Report Says M&A Deal Flow Will Pick Up, Lists Potential Candidates

By | December 13, 2011

The insurance industry is likely to see more robust mergers-and-acquisitions activities in 2012, according to a New York investment and research firm.

In 2011, the M&A deal volume started off relatively slowly, followed by a notable pick up in the latter half of the year.

Keefe, Bruyette & Woods said in its Dec. 11 report that it expects the M&A deal flow to pick up even more next year because of continuation of limited organic growth opportunities, coupled with declines in investment returns and excess capital placing a drag on returns on equity (ROEs).

Report Names Potential M&A Candidates

The firm said most of Bermuda remains open to M&A, likely in the form of mergers of equals. It also expects M&A activities to continue in the small-to-mid cap specialty/regional insurer space.

It said it is highlighting names such as American Safety, Eastern Insurance and Navigators Group as potential takeout candidates.

The report also mentioned Nationwide Mutual’s acquisition of Harleysville this year and how Harleysville was able to fold its mutual under Nationwide’s, essentially leveraging the mutual’s capital to increase the return to public shareholders. The Nationwide/Harleysville deal has created increased interest in other names that have a downstream mutual structure like Donegal, State Auto Financial Corp. and EMC Insurance, the firm said.

‘Unusual Period’ in Insurance Industry

The firm also offered its take on current pricing levels in commercial lines. It said the property/casualty insurance industry has entered an “unusual period.” It said the industry is in a cycle shift where commercial lines prices have bottomed and are selectively rising.

But what is historically unusual is that this shift is occurring despite solid capital positions, which are allowing many leading players to buy back stock, the firm said: “Capital remains plentiful but pricing is improving, yet returns on equity (ROEs) are likely to decline…In our view, the industry is reacting to what appear to be increasingly common ‘unusual’ large loss events and several other steadily building pressures on earnings.”

As a result, the firm expects rate improvement to be modest, not uniform and “not in any way a traditional hard market.” For those well-positioned, this environment could be a boon, but for others, it won’t be enough.

Keefe, Bruyette & Woods said that while industry observers are excited about rising prices, the rate increases have not yet been enough to offset significant earnings pressures. Weakening reserves, claims inflation, and lower reinvestment yields are driving ROEs to low-to-mid single-digit levels, with only the short-tailed reinsurance lines seeing the necessary levels of rate improvement to reverse the trend, it said.

The talk of the industry is pricing improvements, the firm noted. During the third-quarter earnings conference calls, CEOs of industry leaders such as Travelers and Chubb discussed 3-4 percent rate improvements in primary commercial lines and gathering momentum.

In reinsurance, the picture appears even better as the many loss events of 2011 and Risk Management Solutions (RMS) model changes drive low double-digit rate hikes.

What makes these improvements surprising, according to Keefe, Bruyette & Woods, is that historically, hard markets have been driven by an industry balance sheet crisis. However, the industry appears to be financially stable.

Moreover, the liquidity gates appear open with much publicity around the formation of new reinsurers, backed largely by hedge fund capital.

Today’s turn, instead, appears to be driven by rapidly declining earnings. First by weakening investment yields where expiring rates are approximately 100 bps above new money yields. Secondly, reserve releases are rapidly slowing for the industry. Third, underlying pre-cat accident year combined ratios are rising, up 1.7 percent in the third quarter compared to one year ago.

In this environment, Keefe, Bruyette & Woods said it likes the higher quality franchises, the big brokers, and select exposure to the short-tail reinsurers and insurers.

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