Rumors of Consolidation: Reaching the Boiling Point

When it comes to consolidation, do the larger property and casualty players in Canada have anywhere to go, or any companies to acquire? Many anticipate more merger and acquisition (M&A) activity in the future, but few are willing to put a timeline on when or how quickly deals will happen. It’s possible the concept of a consolidated property and casualty sector, similar to life insurance or banking, will likely have to wait five or 10 years.

CONDITIONS ARE RIPE

At face value, conditions in the Canadian property and casualty insurance market seem ideal for a flurry of M&A activity. Many feel the industry is at the top of the market cycle, after several years of above-average profits and solid combined ratios. Larger insurers are flush with capital and ready, willing and able to snap up smaller and medium-sized targets to further accelerate their market strategies.

“The normal growth in this mature market is about the rate of inflation,” Standard & Poor’s director Donald Chu says. “So if a company wants to grow at 10-15%, there are only two options. You can either be extremely aggressive in your pricing and undercut, which tends to come back to bite you in a couple of years, or you have to acquire something.”

The odd thing is, despite the top players’ growth projections, not much has happened recently to transform a fragmented industry into a consolidated market similar to those of the life insurance or banking sectors in Canada. Earlier predictions of a convergence of a few major insurers holding 50% or more of the market have not materialized; the Top 5 insurers still hold roughly the same market share they did in 2000, about 35% (see Figure 1). AXA Canada’s announcement last year that it was buying The Citadel stood out more because it represented one of the few big recent deals in the Canadian marketplace.

KPMG International surveyed executives from 200 non-life and life insurers around the world earlier this year and found the total number of M&A transactions in both sectors “fell significantly,” from 765 in 2000 to 574 in 2002. The total value of transactions over the same period dropped from US$120 billion to just under US$53 billion. And yet, the study Run for Cover also found that 71% of respondents expected consolidation in the global insurance market to accelerate over the next three years.

READY TO EXPLODE?

The culprit for the relatively quiet pace of consolidation in the short-term is pent-up capital with no place to go in the acquisition market. There is a distinct shortage of sellers, and buyers are looking to put their capital to good use and avoid any drag on return on equity (ROE). The result is that would-be buyers are running into a brick wall: they cannot, or don’t want, to meet the inflated expectations of potential targets.

“Theoretically, now is the time you would expect M&A activity to happen, but there just aren’t any sellers in the Canadian marketplace,” Aviva Canada CFO Robin Spencer says. “People at the moment are just very content with the profitability they are making and aren’t looking long-term at the cycle. They just don’t have a selling mindset at the moment.”

Companies that are looking for acquisitions are encountering asking prices that some call “unrealistic.” According to Joel Baker, president and CEO of MSA Research: “We see a log-jam in M&A activity, which is driven by the very high multiples that sellers are seeking. Buyers will have to pay a hefty premium to acquire anything meaningful.”

In the KPMG study, 25% of the respondents who said they had considered specific targets over the past three years, but chose not to acquire them, cited sellers’ high price expectations as the main reason for their decision to stay put. This situation has led to more tire-kicking than actual acquisition. Given the risks associated with a major acquisition, many larger companies are prudent and wary of overpaying at the top of the cycle.

“I think the reality is that the vendors have wanted a price that some buyers didn’t think was that compelling of a proposition,” Neil Parkinson, national director of KPMG’s insurance industry practice, says. “There is a lot of risk in making an acquisition. It is not easy or cheap to put two organizations together. And of course distribution systems come along with any acquisition. Sometimes no deal is better than any deal – even if you have money to spend.”

Clearly, the capital exists in the industry to fuel consolidation, according to Chu. “If you look at the industry in general and a Minimum Capital Test (MCT) ratio of 200%, from where we sit, there is probably excess capital beyond that ratio of about CD$5 billion,” he says. “That is quite significant for this industry. When you look at the top three companies, we know they have significant capacity in terms of writing a cheque and making an acquisition.”

Insurance companies are generally sold on multiples of earnings, and the past few years have seen robust ROE for most property and casualty companies. Claude Dussault, president and CEO of ING Canada, says the price expectations of selling companies are often reflective of the stage of the insurance cycle. And the issue becomes predicting how long current earnings levels will continue.

“Obviously, you need to have a good sense of the future earnings of the business, and that will drive the price,” Dussault notes. “When you are in a good part of the cycle, the expectation for future earnings are better than in the lower part of the cycle. But I think it becomes a question of: Can this industry perform better over the long-term than it has in the past? I think most people would say there is nothing fundamental that has changed that will make the industry more profitable in the longer-term.”

Jean-Francois Blais, president and CEO of AXA Canada, says there are always transactions at the top or bottom of the cycle, which is similar to the way things happen in the stock market. “Obviously, you pay more when a company is making more profits and has a solid balance sheet,” he observes. “However, on the other hand, is it going to save you the time and money you would have spent on fixing up a weak balance sheet? In the end, there is no problem paying more if you get more and there is a return on your investment.”

