For insurance and related companies seeking capital, some reinsurers have financial solutions beyond quota share and excess of loss reinsurance. Mindy Pollack shows how a few innovative reinsurers are investing in insurance companies and redefining the role of the reinsurer.
When is a reinsurer like a bank? In a soft market with escalating loss ratios, insurers and reinsurers may feel like ATM machines with more withdrawals than deposits. But aside from their traditional role, reinsurers are taking on other banking and investment functions. They are financing - through loan and investment - the activities of insurance and insurance-related companies.
Providing capital to the insurance industry is not a new concept. Reinsurance is, after all, one form of capital making up the financial foundation of an insurance company. In its simplest forms, reinsurance increases and replenishes policyholder surplus, protecting the asset base of the insurer and allowing it to write more business. Reinsurers have also made cash injections into financially troubled insurance companies. When faced with an insolvent or runoff client, the reinsurer may find that its overall business interests are better protected by tiding the company over until better times.
In recent years a few reinsurers have crossed these established boundaries to become investors in insurance companies, agencies and other industry entities. Through equity or debt, these reinsurers are venture capitalists for start-up companies or management buying out retiring owners or just growing insurers with surplus needs. Sometimes the investment is accompanied by reinsurance, tailored to complement the investment for reaching financial or growth goals, and then the insurer has all its financial needs met by a single source.
Reinsurers are taking on this new investment role just at the time when barriers between insurance and finance are giving way to a more open and competitive marketplace. For the insurer in search of more flexible forms of capital, this convergence of financial products and markets means more choices than the cash from the bank or other loan facility. For the reinsurers entering this brave new world, it means another way to deploy capital and unlock new reinsurance opportunities. For insurer and reinsurer alike, it means a business relationship that endures beyond the next earnings release or renewal season.
Who needs capital?
In an industry awash in capital, it may seem that there are few interested or worthy insurers and agencies for significant investments. Large insurance companies are more interested in premium than capital, and appear more inclined to buy up smaller players or books of business to justify their existing capital base. Small, and certainly new small, companies face enormous competitive pressure to survive, let alone thrive. Who, then, are the buyers and sellers in the investment equation?
The companies seeking equity, or combined equity and reinsurance, are actually numerous and diverse. They may be small, but the similarity ends there. Looking just at the current Risk Capital Re investment roster, there are property/casualty insurers, reinsurers, managing general agencies, investment funds and brokers. However, the list could surely extend to specialty writers, Lloyd's and any other entity operating in the insurance industry. There are no global boundaries here; our investees operate from the US to Eastern Europe and points in between, as there are no geographic limits on capital needs.
The reasons for private financing vary with each segment and company. Growth fuels most of our submissions, where companies just seek more surplus to compete effectively or otherwise reach their business goals. In many other cases, the company is a start-up raising venture capital, or a buy-out where existing or new management wish to assume financial control from retiring partners. Additional reasons include mergers and acquisitions, as well as sales, spin-offs and turnarounds, but in our experience, the first three circumstances - growth, start-up and buy-out - comprise over four-fifths of all submission activity.
Although any reinsurer can theoretically enter the investment arena, relatively few have strayed outside the boundaries of traditional reinsurance. The largest, global reinsurers - like Swiss Re and Munich American/American Re - have formed internal units to market and package their investment capabilities. Risk Capital Re is one of the smaller reinsurers actively investing in insurance companies, and perhaps the only reinsurer created for this express purpose. The only critical characteristic for a reinsurer is having the committed resources - financial, legal, actuarial, underwriting and audit - to make and close the deals.
Investment process and considerations
During its four years in the industry, Risk Capital Re has received over 400 inquiries from insurance-related entities seeking capital other than traditional reinsurance. As with any investment and loan operation, only a small percentage of these submissions progress all the way from initial interest to actual investment. Both investor and investee know the importance of the transaction, as to content and partner, so it is not surprising that fewer than 10% ever reach fruition.
The process begins with pre-screening potential investees for their needs, business plans and ultimate profitability. The reinsurer will study the company's business plan and historical results, and match its findings with the proposed parameters of the transaction. Factors such as the size of the investment, ownership shares and reinsurance opportunities will be considered. While valuation is the overriding consideration, any expectations of future reinsurance premium and losses can influence that assessment.
