Des Potter, Head of GC Securities (EMEA)
Faced with an abundance of excess capital, negligible growth in global reinsurance spend and the pricing outlook continuing to soften, one of the biggest challenges for reinsurers is deciding how to deploy excess capital to generate a return that meets or exceeds the expectations of shareholders.
The options under consideration in the reinsurance sector will include maintaining the status quo, returning capital to shareholders and investing in a growth/diversification strategy, either organically or by seeking mergers and acquisitions (M&A) opportunities.*
Evaluating the merits of each option and the interplay between them is not an easy assessment, with the best capital stewards employing an all-encompassing strategy.
Maintaining the Status Quo
There has often been reluctance among reinsurers to return excess capital to shareholders. Once capital is returned it is not certain that it will be provided again, in a timely fashion or on acceptable economic terms, when the balance sheet needs repair or an interesting investment opportunity arises.
Excess capital acts as a buffer against future losses, particularly relevant in today’s world of low investment returns, volatility in fixed income asset valuations and diminishing reserve releases.
While recent catastrophe activity has been relatively light, we only need to look back to the series of international catastrophe losses in 2010 and 2011 and the subsequent distressed acquisitions or recapitalizations of badly hit companies to observe the ramifications of exhausting this capital buffer. Following such events, (re)insurers want to be well placed to take advantage of a hardening rate environment.
Increasing retentions and cutting reinsurance spend is another way to deploy excess capital. However, given current capacity and competitive rates available in the reinsurance and retrocession markets, it is debateable whether this is the right time to be retaining more risk and potentially increasing earnings volatility.
Return to Shareholders
During the last eight years, reinsurers have been relatively disciplined in returning capital to shareholders when the pricing environment has softened. This was clearly evident during the softening market of 2008, when 13 percent of tangible net asset value (TNAV) globally(1) was returned to shareholders. Conversely, only three percent of TNAV was returned to shareholders when the market hardened in 2006. Given current market conditions, we expect the level of capital returned to shareholders to accelerate in 2013.
Invest in Growth or Diversification
A combination of both organic and acquisitive growth is likely to feature in most successful strategies, with decisions made on an opportunity-by-opportunity basis after considering factors such as strategic alignment, accretive earnings and book value potential, timetable for execution, integration and achievement of critical mass, together with an assessment of the political and regulatory risks.
The need to adapt the reinsurance business model in the current market is focusing executives on the need for economies of scale, product specialism and global reach:
- Achieving meaningful scale – in a reinsurance market with abundant excess capital and where most reinsurance programs are oversubscribed, the need for a meaningful line size or differentiated underwriting contribution has never been more relevant. An obvious tool for the management of expense ratios is achieving economies of scale and diffusing the semi-variable expense base over a larger portfolio of premiums. Equally, capital efficiencies are more obvious for larger entities, with greater diversification credit, better access to financing and an implied reduction in the cost of equity.
- Growing/diversifying by product line – specialty insurance is one of the few market sectors where underwriting and claims management expertise and client/broker relationships are still the predominant differentiators for a successful business. The specialty pricing environment has recently improved, though there are signs that this pricing momentum may diminish with increased competition and competitively priced reinsurance.
- Growing/ diversifying by territory – with growth opportunities limited in mature markets, many insurers are looking to emerging markets for future expansion, in particular China, Southeast Asia and Central and Latin America. This is a longer term strategic play with the potential scarcity of viable targets in these emerging markets continuing to drive premium valuations.
Increasingly, the focus for growth and competiveness in an evolving reinsurance market is moving towards more M&A activity, particularly strategic bolt-on transactions as the need to adapt business models to achieve scale, global reach and a diversified product suite increases.
Guy Carpenter is committed to assisting carriers in plotting their path to sustainable profitable growth and becoming their trusted strategic advisor. GC Securities* provides industry leading M&A advice with deep industry experience and a successful track record. The team is committed to advising and assisting Guy Carpenter clients with their M&A strategies to exploit growth opportunities as they arise.
(1) Based on an analysis of Guy Carpenter’s Global Reinsurance Composite
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*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/NFA/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. (MMCSEL), which is authorized and regulated by the Financial Conduct Authority, main office 25 The North Colonnade, Canary Wharf, London E14 5HS. 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. **GC Analytics is a registered mark with the U.S. Patent and Trademark Office.