The Bermuda reinsurance market and its participants are being pressured to consolidate, through mergers and acquisitions (M&A), by challenging market conditions and increasing competition, according to rating agency Fitch.
Market pressures continue to ramp up while competition from both traditional reinsurance capital and insurance-linked securities (ILS) or alternative capital sources increases, resulting in a perceived need to achieve greater scale, diversification and efficiencies in order to successfully navigate the challenging reinsurance market environment.
As a result of these pressures, Fitch Ratings explains in a new report that the Bermuda market is seeing increased consolidation activity in 2015, resulting in a number of companies jumping into the merger and acquisition (M&A) forum in order to fend off the competitive stress in the reinsurance market.
Fitch sees this trend as driven by the challenging market conditions which are effectively limiting reinsurers organic growth potential. Fitch notes that record traditional reinsurer capital along with the growing capacity from alternative capital providers in ILS and catastrophe bond form, are together softening reinsurance pricing.
Importantly Fitch notes that there is currently no catalyst for a reversal of these trends, of reducing organic growth opportunities and softened reinsurance pricing, in sight.
So the most recent M&A deal is of course the AXIS Capital PartnerRe combination, which we’ve covered extensively. Fitch notes that it generally views M&A as credit negative, citing the integration and execution risks that other rating agencies have also highlighted as key.
The Bermuda market now appears to be headed for a “wave of consolidation,” Fitch says. A certain degree of consolidation is actually positive for the market, Fitch continues, as “a reduction in the number of (re)insurers and associated underwriting capacity may moderate competitive pressure.”
The lack of adequate returns on reinsurance underwriting business is expected to continue to apply pressure to consolidate on reinsurers in Bermuda. They will likely seek organic growth as well as acquisition, to move into specialty lines of business and markets such as Lloyd’s of London in search of better margin business, Fitch explains.
Fitch notes that those who manage to execute an M&A deal well will stand to reap the benefits, saying; “Successful execution of an acquisition could provide longer term positive credit benefits relating to further diversification of earnings and business profile, leveraging the benefits of a larger organization.”
Absolute size of capital wielded remains an important factor in the reinsurance industry, so in this case size does matter. Fitch explains; “In the current competitive environment, stronger, more established reinsurers are maintaining capacity at the expense of smaller, weaker players, as cedents concentrate treaty participation with fewer individual reinsurers.”
However, size is not everything, efficiency is key too and execution risk can lower the expected efficiency that would be expected as a result of an M&A deal. Also, as we asked the other day, how big is ‘big enough’ to maintain relevance in a tiered reinsurance market where agility is also a key factor.
It’s also worth considering our other point, that as companies go through the execution phase of M&A those larger reinsurance firms that do not need to merge are able to carry on without that additional M&A burden. In fact, the large global reinsurers could actually stretch the gap between them and the smaller, but still top-ten, players making the question of ‘big enough?’ ever more important.
Bermuda continues to embrace alternative reinsurance capital and insurance-linked securities (ILS), Fitch says in the report, noting that “Almost all Bermuda (re)insurers make use of some form of alternative reinsurance and expect to expand their participation in capital market reinsurance vehicles going forward.”
However, Fitch also notes that due to many Bermudian reinsurers focus on U.S. property catastrophe risks, they are actually among the most exposed to the competitive threat posed by lower-cost ILS capital seeking out the returns of catastrophe risk business.
However, some nimble Bermudian specialists could find their own happy middle ground, between alternative capital and balance-sheet, with enough efficiency to maintain profit margins. A mixed capital approach could be viable for a specialist, smaller player, if they can use the leverage and fronting of their balance-sheet to successfully create opportunities for capital markets investors.
This hybrid model has yet to be proven entirely. Reinsurers like RenaissanceRe and Montpelier Re perhaps come closest to fully embracing alternative capital in this way. However to take it to its extreme could mean down-sizing the balance-sheet, while significantly upsizing the third-party capital managed, perhaps even making third-party capital the larger proportion. Then seeking to realise the benefits of the lower-cost capital through the fronting and leverage provided by the balance-sheet arm.
A delicate balancing act, but with the potential to turn a traditional player into a larger ILS player with the benefits of its own fronting and leverage. It could be a compelling direction for some reinsurers to head in, but it will take a brave management team to follow that path over seeking scale through M&A.
So, in essence, reinsurers could actually be undoing some of their own efforts to improve margins by accessing or managing alternative capital and ILS, unless it is with some discipline and with a defined strategy in mind.
It’s also worth considering that while burdened with M&A execution risks, and perhaps at the same time seeking to grow their use of alternative capital, a Bermudian reinsurer could risk the specialist ILS managers and the large global reinsurers both leaving them behind as they carry on forwards with a focus on their core business (again unburdened themselves by M&A implementation).
This all suggests that while many reinsurers are eventually expected to seek out M&A of one sort or another, it must be approached with care and a clear strategic plan for how to bring two companies together in an efficient and cost-effective manner, which has the least disruption possible for the existing business.
Interestingly, while the pressure to become active in the M&A market is increasing, Bermuda reinsurers remain profitable and are likely to again report good results, Fitch explains.
“Favorably, Bermuda (re)insurers will report a second year of solid operating results in 2014, driven largely by continued low catastrophe losses,” Fitch says. The rating agency expects the full-year 2014 combined ratio for the group of 15 large Bermuda reinsurers that it tracks to remain near the 86.4% posted through the first nine months of 2014.
However, Fitch notes that expected continued softening market conditions and a potential return to more normal catastrophe losses could create real earnings pressure for reinsurers in 2015. While margins continue to be eroded, if catastrophe losses increased a lot reinsurers could suddenly find themselves reporting much less favourable numbers.
Fitch still considers that pricing across most re/insurance lines remains generally adequate, however it notes that returns are nearing the cost of capital at which profitability disappears. This could be another trigger for M&A, as firms that fear underwriting at or below cost-of-capital will likely seek diversification and the fastest way to achieve that right now may be M&A.
There is no sign of the market pressure relenting, which means that Bermuda reinsurers will remain a focus from an M&A point of view. Companies should think carefully before jumping into a deal, ensuring that the end-result is likely to propel them to a level in the market where by they can prosper and grow.
M&A deals which don’t result in significant synergies, cost-savings, efficiencies and growth for both parties, just seem more risky that they might be worth. No doubt, for some of the mergers that are either underway or will be in the near future, the question will at some point be asked: Was it worth it? Perhaps in some of these cases where the answer is no, the hybrid or mixed-capital approach would have been a better strategy?
You can access the full Bermuda 2015 Market Update from Fitch Ratings via its website here.