Mutual cost-of-capital can resist ILS competition. KBW on Covéa & AXA XL

In response to the reports that insurance group Covéa wants to acquire AXA’s non-life reinsurance operations, the Bermuda headquartered AXA XL Re division, analysts at Keefe, Bruyette & Woods have mused that the lower cost-of-capital of a mutual insurer’s strategy may be better able to withstand competition from the ILS market.

It’s an interesting point and one worth considering, that the mutual insurance group strategy followed by Covéa and similar insurers, may prove to be better homes for the more volatile lines of reinsurance business, than some other global insurers, such as AXA.

AXA has itself struggled with volatility in the AXA XL business, but has been getting the results under control in recent quarters of reporting.

However, analysts don’t seem convinced that reinsurance is considered core at the highest levels within AXA Group and so the majority seem open to the approach Covéa is reported to have made and don’t find it too surprising.

Of course Covéa has been trying to buy itself a global reinsurance operation for some years now, with failed attempts to consummate a deal with PartnerRe and also SCOR.

So the appetite for this kind of acquisition is clear and has always been there, but perhaps KBW’s analyst team hit on a relevant driver.

Diversification has always been part of it, with Covéa largely focused on European retail mutual insurance business.

Adding global specialty reinsurance and catastrophe reinsurance to that has always appealed to the company, as evidenced by its deal to inject €750 million of capital into special purpose reinsurance vehicles managed by PartnerRe, as a way to generate returns from reinsurance business, as part of a settlement of sorts after the acquisition attempt went awry.

KBW’s analysts said that they don’t think Covéa’s reported approach to AXA is related to the market pricing-cycle. Rather they suggest it is more strategic in its naturee.

The analysts expanded saying, “To some extent, we think mutual insurers (like Covea) that can absorb near-term earnings volatility without raising shareholder concerns, and whose generally lower costs of capital can withstand competition from apparently permanent ILS capital could represent better homes for relatively volatile reinsurance businesses.”

Which is very true and some insurers like AXA don’t benefit from the lower-costs of capital that a mutual strategy could generate, making competing with insurance-linked securities (ILS) capital costs more challenging.

Looking at the catastrophe bond market right now is one source of evidence of the capital markets cost-of-capital efficiencies being exerted, as tight pricing indicates through recent months of cat bond issues.

But, on the other hand, AXA itself, within its AXA XL Bermuda operations where a significant proportion of the AXA XL Re reinsurance team reside, also has access to alternative capital and is experienced in leveraging the capital efficiencies of institutional funding alongside its own reinsurance underwriting.

Which suggests AXA too has benefits to derive from holding onto its reinsurance business, volatility management aside.

Through the use of alternative capital it manages, AXA XL can reduce its own cost-of-capital, to the benefit of its parent, while also providing diversification and market access that AXA without its reinsurance unit may not have.

So there are perhaps benefits to keeping the AXA XL Re unit and not selling, which are also related to ILS capital.

Whether the deal closes or not, so far there’s been no confirmation of it even being considered by the parties, KBW’s analyst team said, “We don’t expect it to materially impact the reinsurers’ competitive landscape or to spark additional reinsurer consolidation, since it’s not creating a bigger or more diversified reinsurer.”

In addition, they suggest that, “We also think that most Bermudian reinsurers are more optimistic about the underwriting profitability embedded in current rate levels than the group’s current valuations suggest, which in turn suggests limited interest in selling for prices based on current multiples.”

So there may be a case for Covéa expanding into reinsurance and exerting the benefits of its lower-cost of capital business model to compete with ILS.

But at the same time, the alternative capital and ILS strategies AXA has embedded within AXA XL could perhaps be utilised more to its own benefit, as an additional capital lever.