Fitch Ratings says, Merger and Acquisitions in the European insurance sector is likely to increase as firms make the transition to Solvency II regulations and profitability remains under pressure.
Low interest rates have driven down profits across Europe and business models have come under strain from reforms in some markets, such as the UK, where pension law changes have hit the market for annuities. This probably contributed to Aviva's agreement to buy rival Friends Life, which should help generate economies of scale for the combined business and would also be modestly positive for the sector as a whole by reducing competition following the pension reforms.
Saturated markets in most big European countries will make buying market share through consolidation an attractive option for some insurers. But we believe deals are most likely among smaller insurers because the upcoming transition to Solvency II regulations is likely to be less problematic for bigger firms.
Larger insurers are more likely to receive a benefit for diversification in the calculation of their capital charges, are generally likely to be better prepared for the new regulations, and have better access to capital if necessary. The rules do take account of an insurer's size using the principle of proportionality, which allows smaller, less complex firms to use approximations(for example to value their liabilities), but Fitch believes that the sharp increase in costs associated with Solvency II will be a greater burden for smaller firms, which are also likely to be less well prepared.
This view is supported by BaFin's recent study. The German regulator found that if Solvency II were already fully in effect 25% of German companies, with a combined market share of 10%, would not meet the capital requirements, suggesting smaller firms were more likely to fall short. The rules will be phased in over 16 years from 2016, so insurers have time to change their business models, restructure and improve solvency, and they could benefit as interest rates start to recover. But the results show they are vulnerable to takeover and some may prefer that option.
From a credit perspective, M&A can be positive if it increases diversification, market share and leads to economies of scale. But often execution risks such as failure to realise expected cost synergies, lower profits than forecast, poor integration of businesses and systems, and subsequent strategy changes leading to losses on disposal prove the overriding rating factors.
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