Carl Boulton: Think strategically over consolidation

As the industry heads into the home stretch of 2010, many successful insurers in almost all segments of the market will be debating the merits of a conservative or, in select cases, aggressive acquisition strategy.

A softening market with significant excess underwriting capacity and relatively weak investment returns for shareholders is pushing the industry towards an interest in consolidation.

It is clear that using size and scale to generate efficiencies can help overcome the challenges presented by the limited profits currently available.

Also, low interest rates coupled with the uncertain economic outlook, are affecting investment returns.

The question is: should excess capital reserves be channelled into acquisitions, and if so where?

We have already seen some of the bigger players start to sound out potential acquisitions and make plays towards consolidating – RSA/Aviva, Resolution/AXA and Prudential/AIG are among those that spring to mind.

However, size-building to gain volume is, in itself, not a long-term solution.

Successful M&As generally involve two companies that did well on their own but that do brilliantly together, developing an expertise and dominance in a particular sector.

The argument for diversification of lines may seem reasonable, but without strength and depth in a segment of the market, the benefits may be limited (in some cases firms may be left to still chase the same small pool of business).

The most straightforward part of the process at present might be building up a war chest as, with many firms trading well below book value, a company’s incentive to sell is low.

At the same time, all insurers will be keeping a close eye on developments caused by Solvency II; they may choose to sit on capital until the liquidity requirements are fully understood.

On the flip side, the run-up to Solvency II may lead to smaller players across Europe finding that they are undercapitalised – and that they have no choice but to merge with a larger group, even at a discounted value.

What can smaller niche players do to realise value through a sale when book values and market prices may not be in sync?

One option is to approach those potential buyers that offer the greatest synergies.

By marketing complementary objectives/activities, sellers may achieve more favourable terms, and the result could be mutually beneficial: the smaller player provides sector expertise, growth potential and increased volume while the larger player brings management expertise, capital and access to markets.

Valuations may start improving from next year, but the unpredictable nature of risks within the sector may see today’s surplus capital diminished.

The industry is ripe for a surge of consolidation. To ensure that the maximum value is unlocked in any transaction, a strategic approach to due diligence will be vital. IT

Carl Boulton is head of insurance at Barclays Corporate.