The global reinsurance sector continues to face challenging business conditions, although the sector managed to benefit from modest rate increases in 2018 and in the first half of 2019, after record back-to-back catastrophe losses in 2017 and 2018. However, pressure on the sector's earnings continues, with plentiful traditional and alternative capacity, changing cedants' demand, and the commoditization of property risks. Thus, reinsurers want to strengthen their relevance and improve the resilience of their business and financial positions. To achieve this, the industry has employed various strategies, including highly tailored reinsurance solutions, pairing up with alternative capital providers, enhancing digital capabilities, and exploring opportunities to close the protection gap.

Mergers And Acquisitions Will Likely Continue In Earnest

Reinsurers' merger and acquisition (M&A) activity is still a hot topic, particularly because some players are posting subpar shareholder returns due to cost inefficiency, margin pressure, and still-excess capacity. Through the first half of 2019, the deal value of M&A activity in the insurance world totaled more than $20 billion (see chart 1). Whilst this is below the average of recent years (compared to same periods in prior years) we think this represents a temporary lull rather than the end of the M&A dance.

Chart 1

Continued challenging business conditions, coupled with cheap financing in the debt market, will continue to fuel M&A activity for the next few years. In particular, those competitors with a more narrow business profile or limited geographic footprint will likely either consider M&A or become targets themselves. Further, the ongoing convergence of the insurance, reinsurance, and insurance-linked securities (ILS) markets through M&A will continue. We therefore anticipate more deals similar to AXA and XL, and Markel and Nephila (one of the largest alternative capital managers). Geographic diversification will also continue to drive deals, as demonstrated by China Re's acquisition of The Hanover Insurance International Holdings and RenRe's acquisition of Tokio Millennium Re. If executed well such strategic deals can improve prospects for the combined group through a better competitive position built on scale, expertise, diversity, and profitability.

That said, we do not expect consolidation among the top 10 reinsurers as they already account for about 70% of the total net reinsurance premium (about $210 billion) emanating from the top 25 reinsurers (see chart 2). Furthermore, many of them have a material amount of direct insurance business. A merger among these reinsurers would bring not only significant execution risk, but also counterparty concentration risk for the cedants, and thereby could lead to a substantial overlap and the resulting loss of business for the consolidated group.

Chart 2

Pressure Is On The Less-Diversified And Higher-Expense-Base Players

The reinsurance sector's earnings prospects are slightly better given it managed to stop the pricing decline in 2018 and achieved a slight increase in 2019 after heavy catastrophe losses in 2018 and 2017. However, conditions remain somewhat difficult. We do not foresee a significant change in these underlying conditions because there is enough capital on the sidelines waiting to join the sector.

Competitive pressure, in our view, is more intense for reinsurers that are less diversified or suffer from higher expense ratios relative to peers. Many of the reinsurers continue to focus on cost efficiencies to mitigate margin pressure. This is not a surprise, bearing in mind that the average expense ratio for the top 20 rated reinsurers is about 36% (and the average acquisition ratio at about 23%), with a few above 40%. While we recognize that part of the high expense ratio is due to offering value-added services, expense management is on the agenda for most reinsurers in order to stay competitive. For example, Lloyd's expense ratio is significantly higher than that of peers (39.2% in 2018). This is due, in part, to high acquisition costs, but also to Lloyd's dependence on coverholders who produce close to 30% of its premium. Lloyd's management is working to change its operating model to address this issue by introducing initiatives such as electronic placement and simplifying claims handling.

Diversified players with scale, breadth, and depth of products, sophisticated underwriting capabilities, and the ability to build long-term partnerships with cedants are better positioned, in our view, to navigate the difficult business conditions. These factors provide reinsurers with greater flexibility to change the portfolio mix by dynamically increasing or decreasing the line size across products and markets as pricing/conditions change.

Further, cedants' expectations have evolved. In recognition, some global reinsurers have upped their game by offering tailored reinsurance and capital market solutions that help with the risk management and capital strategies of clients. Such product offerings mitigate the risk of being marginalized because clients are more likely to stick to reinsurers that offer long-term partnerships.

Good targets are increasingly harder to find

Small-to-midsize specialty reinsurers or insurers with a niche sector focus that have good underwriting books are appealing targets for players that seek growth and diversification. However, the number of potential targets within this space has shrunk, reflecting the significant number of M&A deals over the past decade.

Despite lower returns on capital in recent years, price-to-book valuations have steadily increased (see chart 3). Equity valuation multiples, however, are lower when compared to all corporations (see chart 4), mostly because of the capital intensity of the insurance sector (some of the M&A deals or divestments in the insurance sector have been driven by increasing capital demands from regulators). These multiples would be even lower if off-balance soft forms capital (i.e., present value of future profit on the life insurance side) were included. Nonetheless, with the increased valuations, the argument for acquisition is harder to justify to shareholders as the sector continues to struggle to meet its cost of capital.

Chart 3

Chart 4

Ultimately, the attractiveness of the target's business model and its ability to generate acceptable returns relative to yields available elsewhere continue to motivate the deals.

