View this article online: https://www.insurancejournal.com/news/national/2014/01/09/316503.htm
Encouraged by a vigorous period of insurance M&A activity in the second half of 2012, many in the industry had high expectations of robustness in 2013. It’s clear now that 2013 M&A activity did not reach the levels of 2012 and in fact, 2013 insurance M&A activity resulted in the slowest pace in many years.
Negative factors such as continued macroeconomic uncertainly, overhang of regulatory reform (Dodd Frank and Affordable Health Care Act) and high company valuations have all contributed to the slowdown in the number of acquisitions. Despite these factors, the mood in the market remains positive and many have attributed the general slowdown as simply being related to a period of pause. Although this phase of relative calm may not be completely over, there is reason for optimism: strong fundamental attributes exist supporting M&A opportunities, tax changes that distorted 2013 are abating, the pool of buyers appears to be increasing, a rebuilding of acquisition pipelines for corporate acquirers appears to be occurring and an improving economic climate in the United States should all combine to motivate investors to enter the fray.
Fundamental attributes to the sector will support a return of strong M&A activity.
According to data derived from SNL, in 2010, a total of 336 (225 insurance brokers (IB); 111 underwriters (UW)) deals were announced in the U.S., 401 (288 IB; 113 UW) in 2011 and 416 (IB 322; 94 UW) in 2012.Through the end of September 2013, a mere 168 (120 IB; 48 UW) U.S. based deals were announced equating to around 224 deals on a run-rate basis for the full year 2013. Notwithstanding this recent downturn, the insurance sector has fundamental attributes which when coupled with other macro-economic and industry specific factors and a release of pent-up demand, will lead to a significant increase in M&A activity in the near term.
One of the most positive attributes to consider, particularly as it relates to M&A in the brokerage space, is that it is one which remains highly fragmented with over 40 percent of industry revenues controlled by companies with less than $10 million in annual revenue. To illustrate, between 35,000 and 40,000 brokers and agents operate in the U.S. generating over $100 billion in annual revenues of which only seven brokers each generate more than $1 billion in revenue. Further, no individual broker holds more than 5 percent of the middle market with regional brokers and agents holding around 75 percent. Given these attributes, when compared with other sectors of the economy, we believe the insurance sector represents an unusually ripe space for M&A opportunities, particularly for those with an aggressive plan of building through acquisition.
Tax policies have distorted the trend, but such distortion was largely a 2013 phenomenon.
Expectation of deal activity in 2013 was somewhat tempered by the fact that 2012 was extremely robust. In the fourth quarter of 2012 alone, over 130 insurance broker deals closed in addition to over 20 carrier deals, almost doubling the quarterly average for the last four years. The scheduled increases in capital gains taxes scheduled for 2013 likely caused a significant amount of deal activity to be pulled forward into the fourth quarter of 2012. It is further likely that a similar phenomenon occurred in 2011 as there were similar discussions on raising capital gains tax rates at the end of that year. Notwithstanding the recent talks on the debt ceiling and budget in the current year, there is no clear indication of any impending tax changes of significance upcoming in 2014 that would have a similar impact on pressuring sellers to divest ahead of such changes, thus pulling forward M&A activity.
As deal volumes evaporated in 2013, the bid-ask spread widened somewhat as sellers took advantage of the robust interest which remained in the marketplace — a classic case of demand outpacing supply. This not only depressed activity but also elongated deal processes as buyers and sellers haggled over price which in turn, adversely impacted the number of deals closed. It seems that supply and demand have begun to return to balance, which will presumably have a favorable impact on overall deal activity for the sector.
The pool of buyers interested in the segment is growing.
Historically strategic buyers (i.e., corporations) accounted for well over 90 percent of deal volume in each of the last three years. Notwithstanding this fact, we believe there is increasing interest in the sector by private equity funds which will generate greater demand for deals, thus prompting an increase in opportunities in the marketplace.
The fee-based service nature of insurance brokers typically delivers stable cash-flows while carrying a low balance sheet risk, a structure that aligns positively with the leveraged risk and return strategy employed by private equity funds. In partnership with strong management teams who have built solid platforms, sponsors have increasingly participated in the market in the past year particularly in the insurance service segment.
The $4.4 billion purchase of Chicago-based Hub International Ltd by Hellman & Friedman LLC in August 2013 that came within 12 months of New York-based USI Holdings Corp. and California-based Alliant Insurance Services Inc. and Confie Seguros Insurance Services, were some of the largest in recent years and were all sponsor-to-sponsor deals. This is an evolving trend which we expect will expand as funds both with and without a historical interest in the insurance sector will seek transactions in the space.
This escalated level of activity was clear as more recently Department of Financial Services and other regulators have voiced concern over the risk management landscape of annuity portfolios under private equity ownership. Furthermore, overall regulatory changes and the resulting cost pressures could ultimately be a driving factor causing small and medium sized firms to consider consolidation with larger parties including both corporate and private equity backed platforms.
Specific industry matters on the commercial and regulatory front have temporarily reduced M&A demand but their impact will subside over time.
Industry specific issues impacted the property and casualty (P/C) and life and health sectors respectively. Insurance companies in the P/C sector experienced fairly robust organic growth over the last two years as a result of price increases across most major lines; however, this “rate hardening” appears to be abating somewhat which will lead to increased demand for M&A activity to achieve growth.
According to the Council of Insurance Agents & Brokers’ quarterly Commercial P/C Market Index Survey, the expansion in pricing increases peaked at 5.2 percent in the first quarter of 2013, subsequently dipping to an increase of 4.3 percent on average in the second quarter of 2013. This trend is expected to continue given historical cycles with rate hardening continuing, but at a lower rate that experienced in the first half of 2013 and 2012.
A convergence of challenges also inhibited M&A prospects for life and health (LH&A) insurers. L&H insurers continued to face low interest rates, a challenging regulatory environment and uncertainty surrounding health insurance reform — particularly the implementation of healthcare exchanges.
New capital requirements as a result of the Solvency Modernization Initiative as well as the National Association of Insurance Commissioners’ adoption of principals-based reserving by life insurance companies has begun a new era of risk-based supervision for the industry. These factors have contributed to many life insurers trading below book value, impeding deal activity as difficulties in agreeing on deal terms proved to be an obstacle.
Although rates remain fairly low by historical standards, L&H carriers are likely to benefit from a boost in investment yields as a result of the May 2013 spike in interest rates after the Federal Reserve signaled it could begin scaling back its $85 billion in monthly bond purchases by the end of the year.
Despite the debt crisis of late and the uncertainty it creates, overall economic activity appears to continue to be trending upwards which should positively impact insurance M&A.
An improved economy particularly in the United States, a U.S. stock market at record highs, and a favorable lending environment will result in high levels of capital in the market which we believe will support those seeking expansion through acquisition.
This environment, coupled with the aforementioned factors, represent a “perfect storm” that could result in a very strong level of M&A activity in the insurance sector in 2014 and beyond.
Mark Sponseller, managing director, and Brent Perkel, director, transactions advisory practice, are both with the firm Alvarez & Marsal based in New York.