Following a review (Part I) of two significant “X-factors” that exist in the market that continue to stifle M&A activity, we explore the reasons why one would expect to see more M&A activity occurring in the next 6 to 12 months.
All that said, many of the other leading indicators point towards a market that should experience an increased level of M&A over the next 6-12 months.
1. Excess capital: Since the asset-driven capital depletions associated with the global financial crisis in the fourth quarter of 2008 and the first quarter of 2009, the industry’s balance sheets have been restored to year-end 2007 levels - levels at which many felt the industry was overcapitalized.
The table above highlights several important factors driving the industry’s current capital position. First, the capital depletion in the fourth quarter of 2008 was driven in large part by unrealized losses on investment portfolios, which increased during 2009 - thereby “restoring” capital. Unlike claims-driven capital depletions where capital is paid out to claimants and is “restored” by rate increases and/or new capital, asset-driven capital depletions can revert to capital replenishment with a turn in market conditions. Second, the lack of significant catastrophe activity drove high net income levels, thereby restoring capital accounts. Third, boards and management teams curtailed traditional capital management strategies of share repurchases and dividends during the period. One lesson that was very clear from the global financial crisis is that access to capital can be significantly impaired, which continues to haunt boards and management teams in the current environment - again, serving to increase the capital position of the industry.
2. Soft market conditions: A natural by-product of excess capital is soft market conditions. As the table below illustrates, pricing levels are back to the pre-2001 levels after a period of steep increases from the period following the events of September 11, 2001 through 2004.
While the table above is for U.S. commercial lines, the softening trend is consistent across most product lines globally in the current environment.
3. Need for growth: The combination of excess capital and soft market conditions creates an environment whereby carriers seek premium growth - driving M&A activity.
Overall, factors suggest there should be an increased level of M&A activity over the next 6-12 months; however, the market cannot ignore current valuation levels and the macro-economic environment (the “X-factors”). As has been the case thus far in 2010, transactions will continue to be done - it is the level of activity that remains uncertain. Regarding year-to-date activity in 2010, buyers were consistent on two fronts across most transactions, specifically (i) being opportunistic and disciplined and (ii) satisfying a need to show top-line growth in discrete segments of the market. The market is also seeing a number of private equity firms realizing investments on portfolio companies, in particular on risk-bearing entities. For the most part, private equity firms are cautious with respect to making investments in risk-bearing entities - but will do so in support of existing portfolio companies. Instead, insurance-focused private equity firms appear to be most interested in making insurance services investments in the current environment. Lastly, the market is seeing increased M&A activity with U.S. specialty firms. Be it a managing general agency with a particular niche focus or a risk-bearing entity with specific expertise, U.S. specialty is seeing M&A activity - which we expect to continue over the next 6-12 months.
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Norman Brown, Geoff Sweitzer and Bart Zanelli are registered representatives of MMC Securities Corp.