Mergers and acquisitions seem firmly in the reinsurance markets future with excess capital, growing competition and the increasing availability of alternative reinsurance capital seen as a source of fuel for the M&A deal-making fire, according to Fitch Ratings.
In its latest report on the reinsurance sector the ratings agency highlights the increasing likelihood that M&A will increase as the reinsurance market has become ripe for consolidation. Reinsurance has seemed a strong candidate for M&A for a number of years, according to Fitch, but the increasing availability of alternative capital is exacerbating key market trends.
High levels of undeployed and excess capital, coupled with the number of small to medium-sized reinsurance firms with limited organic growth options makes the sector a candidate for M&A, said Fitch in its report. A certain amount of consolidation would be a ‘modest positive’ for the reinsurance sector, the rating agency explained, as any reduction in the number of reinsurers and capacity available could ease the competitive pressure.
Alternative capital could add to this M&A trend, by providing additional capital to an already well-capitalised reinsurance market, thus further reducing growth opportunities for traditional reinsurers that find themselves in direct competition for business with alternative or third-party capital and insurance-linked securities (ILS).
These traditional reinsurance companies most impacted by competition from alternative capital, on top of the already competitive traditional reinsurance capital environment, have in some cases already seen their franchise value diminished, said Fitch. Affected companies risk becoming marginalised in the face of competition from the capital markets and could be viewed as prime targets for acquisition.
Despite the environment for M&A becoming more conducive, as valuation multiples have changed to be more in favour of deal-making, there are roadblocks which make M&A difficult primarily a lack of willing sellers as witnessed in the Endurance – Aspen attempted deal. As a result, Fitch says that it expects very few transformational acquisitions will occur.
Various risks surround M&A in reinsurance which also hold back the market from much more rapid consolidation, with the uncertainty inherent in large acquisitions or mergers one factor that leads to fewer completed deals. Fitch cites integration challenges, uncertainty due to regulatory issues such as Solvency II and the potential to erode shareholder value by overpaying, as key risks holding back reinsurance M&A.
One trend being seen is reinsurers deal-making to diversify outside of reinsurance, as evidenced by Arch Capital moving into the mortgage insurance market and Validus’ pending acquisition of Western World. Fitch sees these deals as a reaction to the lack of adequate returns on reinsurance capital and an attempt to improve future return prospects. Fitch says it generally views these diversifying M&A transactions as potential credit negatives for the acquirer, with high execution risks over the near-term.
Consolidation in the reinsurance market would foster a more efficient use of underwriting capacity and reduce undeployed capital, said Fitch, but any meaningful decline in the number of reinsurance markets would also reduce cedents’ ability to diversify their risk exposures.
That could become a positive for the ILS and alternative reinsurance capital market, as if reinsurance markets consolidate meaningfully the benefits of tapping the capital markets as a diversifying source of risk capital could appear even greater to cedents.
Of course we may also see M&A in the ILS space, as lower spreads and returns due to lower catastrophe bond and reinsurance pricing make it harder to maintain targets especially at smaller ILS managers. If reinsurance market conditions persist we could see some smaller ILS managers looking to deal-making as a way to achieve greater scale and more relevance, particularly in the collateralized reinsurance and private ILS arena.
Fitch said that it expects the convergence trend between traditional reinsurers and the capital markets will continue, as reinsurers look for more flexible and efficient ways to manage capacity. Most reinsurers have now accepted that the dynamics of the reinsurance market have structurally changed, as a result of which they are looking for ways to match clients needs to the appropriate form of capital, be that traditional or alternative.
Fitch’s report highlights what many already accept, that the reinsurance market is ripe for M&A due to the increasing capitalisation of reinsurers and that the growth of ILS and third-party reinsurance capital is exacerbating this, for some. As we move towards the January renewals the M&A pressure will likely grow and beyond January we could see meaningful attempts to consolidate and acquire scale emerge.
As the reinsurance market continues to go through structural change, in the way risk and capital meet, are transacted and deployed, the M&A trend won’t go away. For some M&A can be seen as a threat or risk, of being swallowed up by larger players, but for others it is an opportunity, to acquire greater relevance, new diversification, skills, underwriting platforms and entry to new markets.
Read the press release and download the Fitch report here (login may be required).
Read some of our other articles on the M&A trend in reinsurance and alternative capital’s impact: