Rating the M&A frenzy
The pace of mergers and acquisitions (M&A) on Bermuda’s re/insurance market turned from a steady drip to a frenzy this year, as the proposed Axis-PartnerRe merger became first a three-sided struggle, following the intervention of Italian investment fund Exor, and then a possibly four-sided melee when Arch Capital Group was also reported to be interested in buying Axis.
Whatever entity emerges from the fracas will have to negotiate a Bermuda market that is rapidly changing thanks to the various permutations of M&A. As the market changes the rating agencies are watching events unfold with obvious interest.
John Andre, group vice president–property & casualty, and Mariza Costa, senior financial analyst–property & casualty, at AM Best, say that M&A has been driven by the need for companies to diversify into new products or markets to develop scale in order to be perceived as remaining a relevant player in the market.
Customers (cedants) want stronger partners that can provide more complex products and strong protection (ie, terrorism, business interruption, etc). Companies realise that the market is getting increasingly challenging. They now must compete on a global level, so the need for diversification, scale and strong capital positions is becoming more relevant for companies that need to attract and maintain a strong and loyal customer base.
“It seems the industry is favouring larger reinsurers at the moment, and there are multiple reasons for this,” says Taoufik Gharib, director, insurance, North American Financial Services Ratings at Standard & Poor’s.
“First, primary insurance companies are streamlining their reinsurance programmes as they are using fewer reinsurers for protection. Reinsurance purchasing decisions have moved to the holding companies to benefit from the economies of scale, and optimise risk exposure on an aggregate basis.
"The more recent M&A have been driven by strategic moves by companies made not for the purpose of manipulating or disrupting renewals." John Andre, AM Best
“As a result, many large, global insurance companies are choosing to do business with a select few reinsurers that can offer capacity across a range of lines and regions. This is increasingly marginalising smaller, less-diversified reinsurers.
“Second, over the past couple of years reinsurance premium rates have been declining because of overcapacity,” says Gharib.
“This has been exacerbated by the influx of third party capital that has significantly affected property catastrophe business and may potentially spill over to other lines of business. We believe competitive pressures will remain heightened in the reinsurance sector, and we don’t expect the recent spate of consolidation will alleviate that burden.
“In fact, we believe this trend toward greater scale highlights how hard it will be for management teams to defend their market positions.”
Merge in haste, repent at leisure
Brian Schneider, senior director, Fitch Ratings agrees that many re/insurance companies were consolidating in order to get the most out of economies of size and scale, but that careful consideration was required for this.
According to Schneider the smoothest mergers occur when a company considers potential partners in the long term, looking at what might make a good fit as their business evolves over time. He points to the XL-Catlin deal in early 2015 as a good example of how smooth the process can be. However, he cites the PartnerRe–Axis potential merger as an example of a deal that has been disrupted, due to Exor questioning the PartnerRe bid.
“Companies also need to avoid integration issues,” he adds. “They don’t want key underwriters to move out to join other companies because they’re unsettled by the merger and companies also need to manage integration issues.”
AM Best agrees that a merger has to involve companies achieving a good fit with each other. “It is essential—significant due diligence is foremost for any deal to be successful. When legacy or potential legacy issues are at stake, these need to be identified up front,” Costa says.
“Finding the right product line and geographic presence that will complement a company’s existing book of business is the focus for many. Getting the right partner, one that will allow the company to reach a larger audience or diversify its current books of business with expertise it did not possess prior to that ‘marriage’, is what could make a company more successful than some of its competitors.
“On the other hand the possibility of combining with a company that is not a good fit or only increases one’s exposure or risk may become costly in the case of an event. So the importance of the right fit should be a top requirement when deciding on an acquisition or a merger.”
S&P’s Gharib also highlights this issue, stressing that one of the most important aspects of a prospective merger or acquisition is what eventually emerges several years afterwards. “The industry doesn’t have a good track record here,” he says.
“Acquiring another company for its size alone is not a good idea—it must add value. The strategic fit is important. You need to find the right strategic partner, at the right price and for the right rationale—are the cultures of the two companies compatible?
“There is always a degree of execution and integration risk inherent in these deals. Some transactions can take one to two years to fully integrate, and there’s the danger of things falling into the cracks in that time, such as underestimating the aggregate risk exposure.”
AM Best also comments on the issue of the best time for such mergers to be pushed through. Its analysts say that the timing for M&A activity usually has to do with what is going on in the market at that time.
“The reinsurance market has too many companies that are fighting for a shrinking piece of the pie, so the number of companies competing must decrease or diversify in order for returns to remain acceptable,” says Andre.
“The most important consideration in terms of timing for the reinsurance market is that companies should be conscious that if they merge or combine with another reinsurer with risks that could possibly overlap with their own before a renewal season (when books of business can be rewritten) then the risk to be overexposed on a particular risk in the case of an event could lead to higher than expected losses.
“In our view, timing hasn’t really disrupted renewals in recent years, but rather changes in retentions by the cedants. The more recent M&A have been driven by strategic moves by companies made not for the purpose of manipulating or disrupting renewals.
“As the reinsurance market has changed and the market headwinds persist, rated companies need to evolve in order to remain competitive. How they address the changes is up to each specific management team. We will not prescribe a right or wrong way. We would expect highly rated carriers to have prudent, well-plotted plans for diversification that they can articulate to us, so the rating impact can be determined.”
Timing is not the only issue. Regulatory oversight is a vital part of the process, as without the approval of the regulators a merger is doomed. The Bermuda Monetary Authority (BMA) obviously plays a key part here, as anyone looking to complete a merger or acquisition involving a company on the Island will need its approval.
In addition the BMA regularly publishes statements detailing any changes to its regulatory regime, making it the obvious regulator to consult on a merger.
But, as AM Best also points out, it’s not the only regulator that might need to be consulted, as many UK insurance groups currently have a parent or affiliate domiciled in another jurisdiction.
Having multiple hubs, most recently including Singapore and Dubai, is a strategic advantage for London insurers in terms of access to diversified books of business. The Prudential Regulation Authority in the UK fully understands this business model, and as long as the acquisition funding and post-merger capital structure is appropriate and offers proper policyholder protection, a London company can expect regulatory approval.
Now for a rating
Once a merger or acquisition has been agreed on and the regulatory approval has come through, how long can it take a rating agency to cast an eye over the new entity and provide it with a rating?
According to AM Best, the time required is always a reflection of the size of the transaction. As insiders, ratings agencies hope to be informed of the transaction in advance. This allows AM Best to come up with a rating indication to the public once a definitive agreement has been reached. The impact on risk-adjusted capitalisation of the rated entity, projections for the combined entity and discussion of the execution of the operational issues are among the items that are reviewed.
Schneider says that Fitch Ratings is not involved in negotiations in merging companies. However, as a deal approaches, Fitch looks at any rating differentials between the entities as well as reviewing rating watches for possible changes. If one of the companies in the combined entity is strong, then it will have a strong rating, which could have an impact on the rating of the new company.
With the Bermuda market in a state of flux due to all the all recent M&A activity, rating agencies obviously have their eye on what’s going on. They need to—blink at the wrong moment and they might miss the latest development.