Reinsurance M&A won’t ease softening or competitive pressure: S&P

The growing reinsurance merger & acquisitions (M&A) trend won’t stop the softening of reinsurance pricing, the expansion of terms and conditions, or ease the competitive pressures that make M&A a desirable option, warns rating agency Standard & Poor’s today.

With an increasing expectancy that the recent M&A activity could be just the tip of the iceberg, as insurers and reinsurers seek to acquire scale and diversity as a way to defend their market positions, S&P warns that executing an M&A deal will be no panacea for reinsurance firms.

The soft reinsurance market remains, with rates continuing south at the January renewal, and looks set to deepen even further at future renewals through 2015, at least as long as the market remains free of major loss events, S&P explains.

At the same time the rating agency warns that terms and conditions show signs of widening further, as reinsurers use expansion of coverage as a way to secure business and large primary insurers become ever more adept at negotiating their way to broader protection.

As a response, S&P notes that; “Global reinsurers have seen the future, and it requires greater scale.”

As a result a number of deals have been announced in recent weeks, with the latest being this morning featuring Fairfax Financial’s acquisition of Brit plc.

S&P says that this “confirms the challenges that management teams at global reinsurers face in the current soft market” due to the continued pressure on pricing and profitability, as well as the ongoing interest and expansion of third-party capital and insurance-linked securities (ILS) in reinsurance, which S&P says “poses an additional threat to the traditional players in reinsurance.”

However the competitive pressures and softening pricing that reinsurers face, which are largely the stimulus for M&A activity, is not going away, S&P says. As a result any reinsurers that perceive M&A as a panacea to secure their market position against the challenges posed by competition, lower rates and alternative capital may be in for a nasty surprise.

Scale and diversity is not going to protect reinsurers against market conditions. Diversity may help them to find areas of greater profitability where rates are not as impacted and competition not as fierce, but scale does not equal relevance on its own and there is more to making a larger reinsurer profitable than simply adding two together and hoping to double ROE’s.

S&P says that “competitive pressures will remain heightened in reinsurance” and that it doesn’t foresee the recent M&A and consolidation activity alleviating the burden that reinsurers face.

In fact, S&P warns that those reinsurers who do not execute an M&A deal effectively, making the most of newly acquired scale, diversity or efficiency, may actually find themselves at risk of rating downgrades.

“We believe this trend toward greater scale highlights how hard it will be for management teams to defend their market positions,” the rating agency explains.

While the remaining reinsurer singletons seek to adapt and modify their business models to fit reinsurance market conditions and to manage the competitive pressures, S&P warns that “The newly merged reinsurance groups that fail to profitably use their new size and scale or others that fail to adequately defend their business positions could see their competitive position scores–and ultimately their ratings–deteriorate.”

We discussed this in a number of recent articles (such as here and here), that M&A in search of scale and diversity alone will not be the panacea some hope for, as well as the fact that execution risks in M&A and the process of bringing together two large companies could saddle merging reinsurers with additional cost and actually make them less efficient for some months or years to come.

Those reinsurers merging could, unless the transaction is an extremely good fit both culturally and business wise and executed impeccably, actually find themselves worse off, while some who decide to go solo may find this provides them with opportunities to thrive, despite the pressures.

Another issue that has been cited is the fact that bringing together two reinsurers who perhaps each provide 10% of a counterparties reinsurance cover means that the combined entity provides 20%, which to the counterparty may equal unacceptable counterparty credit risk.

So bringing two firms together in the hopes of maintaining all of the reinsurance business they underwrote could actually be a little naive and firms may find themselves losing some positions, or having them downsized, at future renewals as counterparties look to maintain diversity among their reinsurer panels.

S&P warns that no matter how an M&A deal is executed the fact is that the risk-adjusted profitability of reinsurance firms “will continue to underperform recent history” while rates and pricing continues to fall across almost every global line of business. At the same time the expectation is that investment returns will continue at recent relatively low levels, while the benefit of reserve releases is likely to diminish as well.

With lower income from every unit of capacity deployed due to lower pricing, broader terms meaning reinsurers are accepting more risk, lower investment returns, reserve releases looking likely to slow and the potential drag of an M&A deal which results in exceptional costs and perhaps does not generate the efficiency expected, it is easy to see how mergers hold as much threat as they do promise.

The promise, S&P says, is that it remains a fact that “diversified product offerings, larger balance sheets, global scope, and expertise will continue to be differentiating factors for successful reinsurers.”

