M&A and the pursuit of scale
Mergers and acquisitions (M&A) are a perennial source of discussion in reinsurance circles, and losses in 2011 have certainly helped to concentrate the mind. With the industry taking a close look at its collective balance sheet, questions have been raised as to whether consolidation will be on the cards in the coming months. For smaller players—particularly those battered by recent losses—the question is all the more pressing. But is there a minimum size needed to operate globally and resist the overtures of others? The answer it seems is yes, but it is far from conclusive.
Asked whether $1 billion in gross written premiums might be this threshold, Bradley Kading, president and executive director of the Association of Bermuda Insurers and Reinsurers (ABIR), said that of the association’s 22 members, eight wrote less than $1 billion of group gross written premium in 2011. Six wrote more than $3 billion. “You can be a successful specialist in a specific market segment with less than $1 billion in global gross written premium,” said Kading, and the number of smaller players carving out profitable niches appears to be evidence of that.
David Cash, CEO of Endurance Specialty Holdings, said that it is possible for the focused specialty reinsurance underwriters to remain small, but added that “it is far from a given that they will be around in 10 years’ time if they remain small”, as pressure increases on reinsurers to generate at least $1 billion in premium income.
“If you are not writing more than $1 billion in premium your customers may not view you as being significant to their reinsurance strategy,” said Cash. “Being smaller than a billion is probably too small, positioning you on the edge of the top 25 dedicated openmarket reinsurers in terms of size”—and being outside the premier division has its limitations. Konrad Rentrup, president and CEO of Hannover Re (Bermuda), spoke in a similar vein, arguing that unless you are part of a larger group—a situation Hannover Re (Bermuda) itself enjoys—size will inevitably be an important factor in your market position and success. “$1 billion may not necessarily be the size needed to maintain a significant standalone operation, but size certainly helps ensure you are not the target of a takeover,” Rentrup said.
Premiums aren’t the only metric of size. As Edward Noonan, chairman and CEO of Validus, was keen to point out, “scale is less about premium volume and more about capital and scope of the business”. Rather than scale of premiums written, security is the key differentiator within the industry, he said, with much of this driven by the “size and quality of capital base”. Kading spoke in a similar vein, arguing that “a better case could be made that $1 billion in shareholders’ equity is the minimum size for a successful operation”. He added that only three ABIR members fell below this threshold, with one of those having recently been sold and another expected to be sold.
Cash added a further metric, arguing that companies will inevitably be “judged by investors on their ability to grow book value per share. If you are able to do so, you are meeting your responsibility to your investors” and your relative size will be of less significance. Not being able to do so, he said, could act as a driver of M&A.
There be giants
Despite the possibilities of carving out a lucrative niche, there are challenges faced by smaller reinsurers in a landscape increasingly dominated by reinsurance behemoths. As Noonan explained, most of the smaller players are virtual monoline players writing volatile classes of business in which “their scale is pretty much defined by their capital base”. And such players will find it increasingly difficult to fight for business in the face of larger, stronger rivals.
“When comparing a smaller ‘A-’ rated player with some of the ‘A’ rated, $3+ billion players, buyers obviously feel safer trading with a bigger balance sheet,” Noonan said. As such, smaller players “get marginalised and on bigger capacity items they simply don’t get a showing”. Buyers may take a $100 million line from a larger player, but not from a smaller reinsurer—“and that sort of differentiation feeds on itself”.
“If buyers think less of your balance sheet, then they tend to marginalise your participation and you see less of the good business. You are driven to write lesser quality companies or less wellpriced business and over time underperform. Your franchise is then impacted and you become vulnerable to anyone wanting to expand their market share in the lines you do, who might say to themselves ‘I’ll take them out’,” said Noonan.
The position of smaller players has not been helped by the competitive pricing environment. As Cash indicated, some smaller reinsurers may feel that they are “not well differentiated with their customers, or they are operating in markets where their product is a commodity”. Faced with significant expenses and a struggle to generate revenue and profits, they need to “decide at some point whether there is enough strength in the business to push forward and make it to the scale where they can generate sufficient returns on equity”. If they can’t achieve this aim, they will likely turn to M&A, said Cash, with the question then being: “Is there a natural owner for their business?”
"$1 billion may not necessarily be the size needed to maintain a significant standalone operation, but size certainly helps ensure you are not the target of a takeover."
Further compounding the troubles of smaller players is the fact that there simply isn’t the same “margin for error”, said Noonan. For larger reinsurers, if they are wrong by 20 percent on their probable maximum loss estimates it is not going to be life-threatening. “If you are more thinly capitalised, however, the mistakes are dearer as a percentage of equity.” And metrics of size have inevitably crept into the reporting figures of analysts, with underwriting losses often presented as a percentage of a company’s equity, he said. “It helps to normalise the loss, but just because someone takes a larger bet in a territory, doesn’t necessarily make them a bad company, it is just a view they take.” Unfair it may be, but these are the conditions smaller players face.
Appetite for M&A
Future M&A will, inevitably, be a combination of negotiated mergers and more combative acquisitions. A number of drivers will play their part, but possible synergies will inevitably be high on the list. For smaller players that are looking to build out their platforms, and feel that they have “run out of runway” for organic growth, there will be a hunt for complementary relationships, said Cash. The goal is a “common understanding between buyer and seller—one company that acknowledges that it has not achieved its scale needs and another that believes it can readily integrate the other business and reduce expenses”, he said. If acquirers and acquirees are able to find such synergies, the prospects for M&A are good.
Another element that is likely to drive M&A is a desire among midsized and larger players to either broaden their geographic scope or deepen their bench of available lines. “In the M&A space companies may ask themselves ‘can I serve any customer wanting to shop at my reinsurance store?’,” said Noonan. If the answer is no, the next question would be ‘is there a desire to fulfil this customer need and can synergies with a possible acquiree provide these needs?’.
