M&A: hotting up
The protracted soft cycle has once again raised the perennial question of M&A, with companies considering possible synergies as a means to offset growing market pressure. Execution is not for the faint-hearted however, with challenges ranging from failures to acquire and inadequate due diligence, through to the departure of key personnel and a drag on future ROE; but conditions are nevertheless encouraging closer consideration of the merits of transactions.
“Reinsurers are facing an increasingly competitive environment,” explained Taoufik Gharib, director at Standard & Poor’s. “There is an excess of capital among traditional players, while the influx of third party capital is further exacerbating reinsurance price declines. In the face of these conditions, reinsurers are trying to maintain market share or defend their competitive position.”
M&A is one potential lever that re/insurers are considering in an increasingly tough environment.
The slow pace of recovery in developed markets following the financial crisis of 2008 and the limited role emerging markets can play in complementing peak geographies are further exacerbating conditions.
“Some re/insurers have focused on emerging markets in recent years, but insurance penetration remains low and the business tends not to be as adequately priced,” said Gharib. Add in the prospect of unexpected losses such as the Thai floods, and emerging market prospects appear unlikely to offset sluggish reinsurance growth in developed markets, he explained.
Add into that mix changing reinsurance-buying appetites among the larger cedants—who have “upstreamed their reinsurance decisions to the holding company level” in order to optimise their portfolios, strengthen their negotiating positions and achieve improved pricing—and insurers are tending to favour larger reinsurers offering bundled coverage, said Gharib.
This is putting pressure on smaller reinsurers to scale up, particularly those that are focused on more commoditised products such as property cat, or players that cannot deliver a compelling value proposition. Many smaller and medium-sized players are turning to possible deals as a result.
As Jed Rhoads, president and chief underwriting officer for property reinsurance at Markel Global Reinsurance explained, “We are seeing scale matter more and more”, with the pursuit of growth evident throughout the marketplace. He said that as the largest re/insurers have grown, the broker markets have had to respond too.
“In order to be relevant in an increasingly well-capitalised field you have to put out meaningfully large line sizes.”
Rhoads added that others are pursuing M&A transactions as a means to drive cost efficiencies—an issue that is all the more pressing in the current environment. Consolidation of underwriting teams and back office functions, and other smart synergies, can be achieved following a well thought through acquisition, helping to deliver lasting value in the transaction, he said.
“Acquirers also would do well to consider their capital positions,” said Rhoads, “with pressure evident from shareholders to put excess capital to work or else return it through dividends and share buy-backs.” Citing Markel’s acquisition of Alterra, Rhoads indicated that, in addition to a share exchange, Markel paid $10 for each share of Alterra stock, amounting to cash consideration of approximately $1 billion to Alterra shareholders.
This cash consideration component reduced the amount of post-acquisition shareholders’ equity the merged company would have, making it more capital-efficient. As he explained, “This use of cash helped to deliver immediate value to Alterra shareholders, while signalling a prudent approach to capital management at the new, combined entity.”
Ensuring long-term value
Once the decision to pursue M&A has been made, pressing ahead with the transaction is not without its challenges—particularly in the face of the current soft cycle. As Stuart Shipperlee, partner at Litmus Analysis made clear, “From the acquiring group’s shareholders’ point of view, paying any meaningful premium to book value is a leap in a market where rates are falling. In effect they would be paying to gain more exposure to a soft market.”
He said that while acquisitions can make sense if the current pricing environment is part of the cycle—“as opposed to a structural shift to a lower price environment”—making the case to shareholders can prove a challenge. An acquired entity needs to deliver “meaningful diversification into long-term attractive lines of business or geographies and/or the creation of substantial absolute scale in any given market”.
“From a ratings perspective, we believe M&A needs to be more than 1+1 equals 2,” said Gharib. “We consider M&A in light of the overall group strategy. Is an acquisition going to deliver a better footprint for a competitive position, strengthen the value proposition to cedants or enhance ROE?”
If there is any uncertainty over the answers to these questions, there may be reason to caution against a transaction. Gharib warned against the pursuit of M&A when it delivers only scale and not a more diverse underwriting mix. “Successful acquisitions add to your top line and competitive position, delivering new distribution channels, products and profitable business.”
Gharib said that if companies have similar profiles and are writing the same lines of business, a merger might in fact prove detrimental. As he explained: “You can’t simply add the premiums of the merged entities together, because cedants need to manage their line sizes with one reinsurer, so they may probably end up cutting those line sizes. The combined entity might see its line sizes reduced as a result”—hardly the outcome those pursuing scale and greater participation are seeking.
