Sobriety breaks out in insurance market

The underwriting cycle dictates that the insurance market should currently be in the throes of a mergers and acquisitions frenzy and investment bankers to the sector should be laughing all the way to their hedge fund advisers.

Profits are now gushing into the sector at the reinsurance, primary and broking levels after four years of strongly rising rates, a catastrophe free year in 2006, acceptable investment conditions and a now softening but still generally profitable market.

In the past, insurance company and broking firm boards would now be under intense pressure from investors, investment bankers and their own egos to do something with that all that lovely cash before something catastrophic, or somebody else, takes it away from them.

But despite all the hopeful predictions of action from the bankers and other advisors, it just does not seem to be happening.

There have been some deals over the last five years of course.

Last year, Swiss Reinsurance Co. of Zurich, Switzerland, finally put General Electric of the United States out of its misery and bought its insurance business—GE Insurance Solutions. While AXA S.A., the French insurance giant, snapped up the remains of Credit Suisse's insurance business, Winterthur Group, after Bermuda's XL Capital Ltd. had, in painful retrospect, somewhat expensively acquired its global commercial franchise in 2001.

A big deal was finally done at Lloyd's of London this year as Catlin Group Ltd., the Bermuda-based group, agreed to buy the rival Wellington Underwriting P.L.C business, after countless others failed on the rocks of complexity, cost and common sense.

And, after months and months of ultimately fruitless talk about the supposed merger of London brokers Jardine Lloyd Thompson Group and Heath Lambert Group, a big broker deal was finally sealed this year when Kansas City, Missouri-based Lockton Cos. Inc. acquired the international broking operations of Johannesburg South Africa-based Alexander Forbes Ltd.

But, all of these deals have something in common that does not quite fit with the usual "gung-ho" M&A activity in this sector at this stage in the cycle—they all look eminently sensible.

"Defensible" was the word used by a group of insurance company executives, insurance buyers, investment bankers, accountants, lawyers, equity and credit analysts during an "off the record" roundtable discussion on consolidation hosted by law firm Debevoise & Plimpton L.L.P. and chaired by myself in London recently.

The experts all agreed that traditionally this should be the time for bold action and big number deals in the sector as the market has finally recovered from the woes of the capital-killing year of 2001 and creeping death visited upon the market by the follies of the 1997-2001 underwriting years.

But, even the investment banker and equity analyst, agreed that an unprecedented level of sobriety appears to have broken out in the sector and persuaded insurance executives to hold onto, or even better still—so long as you don't get hammered by a hurricane or two a few months afterwards—hand back capital to investors, rather than fritter it away on reckless acquisitions.

The participants in the debate agreed that most of the big deals in the past at similar stages in the underwriting cycle had been largely driven by investors and their insatiable appetite for growth.

But apparently investors have changed.

Overall they have not done very well out of the insurance sector compared to others, notably banking, over the last five years and are therefore more cautious. They are also supposedly more sophisticated, partly because of the rise of specialist hedge funds, often populated by ex-insurance executives.

These hard-nosed investors apparently recognize that the attractive values of the past were largely driven by asset accumulation rather than underwriting quality, a fact so clearly proven by the painful consequences of the equity market crash of 2000 and 2001.

This has finally led to a realization among many investors that you can demand higher returns on equity or volume growth, but not both in the "normal" underwriting and investment conditions of today.

But, overall sanity is said to have broken out and expectations are far more effectively managed within insurance company management and the investment community, hence the relative lack of action to date.

The conclusions of the Debevoise & Plimpton round table were more or less backed up by a recent report on insurance deals in the United Kingdom published by accounting firm Grant Thornton U.K. L.L.P.

Its survey of United Kingdom market executives found that most see increased interest from investors and expect consolidation to somehow pick up over the coming years, in both the risk carrier and broking markets.

The four main drivers quoted by its respondents were the pressure to cut costs, the search for diversification, the pursuit of scale, and the need to become more specialist.

But two big reasons not to consolidate were also identified that can surely only grow larger.

These were, firstly, capital constraints cause by capital erosion and current regulatory capital requirements plus the pending arrival of Solvency II—Europe's new capital adequacy regime—and, secondly, the Damoclesian sword of prior-year losses and inadequate reserving that have wrecked so many deals of late.

The overall conclusion seems to be that there and not any spectacular deals in the pipeline because they are just too risky in this market and investors are now only too aware of this.

Most activity will continue to be the "defensible" and sensible type of deals seen over the last couple of years, and any legacy-free Bermudian start-ups that manage to find a sufficient number of investors daft enough or desperate enough for diversification to pile into the sector as the market begins to truly soften. Hong Kong was suggested by one analyst as a decent place for a Bermudian start-up to list at this stage.

For Europe's insurance buyers, this is both good and bad news.

It is good because there is already a shortage of serious capacity providers able and willing to lead cross-border, multiline and complex programs.

It is bad because it would be good to see a few of the medium sized or big, but territorially-challenged aspirants get together to form credible alternatives to the few giants that remain.

So for Europe's big insurance buyers a combination of mergers (pick your favorite pairings) between Generali Assicurazioni General S.p.A., Royal & SunAlliance Insurance Group P.L.C., MAPFRE S.A. and Talanx A.G. wouldn't be a bad start would it?