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Think Tank: The Geneva Association - The logic behind consolidation: A view from the outside

Source: Asia Insurance Review | Aug 2016

In this extract from The Geneva Papers, Mr Brian Shea of Willis Capital Markets & Advisory Europe addresses two issues – the drivers of consolidation and if this activity create value. 
Looking at deal volume in the global insurance sector, 2015 was off the charts. We look at the drivers today and in the future. 
Today’s drivers 
There is an impetus for scale today. 
   In Europe, Solvency II raises fixed costs and also gives explicit capital credit for diversification. The tiering of the reinsurance sector also means that reinsurers need to have a wide product and geography footprint and the ability to offer greater line sizes. Low interest rates also drive a greater need for cost efficiency, particularly in the life segment. 
   We all know that the boundary between traditional insurers and reinsurers on the one hand, and alternative capital providers on the other, is blurring. There has been a lot of activity—largely organic—of insurers setting up insurance-linked securities (ILS) vehicles and of ILS managers setting up rated balance sheets. It is not always organic though. Willis advised Catco, the ILS fund manager, on its sale to Markel. We would not be surprised to see more M&A activity between traditional and alternative capital players.
   There are some specific cyclical drivers as well. Cyclically low prices tend to equate to more M&A. At the same time, the sector’s profitability is actually quite good at present. So, excess capital is accumulating, and M&A is a way to invest that. 
Finally, new money is a particularly relevant driver today. The historical interest of private equity (PE) and run-off buyers is being augmented by the likes of EXOR and Asian money. This type of buyer is motivated by its perceived low cost of financing, a desire for diversification and the investment “float” that insurers provide.
Drivers in future 
There has been some disruption to the value chain already. Aggregators and direct writers have taken share away from traditional distributors. And alternative capital has crowded out traditional reinsurance capital, particularly in the Nat CAT space. 
   But the disruption of the value chain to date is nothing compared to what disruptive technology could bring. Going forward, you could have an entirely new way of slicing the value chain, and firms outside the traditional insurance sector could occupy much of the prime real estate. 
   Take personal auto, for example. The “distributor” could be the car manufacturer that has installed the black box telematics device. The data owner could again be a car manufacturer. Or, if it is a smartphone collecting the data, it could be a firm like Apple. And the analytics engine could be provided by Google, or you have specialists like Verisk. 
   Also, much of the value chain going forward, rather than being about loss compensation, could be about risk mitigation. If you can install sensors in the home that detect and mitigate the loss from burst water pipes, that should reduce loss costs, but maybe some of that benefit will be shared and the consumer will be willing to pay for risk mitigation. Who knows, perhaps insurance agents in the future will make some of their money selling Nest thermostats. The point is, maybe today’s insurers can occupy this prime real estate, but it will require some morphing.
   To address this, insurers have already made a few technology-driven acquisitions, for example Generali’s acquisition of MyDrive. But the key word here is few. 
   Over the past four years we count just under 40 transactions that had something to do with technology that could be applied in the insurance sector. Insurance buyers numbered less than five. Surely, we ask, with so much to play for and with the leverage that such an acquisition could provide to a large global insurer, shouldn’t insurers be more active buyers?
   A final point on value chain disruption and future M&A: if disruptive technology works and claim costs fall, this could drive more traditional M&A. Shrinking premium income could encourage acquisitive growth. And shrinking capital requirements could produce ample funding ability. 
Does M&A create value? 
Let’s look at recent deals. We have analysed 12 deals from the past four years where a public company has bought another public company—ie you have a good view of the financials. You have got all the big 2015 deals, for example, from XL/ Catlin at the start of the year to MSI/Amlin which was announced in September. You can see from Figure 1 that deal multiples have been going up, whether you look at price/tangible book value or forward earnings. 
Figure 1: Deal multiples have been going up . . .
   Now, in our opinion, the most important metric you should look at in considering whether an acquisition makes financial sense is the return on investment (or internal rate of return). You then need to independently consider your cost of financing. It is the two together, though, that determine whether a deal is accretive to earnings per share (EPS). And a low return on investment (ROI) deal can still appear accretive to EPS if it is financed inexpensively. 
   From our study, we see that financing costs have come down: debt costs have come down; if using cash in hand, the yield on that foregone cash has come down; and the “cost of equity” has come down as price–earnings ratios (PEs) have gone up. This low cost of financing means that most deals have indeed been EPS-accretive. 
   But our point is that you should not necessarily infer that value is being created. ROIs themselves are running at about 7%–8%. We suggest that this is roughly break-even based on hurdle rate costs of capital.
Measuring long-term success
The problem is: how do you measure long-term success? To address this, we have looked at the longer-term share price performance of acquirers – going out three years from the announcement date of the acquisition. It is not particularly scientific – but is hopefully thought-provoking nonetheless. 
   We looked at 25 deals done over the past 20 years in the global insurance sector where the deal size was at least US$1 billion and it represented at least 20% of the acquirer’s market cap. We then looked at how the acquiring company’s shares performed relative to its local index – for example ACE relative to the S&P 500. We looked at this over the 30 days, 90 days and so on up to 3 years (or 1080 days) after a deal’s announcement.
   The results indicate that, on average, insurers have performed in-line following large acquisitions. They do not support the consensus view that about two-thirds of all M&A destroys value. The bottom line is that maybe, over the long run, a higher proportion of deals actually do create value. It is all down to execution, of course.
Mr Brian Shea is Head of Willis Capital Markets & Advisory Europe.
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