Re/insurance M&A could have upside, alt capital a factor: Goldman Sachs

While the insurance and reinsurance market is engrossed in a search for relevance, scale and diversity of underwriting platform, the resulting M&A activity may present an “upside risk” which could bolster P&C re/insurance shares, despite the clear headwinds, according to Goldman Sachs.

Analysts at investment bank Goldman Sachs, led by Michael Nannizzi, have raised their view of the property & casualty insurance space to Neutral, from Cautious, as they foresee an element of upside risk due to the ongoing and expected to increase merger & acquisition activity in the sector.

M&A is seen as a function of the challenging fundamentals in the insurance and reinsurance market by the analysts, but as it is used to enhance earnings or relevance it also provides upside risk to stocks which could be boosted by this activity. Alternative capital investors are also expected to increasingly play a role in the acquisitions space, having now gained an appreciation for insurance and reinsurance linked returns.

“M&A could bolster shares further despite headwinds from deteriorating fundamentals and the potential for higher interest rates,” the analysts wrote in a report released today.

Given the view that M&A is seen as creating upside risk for P&C insurance (and reinsurance) stocks that are potential candidates, Goldman has adjusted its coverage of these players.

And as a result, the analysts believe that insurer or reinsurer management teams should be obliged to evaluate any potential transactions that come across their desks, given they could create positive upside for their shareholders and investors.

“We believe that management teams should at least evaluate any potential transaction that could serve to unlock shareholder value and/ or support their competitive position,” the analysts explained.

However, the analysts do caution that management teams need to be careful not to engage in transactions that while looking strategic, could place future shareholder value at risk, especially given the softening market environment.

Goldman Sachs said that it believes that more M&A deals are likely, given recent activity, but that fundamental and valuation challenges remain. The analysts expect commercial P&C pricing will turn negative in 2016 and typically stock prices follow this down, they add.

The analysts also believe that benign loss years have been masking deterioration in underwriting margins in property-exposed lines of insurance and reinsurance business, helping to make re/insurer results look more attractive than they are in reality.

Additionally, the analysts expect future rises in interest rates (if or when they come) will add pressure on stocks due to mark-to-market book value erosion.

As a result M&A now might be preferable to a year or two down the line, which could make those companies which have already completed deals, or that are near to completion, look prescient.

“We believe one common incentive to pursue M&A is the desire to offset the headwinds to growth and earnings presented by the current industry outlook, and given how the market has rewarded M&A in the form of higher stock prices, we believe the incentive to pursue M&A has only increased,” the analysts continue.

Goldman’s analysts see three types of M&A currently. Diversifying M&A, which is the type most sought by reinsurers looking for access to new lines or to break into primary insurance and can help to offset the fundamental pressures. Strategic M&A, where most insurance M&A falls, as they try to bring together two complementary books and business strategies in order to better monetise them. And yield-seeking M&A, where investors seek alpha often with an eye on a low correlated returns, this typically involves investors from outside the space looking in and is perhaps less frequently seen.

Insurance and reinsurance M&A levels near to recent historic highs - Source: Goldman Sachs

The chart above shows that in deal volume terms, recent M&A activity is approaching the highs seen in 1998 already, even though the number of transactions remains lower. This perhaps reflects the view held by many, that M&A is only worth entering into if it is going to gain you a significantly greater scale.

Given the high profile nature of recent M&A deals, such as XL Catlin and the most recently announced ACE Group and Chubb deals, Goldman Sachs analysts expect that M&A will become an active talking point at every re/insurer board meeting.

The analysts explain:

“Directors and officers should evaluate all options and assume that any decision to act (or not to act) will be scrutinized in hindsight and create potential risk exposure. One topic would be to evaluate whether strategic transactions can enhance competitive positioning and shareholder value. These transactions are likely to carry the greatest opportunity for value creation, but are also likely to come with the highest price tag. Thus, consideration should incorporate qualitative factors like integration risk, whether from a talent, distribution, or product perspective. Boards should consider transactions that are primarily financially motivated as well, through which management teams believe they can extract value for shareholders in excess of what the companies can reasonably generate on a stand-alone basis. Lastly, boards should also consider how M&A impacts a given company’s position within its competitive landscape—i.e., if competitors combine to become stronger, companies might feel pressure to engage in transactions just to maintain their relative position.”

However, despite the potential positives, the analysts warn that if M&A does not drive clear value creation or erode industry capital, then the basis for valuing these re/insurers will revert to the fundamentals, such as declining pricing. So any upside could be limited, which is perhaps something that shareholders of firms currently engaged in deals need to be aware of.

The capital markets likely has an increasing role to play in M&A, Goldman Sachs analysts explain. The growth of alternative capital structures and insurance-linked securities (ILS) has introduced new investors to the space, which have gained an appreciation for insurance and reinsurance linked returns.

Some of these investors could choose to enter the space through acquisition, as a way to acquire an underwriting platform through acquisition, instead of providing capital through temporary vehicles. This could support valuations, the analysts suggest.

It’s an interesting thought. Many of the large investors in ILS and alternative capital vehicles have come to appreciate the reinsurance business model and its returns, however they do like the lack of operational risk and complexity, that investing via structured ILS vehicles allows.

If a way could be found to bring these large investors into insurance or reinsurance company capital bases, while allowing the operational risks to be shouldered by only a portion of shareholders perhaps, that could be a compelling reason to move into the acquisitions space.

Pensions funds are increasingly investing in insurance operations, and interest is increasingly being shown by the likes of sovereign wealth investors and groups like EXOR. At the same time private equity investors are increasingly showing an interest in ILS and more direct ways of accessing the returns of insurance and reinsurance risks, with a number of start-up initiatives seeing backing from these types of investors now.

Could the capital markets herald a new-wave of M&A? It’s possible, but it will also split investors into the type that like the equity returns and are willing to take on the operational risks, versus those who prefer the less correlated, direct access to insurance and reinsurance risk returns.

Goldman Sachs expects alternative capital providers interest in reinsurance and insurance will continue to grow, as these investors seek ways to pursue risk-adjusted returns from re/insurance, so going one step further than simply adding re/insurance to their existing portfolios to improve returns.

As the focus from the capital markets moves to sourcing risk-adjusted returns, it could increase the interest in acquiring, or financing mergers perhaps. This could lead to interesting attempts to structure deals to allow external capital in to support M&A deals.

The analysts at Goldman Sachs note that they see the risk posed by the continued interest of alternative capital as lowest for primary insurers, given the competitive risk from alternative capital is currently lower.

As capital providers also increasingly look to disintermediate the market, by more closely connecting primary risk and institutional capital sources, this advantage could shrink, as increasingly it is expected that alternative capital and ILS will get into direct competition with some of the large primary players.