The typical insurance cycle lasts for about four or five years, and larger companies are trying to set reasonable expectations of how long a potential takeover target will make money. “Looking at the profitability of the industry, do you want to pay for 10 years of profits at current levels, when in fact this industry hasn’t made profits for five years in a row?” Parkinson asks.

BREAKING THE LOG-JAM

As the soft market becomes more pronounced over the next few years, several sources say things could change. “If, for whatever reason, the log-jam breaks, we could very well see another wave of M&As,” Baker says. “If the market softens sharply or global parents become financially stressed, which I don’t expect in the mid-term, then multiples will decline and some targets will be unmoored. A soft market is favorable for foreign companies that want to exit.”

Spencer notes that “if you see a soft cycle for two or three years, and all of a sudden a company’s capital starts to get eaten into, you will see more movement.” At that point, Spencer adds: “You might find the smaller players realize that they are getting picked off, their premiums are shrinking and they can’t compete in the longer term. Their shareholders will say: ‘Look, what are we doing in this game?’ The irony of course is that those businesses are worth less at that stage.”

Blais says that when you are at the top of the cycle, you have to make sure you invest to get through the next cycle to come. “My feeling is that not all companies are ready to make the investment you need to compete in the market of tomorrow,” he says.

It is not just the insurance cycle or the recent healthy earnings t hat explain the slow buildup of pressure to consolidate. Several factors explain the continuing, relative fragmentation of Canada’s property and casualty market, including the dominant role of foreign competitors, the position of Canadian mutual companies, the broker distribution network, the challenge of estimating reserve liabilities and the mixed track record of acquisitions in terms of increasing shareholder value.

Dussault says the property and casualty insurance industry globally tends to be more fragmented, partially “because it has been very open to foreign competition.” He contrasts this with the experience of the life insurance sector in Canada. “What has driven the consolidation in life insurance has been some very strong Canadian champions who have been doing the consolidation. On the property and casualty side, we will need some of those players who will create that dynamic.”

FACTORS IN CANADIAN M&A

Foreign Subsidiaries

The presence in Canada of subsidiaries of foreign firms is another factor explaining slower-than-expected consolidation. Many larger players are committed to the domestic market, but decisions might be made in foreign head offices, where Canada is factored into company plans only as an ancillary aspect of global operations.

“Some M&A deals have very little to do with domestic considerations,” Parkinson notes. “A company [may decide] to exit the Canadian market or swap positions with another global company or merge globally. Mergers or acquisitions may take place that may not seem like such a good idea in the Canadian marketplace, but, on a global basis, that may not drive the truck.”

Dussault agrees international factors may spur domestic consolidation. “What might drive the process is opportunities outside of Canada,” he says. “Because for these transactions to happen, you need the capacity to buy, but also the incentive for people to sell. What can drive the sellers is looking at ways to redeploy their capital in other markets if they don’t think that their position in the Canadian market is attractive enough. That is the part that will be important in driving (M&As) if the performance continues to be at the level it is now.”

Parkinson adds that excess capital in a specific geographic market is not as much of an issue for a multinational company, which can repatriate that capital to other areas. “The capital that is deployed here can shift offshore and doesn’t have to get spent here,” he notes. “A lot of multinational companies, especially European, are interested in investing in fast growth markets like China and India. If people are looking for places to put capital for a time, it may get shuffled into a jurisdiction with more favorable tax treatment or more strategic interest. There is really only a handful of domestic companies that are thinking: ‘I have excess capital in real terms.'”

Many of those domestic companies are mutual companies. And while the major mutuals have accumulated significant capital over the past three years, they have been relatively quiet on the acquisition front. “Mutual companies like Wawanesa and The Economical are not pressured by shareholders to return equity, so they can just sit on capital,” Chu says. “With that said, they would not be adverse to making an acquisition if it fit strategically.”

Reserve Analysis

Finding the right fit can be an elusive process for property and casualty insurers; several rating agency reports and studies point to a mixed track record for mergers and acquisitions. The KPMG survey found that only 12% of respondents believe that acquisitions enhanced shareholder value over the past three years, while 17% noted a slight increase and 24% noted no change.

Another recent report from Fitch Ratings, focusing on the U.S. insurance market, argues: “There is less strategic interest in M&A due to past disappointments. The greatest inhibitor to property/casualty merger activity today is the poor track record exhibited by the acquisitions completed in the late 1990s. Given the difficulty in estimating loss reserve liabilities, insurance company sellers have significant information advantages in valuing an organization relative to buyers.”

Fitch cites three deals – Berkshire Hathaway’s acquisition of General Reinsurance Corp., XL Capital’s buyout of NAC Re and CNA Financial’s purchase of Continental Insurance – as examples of overpayment due to post-purchase reserve deficiencies.

Estimating loss reserve liabilities is also a challenge in Canada. “I think theoretically companies are supposed to be better prepared when they are acquiring another company, but practically there always seems to be something that comes up,” Chu says. “On the surface, these are relatively simple companies. But when you get below the layers, it can get very complicated to make an assessment on the long-tail lines.”

