Articles - Insurance M&As on the Rise

 Jack Gibson, Managing Director, Global Mergers & Acquisitions at Towers Watson
 Significant Uptick Is Anticipated

 
•   GLB boom never realised. In the U.S., the expectedboom in bank and insurance M&A activity from the 1999 Gramm-Leach-Bliley Act never materialised.
 
•   Lack of available debt. More recently, the lack of available access to debt depressed activity levels.
 
•   Balance sheet management. Companies’ internal focus on balance sheet management and market volatility made it a challenge to structure and close transactions.
 
•   Pricing. A desire to avoid selling at fire-sale prices and depressed equity values across all companies have dampened activity.
 
•   Regulatory uncertainty. Significant regulatory uncertainty — most particularly, surrounding Solvency II — slowed activity. Even so, this will be a driver for transactions and industry consolidation over time.

 But over the next three to five years, we expect a sharp uptick in deal activity driven by an improved economy, gradual recovery in equity markets and company valuations, greater certainty in regulatory environments, and a near-term de-leveraging of balance sheets in the banking and insurance industries. Companies are focused on balance sheet management — de-risking and de-leveraging. A return to core activities and capital markets that are hostile to small players will speed consolidation.

 Companies will seek revenue and earnings growth with increased stability. Opportunities to execute growth and diversification strategies have been presented by the financial crisis that were not readily available pre-crisis. This is most evident from the recent large deals made by MetLife with ALICO, Prudential U.S. with Star-Edison, Ace with the Asian operations of New York Life, and Prudential U.K.’s failed bid for AIA (and AIA’s subsequent IPO) (Figure 1). Further transformation is likely as several European firms such as ING, RBS, LBG, Bank of Ireland, IL&P and others consider significant structural changes following state intervention during the economic crisis (Figure 2).

 Regulation

 Changing capital and regulatory requirements in the U.S. and in Europe will alter the global competitive landscape. In the U.S., the National Association of Insurance Commissioners (NAIC) is working on initiatives to create principle-based reserving and a framework for solvency modernisation. The European Union (EU) is developing Solvency II.

 The influence of Solvency II (both in and outside the EU) is creating some uncertainty about technical valuations and how a new capital regime will affect competition in global insurance markets, as outsiders would be required to have EU-equivalent standards to write business there. Companies are starting to focus on internal capital management by improving risk management and financial modeling. We also see Solvency II acting as a driver of activity levels. Markets will realign to benefit the most capital-advantaged, and companies will reassess the impact of the new requirements on group balance sheets. They will restructure or use M&A to manage or minimise these new capital requirements. Some companies are already preparing for Solvency II either through internal restructuring or Part VII transfers from one insurer to another to free up capital.

 Any significant differences between Solvency II and other regulatory regimes caused by non-equivalence could prompt groups to reorganise their structures or reengineer their intergroup transactions to lower aggregate capital requirements across the group. It may also cause European groups to reconsider the viability of maintaining their holdings in non-equivalent regions, particularly if they are non-core. Solvency II could also disadvantage Europe-domiciled insurers competing globally with insurers based in non-equivalent domiciles. At the very least, it will add a layer of complexity for European insurers compared with their non-equivalent domiciled peers.

 Other regulatory impacts

 The onset of the global financial crisis has also created some difficulties for the CFO Forum’s Market-Consistent Embedded Value (MCEV) project and efforts to achieve greater convergence in supplementary reporting standards. It is difficult to assess how significantly this degree of uncertainty has contributed to current low price-to-book valuations. We still see CFO Forum members publishing significant additional supplementary information in addition to required MCEV or European Embedded Value (EEV) Principles information. This is also reflected in information provided in the course of transactions.

 The proposed Basel III banking reform effort is expected to restrict the extent life company capital can be counted as part of the overall capital of a bank parent. Banks with significant-sized life assurance operations will need to revisit manufacturing and distribution strategies. EU requirements that banks de-leverage, in certain instances, may lead to the demise of the manufacturer-distributor bancassurance entity. We believe this could lead to an increase in closed-book bancassurance sales associated with long-term supplier deals in Europe, Latin America and Asia.

 Capital-Raising Alternatives

 Securing financing and capital-raising alternatives will also pose challenges beyond those raised by regulatory changes. Securitisation — the pooling and selling of pieces of liabilities — is not as popular in Europe as in other global markets. Solvency II, depending on the final Level 2 and Level 3 implementing measures, may continue to diminish this option as a viable source of capital. In the U.S., securitisation is nearly dormant but could return to popularity as economic conditions improve. IPOs are also now considered more viable options. We have seen significant recent activity (e.g., AIA, Delta Lloyd and PZU) or planned activity (e.g., ING, Irish Life and Talanx).

