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Special to Business Insurance

The long-awaited consolidation of various segments of the insurance business has clearly begun. Merger and acquisition activity is widespread as one surveys the property-liability, life and reinsurance landscapes.

The likelihood is that M&A activity will continue to proliferate in the insurance industry as a whole, as profitability declines and other financial service companies expand into the insurance sphere.

The pressure to achieve critical mass in various business segments and the need for more efficient and effective distribution are the primary drivers behind the current level of M&A activity. Put another way, managements are under enormous pressure to compete, but many companies have limited abilities. Hence, mergers and acquisitions may be the only means to achieve the ends. Acquisitions, though, should be a supplement to growth and not the primary reason for an insurance company's growth.

The dynamics in the insurance industry are very similar to what the banking industry faced several years ago when the market was plagued by overcapacity and several key players began to recognize the benefits of consolidation.

M&A activity falls into two basic spheres, strategic and financial. Some of the strategic reasons for acquisitions include:

The need to diversify into new markets and/or geographic areas.

The pressure to find alternative means of distribution.

The need to obtain new products, skills and technological expertise.

The need to follow your customers as globalization pressures rise.

The need to divest or spin off a business segment to focus on a core business.

Some of the financial reasons for M&A activity include:

The need to achieve economies of scale in order to squeeze out inefficiencies.

The need to expand market share and presence in current lines of business and geographic areas served.

The need to strengthen balance sheets and stave off rating downgrades.

The need to produce growth in a stagnant or declining market.

The need to respond to shareholder pressures to raise returns on equity and make use of excess capital.

It should be emphasized that the integration of two entities as business segments is not always as smooth as peaches and cream. Obstacles to a seamless merger or acquisition include: loss of employee focus; roadblocks emanating from entrenched managements; difficulties in blending different corporate and/or business cultures; and problems related to incompatible systems and processing technologies.

Last but not least, the need to produce quick financial returns can drive decisions that ultimately create longer-term problems.

As we have noted in past writings, growth prospects in virtually all segments of the insurance business have stagnated. Compounding the situation are, first, an abundance of capital and/or "stock currencies" that are at levels either not seen in a long time or on new plateaus and, second, enormous pressures on management teams to produce top-line growth, bottom-line growth and raise ROEs.

This consolidation undercurrent is threaded through virtually every insurance stock and will likely remain notwithstanding the prospect of some earnings disappointments. It should be noted that there is a greater likelihood for an acquirer to stub its toes when it is forced to make an acquisition vs. those situations when acquisitions are done at a more rational pace.

Finally, as previously noted, insurance stock valuations are at levels some might refer to as nosebleed territory or certainly well above levels most industry observers would have prognosticated several months ago. Given current valuations, it would appear that the opportunities for management buyouts and leveraged financial buyers appear limited. Today's opportunities appear to be more aligned for strategic buyers that can create value through synergies.