Ahead of the mid-year renewals, Bermudian reinsurers find themselves flush with capital and short on opportunity. So with Validus confirming its bid for Talbot, is an M&A frenzy looking all the more likely? Mairi Mallon reports

No storms, breathtaking profits and a softening market. Cash-rich Bermudians are struggling under the weight of fresh capital which has no obvious place to go. That may not sound like a horrible place to be, particularly after the massive losses sustained following the hurricane seasons in 2004 and 2005, but Bermuda’s good and great know only too well that excess capital is a burden when it’s not put to good use.

In the first three months of 2007 alone, the top two dozen companies have made a profit of $3.3bn – over $1bn a month. That is on top of a record-breaking 2006, when the 16 largest Bermuda reinsurance market companies made a combined full-year profit of $11.6bn (according to the Benfield Bermuda Quarterly). The record-breaking profits Bermudian reinsurers continue to enjoy are not just a recipe for mergers and acquisitions (M&A) in Bermuda, but also a signal that companies may return some of the surplus capital swilling around to shareholders where there is little room for expansion.

M&A gets underway

The predicted increase in M&A activity has already started, with a soon-to-be-public member of the Class of 2005, Validus Re, buying up Talbot, and others acquisitively circling Lime Street for similar rich pickings.

M&A activity can be risky. Without the right fit, it can be an organisational nightmare. And many still remember the legacy issues that dogged ACE and XL Capital when they bought their way into being one of the insurance world’s big boys with a flurry of buy-ups. But that will not stop most companies now. “We are scouring the marketplace for every opportunity that gives us our hurdle rate of return”, said Joan Dillard, chief financial officer of Allied World Assurance Company (AWAC) during a conference call with investors at the beginning of the year. But, she continued, if the point arrived where they could not deploy that capital at acceptable rates they would consider returning it to shareholders.

“This statement sums up the challenge facing the reinsurance market as it tries to feed its bulging balance sheets with rates that have drifted down following the dearth of catastrophes in 2006,” says Chris Klein, analyst at Benfield. “The market, it seems, is awash with capital.” He says the 16 companies they follow in the Benfield Bermuda Quarterly reported a 24% increase in shareholders’ funds to $64bn in 2006, an amount almost double what was reported in 2002. Much of this increase came from retained earnings as the companies’ net income totalled $1.6bn compared to a loss of $2.1bn in 2005.

He adds that it was hard to update this picture with the Q1 results as no one yet knows what will happen in the 2007 hurricane season. “When I listen to Q1 results, when people talk about their combined ratios and our annualised return on equity, to me it is just nonsense,” he says. “To me there is no point in looking at it until after November.”

AM Best analyst John Andre agrees that Bermuda companies will be looking to deploy surplus capital and moving into Lloyd’s of London or buying up another company in Bermuda is one way of doing this. Montpelier Re’s chief executive Tony Taylor said in a recent conference call that he is seeking “meaningful opportunities for growth outside the Bermuda market.”

Montpelier, Validus Re, IPC Re and Ariel Re have all been openly touting for Lloyd’s companies to buy. Others are still said to be on the lookout and some say that companies like Platinum Re and Max Bermuda (formerly Max Re) are ripe for takeovers as their books would offer diversity to traditional catastrophe players.

“Some say that companies like Platinum Re and Max Re are ripe for takeovers as their books would offer diversity to traditional catastrophe players

The reason Lloyd’s is so attractive is that it offers Bermuda players a quick way to expand into international markets. And the recent upgrade of the Lloyd’s market rating following the successful completion of phase 1 of the Equitas/Berkshire Hathaway deal, plus the work done on improving contract certainty, has made London an attractive place once again. The fact a pool of money exists to cover any rogue syndicates is also reassuring, making Lloyd’s a safer place to do business. “They have the capital, but they want the access to international markets and the worldwide licences that Lloyd’s provides,” says president of Lloyd’s America, Wendy Baker.

The allure of Lloyd’s

But all of this is nothing new. Bermuda insurers have been tapping the Lloyd’s market for decades, and were the market’s third-largest source of capital in 2006, contributing more than $1bn. Don Kramer, CEO of Ariel Re has made no secret of the fact he has been looking for something to buy. “For non-traditional reinsurers, Lloyd’s is a great place to be,” he says. “It can offer you instant access to the world’s markets. The AIGs and the likes don’t need Lloyd’s, it is the Bermudian companies that do something different that want to be there.” He says that despite the London market being expensive and bureaucratic, the reforms which have been tackling the market’s efficiency have helped.

Kenneth LeStrange, CEO of Endurance Specialty, which was set up in the wake of the September 11 terrorist attacks, says there are a great number of companies either buying back shares or wanting to return capital and says one of the drivers for this is the rating agency rules on excess capital. He acknowledges that M&A activity has picked up and says he expects the trend to continue, adding, “M&A is not attractive to us. Lloyd’s has become a very different place in the last few years. The Equitas/Berkshire Hathaway deal is a big positive, but for us Lloyd’s does not present a strategic advantage. But I can see why it would be attractive to the Class of 2005.”