However, if these factors are not embraced along with efficiency, reductions in cost-of-capital and also a move towards innovative business practices and new products, there is every chance that those companies who do embrace the new world of lower-cost capital and innovation steal a lead on those slowed down or finding it hard to adjust.

The conclusion that can be drawn from S&P’s latest report, titled ‘Reinsurers’ Shopping Spree Won’t Slow Down Falling Rates” is that M&A won’t be easy, won’t necessarily be the panacea reinsurers are looking for and if it isn’t executed well could actually be a negative, at least over the short-term while market pressures remain.

The report says that S&P maintains its negative outlook for the global reinsurance sector as it believes that market conditions signal further deterioration in credit quality for reinsurers through 2015 and 2016.

Capital levels are expected to remain high, pricing expected to keep declining and third-party capital expected to keep entering the reinsurance space, as ILS and collateralized reinsurance grows its share continuously.

This will force risk adjusted returns down further and even though consolidation will mean fewer players it will not mean lesser competition, S&P warns. In fact it could mean heightened competition, as newly merged firms seek to grow into larger capital bases, ILS and third-party capital seeks to capitalise on the reduced reinsurer counterparty landscape and those who don’t seek M&A continue to defend their positions.

Loss of business is a real prospect for some following the M&A trend, as counterparties look elsewhere to maintain the diversity of their risk capital, which could provide new opportunities for ILS and third-party capital to grow further.

The pressure on once profitable property catastrophe business remains, with ILS and third-party capital expected to increasingly take shares of this sector. At the same time reinsurers attempts to expand into longer-tailed lines such as casualty have no guarantee of being successful over the longer term, and could in fact raise risks of rating actions if not well-managed. “Without prudent risk management and measured decision-making, this could be a slippery slope,” S&P warns.

On M&A specifically, S&P explains why this is also no guarantee of stability or indeed survival:

“Despite claims that the recent wave of M&A would yield material cost-savings or potential benefits from diversifying into new regions or lines of business, we believe each proposed transaction largely reflects the reinsurers’ need for scale to compete in the current market. If these transactions get integrated smoothly, we recognize that the newfound scale and scope should benefit these new groups because the companies will be able to benefit from greater product diversification by offering larger capacity to cedants. However, during the next couple of years these new large players will likely raise the competitive pressures for the remaining small players and for the incumbent larger reinsurers that now face new direct competition.”

S&P says to expect an “arms race” for the remaining small and midsize reinsurers to find a partner for consolidation. At the same time those merging could force down pricing even more, due to their larger capital bases.

Part of the reason for M&A is that a larger capital base and the hoped for efficiencies will allow the merged firms to wield a lower cost-of-capital to compete more strongly with those more efficient and with lower cost ILS capital. That could result in a race to the bottom on price, where we see reinsurers increasingly tempted into breaching technical underwriting levels as they believe their new scale and perceived efficiency can enable them to underwrite at lower levels.

As before S&P stresses that; “Reinsurers that can maintain stringent underwriting discipline and demonstrate their relevance to existing clients will be well positioned to navigate the reconfigured market.”

This is key. Who has the skill to execute M&A effectively, to embrace new opportunities, lower their cost-of-capital, increase operational efficiency, leverage third-party capital where prudent and the will-power to avoid entering into a race to the bottom on price.

Those firms that remain staunchly focused on what they are really good at, where their underwriting skills are best put to use and where their expertise lies will stand the best chance of remaining relevant to their clients.

While reinsurers will report attractive results again for 2014, with combined ratios of 86% to 88% likely, according to S&P, that will not continue the ratings agency says.

While pricing continues to fall in 2015 S&P forecasts a much higher combined ratio, in the range of 97% to 102% for 2015, even assuming only average historical catastrophe losses. At that level, taking into account the fact that reinsurers have been accepting broader terms and conditions for almost two years now, the sector could perhaps be considered almost unprofitable compared to just a few years ago.

And if those broader terms and conditions hit home, if catastrophe losses were above historical averages and some reinsurers get hit harder because of the expansion of T&C’s, results could look very bad very quickly.

Could a tiering of reinsurer results, after a catastrophe loss year even only slightly above average, begin to show up who’s been disciplined and who hasn’t? That’s a possibility and if that does happen, those hit by outsized losses and 100+ combined ratios could find raising rates very difficult, or impossible, if half the market has been more disciplined than they.

Scale is a good thing, notes S&P, but reinsurers must use it wisely the rating agency says.

The path to M&A 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 and investment yields are slow to rise.”

“Eat or get eaten” is the game for reinsurers for the foreseeable future according to S&P.

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