 Buy-side perspectives

 Pre-crisis, buyers’ principal valuation focus was paying an appropriate price that reflected economic valuation based on expected earnings and achieving appropriate ROI hurdle rates. Now earnings volatility, earnings profile and payback, and capital requirements are equally important focal points for buyers.

 Quality of assets, which became a prominent focal point immediately at the onset of the global financial crisis, has remained a significant due diligence issue. Sovereign debt levels and a low-interest-rate environment have raised concerns, especially for economically sensitive or intrinsically volatile products that have typically been priced in an environment where interest rates were above current levels. These products include fixed annuities, variable annuities, traditional participating contracts, guaranteed universal life, unit-linked contracts and long-term care contracts that are very long dated.

 Property & casualty (P&C) buyers are targeting acquisitions to generate inorganic growth that they have not been able to achieve as the soft market continues. This activity has led to smaller niche deals such as bolt-on acquisitions to expand into new lines of business (e.g., Ace’s acquisition of Combined, QBE/CNA Art, Amlin/Lead Yacht Underwriters, Bankinter/Linea Directa Aseguradora and Caser Seguros/Caixa Penedes). We have also seen recent activity in the middle market (e.g., MarkerStudy/Zenith, Catalina/Alea, Sparebank/Unison Forsikring and QBE/Secura). There have also been a lot of runoff acquisitions. Some are renewal rights deals, acquisition of distributors (e.g., MGA/MGU, Ageas/Castle Cover and Ageas/Kwik-Fit) and acquisition of underwriting teams with specific expertise.

 Prospective life insurance deals are much larger, with buyers looking to diversify geographic and product-related risk, secure new sources of distribution or create stronger revenue growth.

 We are seeing signs of an increasing and varied number of interested buyers. While financial or trade buyers have been reasonably active, they have not been as active as we saw in the pre-crisis era. But their activity may increase as their own investors start returning to the market and opportunities emerge within the financial sector. Another catalyst is the surplus cash holdings of some companies that tightened their belts, a discipline that is creating a noticeable drag on the returns they can provide to their investors. This is causing some companies to become more open-minded about the kinds of products and businesses they will consider for acquisition. However, with relatively low valuations, the insurance sector is now a more attractive, strong return-on-equity story.

 Sell-side perspectives

 Immediately after the financial crisis, fire-sale price expectations dampened insurers’ willingness to be sellers. But now, distressed sales are only one of the drivers of seller activity. Sellers are also exiting non-core businesses, reducing earnings volatility and raising capital.

 Insurance pricing conditions, rising equity markets and correspondingly higher insurance company valuations are also factors. There also is pent-up demand from buyers that have stronger balance sheets. We also sense a greater willingness to transact, although negotiations on price and terms remain robust.

 P&C companies that waited for improved market conditions are likely to spur IPOs, and sales or transfers of non-core businesses. Streamlining could affect portfolio managers and consolidate mid-size to smaller firms.

 On the life side, we see similar pent-up supply. However, to some extent, emerging supply has been choked by low equity values and prospective sellers’ internal focus on balance sheet and risk management. Insurance businesses with bright futures aligning with companies with stronger capital will drive mergers and stock-for-stock activity, particularly where risk diversification benefits exist. This will also be the case for prospective IPOs, although timing will be dictated by market conditions.

 Current market conditions bear similarities to the U.K. life industry in the early 1990s. At that time, a financial crisis weakened balance sheets, and prompted de-risking strategies and market consolidation. Growth of the closed fund market resulted. Today, it is reasonable to expect that European markets will respond similarly through local market consolidators or closed funds.

 Valuations

 P&C and life companies are both trading below book and embedded values, reflecting:

 
•   Uncertainty over the future direction of regulation
 
•   Underlying macroeconomic factors
 
•   The continued fallout of the global financial crisis on the financial sector

 These factors continue even as insurers struggle to converge to a consistent reporting measure (whether this is MCEV, traditional appraisal values, IFRS fair value or some other measure).

 Challenges are being created by the ability to finance deals and by significant differences in buyer/seller price expectations. The recent environment has been weighted toward prospective buyers, forcing sellers to consider selling for a variety of reasons. Declining price multiples have made sellers reluctant to accept fire-sale prices, adversely impacting supply. On the demand side, lower multiples created stronger returns on equity, overcoming earnings dilution from pre-crisis transactions. Still, these attractive valuations were not always sufficient to overcome buyers’ reticence in an uncertain market. The significant disparity in buyer/seller price valuation expectations has helped depress transaction activity over recent years.

 Moving Ahead

 Further insurance industry consolidation is likely over the next three to five years. Companies will de-leverage, especially from non-core activities, and mitigate exposures where risk appetite and risk management expertise are limited. Insurers will seek to improve earnings stability through increased diversification across products and geographies. Mergers and acquisitions may be slowed in the short term by regulatory uncertainty, different buyer/seller price valuation expectations and sellers’ capital management efforts. But near term, significantly greater deal flow appears inevitable.