Big Deal

When it comes to mergers and acquisitions, two factors tend to drive activity – market access (or market share) and capital allocation. In the case of Travelers’ announcement June 10 that it was acquiring one of Canada’s oldest insurers in The Dominion for $1.25 billion, both elements were in play.

The deal gave Travelers access to The Dominion’s hefty domestic personal lines book and a small-mid-market commercial segment to augment the former’s focus on surety, management liability and commercial mid-market products, vaulting Travelers into the top 10 in Canadian p&c industry market share.

“The Dominion is a great franchise, and this is a very good opportunity for Travelers to significantly improve its market position and scale in a meaningful market,” said Jay Fishman, chairman and chief executive officer of Travelers.

The acquisition was also a good example of a major U.S. insurance company that recovered from the financial crisis with an eagerness to deploy its capital for business growth.

BUY OPPORTUNITIES

“Many U.S. and foreign insurance companies have recapitalized over the last several years and have begun to return some of the excess capital to shareholders through stock buybacks and, to a lesser extent, through dividend increases,” PwC pointed out in a spring 2012 report on M&A activity in Canada. “Insurers will be evaluating whether to continue returning their excess capital to shareholders or to put their capital to use by expanding their core business through M&A,” it added.

Increasingly, well-capitalized insurers are scouring the market for buy opportunities, seeking to grow market share through acquisition or looking to turn around underperforming books of business. The competition for buyout targets is enhanced by a renewed interest in the insurance industry from private equity firms and hedge fund managers.

POSITIVE, LESS POSITIVE

The reaction from brokers on Travelers putting its capital “to use” in acquiring The Dominion was largely positive. “From a broker perspective, I don’t want to see a market leave my office, and that didn’t happen with this acquisition,” says Randy Carroll, CEO of the Insurance Brokers Association of Ontario (IBAO). “This is a good example of strategic partners that complement each other. There are lots of opportunities there, and also, I’m sure, some challenges when it comes to branding and operations,” Carroll notes.

“We have a new player in the market, and it will be interesting to see Travelers plans and how they hit the ground running. I’m sure they didn’t invest more than $1 billion to wade in quietly.”

Reinsurance companies, which have seen larger p&c carriers upping their retentions and moving steadily away from pro rata to excess of loss treaties, tend to be less positive about potential spikes in M&A activity, particularly with the absorption of a Canadian insurer with a substantial reinsurance program.

“It does make the pie smaller from a reinsurance perspective,” says Cam MacDonald, vice president of Transatlantic Re. “Reinsurers will lose premium from Dominion’s program, which was significant. They will get some back for the Travelers’ program, particularly on the cat layers, but it will not be a one-to-one equation.”

This smaller pie comes at a time of intensified competition in reinsurance, with more new entrants moving into a relatively small, but stable, Canadian market. To address these challenges, reinsurers are looking at diversifying product lines into specialist areas, such as accident and health, crop insurance, fidelity, errors and omissions (E&O) and directors and officers (D&O), MacDonald reports.

“You have to develop the expertise and be prepared to jump in when opportunities arise,” he says. “It is a matter of being fully committed to the market.”

Another reality for reinsurers and insurers in a consolidating market may be rate increases for reinsurance programs. “This will be driven by results, profitability and ROE of individual programs, but reinsurers are facing declining premium volume – rate increases may become a reality,” MacDonald says. “I have no doubt that we will see more M&A activity at the primary company level.”

LEVERAGING SIZE AND ANALYTICS

For primary insurers, there are factors other than market access and capital allocation that spur M&A movement. In the case of Travelers (and other acquisitors in the primary insurance market), one emerging strategy is whether or not it can apply scale and analytics to improve The Dominion’s so-so financial performance over the past several years, suggests BMO analyst Charles Sebaski.

“Travelers anticipates being able to use its considerable resources in systems and data analytics to improve the underlying combined ratios of Dominion, which has been operating at an underwriting loss for the last several years,” Sebaski wrote in an analyst note. “Travelers believes it can transition this operation to an underwriting profit, as is consistent with (its) overall business philosophy,” he added.

This leveraging of size and analytics is a trend that industry observers see taking place with M&A activity. “I think there is more of a case for economies of scale when you look at developments like big data,” says Doug McPhie, a partner in the financial services group of Ernst & Young. “This is a huge opportunity for the p&c industry. If you get more clients, you get more underwriting and claims experience, you can better understand patterns and this will lead to better pricing on products, more targeted products and improved claims experience.”

Achieving economies of scale to realize better underwriting results is particularly attractive in today’s sluggish market of soft pricing and weak investment returns, suggests Allan Buitendag, leader of PwC’s national insurance consulting practice.

