Analysts: Travelers/Dominion Deal Makes Sense, More U.S.-Canadian M&A May Follow

June 18, 2013

The Travelers Companies’ decision to acquire Dominion of Canada General Insurance, a unit of E-L Financial Corp., for $1.1 billion makes strategic sense, according to analysts.

The acquisition now allows Travelers to quickly build up economies of scale for its Canadian operation, observers said.

And from Dominion’s perspective, this merger gives the Canadian insurer a strategic advantage ahead of the upcoming regulatory changes, according to one analyst.

Dominion earns half of its premiums in the Ontario Province where the Liberal Party government is working on implementing a 15 percent across-the-board auto insurance rate rollback as well as other possible restrictions.

And many Canadian insurers are scrambling to prepare for this regulatory change which would likely be implemented in late 2014 or early 2015, and some insurers may be open to attractive merger offers either within Canada or across the border, according to Stephen Applebaum, a senior analyst from Aite Group.

No Hurdles to Closing Acquisition

Mark Dwelle, an equity analyst at RBC Capital Markets, said in his research note that the deal multiple paid amounts to approximately 1.25x book value, which looks like “a reasonable multiple to us given the size and scope of the property acquired.”

“We see no hurdles to closing the acquisition for Travelers, particularly given their familiarity with the Canadian insurance market and regulators,” he commented.

Dwelle said Dominion’s product mix, as of 2013 first quarter, was 61 percent auto, 20 percent personal property, and 19 percent commercial P/C. In 2011, Dominion of Canada was the 10th-largest P/C insurer in the Canadian market with $1.3 billion in premiums and a 3 percent market share. Dominion has produced underwriting losses over the past five years, with a 107 percent combined ratio generated for full-year 2012.

He added that Travelers has been writing only a modest amount of business in Canada, mostly surety and commercial, and this acquisition should complement Travelers’ existing mix and broaden out their Canadian platform — both through new products and new distribution channels.

“We think the way the deal will work is by (a) applying their underwriting/technology to improve loss ratios (b) ramping up premiums to realize the benefits of scale and (c) potentially removing some costs,” Dwelle said.

When asked whether Travelers might also be looking for potential acquisitions within the U.S., Dwelle said Travelers has indicated “a preference to grow organically” in the U.S. “They already offer all major standard lines products — an acquisition would just give share, not strategic benefits.”

And while Travelers has shied away from acquisitions domestically, this type of acquisition makes sense when trying to effectively build out a platform in a major international market, Dwelle said. Travelers could have continued to grow its Canadian presence, but that would have taken a much longer time to execute and gain scale, he said.

Dwelle added, however, that the real margin benefit from this transaction may take some time, as Travelers repositions the book and returns Dominion’s operations to an underwriting profit.

Deal Makes Strategic Sense

Paul Newsome, managing director at Sandler O’Neill and Partners, also said the acquisition gives Travelers more scale in Canada and that the deal makes a fair amount of strategic sense for Travelers, even though “it doesn’t look like they got an absolute steal of a price on it.”

Commenting on how Travelers is paying close to 130 percent of Dominion’s book value, Newsome said “that’s actually a little higher than where U.S. insurance companies are trading and a little higher than where Travelers is trading at, so there was a premium paid relative to U.S. operations.”

Newsome also noted that Dominion is running a combined ratio of about 107, “which is not terribly good. It’s definitely worse than what Travelers has been doing in recent years.”

Still, Newsome said the deal is expected to help Dominion’s operations going forward. “I would expect them to try to improve the underwriting performance. Travelers has a pretty good track record of doing that,” he said.

Insurance ratings firm A.M. Best Co. also commented favorably on the deal. The firm stated that the transaction will enhance Travelers’ scale and product breadth in Canada by coupling Dominion’s small commercial and personal portfolios with Travelers Canada’s surety, management liability and commercial middle market products.

Travelers will fund the transaction through a combination of debt and/or preferred stock financing and internal resources, A.M. Best said.

“Given Travelers’ strong consolidated risk-adjusted capitalization, historically favorable operating results, comprehensive risk management, modest financial leverage and relatively strong interest coverage, the proposed acquisition is not expected to adversely impact the financial position of Travelers or its subsidiaries,” according to A.M. Best.

More U.S.-Canadian M&A Deals?

Stephen Applebaum, a senior analyst in property/casualty insurance at Aite Group, also said the transaction will allow Travelers to quickly expand its operations in Canada.

Travelers’ Canada unit, with a mere 0.64 percent market share and only $268 million in premium, will now immediately join the ranks of the top 10 Canadian P/C carriers by acquiring Dominion, he said.

Applebaum forecasts there could be more M&A transactions involving Canadian insurers in coming months as the Ontario government prepares to implement a mandatory auto insurance rate reduction.

Ontario’s auto insurance market, at CDN$12.3 billion in 2012, represents 60 percent of the entire Canadian auto insurance market of CDN$ 20.6 billion for 2012, excluding government operated plans in BC, Manitoba and Saskatchewan, he said.

“Going back several years, auto insurance rates in Ontario have been among the highest in North America,” he said.

“As a result, the Ontario government, which is a Liberal Party government, and a second party called New Democratic Party together have a proposal to mandate insurance companies to reduce auto insurance rates by 15 percent and to do whatever they have to do to make the reduction. That was in response to the public outcry over rates.”

And just last week, he said, the Ontario government formalized in its budget the proposal to reduce auto rates by 15 percent. Furthermore, the provincial government also included a reference to limiting the return on equity that an insurance company can earn. The Ontario government will work on detailed regulations and release them later this year. “I would expect adoption probably in late 2014, early 2015,” he said.

“So now, some very large insurers that sell auto insurance in Ontario are scrambling to figure out how to cut costs enough and perhaps raise premiums to meet the 15 percent mandate,” Applebaum said.

“They will have to get smarter and faster and better at what they do. But some of these insurance companies are just not capable of changing that quickly,” he said. “That leads me to think that companies like Dominion, which had underwriting losses for the past five consecutive years, just would not survive well in that environment.”

“And if an attractive offer comes along, such as the Travelers’ offer, I think those companies in that position will consider those offers much more carefully than in the past,” Applebaum said.

On the other side of the coin, Travelers, which has a tiny position in the Canadian market but a very dominant position in the U.S. market, has been looking for growth opportunities internationally and has found one in this situation, he added.

“And I think other companies will follow suit. There are other large U.S. auto insurance companies who have really perfected the auto insurance process, the entire process by which auto insurance is sold, packaged and — most importantly — by which claims are adjudicated. The key to this 15 percent rate reduction will be the claims adjudication.”

Applebaum forecast that at least two and perhaps three more similar transactions could materialize in next 18 months.

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