Can M&A help reinsurance capital to be as low-cost & efficient as ILS?

With merger and acquisition anticipation sweeping the reinsurance market, with some reinsurers that have not yet announced an M&A deal thought likely to soon, it’s worth revisiting an old topic, comparing re/insurer capital efficiency with ILS players.

The latest reinsurance merger to be announced was, of course, AXIS Capital and PartnerRe, who revealed their intention to engage in a merger of equals as a response to the structural change they face in the reinsurance market. Their announcement came not long after XL Group bought Catlin, before which RenaissanceRe announced it’s intention to acquire Platinum Holdings.

Once again, scale is a key reason for these M&A deals, the thinking being that by having a larger footprint, broader reach, greater diversity in terms of both line of business and geography and more reinsurance capacity, the resulting combination would emerge a stronger company, more resilient to the challenging reinsurance market environment.

The other key reason that is cited in these M&A deals is the need for efficiency. Bringing two companies together is always hoped to result in greater efficiencies, as costs can be cut, offices merged, head counts reduced and again the combined entity is hoped to be more efficient.

Cost-of-capital after these efficiency seeking measures is also, naturally, a key concern and reason for the M&A wave. Having a lower-cost of underwriting capital enables reinsurers to be more efficient in their underwriting, lowering the technical return hurdles they require as a minimum for the risk they assume.

But how much more efficient do these growing reinsurers need to be in order to compete with the accepted lower-cost capital, often more efficient, insurance-linked securities (ILS) and third-party reinsurance managers?

One way to think about this is to use simple metrics to allow for a rudimentary comparison to be made between reinsurance firms of differing size and of course ILS managers.

This simple metric involves the premiums wielded by a reinsurance or ILS player and the size of their workforce, providing a very simplistic way to compare efficiency of the premium capacity (per employee) that each firm has at its disposal.

We wrote about this previously here, using data included in a presentation sourced from reinsurance broker Willis Re. The presentation compared UK personal lines specialist Esure with the world’s largest reinsurer Munich Re and London-based ILS specialist Leadenhall Capital Partners LLP. The results below, in terms of premium per employee, are telling.

Looking at Leadenhall Capital, which is clearly the most capital efficient on this metric, you can take a similar ratio of assets under management to premiums generated for other ILS managers for whom we know the AuM. The results are interesting as the vast majority of ILS managers fall into a range of $20m to $30m of premium generated per employee. Interestingly many come close to the $25m mark, which could indicate a sweet-spot for ILS efficiency.

Clearly generating around $25m of premiums per employee is a more efficient use of underwriting capital than less than $5m per employee and demonstrates why ILS capital can support lower return hurdles than large, traditional reinsurers (to a degree). It’s not the whole story, that requires a much more in-depth look at expenses, cost of risk, combined ratios and the lines of business reinsurers work in.

But, with the current reinsurance merger wave in mind, we thought it might be interesting to look at the reinsurance firm’s that have announced M&A deals using this same metric of premium generated per employee, both for before the merger happens and after.

Amongst other things, these numbers may give an idea of exactly where these merging reinsurance firms will aim to get to in terms of reductions in headcount.

Or if not where they aim to get to, where they might need to get to over the coming years. If ILS continues to take a share of the market the only responses will be either relinquishing that piece of the re/insurance market to ILS, or competing on cost-of-capital and service levels. If the pressure to reduce your cost-of-capital continues and reinsurers seek to become as efficient as the ILS business underwriting model, where would that leave them?

It should be noted that we’ve taken these figures for premiums written, which are largely 2013 gross premiums, and headcount from the websites of the companies or from their announcements regarding the M&A deal. Hence not all the combined premiums will be accurate, as during the combination some of the premiums may be reduced due to double-counting and there will be a margin for error.

However, it gives a reasonably accurate picture of the premiums per employee underwritten by each firm and how that would translate to the combined entities if no reductions in headcount, or increase in efficiency, were made.

On this premium-per-employee basis, the most transaction which results in the most efficient looking platform, before any cuts or efficiencies are made, looks to be the RenRe-Platinum deal. However, it’s important to note that RenRe’s premiums per employee is higher than the combined firm, which perhaps gives you an idea that the combined workforce will shrink significantly in order to maintain a cost-of-capital that RenRe (as the acquirer) is used to.

On this basis the AXIS-PartnerRe deal truly does look like a merger of equals, with both firms premium per employee figure being very close to each other and the combined metric not moving very much at all.

XL-Catlin, however, looks the least attractive. But, both of these firms have primary insurance businesses which generate more investment income, which may not be fully reflected here (see Esure in the original table above for a primary company to compare with).

However, what is really starkly clear from this data is the advantage ILS capital has on a premium per employee basis. In fact, this simple metric points to ILS being around 5X’s as efficient in its use of underwriting capacity per employee, whether that equals profitability we’ll leave you to decide.

Would some of these merging firms be better off remaining single, rather than entering into a marriage which actually reduces their capital efficiency? Maybe, but as we said these numbers can give you an idea of how far these firm’s need to go, in terms of increased efficiency or reduced headcount, so what will be really telling is where these metrics sit in a couple of years time and how the premium per employee of the average ILS fund manager has also changed.

Will the search for scale really help these reinsurers, in a world where capital efficiency and cost-of-capital are increasingly important? The proof will be in the execution and how the firm’s are brought together, which may be something we look back on in years to come and see as a necessary evil in the currently challenging market environment.