Clare Bates outlines the slowdown in M&A activity over the course of last year.

Thanks to American International Group's (AIG) acquisition of American General Corp (AGC), 2001 narrowly escaped being a truly pitiful year for insurance M&A in North America. Without AIG's $23.4bn counter bid for AGC (see box), the top ten deals, which totalled $33.4bn in 2001, would barely have scraped the $10bn mark - a shortfall of about $8bn, compared to the $18.3bn total for the top ten deals in the region in 2000 (see tables).

Recent M&A activity has failed to live up to the bumper levels seen in 1998, which yielded a total of 565 deals, valued at $165.4bn. The top ten transactions for the year totalled $69.3bn, more than double the figure for 2001. All of the top ten deals were valued at more than $1bn.

The AIG/AGC deal was just one of a number of transactions in the North American life sector in 2001, a year that saw little deal action in the non-life arena, the notable exception being XL Capital's acquisition of Credit Suisse Group's insurance subsidiary, Winterthur International Insurance Co, for $600m.

One US non-life analyst, who declined to be named, said that reduced activity was the result of companies holding onto business lines in the hope that book value would improve and yield greater sale profits. However, he said, in the short-term this was unlikely to happen.

Losses from the World Trade Center and the Enron collapse are being touted as possible catalysts for increased consolidation in the re/insurance market as companies look to exit unprofitable lines of business and many smaller concerns, unable to replace lost capital, look to exit the market via a sale. But who is buying? With companies such as Chicago-based broker Aon, one of the most aggressively acquisitive companies, now looking to organic growth and some of the biggest names in the market focusing heavily on core competencies, where will the buyers come from?

Life pick-up
M&A activity in the life sector dropped off in 2001 largely as a result of less favourable economic and capital market environments, the immediacy of claims payments following September 11 and a period of post-merger integration after high levels of consolidation between 1998 and 2000. But activity is expected to pick up in 2002 and beyond, as competitive forces including slower organic revenue growth, a converging financial services marketplace and the advantage of size - in terms of economies of scale and ability to ride out economic environments - make growth through acquisition more attractive, according to rating agency Fitch.

Prudential is tipped to hit the acquisition trail again - despite disappointment at not getting AGC - according to Fox-Pitt, Kelton's European Insurance - Outlook 2002 report. Without a major acquisition, which is strongly expected to be in the retirement sector, the UK insurer's US business objectives are unclear, the report states.

The life M&A landscape is likely to become more varied over the next few years compared to 2001, according to Fitch, and is expected to include more insurance company acquisitions of asset managers and stand-alone concerns, and ultimately convergence. Although a number of insurance companies which bought investment management properties in the boom years have been burnt by a significant reduction in value due to the equity market downturn and the subsequent decline in assets under management, insurers that shied away from the sector may again look at asset managers now they are more reasonably valued.

The lack of consolidation in the non-life sector has been put down to investor caution in the sector with one of the biggest problems cited as being the absence of truly comprehensive due diligence. The number of nasty skeletons emerging from the cupboard post-merger, including long-tail liabilities such as D&O and asbestos-related disease, is on the increase - or at least better documented. The acquisition of US firm Combustion Engineering, which has extensive asbestos exposures, by Swedish engineering company ABB is just one of an ever-increasing number of deals to reveal huge liabilities. ABB has also taken a heavy hit in its financial services business. Bermuda-based reinsurer Scandinavian Re Co Ltd ceased trading as a result of the $138m 2001 losses suffered by its parent company, ABB's Sirius International Insurance Corp.

Property/casualty sector
Property/casualty insurance consolidation was conspicuous predominantly by its absence in 2001. Since 1998, when 90 deals worth $40.8bn were announced, the number of announced deals has declined steadily. In 1999 it dropped to 63 deals worth $19.1bn and by 2000 this had fallen again to just 54 deals with a total value of $8.9bn.

The most significant property/casualty deal in 2001 (06/01/2001) was the previously announced purchase of CGU Insurance's US property/casualty operations by White Mountains Insurance Group for $2.1bn. The other notable deal, and the only one to come in above the $500m mark, was the sale of Winterthur International to XL Capital for $600m.

Fitch put the decline in M&A transactions down to changing macroeconomic conditions and industry fundamentals, as well as increased recognition that "there are considerable challenges in realizing potential benefits from an acquisition, and uncertainty that weaknesses and deficiencies of acquired firms may not be discovered in the due diligence and evaluation process."

