The role of capital markets in the (re)insurance industry was uncertain a year ago. The eruption of the financial catastrophe within weeks of last year’s Rendez-Vous caused credit markets to seize and wreaked havoc on equities. Access to capital not in the reinsurance system already effectively closed. Today, however, the situation is vastly different. Financial markets are thawing, and equity values are coming back. Investors are showing more confidence in insurance risks — both directly, through catastrophe bonds, and indirectly, via equity markets. Mergers and acquisitions (M&A) are gaining momentum, as well. We’ve pierced last year’s cloud of pessimism, and the opportunities ahead are quite clear.
Through the first quarter of 2009, the (re)insurance industry felt the effects of the financial crisis. Balance sheet bleeding stopped, but risk-bearers struggled to secure replacement capital. The few attempts to raise capital showed limited success at best. By the end of the second quarter, though, the marketplace was much different. The Guy Carpenter Global Reinsurance Composite increased its aggregate shareholders’ equity by 8.2 percent. Share prices stabilized, and reinsurance rates held steady. The flow of capital resumed, with momentum continuing to grow in the early weeks of the third quarter.
Nowhere is this more salient than in the catastrophe bond market. After a silent fourth quarter, three catastrophe bonds were issued in the first three months of 2009, and the second quarter added another six. In all, USD1.38 billion in risk capital came to market. While this is down 42.5 percent from the first half of 2008, it certainly points to a rebound from the last quarter of last year.
Emphasizing the strengthening of the catastrophe bond market is the tightening of prices at the end of the second quarter. Through much of 2009, catastrophe bond spreads widened, based on prevailing financial market conditions and the fact that, despite the financial catastrophe, traditional property-catastrophe reinsurance rates did not even return to 2007 levels. As expected, calmer market conditions have put downward pressure on catastrophe bond spreads recently. Parkton Re Ltd., for the benefit of the North Carolina Joint Underwriting Association and the North Carolina Insurance Underwriting Association (NC JUA/IUA) and on which GC Securities* served as co-lead manager and joint bookrunner, was priced at nearly half of the 2009 average. Further, it was the only catastrophe bond this year, as of this writing, to be priced 25 basis points below the low-end of guidance … during wind season. Parkton Re was also the first sponsored by a residual market, signaling an increase in flexibility in an issuance year dominated by experienced sponsors.
The 89 percent of sponsors that were not first-time catastrophe bond market participants highlight the strategic value of this type of capacity. Though having to contend with above-market pricing for the first half of the year, they transferred risk in accordance with plans intended to address specific perils that can be difficult to lay off using traditional reinsurance. The familiarity of repeat sponsors with the intricacies of the catastrophe bond market contributed to making 2009 the fifth most active year in the history of this segment in terms of risk capital issued — with two quarters still to go. If forecasts of a USD3 billion issuance year are attained, 2009 will supplant 2008 as the third-busiest catastrophe bond year in history.
Investor demand played a significant role in the rapid turnaround. Their appetite for direct participation insurance risks resulted not only in the completion of the nine transactions but also led to the upsizing of several bonds. For an industry concerned about the availability of capital in September, the fact that anxiety virtually disappeared by August is nothing short of remarkable.
The same trend is at work for the indirect consumption of insurance risks. Carrier efforts to restore balance sheets began to bear fruit in the second quarter of 2009, though a return to the capital levels of late 2007 is unlikely in the near future. (Re)insurers will have to operate in 2010 without the cushion on which they relied in 2008, but fears of a capital famine — permeating the industry in 2009 — appear to have been allayed.
The resurgence in capital availability has implications for (re)insurers beyond the direct assumption and transfer of risk. In combination with low equity values for many carriers, it is leading to an increase in M&A activity. M&A can accelerate growth efforts, allowing carriers to enhance their businesses without having to invest in the development of new lines of business and having to wait for organic growth to deliver target returns.
Many carriers see that they can acquire supplemental or complementary businesses either at or close to book value, which sets the stage for an outsized return on equity (ROE) as capital markets continue their trajectory toward recovery. Last year, average ROEs for the property and casualty sector fell from 15.2 percent to 4.4 percent. This measure has rebounded, reaching 13.7 percent at the end of the second quarter of this year, though the 12-month period ending July 31, 2009 shows an average ROE of 1.9 percent. Further, the fact that many carriers have been trading at or below book value has prompted them to hold their cash until the market turns.
After a record year for M&A in 2003 — with 42 deals at an aggregate transaction value of above USD18 billion closing - the market slowed through 2006. Some momentum returned in 2007 — 48 transactions amounted to an aggregate value of just under USD13 billion — and the market became robust last year. More than USD16 billion in M&A was executed over 59 transactions. This year is busy as well: 30 deals were closed by the end of the second quarter, with a combined value of USD5.7 billion. As this situation unfolds, we believe that M&A activity will gain momentum, with acquirers particularly focused on specialty lines and excess & surplus companies, as well as tactical growth opportunities with expense synergies as they arise.
In the near-term, the challenge that many (re)insurers face is to attain profitable growth. The reopening of capital markets around the world has instigated interest in M&A, as carriers will be able to source the resources necessary to expand. Over the coming 24 months, expect (re)insurers to consolidate to accelerate growth, capture market share and use economies of scale to push margins wider. During this time, it’s clear that carriers may acquire or be acquired.
From capital constraints and “doing more with less,” the (re)insurance industry’s perspective has changed drastically to one focused on replenishing balance sheets, pursuing M&A agendas and sourcing risk capital from catastrophe bonds. Options that were unavailable nine months ago have become crucial to growth plans, and carriers are already executing them. Uncertainty has given way to expansion, yet caution remains. The impact of capital markets on (re)insurers has never been more evident, leading risk-bearers to manage their capital carefully in pursuit of higher ROEs and increased shareholder value.
* Securities or investments, as applicable, are offered in the United States through GC Securities, a division of MMC Securities Corp., a US registered broker-dealer and member FINRA/SIPC. Main Office: 1166 Avenue of the Americas, New York, NY 10036. Phone: (212) 345-5000. Securities or investments, as applicable, are offered in the European Union by GC Securities, a division of MMC Securities (Europe) Ltd., which is authorized and regulated by the Financial Services Authority. Reinsurance products are placed through qualified affiliates of Guy Carpenter & Company, LLC. MMC Securities Corp., MMC Securities (Europe) Ltd. and Guy Carpenter & Company, LLC are affiliates owned by Marsh & McLennan Companies. This communication is not intended as an offer to sell or a solicitation of any offer to buy any security, financial instrument, reinsurance or insurance product. David Priebe is the Chairman of Global Client Development at Guy Carpenter & Company LLC.