Everyone seems to agree that 2007 will see an increase in M&A activity in the reinsurance sector. But what is less clear is whether any of the deals will represent good value for the shareholders of the companies involved. Lindsey Rogerson investigates.
In its recent renewals report, JLT Re hit the sentiment nail on the head when it described a rise in merger and acquisition (M&A) activity as "inestimable". The report said: "One of the consequences of excess capital is continued M&A activity. In a capital-rich environment, growth is harder to come by. Some companies, especially mono-line reinsurers, may start looking for diversification through acquisition. On the other hand, the shortage of affordable retro coverage has already put pressure on smaller insurers and will continue to do so. The ability to reduce outward reinsurance costs through M&A may prove attractive to a number of players."
However John Marra, a partner in the transaction services practice of PricewaterhouseCoopers (PWC), believes that M&A pressure is coming not just from reinsurance companies but from the money men as well. Marra suggested that private equity firms could already have one hand on the exit handle when he said he believed their patience for returns was beginning to wear thin, which would "precipitate more deal activity as they looked to monetise returns from this lucrative sector". PWC singled out the property and casualty sector in particular as one to watch in 2007.
Sharing the wealth
Using the example of recent European deals, Andrew Crean and William Elderkin, insurance analysts at Citigroup, questioned whether such deals really represent value for shareholders. "The main justification for these transactions has been on the extent to which they are 'EPS (earnings per share) accretive'. However, this is an extremely poor way of judging value creation - no company has focused on return on investment (ROI) and even fewer have judged how this compares with the company's current implied cost of capital. If the ROI is lower than the cost of capital implied by the current share price then companies should clearly be buying back their own stock first."
Even letting EPS accretion hold sway, Crean and Elderkin contend that the deals done to date represent poor value for shareholders. They calculate that the potential EPS for the Swiss Re/GEIS deal is 0-3%, 7-8% for SCOR/Revios and 10% by 2008/2009 for Catlin/Wellington, although much of the latter comes as a result of the leverage employed in that deal.
Citigroup continued: "Given this situation, it is not surprising that these transactions were not welcomed by the market. This was further exacerbated by the fact that the equity issuance to fund the deals was occurring at the same time and with shares prices at their annual lows. As a consequence the subsequent relative performance of the acquiring companies has been uninspiring."
The reinsurers concerned all beg to differ of course. In fact SCOR, whose deal with Revios rocketed it to fourth spot in the global life reinsurance table (see figure 1) and which is now aggressively targeting Converium, only ever said its EPS would be 7% in the first year after the deal went through, rising to 10% in the second year (see figure 2). For its part, Catlin cites the evidence of its 1 January 2007 renewals that it will be able to deliver value to shareholders going forward. Stephen Catlin, chief executive of Catlin, said: "We have been very encouraged during our 1 January renewal season by our ability to retain quality business." The company also added that it had lost considerably less business at renewal than it had anticipated when it announced it was taking over Wellington last year.
As the oft-quoted mantra of the reinsurance industry tells us, keeping quality business on its book is important, if not the most important thing for any reinsurance group, as it is key to delivering profits down the line. Nick Martin, an investment analyst for the Hiscox Insurance Portfolio, believes it is still too early to say whether or not the Catlin deal will deliver value for shareholders.
Hiscox has maintained its holding in Catlin through the merger with Wellington and is taking a distinctly longer term view of the deal. Indeed, Martin thinks that if successful, the Catlin deal could act as a wake-up call to other Lloyd's players. Specifically, he thinks Chaucer, Atrium and Kiln will have their eyes on how the Catlin deal pans out. Martin said: "I think we are going to have to address the size issue at some point soon. Some reinsurers are increasingly sub-scale in a world of regulation and everything that entails in terms of cost."
In fact, Martin thinks that Lloyd's could prove the hotbed of M&A activity this year. In particular Hiscox thinks Bermudian groups could start to pick off Lloyd's reinsurers. A feeling that was reinforced on a recent trip out to the island when an "unnamed" Bermudian reinsurer, who for years had not had one good word to say about Lloyd's, began singing the praises of the London market. If Ariel Re does announce it is buying Lloyd's insurer Talbot, as it has been tipped to do, it could signal the start of a major trend.
Several things have come together at the same time to bring about this change in attitude and Warren Buffett's decision to purchase Equitas is the most obvious. The $3.8bn deal has served to bring many former doubters around to the idea of investing in the London market, assuming that if it is good enough for Buffett then it will be good enough for them. That, coupled with plentiful capital reserves and the obvious tax benefits of buying a Lloyd's company with a good book and then putting some of that business through Bermuda, make a convincing argument for purchase.
Martin added: "I think if you saw Bermudian companies coming in to buy Lloyd's companies you would be looking at premiums probably above 20%." He also believes there could be a move by some US companies to merge with Bermuda-domiciled reinsurers as it would be less publicly controversial than if they simply announced they were to move to the island. "What Hiscox have done by effectively moving to Bermuda would be frowned upon in the US but there is the alternative option for a US company to merge with a Bermudian company."
That said and despite being convinced that if there ever was a time for consolidation in the reinsurance sector it is now, Hiscox is not prepared to engage in market speculation. Martin says that the likelihood of a company becoming an M&A target would never outweigh the fundamentals of a company when it came to the decision of whether or not to buy.
- Lindsey Rogerson is a freelance journalist.
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INVESTMENT - TWO LIKELY EUROPEAN TAKEOVER TARGETS
Chaucer - Outperform, market cap EUR0.4bn. The Lloyd's insurance market is a natural place for Bermudians to seek to achieve diversification. Just as Lloyd's insurers have valued the tax environment in Bermuda, so Bermudians may come to value the capital flexibility and access to a wider range of attractive markets through Lloyd's. Equally, Catlin/Wellington demonstrates that the Lloyd's market itself offers opportunities for internal consolidation. Chaucer has relatively attractive valuation multiples and a small market capitalisation with a high free float. It has relatively high cash generation and a management willing to consider consolidation, as seen in the aborted talks with Amlin in July 2005.
Converium - Underperform, market cap EUR1.5bn. KBW's cautious outlook on the reinsurance pricing cycle and the considerable uncertainty about Converium's ability to source attractive business as conditions deteriorate make it fundamentally negative on the share. However, as the business recovers, it could generate a reported earnings recovery that is more rapid than it has factored into its 9% RoEs in 2007/2008. This, in turn, could attract a Bermudian vehicle that is looking for a step-change into a global franchise. Converium's comfortable capital position and greater certainty on its reserve adequacy may prove enticing (as has already been proved by SCOR's interest in acquiring the company).