Reinsurance M&A no panacea, but momentum to continue: S&P

Merger and acquisition activity among global reinsurance firms is expected to continue through the rest of 2015 and into 2016, with only the strongest expected to have the best future prospects, according to rating agency Standard & Poor’s.

In another pre-Monte Carlo reinsurance report, yes it’s that time of year again, S&P discusses the continued drive to merge or acquire in search of scale, diversification and growth among reinsurers around the world.

The latest report from S&P is titled “Reinsurance Shark Tank—Only The Strong Will Survive,” which is perhaps a little extreme, but accurately describes the desire to merge or acquire among reinsurers right now.

However S&P once again highlights that while it is the strongest (biggest and most diversified) which have the best chances of maintaining a traditional business model through the structural challenges that the reinsurance market currently faces, M&A is itself no panacea in the short-term.

“We believe competitive pressures will remain elevated in reinsurance for the next 12-24 months, and we don’t see the recent spate of consolidation as a panacea to alleviate that burden,” S&P credit analyst Taoufik Gharib writes in the report.

As the management teams of reinsurers respond to clients demands for scale and focus on growth, M&A remains the best way to achieve that in the current market. Organic growth has increasingly been harder to come by for the small to mid-sized firms, making M&A the best way to propel your company into the bigger leagues of reinsurance.

“Global reinsurers have seen the future, and it requires greater scale and diversification for them to remain relevant,” S&P explains.

However scale and diversification is no guarantee of success, with quality of execution yet to be proven and competition spreading out to other areas of the reinsurance market.

But despite any doubts about the M&A strategy of some reinsurers, the market is expecting to see the desire to grow and acquire scale continue to be a feature over the coming year.

“We expect reinsurance M&A momentum to continue for the rest of 2015 and into 2016 as the remaining small and midsize reinsurers race to find consolidation partners,” Gharib explained.

S&P notes that investors (perhaps meaning EXOR), on the other hand, have continued to show interest in emulating the diversified investment organisation and float approach of Berkshire Hathaway, but the rating agency says that “the success of this strategy remains to be seen.”

With no sign of pricing improving over the next year or two and competition set to remain high and in fact likely increase, as the influence of alternative capital and risk management strategies spreads to new classes of business, there seems little to believe the pressure on reinsurers will subside.

As a result the desire to enter into M&A is likely to persist. S&P explains that “for reinsurers, there seems to be a Darwinian concept at work, as only those strong enough to adapt or evolve will survive.”

Adapt is a word perhaps not used often enough in the report, as it is the other option aside from getting embroiled in M&A. However, in order to successfully adapt to manage the challenges that the reinsurance market can throw at them, it’s likely that many reinsurers will feel that scale and reach are required in order to achieve this.

So further consolidation is on the horizon in reinsurance, according to S&P. That will shrink the available set of counterparties further, perhaps enhancing the opportunities for the larger of the ILS fund manager group to get onto more reinsurance renewal panels.

The M&A trend “Confirms the challenges that global reinsurers’ management teams face in the current soft market, including an ongoing downtrend in pricing and underwriting conditions exacerbated by an influx of third-party capital that poses an additional threat to traditional reinsurance players,” Gharib writes.

As reinsurers seek M&A partners to alleviate the pressures, find profitable growth, cost savings and capital efficiencies, they are in turn embroiled in processes which can be lengthy, challenging and costly.

S&P sees no sign of the pressure abating, saying; “We believe the trend toward greater scale highlights how hard it will be for management teams to defend their market positions. Few of these competitive pressures will abate as long as capital remains at or near all-time highs.”

To date, S&P explains most of the M&A deals completed as “defensive in nature”.

“We see some potential benefits to each of the individual deals, if executed correctly. However, we would classify all of these transactions as primarily defensive in nature, as the management teams have taken the view that combining forces with another player will make their companies more viable to compete in the coming years,” writes Gharib.

So no panacea there, as reinsurers defensively look to build scale and diversity, something that other rating agency Fitch said could in some cases be looked on as unfavourable now.

But Gharib explians why this is still attractive to the companies involved; “At a time when organic growth is proving to be challenging for many re/insurers, acquisition is a quicker route to growth for some.”

However he warns that this can also increase excess capital in areas of the market where there is overlap between the two firms involved in the M&A deal, which can result in increased pressures on certain lines.

“The current reshaping within the reinsurance sector, most of which is taking place among the small and midsize reinsurers, will not result in a meaningful reduction of industry capital,” Gharib writes.

Without the reinsurance capital base being depleted at all by these deals, and while reinsurance capacity globally keeps growing thanks to the growth of ILS and alternative capital as well as new entrants to the market, the pressure is set to continue and size won’t insulate you from that.

While scale may not insulate reinsurers from the pressure it could make it a little easier to navigate and provide more options for surviving the challenges that the market currently faces though, so this perhaps explains the continued attraction to M&A.

S&P believes that; “The primary motivation for these transactions is to achieve the scale that management teams deem necessary to compete in the global market. Thus, significant capital returns are unlikely in these deals.”

“The industry is undergoing a reconfiguration that will result in fewer but larger reinsurers,” Gharib writes, going on to explain that the path to that result will be “strewn with challenges in executing and integrating new transactions, growing into new capital bases, and competing against a different set of peers.”

Also, future profitability and capital preservation are going to be difficult for reinsurers to achieve, while pricing remains under pressure and the asset side of the business suffers from continued low investment yields.

“We foresee another competitive and difficult year for the reinsurance sector,” Gharib explains.

With the reinsurance market set to remain soft, the commercial insurance market on the cusp of softening and pressure from new business models, new capital, insurance-linked securities (ILS) and new strategies seeing insurers retaining more risk into managed vehicles, reinsurers face another year of challenges.

The question of ‘how much scale or diversity is enough’ remains unanswered in reinsurance.

While the market remains challenged we may not find an answer to this and it could be some time until we establish whether M&A transactions have been really worth the time, cost and effort for those involved.

We believe it could be some years until we see the reinsurance market find a greater level of stability, by which point some areas of it may be unrecognisable.