Although a forecast reduction in earnings multiples in the second half of this year in the property/casualty sector could boost M&A levels as insurers sell off lines and units, Fitch does not believe there will be a significant near-term increase in merger activity in the property/casualty sector, as companies focus on recovering from September 11 and other dramatic changes in market conditions. With property/casualty poised for the best organic growth it has seen since the 1980s, there is less incentive to pursue growth through acquisition.Fitch does not, however, believe there will be a permanent lull in property/casualty consolidation. "Assuming the market environment stabilises and there are no other major shock-loss events in the industry, acquisition activity is likely to pick up sometime in 2003."

Exit strategies
Heavy losses in 2001 have spurred companies to rethink corporate strategies and in many cases make a swift exit from unprofitable business lines in an attempt to stem further profit losses. St Paul Cos, which has put its domestic and international medical malpractice unit into run-off, is opting to shut down specialist business units rather than sell them off.

The firm has also said its reinsurance unit will no longer underwrite aviation reinsurance, bond and credit reinsurance or offer financial risk and capital markets reinsurance products. It also plans to significantly reduce the North American business it underwrites at Lloyd's.

St Paul was the second largest writer of medical malpractice insurance with forecasted written premiums of $530m for 2001 - about 10% of the medical malpractice market. Its departure will cause significant levels of disruption, according to Fitch, as policyholders "scramble to replace lost coverage and other insurers look to increase their market share."

Fitch believes that similar action could be taken in the future by other companies exiting major lines of business because of concerns about future profitability.

There is also evidence of primary insurance companies retreating from the reinsurance sector. Lincoln National sold its reinsurance unit to Swiss Re for $2bn because of volatile earnings and in order to concentrate on the asset management side of its business.

In December last year, Zurich cut its ties with its reinsurance operations, now known as Converium, which has just announced that it expects to post net income of at least $200m in 2002 and a significant improvement in its underwriting record. Similar moves include: Fairfax's sale of 26% of Odyssey Re Holdings; the retrenchment of CNA Re, Hartford, St Paul and Denmark's Alm; and Copenhagen Re's decision to stop writing new business.

The next high-profile player to hit the exit trail could be General Electric (GE), which is rumoured to be considering the spin-off of its property/casualty business, Employers Reinsurance Corp. GE could not be reached for comment about the spin off, but reports in the Wall Street Journal suggested that plans might include an initial public offering for 20% of Employers Re, which could generate billions of dollars. The move follows Citigroup's decision late last year to spin-off its property/casualty business, Travelers Property Casualty.

Employers Re's parent company, GE Global Insurance Holdings reported losses of $47m in 2001. The bulk of the losses from last year stemmed from an estimated $575m in claims from the September 11 attacks. The decision by Citigroup CEO Sanford Weill late last year to spin-off Travelers Property Casualty is undoubtedly the most significant exit announcement. Economically, the sale of Travelers proved worthwhile; the IPO on March 22 raised about $3.9bn, but for the financial services industry as a whole the move has added to an already long list of questions regarding the merits of convergence.

The offering, which involves the sale of 20% of Travelers to the public before the end of this year and the spin-off of the remaining balance to Citigroup shareholders, depending on market demand, could raise be $4bn and $6bn, according to analysts (see Global Reinsurance, February pages 32-37). Mr Weill's decision signals that "despite the upcoming hard market, many [companies] still have long-term doubts as to the profit opportunities available in the property/casualty industry," Fitch states in its Review & Outlook of the US property/casualty sector.

Bancassurance has never really taken off in the US and in the wake of the Travelers' spin-off it is unlikely to be welcomed - in the non-life sector at least - for some time. Indifference towards convergence has been attributed to complex regulatory burdens and vastly differing business models. The main reason however, is more likely to be that many insurers' lines of business are too volatile to be an attractive prospect for banks, which are already being pushed to make higher revenues than at present - a level that exceeds the revenue levels seen in the insurance sector and therefore undermines the need for banks to acquire insurers.

According to Fitch, the slower, reliable revenue growth of life insurers would be a better bet.

In contrast, the property/casualty sector, for example, has lower and more volatile returns on capital relative to banks, which points to any banking participation in the property/casualty sector being focused on creating fee revenue from sales and brokerage activity rather than retaining premiums and bearing underwriting risk.

Vindication of this is the sale of Travelers.

The 1998 merger of Citigroup and Travelers P-C memorably flouted the Glass-Stegall law prohibiting the combination of banks, stockbrokerages and insurance companies - a law which was repealed in 1999 and replaced by the Gramm-Leach-Bliley Act (Financial Services Modernisation Act). The Citigroup/Travelers deal, the only property/casualty consolidation to originate outside the insurance industry, is now being unwound because of lower run-rate returns and earnings volatility despite Travelers' profitability record over the last few years. The exception to Travelers' clean run was a $52m loss in the third quarter of 2001, the result of $490m in net losses from the WTC collapse.