PwC points out that the number of M&As has climbed consistently in the Canadian p&c industry over the past several years, with 12 announced deals in 2009, 21 in 2010 and 29 in 2011. It notes that these only represent a proportion of transactions, as not all deals are disclosed.

“Some companies are looking at growth through acquisition to drive additional scale,” Buitendag says. “That means they are leveraging back-office platforms to gain efficiency and cost savings in operations, underwriting and claims. There is much more of an emphasis today on underwriting profitability,” he notes.

Intact Financial president and chief operating officer Louis Gagnon echoes this assessment. “The industry has become increasingly sophisticated in the areas of underwriting and pricing, as well as infrastructure and technology to contend with changing consumer expectations and behaviours,” Gagnon says.

“The profitability of the industry will increasingly rely on underwriting performance as interest rates remain low. This increased sophistication enables better customer service and puts pressure on the lower performing insurers,” he adds.

CONSOLIDATION GREEN LIGHT

Industry sources say the Canadian p&c insurance environment is conducive to consolidation, as it has nowhere near the concentration of dominant players as the other financial services pillars, such as life insurance and banking. The top five p&c carriers represent just 43% of the market, versus the bank and life insurance companies, which are closer to 65% to 75% of their respective markets.

“The Canadian p&c insurance industry, which currently operates in a slow economic growth environment, is mature, competitive and fragmented,” notes Gagnon. “Despite the recent consolidation over the last few years, the industry remains highly fragmented as the top 10 p&c insurers make up 65% of the mark et, and there are a large number of insurers/reinsurers operating in Canada to service a population of approximately 35 million,” he adds.

Intact Financial has made clear its intentions to grow through acquisitions when the right opportunities emerge in the marketplace. “I do think that this is an environment that will present (acquisition) opportunities within a reasonable period of time, and on that basis, there is no (share) buyback activity at this stage,” Intact Financial CEO Charles Brindamour said on a conference call to investors in February.

Gagnon, who estimates a 15 to 20 point trade in market share over the next five years, also observes that ongoing changes in regulation around capital requirements could put a strain on some insurers.

“The uneven performance of individual Canadian p&c insurers has an impact on the allocation of capital,” Gagnon notes. “Generally speaking, industry profitability is relatively low with capital pressure from abroad. In recent years, capital requirements have been trending upwards and there is greater regulation around solvency and capital risk,” he adds.

FINDING A NICHE

The pressure of soft market conditions, low investment returns and more stringent capital/regulatory requirements may create a more willing group of sellers – something that has been at times lacking in predictions of increased M&A activity in Canada.

“I think there are more sellers today,” says McPhie. “A lot of European insurers with subsidiaries are facing pressures when it comes to capital and risk management. When you combine that with the economic slowdown in Europe and the low interest rates across the financial markets, you could see some of these global companies looking at carving out non-core operations.”

In addition to this potential acquisition target, McPhie adds other potential companies for sale may involve mid-sized insurers with unfocused business strategies or indistinct client segments. “I think the other sellers may be those companies that are small to mid-sized and don’t have a defined niche or specialty,” he notes.

In a market report released earlier this year, Aon Benfield made similar observations about this target group. “Many small and mid-cap insurers have been managing through very tough multi-year underwriting conditions in the hope that a market hardening will compensate for many ills of the past,” Aon Benfield noted. “Absent a more rapid hardening in the market, mid-to-smaller insurers are likely to merge with competitors in an effort to extract synergies and benefit from economies of scale.”

For Gagnon, consolidation really comes down to the business case. “Ultimately, M&A activity and consolidation is driven by a company’s business and growth strategy,” he says. “In our case, the recent acquisitions have allowed us to strengthen and broaden our product offering, improve our capability to support brokers, expand our distribution platform, reinforce competencies in risk selection and enhance our competitive position,” he reports.

Protecting the distribution channel, especially independent brokers, is a variable that could spike M&A activity, Buitendag suggests. “The independent broker channel is increasingly being consolidated and companies are seeing some of their business at risk,” he notes. “So there are more insurers buying into brokers or buying brokers outright to protect their business or buy into geographic areas they don’t currently operate in,” he adds.

Buitendag cites Desjardins Financial’s acquisition of Western Financial Group as an example of such a strategy. “For Desjardins to grow that business organically would have been much more difficult,” he suggests.

BROKER FOCUS

While insurance companies are investing in brokerages for full or partial control, the distribution channel itself has been the most active area of M&A in the p&c insurance industry to date. The number of mergers or acquisitions in the United States and Canada hit an all-time high in 2012, with 291 transactions, reports OPTIS Partners, a financial consulting firm specializing in the insurance industry. That number was up from 279 deals in 2011.

