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Efficient reinsurance capital forcing change, M&A inevitable: Nomura


The evolution of the reinsurance market, as it embraces and adapts to new capital from alternative sources and insurance-linked securities (ILS), will see change forced upon the incumbent reinsurers and mergers and acquisitions (M&A) becoming inevitable.

So says the latest research report from analysts at investment bank Nomura. The analysts discuss the evolutionary process that reinsurance has been undergoing for a number of decades, with the first catastrophe bonds issued in the 1990’s to reinsurance linked investment funds and specialists and more recently the influx of alternative capital disrupting the status quo.

Nomura’s analysts expect that the continuing evolution of the reinsurance market, with the introduction of alternative capital a leading force, will see a more efficient business model emerge that will force change on the reinsurance industry as a whole.

This is the disruption, innovation and convergence that Artemis writes about on a daily basis. The evolution of the reinsurance business model is now becoming apparent enough for analysts to warn their clients that this is an industry facing, perhaps dramatic, changes.

It was Frank Majors of the largest ILS investment management firm Nephila Capital who called ILS capital efficient capital, preferring the term to alternative, and it is these efficiencies of lower-cost, an ability to recapitalise quickly, appetite for risk and diversification and an innovative approach to structuring reinsurance contracts that are driving change through the traditional market, whether it likes it or not.

The property and catastrophe reinsurance market has borne the brunt of the changes forced upon it by new and more efficient capital sources entering the market, but now the ILS and alternative reinsurance capital market is developing a taste for other lines of business.

As a result, the Nomura analysts say that they expect pressure on pricing across lines of business in both the reinsurance and insurance markets, with alternative capitals set to double in the coming years according to estimates. As we wrote here yesterday, similar effects are converging on P&C insurers with the results being a slow down in rate advances. That may now spread further over the coming years if the efficiency of new capital sources continues to become a norm within the reinsurance marketplace.

Nomura’s report is related to the Bermuda reinsurance market and the analysts said that while it will be forced to change it will likely adapt and increasingly become a hub for this more efficient ILS capital. Nomura expects the Bermuda reinsurance market to adapt to change, something it has already been doing for a number of years.

Consolidation in the form of mergers or acquisitions, however, is inevitable say the analysts. As pressure continues to build up on the traditional reinsurance business model existing players will continue to adapt, but M&A may be in some of their futures as they find merging a route to survival.

The analysts say that there may be some involved in M&A who we currently do not expect to be targets or targeting mergers. This could be a way for some of the larger players who are more immune to market conditions to achieve rapid growth by acquiring those under pressure. The analysts note that the pressures of a bad soft market cannot be underestimated, suggesting that this could affect anyone and we shouldn’t be surprised if M&A news involves companies we might never have expected it of.

In M&A the buyers will have the upper hand, believe the analysts, with economics favoring them over sellers and those needing to sell unable to achieve significant premiums to market prices. Buyers in M&A could gain from size, diversity, expense cuts, new expertise and underleveraged balance sheets, said Nomura, making M&A a tempting proposition for those in the buying seat.

In terms of the evolution of the reinsurance market, the Nomura analysts believe that the recent price and rate declines are just a first wave of change faced by reinsurers. There is more to come and efficient capital from ILS and alternative sources will be a leading cause of change for the traditional reinsurance market.

Nomura cites the “Tidal wave of alternative reinsurance issuance in the form of catastrophe bonds, collateralized reinsurance, retrocessional reinsurance, and industry-loss warranties.” Nomura expects this to continue and notes the efficient nature of lower-cost ILS capital on a fully collateralized basis as well as the continued attraction for investors in a new and diversifying asset class with low-correlation to wider financial markets.

Nomura expects the pricing environment in reinsurance will be the driver for this inevitable consolidation and M&A that it expects. Previously unwilling participants in M&A may have no choice as they need to become more efficient themselves to compete with the more efficient sources of capital.

Lay offs are possible as reinsurers seek to reduce expense ratios and pull back from unprofitable lines of business, but Nomura believes this would be the beginning of capitulation for reinsurers and a sure sign of M&A ahead. Also the new initiatives that reinsurers have set up will not be enough to save them from the pull of M&A unless they are meaningfully underway already.

This is a good point and relevant to reinsurers that have established third-party capital initiatives. These initiatives are not going to be enough alone to compensate for lost income from lower pricing and pulling back from competitive areas of the market. Unless these third-party capital units are established and making good headway they are unlikely to make the difference when the expense ratios begin to climb, as may be witnessed later this year.

Once decline begin they simply worsen, said the Nomura analysts, perhaps suggesting that for some reinsurers taking one step on the slipper slope will be enough to see them heading towards M&A:

Should total premium volumes or assets decline too much, clients may no longer be comfortable using a small balance sheet reinsurer.

We are not there yet. But we expect that, over the next 12-18 months, managements are increasingly likely to see that they are better off selling while they still have a franchise intact to sell.

There remain some wildcards which could see the trends reversed, to a degree, with major loss events, timing, entrenched management and rising investment yields potentially able to stave off M&A. However Nomura believes that managements will capitulate to M&A as the softening reinsurance market forces them to salvage what value they can via M&A.

Nomura’s report might be a difficult read for some in the reinsurance space, however it is accurate. The evolution of the market begun as a result of growing interest in ILS and the returns of reinsurance linked investments is set to accelerate. The effects have been exacerbated by the high levels of capital among traditional players and their highly competitive response to ILS.

As we said in an article yesterday, ILS and alternative capital cannot alone be blamed for the steep declines in pricing, however they have been able to take advantage of this by responding to traditional reinsurers competitive natures to match them on price. As capital market interest reinsurance continues and looks set to grow the reinsurers may be left feeling like they can do no more to compete as prices hit a profitability floor.

The potential for M&A is certainly looking more assured by the day, as market conditions show no sign of changing and the mid-year renewals look set to see prices slashed further again. As the impact of price declines begin to bite later this year and expense ratios start to look less attractive, we may see the M&A wheels start to turn more meaningfully.

Innovation could be the one saviour for reinsurers, initiatives to move into new regions of the world or new lines of business, or the creation of new markets and products could provide a lifeline.

Reinsurers will have a choice, adapt, innovate, evolve or capitulate. The first three are within most reinsurers grasps. However for a few reinsurers it may be too late by now if they haven’t already put the wheels in motion to embrace change proactively rather than always reacting to it.

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