Over-ripe for picking

In a 7 September report, FBR Capital Markets insurance analyst Bijan Moazami highlighted Bermuda-based XL Group as a possible acquisition target, citing the low value of the (re)insurer’s stock relative to book value, favourable tax status and its potential to generate a high return on equity (ROE) with the right partnership.

He named Canadian insurance group Fairfax Financial Holdings and billionaire investor Warren Buffett’s Berkshire Hathaway as potential suitors, as well as global (re)insurers Munich Re, Swiss Re, Allianz and Zurich.

“XL has plenty of opportunities as a stand-alone company but you can’t deny, looking at the price and knowing what the company is worth, that there could be interested buyers,” Keefe Bruyette & Woods (KBW) equity analyst Cliff Gallant says.

XL is not alone in having obvious potential as a takeover target. Insurance and reinsurance industry stocks are, in general, trading below book value, making the companies potentially attractive to buyers looking to acquire assets at a discount.

In a presentation at this year’s Monte Carlo Rendez-Vous, reinsurance broker Guy Carpenter pointed out that the US property/casualty insurance sector’s share prices had been between 0.8 and 0.9 times book value so far in 2010, compared to a 20-year average of 1.3 to 1.4 times book value.

Furthermore, the reinsurance industry as a whole has a glut of excess capital, as evidenced by the number of share buy-back

programmes and special dividends. Guy Carpenter estimates that the industry was overcapitalised by as much as $20bn at the beginning of 2010. Reinsurers could put this capital to work by buying their rivals.

Not without challenges

In addition, softening rates and falling demand means there are few prospects for organic growth in the reinsurance industry, making growth by acquisition a natural step.

Chief executive of Lloyd’s insurer Canopius, Michael Watson, tells Global Reinsurance that his firm is looking for acquisitions in the wholesale insurance and reinsurance sectors. “Meaningful organic growth in the context of our size is a difficult and dangerous proposition,” he says. “Mergers and acquisitions are not without their challenges but we have shown we can do that and we are keen to find other opportunities.”

According to analysts, the Bermuda market is ripe for M&A. “In Bermuda, you still have a fair amount of reinsurers who are small but looking to get scale,” AM Best ratings analyst Greg Reisner says. “If you look at some of the Class of 2005 in general, some of them are looking to diversify, grow or get scale, so there is potential for deals to happen based on that.”

However, with the exception of the continuing attempt to buy Lloyd’s (re)insurer Brit by private equity firms Apollo and CVC Capital Partners, the reinsurance M&A market is quiet, despite the seemingly favourable conditions.

Obstacle course

Low valuations are both a blessing and a curse for M&A. Buyers are reluctant to pay book value or above, but sellers are equally keen not to sell their assets at a discount. “Companies and boards aren’t willing to come to terms on a deal where there isn’t a reasonable premium on the table for their shareholders,” AM Best ratings analyst Robert DeRose says. “I think the valuations themselves are muting the number of deals that are being done.”

Gallant agrees: “Sellers are frustrated because their stocks are cheap, so I think they would like to realise some of that value and sell.”

Also, the egos of chief executives of merging companies can get in the way of a good deal. “There are issues with management teams – who gets to survive, who will run the company if the companies merge?” Gallant says.

Another deal dampener is the prospect of taking on another firm’s liabilities. The target company’s underwriting standards may be lower than those of the acquiring firm, and any poorly underwritten business could come back to bite the buyer.

In relation to XL, one observer says: “If you acquire that XL balance sheet, there are certain legacies that will come with it. You have to be willing to take the risk associated with those legacies.”

Big changes are required to awaken the mergers and acquisitions market. Better valuations require better prospects, which in turn would need a hard market, and the onset of firmer pricing is usually triggered by a large loss event.

However, while buyers’ and sellers’ expectations from M&A deals diverge, market pressures could force them together. “Perhaps companies will suddenly decide to sell below book value. Otherwise, you are looking at a group that will steadily shrink,” Gallant says. “They are not going to be able to tolerate that for too long.”