PE Firms Target Insurers
Experts are predicting an uptick in merger and acquisition activity within the property and casualty insurance marketplace, particularly by private equity firms and alternative asset managers. But it’s unclear whether more PE firms entering the sector will impact pricing for risk managers.
Nearly three-quarters (71 percent) of surveyed insurers, reinsurers and bankers that have worked on insurance M&A transactions said that alternative asset managers and/or private equity firms will be among the most active buyers within the P&C sector over the next 12 months.
The survey was part of a report, Global Insurance M&A Outlook, released in April by Mayer Brown global law firm, and published in association with Mergermarket.
Observers weighing in on the report had mixed predictions on the impact of that M&A activity on pricing for risk managers.
Within the P&C sector, prices are generally based on supply and demand, typically rising after a large catastrophic event, said Edward Best, a partner at Mayer Brown corporate and securities, and co-leader of the firm’s capital markets and financial institutions groups.
The greater the consolidation, the lower the supply and — theoretically — prices could get lower, he said.
“But the P&C market is so large, that the opportunity for private equity firms to consolidate the market could be very tough,” Best said.
With that said, however, PE firms do try to push efficiencies into the companies they buy, which could help the P&C industry drive down costs, he said. Large P&C insurers historically have not been highly efficient, although they are getting “much better at being disciplined,” he said.
“However, PE firms need to know something about underwriting to be successful in P&C lines, as losses from bad underwriting can really hurt a P&C company,” Best said. “Also, private equity firms tend to want to lever up companies they buy, and regulators may not allow that for P&C companies, because they need steady cash flow to service the debt and P&C companies could lose a ton of money.”
While holding companies with insurance units don’t need approval to borrow money, regulators must sign off on would-be acquirers’ financing plans before they approve the deals, he said.
PE firms may want to roll over debt and place it into the insurance unit as equity, but regulators are increasingly skeptical about whether this is truly capitalization, because the holding company could just take the cash back out to service the debt if they had to avoid default.
Best said he suspected that PE firms would instead just buy certain units of P&C companies, particularly those that are no longer writing business, but just have runoff.
“Then the PE firms are just servicing the runoff and that could bode well for them financially,” he said. “They might also want to buy certain lines of business that are high frequency, low severity, such as car insurance, but they still can’t put too much leverage in the business or they run into the risk of not getting regulatory approval for the acquisition.”
Robert Hartwig, president of the Insurance Information Institute in New York, agreed that longer-term pricing could theoretically improve if PE firms created large insurance companies by consolidating disparate operations of various insurers, as efficiencies through economies of scale could be realized.
“I would suspect that could happen within three to five years, but it would take a while to piece together an insurer of that magnitude,” Hartwig said.
Indeed, pricing of reinsurance has dropped since alternative capital has been flowing into the market from PE firms, hedge funds and institutional investments such as pension fund managers, he said.
Private equity firms have been investing in the P&C business for many years, but that stopped with the financial crisis in 2008, said Sean McDermott, a director at Towers Watson in Philadelphia.
“Now, a lot of PE firms are sitting on a pile of money that they have to either invest or return to investors,” McDermott said.
Currently PE firms as well as hedge funds are investing in existing companies or starting new companies — in fact, three new firms have started in Bermuda in the past two to three months, he said.
Usually, the “ultimate game” is to provide just reinsurance and just insurance coverage, but the new companies sometimes quickly move to offer both types of coverages, depending on the management’s strategy and “zeal for growth.”
“This creates more competition because there are new entrants to the market, which usually lowers pricing,” McDermott said. “But it is important to note that these firms move their capital into the market anticipating that ultimately the pricing will get better.”
While pricing is still positive on the P&C side, pricing in the third and fourth quarters of 2013 was somewhat smaller in magnitude than the increases reported in the second half of 2012 and first half of 2013, he said.
PE firms continue to invest into the market because they think prices will rise again, McDermott said.
Property reinsurance prices have started to decline for another reason: the increase of insurance-linked securities as an alternative option to transfer risk, he said. These contracts, which transfer risks to investors, provide competition to traditional reinsurers as well as the PE and hedge fund start-ups.
“But overall, for risk managers, capital flowing into existing carriers and new entrants as well as alternative ways to transfer risk has got to be better for them, compared to consolidation across the industry and leaving fewer players in the market,” he said. “This gives risk managers more product choices and alternatives to place their risks.”
Other key findings from the Mayer Brown report include:
• 88 percent of respondents said that M&A activity would rise in the P&C sector, spurred mainly by the improving economy.
• 85 percent said they would finance their acquisitions using their balance sheets, reflecting their strong capital position.
• 50 percent said that development of new distribution channels would be one of the most important alternative growth strategies.