The fact that two insurance and reinsurance firms of the size and scale of XL Group and Catlin Group have felt the need to come together, in order to achieve even greater scale and relevance, is a “sign of how bad the market really is”, according to analysts at KBW.
Having had time to digest what XL’s acquisition of Catlin really means for the market environment, other potential acquirers and targets, the KBW insurance equity analysts led by Meyer Shields said that “this deal highlights how truly challenging the reinsurance market environment has become.”
KBW said that just a month ago it hadn’t been considering the prospect that XL and Catlin would be doing a deal, as they felt that the two re/insurers would have already had sufficient scale and relevance to enable them to survive. Had this really been the case the analysts said they do not think that either management team would have gone through with the hassle of a merger. The fact they are shows that the situation is potentially worse than at first thought.
So the market looked bad but as it turns out conditions for reinsurance firms may be worse than appreciated and the XL Catlin deal could show just how desperate things may get. The question is, what level of scale is required to be truly relevant going forwards?
Is it the size of a combined XL Catlin? Or the size of a combined RenaissanceRe and Platinum? A Validus after the acquisition of Western World? Or perhaps even bigger? Just how far will the merger activity go and how many reinsurers are going to be left standing in the end?
The other question is why? Is it to achieve this scale and broader diversification and reach? Or is efficiency the really important factor here if traditional reinsurance firms are going to be able to compete with growing amounts of capital markets money in the form of ILS funds and managers?
If indeed efficiency and achieving a lower cost-of-capital is actually as important, are these mergers going to help in that respect anyway? Typically, merging two businesses results in costs, expense overflow and can take years for efficiencies to really be realised. Will that be fast enough to help these companies get to the level of relevance they really seek?
These deals raise many questions. How big is big enough? How efficient is efficient enough? How quickly can the benefits be realised? If all the smaller players start acquiring and merging and get bogged down in the process this entails will the largest global reinsurance firms, who aren’t in the middle of a fundamental M&A, get the chance to accelerate their domination of this market?
As ever, many questions that we likely won’t know the answer to until further down the line as some of these M&A deals come to fruition.
KBW’s analysts say that they expect the market to respond and that the large reinsurance firms are likely to say that this deal doesn’t affect them, that it is irrelevant or maybe even positive for their businesses.
KBW explains; “Given both the implicit vindication of their business model when contrasted with the challenges faced by the smaller, more property-catastrophe and regionally limited Bermudian reinsurers, as well as the potential for marketplace disruption as two large competitors combine to form the world’s eighth-largest reinsurer (on a pro forma basis).”
However KBW is not convinced by these arguments, saying; “While we agree that this deal highlights the advantages of the multi-line, multi-region reinsurance strategy, it creates another reinsurer likely to compete on a similar footing with the existing larger European reinsurers, so the improvement in perception is more than offset by the actually more-competitive reality.”
The analysts also believe that the combined XL-Catlin is likely to be more aggressive in the market, because; “Why create a (stronger) tier 1 reinsurer if not to compete more aggressively?”
Bermudian reinsurers seeking to diversify away from property catastrophe risks are seen as the most likely acquirers. However, the analysts note that while more consolidation is likely the reinsurers in the mid-tier, of positions 6 to 20 in the world, may benefit from the Solvency II world which supports diversification of the reinsurance panel.
This leads us to wonder whether the mid-tier, positions 6 to 20, now include the larger ILS managers of the world. In the Solvency II, reinsurance diversification world, it may not just be mid-tier traditional reinsurers that benefit as this will put them up against the ILS managers whose fully-collateralized capacity may also win them diversification points.
KBW believes that reinsurers may try to position themselves in this sweet spot, of position 6 to 20 in the world. The top positions are out of reach unless a firm is bought by a major reinsurer, but these mid-tier positions could be the best place to be for the moment, although definitely squarely in the range where competition with ILS could be at its greatest.
On primary insurer consolidation, the KBW analysts say they are; “Less confident in XL’s stated rationale for primary insurer consolidation, since we see little historical evidence for the proposition that bigger underwriters produce better underwriting results.”
They continue; “In our view, underwriting success is typically a consequence of culture, agility, and expertise, none of which are necessarily tied to size. Obviously, some fixed costs should decline when companies combine, and we (eagerly!) concede that the currently overpopulated insurance space is itself inefficient, but we still see significant risk for primary insurance acquirers, ranging from the risk of faster loss cost inflation (potentially affecting both reserve development trends and current accident-period results) as the U.S. economy recovers, to potential lost business as brokers and insureds look to avoid over-concentration, to the more mundane risk of employee morale (and for casualty lines in particular), distracted decision-making can have long-term negative effects.”
So, while acquiring primary insurance business may be attractive and a stated target of some reinsurers looking for broader diversity in their books, the merging of them may not have the desired effects, the analysts believe. Although the analysts note that perception here could be everything and if enough market participants believe that insurer size matters we could see more consolidation here as well.
Bermudians are, even at the smaller end, more likely buyers than sellers, the analysts believe. As any company with excess capitalisation, as all the property catastrophe players now have on the back of some low loss years, could be viewed as a potential buyer.
The transaction is also expected to fuel the debate on Lloyd’s and how it maintains its relative benefits for its participants, especially in a market that increasingly consolidates and where origination becomes more open.
There are many potential targets for acquirers to look at, the KBW analysts note, but not all deals will be attractive as not every pair of insurance or reinsurance firms will have the clear expense synergies or look like such a good pairing.
In conclusion the analysts say; “We believe that consolidation in the reinsurance market is a defensive response to deepening profitability challenges and that the XL / Catlin proposed deal highlights this risk as well as (hopefully) addresses it for them.”
The reinsurance market challenges may be much worse than originally thought. The January 2015 renewals showed that pricing continued to deteriorate despite underwriters hopes that a pricing floor would be found when pricing neared return hurdle rates. It can get worse still, the KBW analysts state, with Europe a region where softness could have a way to go.
The fact that XL and Catlin are to come together does perhaps show that the market is worse than had been appreciated. Or perhaps it shows that the management of these two firms have been prescient enough to take action before things get too bad for a deal to even be done.
If catastrophe reinsurance pricing truly does go below traditional reinsurers technical return hurdles, as many have suggested is possible in 2015, the shareholder base may not support any M&A activity which could worsen their returns in the short-term with no guarantee of seeing a successful recovery further down the line.
Of course, the other option for smaller insurers or reinsurers might be to avoid the M&A bandwagon entirely and try to innovate to find something to do with all this (super)abundant re/insurance capital.