So why has Mr Weill decided to hive off one of most essential sections of the one-stop-shop jigsaw?

The most likely explanation is that he has recognised that the banking industry has more obvious synergies with life insurance and pensions than with property/casualty, Steve Bolland, senior vice president, Gill & Rosser Inc Intermediaries & Financial Consultants said.

Prior to the events of September 11, ratings agency Fitch indicted convergence would have a greater impact on the life sector, as life insurers continued to evolve further into asset accumulation companies with products similar to those offered by other financial services providers. Fitch also commented: "property/casualty companies would be unlikely to participate in any large-scale financial services consolidation."

In its Review & Outlook of the US property/casualty sector, Fitch reiterated this point. "Following the events of 2001, we now believe that banks and other financial firms are less interested in entering the property/casualty insurance business than ever before. Citigroup' s decision to exit property/casualty insurance in December 2001 was the final `icing on the cake' that solidifies our opinion."

Further to this, the ratings agency stated that the "only plausible reason for a bank to merge with a property/casualty company would be for operational diversification benefits". But it warns that the "trade-off" would be volatility in operating performance that may be "influenced by uncontrollable factors, such as weather."

Fitch's forward projects suggest that a "true merger" between banks and property/casualty insurers will come through marketing partnerships, which it notes "have a long way to evolve before a proven model emerges."

Three's a crowd
American General Corp (AGC) was in demand in 2001. In March, the insurance group was subject to a $24.5bn all stock bid from Prudential - a deal which would have created the sixth-largest insurer worldwide, with complementary product lines and little overlap. The proposed acquisition would have been the largest in insurance history, beating Berkshire Hathaway's $22.3bn acquisition of General Re in 1998. The bid received a negative reaction in London, Wall Street asked questions about the viability of such a transaction, and AGC shareholders indicated that they were not happy with the all-paper nature of the deal as they didn't want Prudential stock.

Valuations for the deal varied dramatically. Prudential's offer had an implied value of $49.5 a share, but a 15% drop in American Depository Receipts (ADRs) and a fall in stock price that saw the original offer price drop to $23.4bn, and at one point to below $20bn. Prudential's stock was savaged by investor concerns that at three times book value it was paying too much for AGC, although many analysts felt this was in line with market values.

The high levels of market and shareholder disapproval left the door wide open for counter-offers. In just three weeks, American International Group (AIG) made an unsolicited counter-offer for AGC, outstripping Prudential's $23.4bn bid offer by $5 per share. Unlike Prudential, AIG put a collar mechanism in place to protect US shareholders from any fall in share price which added to its attraction.

AIG's counter bid increased speculation that yet another high profile company would bid for AGC. Dresdner Kleinwort Wasserstein suggested that General Electric could be another possible bidder.

As Prudential's stock price continued to plummet, AIG CEO Maurice `Hank' Greenberg wrote a letter to AGC CEO Robert M Devlin. In the letter Greenberg stated: "In sum, the transaction we are offering provides to the American General shareholders considerably [more] growth value than the Prudential proposal, through a higher current value and the opportunity to share, as AIG shareholders, in the earnings accretion deriving from a stronger combined franchise."

The tussle was short-lived and AIG won the battle, leaving Prudential with just a $600m break-up fee, which was small comfort to the company that had missed out in quite spectacular fashion.

Extending life
Swiss Re bought Lincoln Re, the reinsurance arm of US insurer Lincoln National Corp, for $2bn. The acquisition saw Swiss Re, the world's second-largest reinsurer, consolidate its leading position in the US market, adding Lincoln Re to its North American life and health unit.

The acquisition provided the Zurich-based company with a 29% share in the US life and health market for reinsurance. Increasing its presence in this part of the US market was important for Swiss Re as the sector is projected to grow faster than the property/casualty business over the next few years.

Lincoln National decided to sell off its reinsurance unit because of unpredictable earnings, and planned to use the proceeds of the sale to buy back stock. It also opted to spin off the reinsurance arm so it could concentrate on the asset management side of the business.

The transaction will be financed through the issue of 28,522,370 registered shares over the next two years. Developments in the capital markets will be a deciding factor in how the deal is ultimately financed and to what extent the board decides to make use of a capital increase.

When the deal was announced, Swiss Re chairman Walter Kielholz said: "Lincoln Re is an excellent strategic fit with our plans to expand our life and health reinsurance business globally and to further strengthen our leading life and health reinsurance business in North America."