Recent M&A highlights in the reinsurance space include the following:

• Apollo Global Management's new private equity fund completed its acquisition of Aspen, with a view toward strengthening the majority of its existing business, jettisoning unprofitable business, and building on the operational efficiency program that Aspen had launched.
• RenRe acquired Tokio Millennium Re. The transaction is sizable, providing RenRe with greater access to risk, increasing its scale, raising its relative importance to its clients and brokers, and broadening its footprint geographically and in the casualty business, which it has been ramping up.
• China Re acquired The Hanover Insurance International Holdings Ltd., including its flagship Lloyd's Syndicate 1084. We expect this acquisition to help strengthen China Re's existing presence (including Syndicate 2088) within the Lloyd's market and to further geographical diversification outside the domestic Chinese market.

Acquisitions of alternative capital managers is also heating up

Alternative capital has grown in importance (making up 15% of total reinsurance capital, which stood at $605 billion at the end of March 2019 according to Aon). In recognition, reinsurers and some insurers continue to build their strategies around alternative capital to harness the opportunities pertaining to this area. In 2018, Markel Corp. acquired Nephila Holdings Ltd. (with assets under management over $10 billion), specializing in reinsurance product offering a broad range of reinsurance products, including ILS and catastrophe bonds. SCOR is acquiring Coriolis Capital (about $800 million of assets) to boost its alternative asset management capabilities. White Mountains is buying 30% stake in Elementum Advisors (with over $4 billion of assets).

We foresee further convergence in the insurance, reinsurance, and ILS markets in the next few years as structural changes in the industry continue to place pressure on reinsurers, especially considering that capital is still relatively cheap. A mega deal involving large players that shakes up the market order would be a surprise, but is not totally out of the question. For example, towards the end of 2018, we saw primary insurer Covea's unsuccessful bid for SCOR. Other examples include Japan-based Softbank's failed plan to buy a minority stake in Swiss Re. Such a move could have potentially accelerated the role of technology in the reinsurance space, bearing in mind SoftBank's domestic and overseas technology companies, such as its e-commerce platform in China and its telecommunications businesses in Japan and the U.S., not to mention its large balance sheet, with assets exceeding $260 billion.

M&A Is Typically Ratings-Neutral At Best

Multiple forces drive consolidation and, therefore, the establishment of a clear objective is vital for a successful M&A transaction. Consolidation could be used to create growth opportunities through combined platforms, a stronger position in chosen products and regions, increased diversification, and potential expense synergies that could improve the earnings profile. A well-executed deal can protect creditworthiness and improve shareholder value. However, M&A deals come with inherent execution risks and, in particular, can dilute capital adequacy, depending on the chosen financing structure.

From a credit perspective, M&A transactions are usually slightly negative when first completed in view of the execution risk and given that stronger players often take over weaker rivals, except if it's a merger of equals with minimal overlap. Furthermore, private equity or investment holding companies generally acquire (re)insurers to enhance returns through transformational changes (expense reduction, capital optimization, etc.) or to diversify their source of earnings. In our view, these types of investors generally appreciate the potential credit rating sensitivities of overleveraging the balance sheet and disrupting the business. As such, we typically do not see material changes in the financial or business risk profiles of the reinsurers. The risk of a downgrade could raise significant concerns from both policyholders and investors.

The acquirer perspective

We have typically kept our ratings on the buyers at the same level as pre-M&A. Of the rated entities listed in table 1 in the Appendix, we placed 30% on CreditWatch negative or revised the rating outlook to negative upon the announcement of an acquisition (see chart 5). We eventually affirmed the ratings on almost all of these companies during the subsequent two years. This demonstrates our conservative view of M&A at the initial stage, when we place more weight on some of the execution risks, despite potential upside from the strategic rationale underlying the deal. As we see evidence that the transaction has helped (or is unlikely to reduce) the combined group's creditworthiness, we tend to revert to a stable view.

Chart 5

The target perspective

Our assessment of acquired companies reflects any upside or downside potential, based on our view of the combined entity. Typically, we limit the ratings on a subsidiary to its parent rating level or lower, unless there is strong evidence that the parent is unlikely to negatively affect the subsidiary's business and financial profiles.

The ratings impact following an acquisition is generally mixed (see chart 6). Some entities may cease to exist following optimization of legal and organization structures (in which case, we would withdraw the ratings). The surviving entities may see a change in their relative importance to the combined group (in which case, we would take a positive or negative rating action, or none at all, as appropriate).

Chart 6

The M&A Dance Will Continue

Challenging operating conditions may push a few insurers to pair up to mitigate competitive pressures. In particular, those that are less diversified or have a higher expense base will continue to find it difficult to compete with players with larger diversification and scale. We also believe that reinsurers, insurers, and alternative capital providers will continue their path of convergence, with the potential for more deals among these sectors.

A well-executed M&A that has a sound rationale can improve the competitive standing of the combined entity. However, from a credit perspective, M&A transactions are usually slightly negative when first completed in view of the execution risk.

Appendix

Table 1

Related Research

• Bermuda-Based Aspen Insurance Affirmed At 'A'; Outlook Remains Negative On Performance Pressure, July 25, 2019
• RenaissanceRe Holdings Ltd. Outlook Revised To Stable From Negative On Improved View Of Capitalization; Ratings Affirmed, March 25, 2019
• China Reinsurance (Group) Corp. And Subsidiaries 'A' Ratings Affirmed On Chaucer Acquisition; Outlook Stable, Sept. 17, 2018
• Markel Corp. And Subs Ratings Affirmed Following Announcement Of Acquisition Of Nephila Holdings Ltd; Outlook Is Stable, Aug. 31, 2018