Rhoads said that M&A needs to be considered in two ways: strategic and financial. The strategic side is developing the scope and scale of your business and delivering an improved underwriting proposition to clients. The financial side is delivering efficiencies in the underwriting and back office function and potentially pursuing a more aggressive investment strategy on the asset side of the book by leveraging your increased scale and expertise.
Addressing Markel’s acquisition of Alterra, Rhoads described it as a “grand slam”, delivering both strategic and financial benefits for the merged entity. “It was strategic because Markel was not writing reinsurance or large retail P&C insurance business. The acquisition added these two new categories of business, complementing Markel’s existing underwriting portfolio.
“Additionally, we have been able to apply Markel’s successful investment strategy to the combined company’s invested assets, including a greater allocation to equities and non-insurance ventures.”
Rhoads said that many companies considering M&A are struggling to get a firm handle on either the strategic or the financial benefits of transactions and, in the worst cases, are finding themselves unable to achieve either in their blind pursuit of M&A. Such pitfalls are particularly dangerous for smaller players who feel a pressing need to scale up in order to remain relevant.
Although M&A among smaller entities might make sense as they look to establish themselves on the reinsurance panels of choice cedants, the motivations for M&A for medium and large-sized re/insurers is less clear.
Shipperlee said that bolt-on acquisitions can make sense if the target is “attractively priced” or can fill a gap in the acquirer’s portfolio, but he warned that a large acquirer can “undermine the specific qualities that led to the target being attractive in the first place”. This can range from dynamism and an ability to react to change, through to a highly focused leadership and the fact that as a niche player they were highly valued by cedants or brokers.
Acquirers need to be careful not to erode those qualities that drew them to the acquisition and consider their long-term, mutual development.
Pulling the trigger
Having opted to pursue M&A, the next major hurdle is execution, and it is evident that transactions require a strong hand. “Those pursuing a transaction need to consider a host of factors,” said Rhoads. “Is the deal accretive to shareholder value; will customers benefit; can you retain the best people in the merged entity or do you end up losing your best and retaining your worst?
“Do you achieve cost efficiencies; and do the brokers view the move as a good or bad thing?”
Rhoads warned that with so many factors playing a part in the decision, transactions “require detailed analysis and a lot of nerve”.
Gharib said that a lot will depend upon appropriate due diligence, with the acquired entities’ liabilities a key concern. Shipperlee spoke in a similar vein, arguing that “the challenge for the acquirer is truly getting a handle on reserve adequacy at the target group”. But predominantly it is about people and business cultures.
“Will the two firms gel, can you keep the people in place at the combined entity and how do the two risk tolerances measure up?” asked Gharib. Creating continuity and securing the buy-in of key staff are central to the successful execution of any M&A deal, he said.
As Mike Morrison, head of KPMG Advisory, Bermuda explained: “M&A is essentially about people—teams that want to see eye-to-eye and move things forward.” Without management buy-in there can be all sorts of repercussions, he said. M&A is often seen by those outside the transaction as an opportunity to pick up new staff who are forced or feel the need to jump ship, said Morrison.
“If teams leave it can severely impair the franchise,” said Charlie Thresh, a managing director at KPMG Advisory, Bermuda. However, he warned that the merger of two entities can create just the sort of competitive dynamics that would make such an outcome more likely.
“Deals are often predicated on post-acquisition synergies, but people might see new underwriters as a competitive threat. As a result such synergies might be difficult to find,” said Thresh. Morrison added that one of the major reasons that M&A deals fail is that “people within the company cannot see it being beneficial to them, never mind that shareholders’ interests should ultimately be the motive behind such deals”.
Without making the case to key members of the team, transactions may threaten the integrity of the combined entity and even existing entities that do not pull the trigger on a transaction.
Shipperlee added that deals also need to be “sold to shareholders” with a medium-term risk that “the acquiring leadership subsequently feel the need to grow the combined group into a soft market to try and prove the transaction was a success and hence be less willing to turn down poorly priced business”. While a turn in the market might provide all the justification a board needs, a protracted soft cycle could result in the acquirer having to justify again the value of the transaction it pursued.
“These issues combined with any reduction in the combined risk-adjusted capital adequacy position (dependent on how the deal is financed) will be concerns for the ratings agencies. Conversely substantially enhanced diversification can support risk-adjusted capital and the agencies’ views of the combined group’s business profile,” said Shipperlee. It is apparent that acquirers need to tread carefully as they approach such significant, strategic decisions.
Despite the evident challenges of pursuing M&A, Rhoads said that “the environment for M&A is pretty ripe right now”. Gharib concurred, adding that S&P “expects consolidation to rise in importance on the strategic agendas of Bermuda boards—particularly those of smaller players” over the next 12 to 24 months. Although one transaction—Aspen-Endurance—has recently fallen through, there is every expectation that others will be attempted.