The reserve analysis of any transaction is always a difficult one, Blais agrees. “You have to be prudent and careful, because this is exactly where it can turn sour,” he says. “That is the knowledge that each insurer brings in evaluating reserves. At AXA, we think this is a competitive advantage on our part. Obviously, we did our homework on The Citadel to see where the reserves should be.”

Baker notes that the Canadian experience in estimating reserves has been generally more positive than in the U.S. But it “is always a concern,” he adds. “Yet, with excellent market knowledge, due diligence and contractual guarantees, hazards such as these can be overcome. ING has demonstrated this time and again.”

Dussault says “part of the ability to make acquisitions involves properly assessing a company when you acquire it and the potential you can derive from it. Clearly, one important thing is how true the balance sheet is from a liability point of view. You have to have the expertise to assess that properly and that is what the due diligence process will do. Understanding the business and the market will give an advantage because you can compare with your own observations.”

Broker Distribution

In other cases, the role of the broker distribution channel may result in “leakage” of business from the acquired company, Baker says. “Broker business is very hard to hold onto… If they lose one market, they often try to add another to their portfolio. You buy a book of broker business, you get some leakage but it can happen more than expected.”

Chu says brokers may sometimes act as a constraining force on consolidation within the property and casualty industry. “If there is further consolidation in the marketplace, the brokers tend to want to spread their business. If they have 90% of their business with the Top 3, that is a lot of concentration, so often a broker will just place business with other markets. In the back of their minds, they want to take care of their book. Brokers themselves could dissipate some of the concentration in the market.”

Dussault believes the amount of “leaked” business from the broker channel depends on when in the cycle a company is acquired. “We believe we have been pretty accurate in making those assessments because we understand the market,” he says. “When we acquired Zurich just before the hardening market, we had higher expectations for retention and we got higher retention. When we acquired Allianz just before the soft market, we knew there would be more erosion of business and that is what happened.”

PROGNOSIS FOR M&A IN CANADA

Even with the challenges facing consolidation in the Canadian property and casualty market, many of the larger players say they are committed to making strategic acquisitions in the years ahead. ING Canada, which has made 11 acquisitions since 1988, is singled out as the most likely candidate for a move in the near-term. “If they wanted to, ING has the paperwork in place to issue CD$1 billion in debt or preferred shares or common equity in relatively short order,” Chu notes. “In addition, with their robust earnings, it has allowed them to grow their internal capital base.”

Others are eager to step up to the consolidation table. Individual company strategies vary from geographic and product diversification, to economies of scale and market share.

For Blais, “the Number 1 reason behind any acquisition is to accelerate out strategic plan. We are trying to create a company that is a 50/50 mix between personal and commercial lines in all provinces. If you are concentrated in one province or in one line of business, there are high ups and very low downs. Our goal is to create this mix across Canada, to fight cycles and trends in the economy. That was a main reason why we bought Citadel.”

According to Spencer at Aviva Canada, “the key economic benefits for us are all around scale. Just being able to spread your overheads over a larger premium base is advantageous. There is always a huge amount of synergy in terms of scale and cost reduction out of acquisitions. I am sure it is of no surprise that we are in the market for acquisitions.”

Parkinson suggests the “property and casualty business does not have quite as persuasive an argument for economies of scale, [since] much more of the cost base is related to paying claims rather than operating costs.”

Improved claims management and access to more comprehensive data are equally important drivers of acquisition activity for Aviva Canada, according to Spencer. “There is a scale to influence the supply chain from a claims perspective,” he says. “You can start leveraging with suppliers much more effectively when you are bigger. The other thing, often overlooked, is data. By writing a lot more policies, it gives you far more data from an underwriting and actuarial perspective to understand risk in different regions better. It allows for more accurate pricing and better risk selection.”

Interestingly, Dussault also cites access to broader information as a prime motivation for M&A. “The main area where we see we can create an advantage is by having better information, better data in every market where we operate,” he says. “It gives us better understanding and better segmenting of the business. Very often, people see scale as being driven purely by an expense play; we think it is more from the loss ratio side.”

Many sources say the competitive advantages of diversification, greater market share and more in-depth penetration of underwriting and claims data will, in the longer-term, overcome any immediate obstacles of fragmentation. The window for when this consolidation will occur is difficult to predict. Will it be months or years?

“It doesn’t take much,” Baker notes. “Two or three major M&As can significantly change the profile of the industry.”

Dussault adds: “You need to have players that reach a certain level and then drive the consolidation. When that happens, it tends to accelerate activity. I think we are getting closer to that point.”

Parkinson says that instead of a tidal wave of M&A activity, the more appropriate image may be one of steady and constant waves gradually changing the coastline of the property and casualty industry, towards greater consolidation. “I don’t think we will wake up in a brief period and see a doubling of concentration in this industry,” he notes.

Blais believes it is only “a matter of time” before things start to change. “Is it going to change in the next year?” he asks rhetorically. “No. But in the next 10 years, I am sure this industry will be completely different.”

In the meantime, the pressure of pent-up capital from larger property and casualty players will be looking for release, assuming reasonable price expectations of target companies. As earnings flatten out in a softer market and book values of target companies potentially come down, it is anyone’s guess how quickly the pace of acquisition activity will rev up.