Industry consolidation is a classic feature of the insurance cycle. But while buying a company can be relatively easy, buying the right company is far more difficult, writes Roger Crombie.

PartnerRe’s purchase of Paris Re renders obsolete the debate on whether consolidation is coming to the reinsurance sector, following as it does hard on the heels of the tussle for control of IPC Holdings.

Now the discussion centres on how much consolidation is to come. The calculation relies on unknowns, such as the speed with which the liquidity crisis eases, the severity of the 2009 Atlantic hurricane season and, to an equal but less knowable degree, the personality match between potential acquirers and their targets. Buying a company, the example of IPC notwithstanding, is easy enough to do. Buying the right company – merging cultures, personalities and reinsurance books – can be the devil’s own work. Most mergers destroy wealth.

Larger profits are not the single driving force right now. Among the many others, survival is key for those mid-sized companies likeliest to feature in the forthcoming war of attrition. Improving the bottom line is never unwelcome, but having a bottom line to improve is far more important.

Beneath the radar in the convoluted IPC story lies a key difference of opinion. Rating agencies argue that IPC’s status as a monoline – more than 90% of its book is property catastrophe reinsurance – somehow renders its business model invalid. The agencies adopted that view after Katrina tore though monoline balance sheets, as it had through the ninth district of New Orleans.

Tell that to the management of the three companies (when GR went to press) that have expressed an interest in snapping up IPC. All three are already concentrated in the same discipline, albeit not to the same extent as IPC, and would be more so if they were to acquire IPC.

Alone among the “class of 1993”, IPC has stuck to its core competence. The others have either been bought (of which more in a moment) or broadened their lines. IPC has prospered as a standalone entity, in line with, but in a different manner from, RenaissanceRe and PartnerRe. The message from the rating agencies appears to be: focus less on what you know, and more on fields in which you have no experience.

The drivers behind the IPC acquisition were primarily price, scale and diversity – in that order.

Each of the bidders, had they won the prize, would have diversified their book away from property catastrophe as soon as was feasible. Each would have maintained the IPC brand in its portfolio and then broadened their pre-deal books to achieve the desired diversity. PartnerRe’s purchase of Paris Re, despite the buyer’s relatively massive size, appears to have been driven by similar thinking.

Industry consolidation is a classic feature of the many insurance cycles. In simple terms, the hardest of market conditions offers opportunities to grow new franchises, and the soft markets that follow offer the best-managed (and perhaps luckiest) companies the chance to invest some of their organically-produced earnings in further growth through acquisition.

So it has been in Bermuda, at least since the market took off in 1993-944 with the introduction of $4bn of property catastrophe capital. The eight companies that propelled Bermuda into the big leagues were soon reduced to three as the hard market that spawned them gave way to over-supply.

“It seems likely that the IPC dogfight has sounded the opening bell for a bout of consolidation in the Bermuda market.

Within five years, ACE and XL Capital had bought four, using the accumulated earnings from their first decade in Bermuda. One, LaSalle Re, experienced problems and the other three survived to reach their 15th birthdays in 2008. The cycle is a constant; timing is not. Just because the “class of 1993” lasted five years before being reduced to a rump did not mean that the “class of 2001” would automatically follow the same pattern.

Indeed, it didn’t. Almost eight years since their formation, although a couple have recently evaporated, not one of the dozen majors formed in the 90 days after 9/11 has yet been acquired.

Why? Because every cycle is different, and because these seven years have been the most tumultuous in insurance history. Because most of them operated a new model, combining insurance and reinsurance under the same parent, making themselves more attractive to rating agencies but less attractive to specialist reinsurers. Because their owners have been satisfied with their performance and the non-correlated risk the books of business bring to their balance sheets. And, lately, because softening markets have been affected by liquidity constraints in the capital markets.

Nevertheless, it seems likely that the IPC dogfight has sounded the opening bell for a bout of consolidation in the Bermuda market, both as acquirers and acquired. Who will the likely candidates be? The same names potentially appear on either side of the equation. A confused stock market undervalues insurers and reinsurers at present, which is a key condition for a wave of mergers and acquisitions. How much more attractive might a marginal candidate for acquisition look if it could be had for less than book value?

The cases of IPC and Paris Re show that the likeliest acquirees would have capital and surplus somewhere between $1bn and $2bn. In IPC’s case, the potential buyers fell into the same category, although PartnerRe shows that few companies would object to strengthening their balance sheet through a sensible acquisition, regardless of their existing scale.

Which Bermuda companies meet the size requirements? In alphabetical order: AEGIS, Argo Group International Holdings, Ariel Reinsurance, Flagstone Reinsurance Holdings, Hiscox, IPC Holdings, Lancashire Holdings, Max Capital Group, Montpelier Re Holdings, OIL Insurance, Platinum underwriters Holdings, Tokio Millennium Re and Validus Holdings.

Assume for these purposes that Flagstone snags IPC, and that both companies are therefore already spoken for. Exclude AEGIS and OIL, which are essentially special purpose vehicles owned by their customers. Assume that Tokio Millennium Re’s single parent is unlikely to want to sell one of the sector’s star performers. That leaves nine mediumsized companies for consideration.

A case could be made on either side of the equation for any of these nine, if the chemistry were right. Most of them are led by men of strong personality, each unlikely at this stage of his career to be likely to enjoy working for someone else. Don Kramer at Ariel Re; Ed Noonan at Validus; Richard Brindle at Lancashire —frankly, it’s hard to see any one of them coming into work in the morning in anything but the top slot. After personalities comes lines of business. If the goal of a merger is diversity, Argo stands out. Its franchise is much broader than most of the others – a plus or a minus, depending on where you stand.

But speculation may be fruitless. What can be said is that we are hard into the hurricane season. It is noticeable that PartnerRe intends not to close its acquisition of Paris Re until after the season has ended. If Flagstone succeeds in the chase for IPC and closes the deal quickly, and the loss profile of 2009 resembles that of, say, 2001, 2004 or 2005, how relieved might Marty Becker at Max Capital be to have lost out in what looked like his done deal for IPC?