David Ezekiel, chief executive officer of IAS, a captive management company which also provided a kind of “incubator” for many of the Class of 2001 and 2005 start-ups, is sceptical that much will come of the M&A speculation in the market at the moment. “It is always something that people talk about when rates seem to soften a bit and people say how they will deploy capital. My guess is it will be at a much later stage and I personally don’t think we will see that many, I don’t see a rash of them.” He says the only instance of M&A occurring at an unusual pace would be if the market continued to soften and a sustained volume drop was seen over a period of time.

Angelo Guagliano, president and chief underwriting officer of insurance operations at Max Bermuda says he expects gross written premiums for 2006/2007 to be flat compared to the year before, apart from slight growth courtesy of its excess and surplus lines operation in the US. He confirms that Max Capital will be looking for more opportunities for growth as the market softened. “Considering market conditions, M&A activity is certainly a consideration,” he says. “It is certainly something everyone (in Bermuda) is talking about in the next couple of years.”

And while he could not confirm if Max Capital might now be looking at London he says the ratings upgrade at Lloyd’s, due to the Equitas/Berkshire Hathaway settlement, has made it that much more attractive.

John Berger, chief executive of 2005 start-up Harbor Point, says he does not think there will be massive amounts of M&A in 2007, “but there will be some”. He says that Harbor Point is at a different place from the other start-ups as it has taken over Chubb Re’s book of business and does not have the same need for quick expansion – but he would not outright confirm or deny whether the company was looking to buy. “We have always sought any business that had the appropriate attributes for a merger,” he says. “But we will not diversify for the sake of diversifying. Our business is risk, and it has to be at the right margins. If we looked at the margins and it made sense, was well priced and offered diversification, we would go for it.” Berger says the Harbor Point board had approved share buybacks though. “Given the constraints of the rating agencies, if we have too much capital, we will find a way to return it (to shareholders).”

Still opportunity in Florida

“The Florida legislation has not wiped out quite as much of the property catastrophe business as feared and prices have not slipped as far

The mood in general in Bermuda is still buoyant. The Florida legislation has not wiped out quite as much of the property catastrophe business as feared and prices have not slipped as far. “We are pleasantly surprised with the property/catastrophe prices,” says LeStrange. “They held up pretty well in the 1 January 2007 renewals. The pricing was down from 1 July 2006, but it was still up from 1 January 2006. So we are seeing good signs of discipline.”

James Kent, who runs Willis’ Bermuda office agrees the softening is not as fast as had been feared. “It is a controlled softening,” he says. “Primary clients are able to retain more themselves. They have raised a lot of capital and so are prepared to retain more risk. But there is still a significant amount of reinsurance coming to the island, with Bermuda getting between 40% and 60% of the placement.”

Florida legislation is not quite a damp squib, but “has not been as severe as we first thought,” says Nigel Clark, president of Carvill Bermuda. “Analysts at the beginning predicted a loss of between $2bn and $4bn. Now I understand that figure is more like between half a billion and $1bn.” He says many companies appear to be buying similar limits to last year, just moving it up above the new level of the fund. “Therefore the overall affect was less dramatic than at first thought,” he adds.

AM Best’s Andre says some companies are still finding opportunity in Florida, the main reason being that relationships are still key. “If you are going to use reinsurance prudently, you are going to look to preserve relationships,” he explains. “In case there is a major event it is best to keep the relationship going.”

It was feared that the Class of 2005, about half a dozen reinsurance companies set up in the wake of Hurricane Katrina, would be worst hit by the Florida legislation – yet they all appear to be thriving. However market watchers say it is too early to tell how the new start-ups will fair if and when they are tested by a catastrophe of any size. “We will have to wait and see who wins out,” says Kramer, adding that anyone could have made money in 2006 – and only after a big event would the quality of the underwriting become evident. “Any major catastrophe is going to be a test,” says Andre. “It will show if they have done their due diligence and how the company has written its book.”

Bermuda remains a very attractive market says Andre. “They go to Bermuda because of the ease of doing business, starting a business and certainly taxes.” But he added that the regulation in Bermuda was less sophisticated than elsewhere and may face future scrutiny. Cheryl-Ann Lister, CEO of the Bermuda Monetary Authority disagrees. “The risk-based regulatory framework governing the insurance industry in Bermuda provides an environment in which reinsurers can thrive and be innovative in developing new products, while at the same time ensuring that companies operate responsibly within strict margins of solvency,” she insists. “Maintaining this balance between the application of practical, effective regulation and fostering business development has contributed to Bermuda’s success as a major insurance jurisdiction.”

David Ezekiel is nothing but upbeat: “2006 was a banner year. It is hard to ask for a year that could be better. 2007 has also started well. The mood in the market is tremendous and Bermuda is going to maintain its market lead in this area for a long time.”

Mairi Mallon is a freelance journalist.