A huge influx of capital is helping to fuel consolidation within the reinsurance industry. However, size alone cannot guarantee success. Innovation and creative thinking will pay the real dividends in the future. Jeremy Scott explains.
Mergers and acquisitions are transforming the entire landscape of global reinsurance. Between 1994 and 1998, firms accounting for around an eighth of worldwide turnover were swallowed up by competitors, concentrating business into fewer and fewer hands.
According to Swiss Re, itself one of the prime movers in the current wave of take-overs, the market share of the world's four largest reinsurance groups has grown from 22% in 1990 to an estimated 34% today. With 25 out of some 9,000 firms now writing over two-thirds of business worldwide, many of the smaller players are being squeezed.
The development of advanced risk analysis systems has added to these competitive pressures. The increasingly sophisticated means by which the resourceful players are able to analyse and select risks is contributing to better and more finely priced underwriting. In addition, more corporations are choosing to self-insure, and, where outside cover is necessary, demanding more flexible and efficient ways of dealing with their exposure. Although many reinsurers have been quick to respond, launching catastrophe bonds, derivatives and other alternative risk transfer innovations, others have failed to keep pace.
While there will always be room for specialist, niche firms, a significant proportion of the smaller commodity reinsurers, and those that lack the necessary resources, will either have to merge or withdraw from the market altogether.
Although consolidation is a global phenomenon, nowhere has it proved more dramatic than in the US, where the number of reinsurers has dropped from around 125 in the 1980s to barely 35 today. The rating agency A.M. Best believes that this figure could fall to around 25 over the next few years.This M&A activity reflects certain levels of convergence as well as consolidation solely within the reinsurance sector, including for example Berkshire Hathaway's $22 billion take-over of General Re. Announcing the deal, General Re's chief executive, Ron Ferguson said: “The combined entity is a unique and extraordinary business model that provides us with the long term commitment, the financial resources and the optimal platform to serve our clients and, thus, grow our franchise. General Re's future has never been brighter.”
Berkshire Hathaway chairman, Warren Buffet, added: “This transaction removes constraints on earnings volatility that have, in the past, caused General Re to decline certain attractive business and, in other cases, to lay off substantial amounts of the business that it does write.”
Vast amounts of capital have also been attracted to Bermuda as a base. From there it has flowed outwards, as the island's reinsurers look to diversify beyond their catastrophe niche into onshore all-lines business. Recent highlights include ACE's $3.5 billion acquisition of the property/casualty operations of CIGNA and XL Capital's $1.2 billion take-over of NAC Re. Bermuda has now overtaken Lloyd's in the table of reinsurance markets with around 5% of worldwide business. As the island grows in importance and integrates ever more closely into the US and global markets, it is beginning to attract significant inward investment. Among the firms keen to gain a foothold are Virginia-based Markel, who recently agreed a $900 million take-over of Terra Nova.
The pace of consolidation has, to a large extent, been fuelled by the unprecedented liquidity within the industry. In an interview with the Financial Times earlier in the year, Bermuda Stock Exchange chief executive, William Woods, said that the island's leading reinsurers “amassed a lot of capital through smart underwriting and were faced with a choice: give the money back to the shareholders or expand their businesses.” Many other leading players across the world are faced with a similar dilemma. Improved productivity, new entrants to the reinsurance sector, better capital management and the strength of the investment markets have all added to the liquidity.
It could be argued that acquisition merely concentrates this excess cash into fewer hands, rather than giving it an outlet in which to create real value. With claims and premium income remaining fairly flat, much of this capital is being invested into new markets and classes of coverage, alternative risk transfer (ART), equities, asset management and venture capital operations, adding further impetus to the growing convergence of reinsurance and banking. One example is XL Capital's recent acquisition of a stake in the New York-based MKP Capital Management. XL Capital's chief financial officer, Rob Lusardi, said that this is “another means of trying to remain relevant and at the forefront of the integration of the insurance and capital markets.”