“A company may become a target for M&A because they have what you don’t—whether it is product, geographical scope or expertise.” Synergies—desired or otherwise—have a significant role to play in M&A.
Addressing the potential for M&A in the Bermuda market, Rentrup singled out the Class of 2005 as being the most likely to be active in that regard. He thought it unlikely that there would be M&A between Island players, but added that they could well act as acquirers. “For them it makes sense to acquire entities outside Bermuda, such as a Lloyd’s syndicate, or else they could invest in primary insurers internationally.” What they are looking for is companies with a different profile from theirs, he said, “although getting into other classes of business—those outside property cat—isn’t always easy”. Noonan was confident that should M&A occur, Bermuda players would be involved. “If there is a spate of M&A across the business I would be shocked if Bermuda companies were not involved,” he said.
Aiding matters has been the recent rise in book value experienced by some players. As Kading outlined: “A good share of the publicly traded re/insurers are now trading at above book value. Stock could be a useful acquisition tool.” Cash concurred that strong book value can “certainly be helpful” to those considering acquisitions. Some players would maintain that book value should be used to achieve organic growth, he said, but when their “existing business has achieved scale, there may be a temptation to further diversify by deploying that book value in M&A”.
Noonan added that “anyone trading at a premium right now has pretty interesting currency relative to others in the industry”, with variation in book value likely to encourage players well-regarded by Wall Street to consider acquiring those firms trading below book. “If you are trading at a premium and other guys are trading at discount that puts you in the catbird seat. Businesses trading at a heavy discount will tend to attract, not dissuade potential buyers,” he said.But as Kading outlined: “The question remains: is acquisition a good strategy for growth? While on the seller side the question is: will a seller take less than book value?”
Validus, for its part, has been active in the M&A space in recent years, so Noonan was asked about the company’s approach. “We have bought in the past and people tend to think of us in that context, but we’ve also built our original business. In each instance you need to consider what is available relative to what you want to accomplish and at what price things are available.” IPC Holdings, for example, was available at a heavy discount, proved a relatively simple business to take onboard and enabled Validus to scale up its operations during the period immediately following the financial crisis, said Noonan. The acquisition enabled Validus to ward off potential acquirers thanks to its increased scale, putting the company’s capital base “into a different league”. The deal played out much as Validus had hoped, but there can be disappointments when it comes to M&A, Noonan said, Transatlantic being Validus’s case in point.
The ability—or inability—to digest the acquired business, continues to act as a significant brake on M&A. As Rentrup outlined, when taking on another firm you need to be fully aware of the liabilities you are inheriting. “It is always a risk when you buy a longstanding company. Yes, you may be able to acquire the business at below book value—and that is always attractive—but do you understand its legacy? You need to pay very close attention to the book of business that you are acquiring. If you are lucky you see everything, but there’s always the risk you may miss something.” Those considering M&A will inevitably have to tread carefully.
Satisfying the demands of the rating agencies can act as a further brake on acquisitions. As Noonan outlined, “One of the impediments to M&A is the rating agencies’ view of additional cat risk.” AM Best, forexample, takes a very conservative view of risk, he said, with companies now unable to “build the kind of cat underwriting leverage that they once could”. This creates a definite impediment to cutting a deal with the smaller cat companies, he said, adding that rating agency capital requirements would leave acquirers decidedly capital-constrained, raising questions regarding whether you could take such companies on board.
The final brake on M&A appears to be the emphasis on alternative forms of reinsurance such as sidecars, cat bonds and collateral-backed reinsurers. “Future capital will flow not into the traditional reinsurance companies, but into sidecars and similar vehicles that will allow investors to get in and out quickly,” said Rentrup. Investors’ horizons have shortened since their experiences with the Class of 2005, he said, although in the current investment environment Rentrup predicted that interest in short-term plays would be significant. Noonan said stories as such Validus’s would likely be “a thing of the past. The way capital now enters the business has fundamentally changed”. Investment leverage-led players and a shorter-term outlook are likely to be the defining features of new ventures, he said, with conditions likely to dampen the appeal of traditional M&A.
Is resistance futile?
With smaller players inevitably attracting overtures, particularly following recent losses, the question arises as to whether they can resist unwanted overtures. An answer seems to boil down to whether they still have a value proposition. If they don’t, and their long-term prospects are weak, “then the board really needs to consider aligning with another organisation through M&A”, said Cash. However, if they feel that they have “legitimate avenues along which to grow organically, they can probably resist M&A”, he added. Rentrup argued that much will depend on shareholders. “If you are a publicly traded company, you hardly have any chance of resisting potential overtures. In the case of privately owned entities, it very much depends on your investors.” The question then becomes “do you want to be part of a larger entity?”, he said.
Not all overtures are welcome however, and hostile takeovers face significant hurdles. As Cash indicated, if an approach is hostile then it will “require a very generous offer to force M&A”. Noonan agreed, stating that “hostile deals are very tough to get done”. The onus really is on the acquirer making a compelling case to investors, the board and management. That said, “once the game is afoot and an entity is facing overtures, it is much tougher to resist. You may not want to be bought by that firm, but once you are in play, it’s very difficult to get yourself out”. Kading concluded that smaller attractive prospects would inevitably face overtures, hostile or otherwise. Such a situation “is simply part of Darwinian law as applied to insurers”.
It would seem that there is still a place for smaller players, but the niche has grown increasingly constrained. In the reinsurance sphere, bigger does mean better and, as Cash indicated, the quest for scale “while not necessarily an imperative, does seem to be a reality”.