M&A Activity To Continue In Second-Tier

With few exceptions, the largest reinsurance groups have achieved a global span in their operations, leaving the second tier of companies to sift through the remaining properties for the perfect fit of market access and limited historical loss exposure. The more recent merger and acquisition activity has tended to fall within the middle tier of reinsurers, which are seeking an equal footing and a more global stature to serve clients.

Standard & Poors believes that the prospect for continued M&A-related activity remains strongest in this second tier as management teams look for growth to build market presence and boost share prices.

On the one hand, more reinsurance companies are available for sale today than five years ago as weak operating results have led primary insurance operations to consider divestment of non-core reinsurance divisions. On the other hand, weak reinsurance operating results have made acquisitions more difficult as shareholders' valuations have shrunk the middle tiers primary currency–stock.

The issue of what constitutes a medium-sized reinsurer is contentious given the perception that when it comes to security, big is better. However, as a quick review of Standard & Poors ratings reflect, a large capital base and significant premium volume is not sufficient to maintain long-term security.

For the purpose of this article a mid-sized reinsurer is defined as one writing less than $1 billion of global reinsurance net written premiums (roughly 1 percent of the global reinsurance market in 2000). The financial characteristics that differentiate mid-reinsurers from the very largest groups, beyond pure size, are less marked than would be expected:

Underwriting Performance. Measured in terms of loss ratios over the course of an underwriting cycle, the difference is not significant. The mid-sized sector has recorded an average of 72 percent over the last five years compared with 73 percent for the sector as a whole. However, there are two distinguishing characteristics. First, the results of the larger reinsurers have experienced a higher mean loss ratio of 78 percent over the period. Secondly, and perhaps more important, is the fact that the results of the mid-sized group tend to be more volatile through the cycle.

Expenses/Costs. Predictably the expense ratios of mid-sized groups tend to be modestly higher indicating the existence of some scale economies. The average expense ratio for the mid-sized group was 31.4 during 1996-2000 compared to 30.6 for the larger groups over the same period.

Investment Performance. The contribution of investment income (including realized gains) to the bottom line of the larger groups is substantially greater than for mid-sized companies. This in part is a function of much larger capital bases generating higher total returns (12.3 percent versus 4.2 percent over 1997-2000, which itself is a function of the ability to absorb more risk on the asset side of the balance sheet). Its also a function of longer-tailed business, which provide for the investment of reserves held on the balance sheet.

Curiously, better investment returns tend not to produce better operating margins or return on equity. Return on revenue, which excludes long-term capital gains, exhibits a dead heat, with a five-year average of 6.8 percent versus 6.7 percent for the sector as a whole. The largest tier has not done any better on an ROE basis, with some of the largest reinsurers producing weaker returns than the rest of the industry.

Business Fundamentals. The next few years are likely to witness insurance parents of reinsurance subsidiaries taking a more critical view of the returns they are seeing on the capital tied up in reinsurance. The prolonged soft market of the 1990s has tried the patience of many primary companies as reflected in the sale of Winterthurs Reinsurance division, the partial spin-off of Le Mans Re, and the for-sale sign up at CNA Re. Strategically, the rationale for maintaining reinsurance divisions appears troubled despite recent rate strengthening.

How do mid-sized reinsurers differentiate themselves in terms of their business position? The following list, while not exhaustive, identifies the main areas.

Alternative Markets. Cedents look to maintain a reasonable spread of reinsurers to avoid an over-reliance on larger players. This point was illustrated in last year's "European Cedents Survey" compiled by Flashp?hler Reyes Business Research in Kansas City, Mo., which found that the typical number of reinsurers on all treaties averaged 21.

Parent/Subsidiary Relationships. Increasingly, few of the companies falling into the mid-sized group are independent. For the most part, the exceptions represent younger companies such as Alea and Renaissance Re, and Bermuda startups of Annuity & Life Re, Max Re and Imagine Re. More often than not, reinsurers are subsidiaries of larger insurance groups.

Under S&Ps group rating methodology, such subsidiaries are considered either core, strategically important or not strategically important, which then determines the rating enhancement given to the reinsurance subsidiary. Aside from direct financial support, the subsidiary can benefit from the cessions of its parents direct business. Generally, benefits flow from the subsidiarys access to a broader range of business and the information flow that comes with this access.

Affiliations. Historically many of the smaller reinsurers had strong links with certain parts of the direct insurance business, particularly mutuals. For instance, American Agriculture, Gothaer Re, PMA Re, Copenhagen Re and Secura NV all benefit from membership of ICMIF and similar groups. For some cedents, mutuals (or smaller) reinsurers have a greater commonality of interest.

Geographic And Line Of Business Niches. Due to their more limited capacity, mid-sized reinsurers cannot achieve leading positions in mainstream business lines and geographies. Despite the difficulty in achieving a spread of risk, a number of this group have managed to create very strong business positions in discrete geographies and specialized business lines.

For instance Nacional de Reaseguros has a strong 17 percent market share of third-party cessions in Spain, while Sirius International has a very strong market position in writing alternative covers in the Nordic market.

What is the prognosis for the mid-sized reinsurer? Inevitably the most successful will fully develop their niche–avoiding, where possible, competing head-to-head with the larger groups where they lack a competitive advantage.

The mantra of sticking to what you are good at becomes ever more important. There is a danger that during the hardening stages of this current cycle some smaller reinsurers will seek the opportunity to "bulk up" in the name of diversification. Where such growth fails to leverage existing strengths, losses will predictably follow during the soft part of this cycle, if not sooner.

Traditional reinsurance remains a relatively homogeneous product with security, capacity and price remaining the most important determinants of where the business is placed. Consolidation of primary insurers, corporate buyers and the brokers inevitably compel reinsurers to grow with the needs of their clients.

However, it is also true to say that cedents and brokers will continue to ensure the survival of a certain number of alternative capacity providers, particularly those providing an attractive service or product proposition.

While the hardening of rates in 2000 and 2001 will provide a much needed boost towards profits and ultimately independence, over the long term, success will favor large capital bases that provide the resources to adapt to changes in market conditions.

Stephen Searby (top) is associate director for Standard & Poors Insurance Ratings in London, and Donald Watson is director of S&Ps Insurance Ratings in New York.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, September 10, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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