Advisen’s MAINsheet monthly column, which tracks mergers and acquisitions in the U.S. p&c insurance industry, has already reported 167 transactions to June 2013, mainly involving brokers and MGAs.

This activity has continued into 2013 in Canada as well, with many consolidators such as Hub Group, Western Financial, CG&B Group Inc. and National Brokers announcing deals this year. Mergers and acquisitions in this space have been steady in spite of what many observe are record valuations for brokers’ books of business. Some analysts have reported that average purchase prices for brokerages are three times commission income – a doubling over the past three decades.

“There is strong demand for good business, whether from companies, direct writers or MGAs,” says Philip Heywood, a director with PwC’s advisory and deals practice. “Even with the higher valuations, there is a large volume of M&A activity. Whether we will see a tipping point where the supply outstrips demand, I don’t know. But I expect to see this activity continue for at least the next two years,” Heywood comments.

The demographics of the broker distribution channel means that more aging brokers are looking for an exit strategy, Buitendag says. “There are a lot of brokers who have yet to retire, and the traditional plan of selling the brokerage within the family is less and less popular,” he adds. “So brokers can sell to other brokers/MGAs, broker-distribution companies or direct writers. While brokers are proud of their independence, they will sell their own business for the best price.”

Gagnon also notes that for brokers it is a “seller’s market due to favourable economic conditions.” He suggests that now is the time for brokers to evaluate their options and choose the long-term solution that fits their needs.

“As the broker owner population is aging, a fair number of deals these days are succession-related transactions,” Gagnon says. “For brokers who would like to participate in market consolidation, there remains a need to team up with a strong strategic partner. In fact, that need will most likely increase with time as brokers are more proactive than ever in their search for long-term partnerships with carriers.”

Even with all this consolidation, IBAO’s Randy Carroll observes that brokers have virtually maintained the number of locations across Ontario.

“When you look at consolidation from our association perspective, we had 683 main locations (brokerage entities) at the end of 2010 and that number has gone down to 630 as of May 2013,” he notes. “However, the number of total office locations has only gone down by 10 over that period, from 1,289 to 1,279. That means that brokers have kept their locations to serve consumers.

Carroll says that he has seen recent signs of a slowdown, or at least a more cautious approach to M&A activity. This is particularly true for books of business heavy in Ontario auto, given the uncertainty around the promised 15% rate decrease by the provincial government.

“The sellers may want to get out of the market quite quickly, but the buyers are looking at terms and conditions, and safeguards they can put in place to ensure they are not overpaying,” Carroll says. “The numbers are being looked at six times, instead of three times. We have talked to several brokers who were nearing agreement on a sale and have taken a step back,” he reports.

DEMAND AND SUPPLY

In this sense, the M&A status quo for brokers is reflective of the situation for primary insurers, where there is an ongoing search for the right intersection between the buyer’s demand and the seller’s supply. “I think brokers and carriers are being much more selective in terms of the mix of business they are looking for, whether geographically or product-wise,” says Buitendag. “If there is a bo ok heavy in Ontario personal lines auto, many are saying, ‘What is the risk of gaining more of that business?’ If someone had a beautiful book of mid-size commercial business, there would be a lot of people beating down that door. But good luck finding that right now.”

In M&A activity, there is commonly a discrepancy between what the seller expects and what the buyer is prepared to pay, McPhie points out. There is also an increasing complexity to the negotiation of transactions, which involve tax considerations, multiple lines of business, subsidiaries, restructuring, due diligence and regulatory approvals.

However, McPhie adds that issues sometimes arise in negotiations that can become sticking points. “For example, a company may have a defined benefits pension plan and that represents a significant cost and a risk to the buyer,” he says. “These kinds of things can hold up a transaction.”

Ironically, it is often brokers and insurers that can structure M&A negotiations through transactional risk solutions, such as warranty and indemnity insurance. Demand for transactional risk insurance grew by 41% globally in 2012 “as firms increasingly turned to the insurance market to protect large deals and cross-border acquisitions or sales,” Marsh noted in a press release in March.

A CLEANER TRANSACTION

McPhie says that some solutions may involve transferring certain items off balance sheet so that a transaction can proceed. “Insurers can, in fact, act as a ‘lubricant’ by transferring these types of things off balance sheet and separating them from the deal for a cleaner transaction,” he explains. “You are seeing more interest in this kind of approach,” McPhie adds.

While the gradual consolidation of the Canadian p&c market is a discernible trend that is expected to continue in the next five years, it is difficult, if not impossible, to predict the timing and players involved.

“I hear more rumours about companies being sold than I come into the office each week,” says Carroll. “The Travelers’ announcement brought The Dominion rumours to an end. So which one is next?”