After both parties are satisfied with the preliminary review, the investment submission moves into a more analytic phase with hands-on audits and interviews. During this period a team from the reinsurer might visit the company to become better acquainted with management and study sample underwriting, claim or other relevant files. The business plan is then tested under various financial models and projections to assess its viability. The reinsurer will also construct various exit scenarios, as the method and timing of any divestment is often critical to maximizing returns.
If both companies are still interested, high level negotiations ensue. A Letter of Intent will set out the key terms of the specific transaction. The structure, amount and price are probably the top three elements, but other details are also addressed. The Letter of Intent may also contain a “no shop” clause to restrict other offers or negotiations, various representations and warrantees regarding the financial condition and legal status of the companies, break-up fees and other expense arrangements, and the exit mechanism mentioned earlier. When the Letter is signed, the parties have probably settled the key issues in any investment.The final confirmatory due diligence efforts may turn up a new concern, such as a tax or regulatory matter just raised by authorities, but typically both parties are focused on closing the transaction and will resolve the newly emerging problem. At this time the final documents are prepared, usually with outside legal input on one or both sides. In addition to the purchase and shareholders' agreements, there may also be employment contracts that are triggered or drafted. When the legal documents are ready, the parties can close the deal subject, as usual, to any regulatory approvals.
The time from original inquiry until closing can range from a month to over six months, depending on the complexity of the transaction, regulatory issues and the interest of both parties. Although no two Risk Capital Re investment decisions are exactly alike, we have found that the process usually takes four to six months, start to finish. Naturally there is substantial information flow during all phases, so any single breakdown in communication from even summer vacations can extend the time line. In any event, both insurer and reinsurer should incorporate some time into their investment process.
Risk Capital Re experience
The link between investment and reinsurance is clear from our premium profiles. Nearly half of Risk Capital Re's core property/casualty reinsurance premium flows from insurers with whom we have investment relationships. Not all of our investees cede us premium, directly or indirectly. Still, these integrated solutions ® of financing and reinsurance demonstrate how effectively these two roles can merge for a reinsurer.
At any one time we have at least 50 submissions under active consideration, and close to 100 may be in some stage of analysis. Of the 24 deals consummated to date, about two-thirds involve insurance companies or agencies with a well-defined book of business, most in the personal lines area. The two most recent investments are integrated transactions with significant reinsurance premium ceded over a multi-year period.
The size of Risk Capital Re's investments range from under $1 million up to $24 million, the latter amount being our support for Latin American Re. Our typical investment is closer to $5 million and does not involve any controlling interest in the company. From a cumulative standpoint, we have invested or committed just over $175 million in the insurance industry. In one year we completed twelve investments, but our more consistent or realistic number of annual closings is around five or six.
Just as there are new financings every year, Risk Capital Re has also exited a few investments due to favorable sale conditions, inadequate returns or changing investee ownership. The sale or public offering of some investees triggered a full or partial divestment, which was anticipated and incorporated into the investment strategy. In a few other cases, the returns fell short of expectations and an early exit was the best course. Like reinsurance and insurance transactions, not all investments generate sufficient positive returns; we have “nonrenewed” those few relationships that did not live up to mutual expectations.
Intermediaries bring the deals
A key player in the investment marketplace is the reinsurance intermediary. Reinsurance brokers are already working closely with insurance companies to place their reinsurance and are keenly aware of the companies' business plans and ability to meet them. They can advise the companies about alternatives to traditional reinsurance, and the availability of other products and markets better suited to client needs. We have found that reinsurance program negotiations sometimes lead to investment discussions, and that the intermediary was instrumental in placing investment options on the table. In the course of exploring quota share or excess of loss protection, the intermediary gets a better sense of the insurer's goals and how other forms of capital might be all or a part of the solution. Sometimes the reinsurer raises the possibility and works with the broker and client to forge the best combination of investment, reinsurance or both. Reinsurance intermediaries are Risk Capital Re's largest source of business, representing 36% of our investments and a commensurate share of all opportunities.
In the end, the investee company and reinsurer are the two entities that must come to agreement and accept the risks and benefits of the transaction. It takes time, resources and commitment, and not all insurers or reinsurers will want to take that big step. For those few that do, as investor or investee, the rewards are there.
Mindy Pollack is Manager, Client Service & Communications, with Risk Capital Reinsurance Company in Greenwich, Connecticut. She produces the RCRe newsletter, At Risk, and frequently contributes to Global Reinsurance on industry topics. Ms Pollack is also an attorney with considerable experience in regulatory, claims, contracts and other legal matters.