Joining forces can offer undoubted advantages including enhanced expertise, economies of scale and a boost to market share. This is proving especially crucial at a time when many clients prefer to place their portfolios with a smaller group of secure reinsurers. With many of the newly enlarged groups posting encouraging returns, analysts are generally in favour of these developments. Swiss Re's interim results, for instance, showed a 49% increase in half year earnings. This was underpinned by the strong performance of the group's investment portfolio.
Swiss Re's overall results over the last five years are indicative of theliquidity and the growing importance of investment performance in the larger groups' returns. While Swiss Re's annual gross premium income showed a steady rise from CHF 13 billion to CHF 18 billion between 1993 and 1998, its investment income virtually tripled from CHF 2.1 billion to CHF 6 billion. The value of its portfolio more than doubled from CHF 34 billion to CHF 77 billion during this period.
The pace of convergence and consolidation is presenting the industry with a host of challenges. How to steer through these uncharted waters was the theme of this year's PricewaterhouseCoopers and Hawksmere International Reinsurance Congress, held in Bermuda, with presentations ranging from “non-traditional solutions to client problems” to “obstacles and opportunities in implementing new securitisation structures”. In this fast evolving market, the effects of price pressure and businessinnovations have also largely superseded the traditional rating cycle.
It is clear is that the current take-over fever will eventually prove unsustainable. Merger can only be effective when it fits into a broader strategy for developing the business and enhancing shareholder value.
Equally, future prosperity will depend on the ability to offer a focused and creative response to clients' specific, yet increasingly globalised, needs. Generally, this will require a combination of cost-effective traditionalunderwriting and more innovative ART instruments. The basis of this dual approach was outlined by Peter Lütke-Bornefeld, chief executive of Cologne Re, in an interview with the Financial Times. Underwriting will remain our “core virtue and core skill,” he said. However, we are also “offering added-value, not least by finding new structures which cannot easily be turned into a commodity.”
As this strategy develops, more of this “core” business will be conducted through the internet. Such e-business has the twin advantages of “connectivity” and reduced cost. A representative can discuss the client's needs face to face, while back room staff in different parts of the world can be putting together a specially designed programme.
The potential of this business model can be seen in the success of Dell Computers, where sales teams devote most of their time to discussing the customer's requirements, leaving all the order processing and other routine work to EDI. A variety of different components are sourced according to the user's specification, adding value to what would otherwise be an “off-the-shelf” commodity product.
The successful reinsurer will need to be more proactive, offering risk management solutions to problems the client may have previously ignored or overlooked. Firms will also be seeking creative ways to cut overheads and free capital. Our own research, for instance, suggests that the outsourcing and guillotining of trapped run off costs could release up to $20 billion.
Finally, what of the bankers' much heralded invasion of the reinsurance market? In a recent survey of leading figures in the industry, carried out earlier in the year, one ceo in particular found the idea rather far-fetched: “Clearly, the financial and insurance markets will continue to converge. But Wall Street will not start writing products which will put reinsurers out of business.
“If you look at the recent debacle over hedge funds, you see that the banks are not very good at handling risk. They leveraged their capital bases way beyond what they could pay. A respected reinsurer would never have done that, and yet these funds were the toast of the markets. Banks won't be dominating the new convergent market. After the recent reverses, banks need reinsurers as partners to take the risks for them.”
While excess capital will continue to spur closer integration, in the shortterm at least, it is also helping to open up new opportunities for a moreknowledge and technology-driven industry. The core expertise of reinsurers will always be in demand, finding new outlets in partnerships with banks and other financial enterprises. Innovations such as e-business, along with the wider focus on risk and how it can be controlled, will call for new skills and a fresh approach to business. The ability to meet these challenges can generate real value and returns for reinsurers.
Jeremy Scott is chairman, global insurance industry group, PriceWaterhouseCoopers.
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