost of capital could push pricing down further.

Unlike in the global reinsurance sector, however, we do not expect a large round of M&A deals among the GMIs.

These insurers have successful standalone strategies and do not face the same competitive pressures. We believe the motivations behind some of these deals were compatible business platforms and customer reach rather than a need to grow in scale or to diversify. In fact, ACE’s $28.3 billion acquisition of Chubb makes it more nationally concentrated.

Conversely, we view Tokio Marine’s $7.5 billion bid to acquire HCC as a continuation of its global business expansion and portfolio-diversification strategy after acquiring Philadelphia Consolidated and Delphi Financial Group a few years ago.

The result of many large transformational M&A deals is larger and more-diversified balance sheets. We’ve noted for some time that GMIs and large insurers are optimising and rationalising their reinsurance purchasing. We expect that, in the longer term, this increased scale and spread of risk will increase these companies’ ability to reap the benefits of diversification within their portfolios and justify buying less reinsurance despite softer pricing.

For example, following the completion of the $4.1 billion merger between XL and Catlin in May 2015, the combined group publicly stated that it has room to optimise its $2.8 billion in ceded premiums further and has increased purchasing power over its reinsurers.

The benefits that companies generally hope to attain from transformational combinations—diversification, expense savings, and greater scale—can have an impact on the prices they charge for coverage, particularly in their reinsurance divisions given the pricing pressures in that market. The premium charged for an insurance contract is a function of the expected loss on the contract, expenses allocated to that contract, and a profit margin.

Return on risk-adjusted capital is the profit margin that the insurer earns on the capital allocated to this risk. A company that has significantly improved its diversification could see a decrease to the risk capital and therefore theoretically could accept lower margins to earn the same return—this could increase the latitude for price decreases further.

Perhaps even more meaningful in this equation is the benefit of reduced expenses that in theory could be passed on to clients in the form of lower pricing. Expense synergies were an important consideration, although not the main driver, for the management teams of ACE and Chubb and XL-Catlin in their assessment of their respective deals.

ACE estimates expense savings of $650 million following the tie-up with Chubb, and XL-Catlin expects to cut $250 million during the next few years. For some companies involved in M&A, which are also operating in highly competitive or softening markets, an ability to lower prices without sacrificing profit could be an important competitive advantage.

However, should companies pull this lever it could also add to pricing declines in the reinsurance market as peers feel the pressure to keep up.

A tough year ahead

We believe the reinsurance M&A momentum will continue for the rest of 2015 and into 2016. The current reshaping within the reinsurance sector, most of which is taking place among the small and midsize reinsurers, will not result in a meaningful reduction of industry capital. This reflects our belief that the primary motivation for these transactions is to achieve the scale that management teams deem necessary to compete in the global market.

We expect further consolidation in the market as smaller reinsurers are squeezed more than globally diversified groups and look to gain scale to compete.

The industry is undergoing a reconfiguration that will result in fewer but larger reinsurers. The path to that result is strewn with challenges in executing and integrating new transactions, growing into new capital bases, and competing against a different set of peers. Profitability and capital preservation will be difficult to achieve as pricing declines continue and investment yields are slow to rise.

We foresee another competitive and difficult year for the reinsurance sector. It is unlikely in the next 12 to 24 months that we will see profitability return to the strong levels of the past five years, that pricing will improve enough to turn the market across the board, or that competition will subside. In the meantime, for reinsurers, there seems to be a

Darwinian concept at work, as only those strong enough to adapt or evolve will survive.

Taoufik Gharib is director, S&P Ratings Services at Standard & Poor’s. He can be contacted at: taoufik.gharib@standardandpoors.com

Dennis Sugrue is  director of insurance at S&P in Europe at Standard & Poor’s. He can be contacted at: dennis.sugrue@standardandpoors.com.