Industry Consolidation: Too Fast for Some

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There are many reasonable and compelling factors driving the ongoing consolidation of the property/casualty insurance industry, from a sheer overabundance of capital to an overwhelming need to reduce expenses. Another factor is human nature.

The problem in this all-too-common scenario is carriers rushing into a deal without due consideration into the hoped-for synergies and the integration processes that will beget them. The M&A literature is littered with failed combinations blamed on a poor understanding of the combined entity’s post-transaction cultural, business and market issues, and an even poorer execution of the integration plan to address them.

Not that these challenges will dissuade P/C insurers from acquiring or being acquired. The reasons to engage in M&A activity at the moment are too powerful to sit idly by, insurance industry analysts at three Big Four audit firms contend. However, in the frenzy to couple up fast and furiously, choosing the wrong partner may be worse than staying single.
“Management and boards of insurance companies expect deals to be guided by a proper thought process into an end result,” said Mike Brosnan, partner and leader of the Americas insurance transaction practice at global accounting firm Ernst & Young. “The end result of post-merger integration two to five years out must be one of value realization. To ensure these values are realized, you need strong integration plans that start at the same time as the due diligence into a potential acquisition.”

In other words, acquiring companies want greater assurance that the post-transaction integration challenges of a prospective transaction are spelled out clearly and addressed via proper integration planning prior to choosing a target, much less inking the contract. Is this occurring?

During a conference call on the day the ACE-Chubb merger was announced, ACE CEO Evan Greenberg stated that the mammoth deal was consummated in a matter of weeks. “We put the deal together rapidly but thoughtfully because it made so much sense to both sides for all our constituents” and given ACE’s acquisition experience, Greenberg said. (See related online article, “ACE-Chubb $28.3B Deal Took Just ‘Weeks’ to Put Together: Greenberg.”)

Apparently not thoughtfully enough for ratings firm Standard & Poor’s, which subsequently placed both insurers on negative outlook.

“We made the [negative outlook] decision based on our assessment of the integration risk and the time it will take for the combined company to restore its AAA capital,” said Tracy Dolin-Benguigui, director of financial services ratings at Standard and Poor’s.

If large insurers are not giving enough consideration to post-transaction integration challenges, what about midsize and smaller insurers eyeing deals? Do they have the expertise to evaluate the combined organization’s post-transaction product, market, technology and other integration issues? Do they have the time to do this in the speeded-up M&A market conditions of the moment? Or might they hastily pick the wrong target, only to suffer the financial consequences?

Everybody in the Pool

Certainly, the impetus to engage in M&A activity is overpowering. Despite mild price firming in the P/C market the past three years, conditions are again softening, due to low property-catastrophe losses, excess capital and an uptick in competition. “M&A goes hand-in-hand with a soft market,” said Jerry Theodorou, vice president of insurance research at Conning. “When organic growth is elusive, inorganic growth looms larger.”

A new and possibly more powerful reason to consider a merger or an acquisition is the gut-wrenching realization that insured losses in the future may be significantly less than they have been historically. “As losses go down, premiums go down,” said Tom Nodine, principal in accounting firm KPMG’s insurance strategy advisory group.

Why will insured losses decline? The answer is technology, specifically data analytics and predictive modeling. A case in point is workers compensation. By enhancing their ability to analyze job-related injury and illness claims data, carriers can posit more effective medical care and earlier return-to-work scenarios, lowering overall claim costs.

Another example is automobile insurance. The wealth of driving data provided by sensors, cameras and algorithmic-driven analytical tools is permitting more incisive underwriting of individual driver risks. “We believe and have said for some time that the expanded use of data analytics should translate into shorter, less acute underwriting cycles,” said S&P’s Dolin-Benguigui.

As data analytics takes hold in the P/C industry—a business long castigated as a technology laggard—expect lower aggregate insured losses and, by extension, less of a rationale for insurers to raise their prices. “In future, there will be fewer auto accidents, fewer fires, less theft and people living longer, due to sensors in a home, car and possibly even the human body wirelessly hooked up to computers to provide specific and detailed information about risks,” Nodine said.

While that’s “wonderful for humanity,” he added, it presents serious issues for companies in the business of absorbing risks for others’ money. “Due to these technological advances, I wouldn’t be surprised to see the industry’s combined ratio fall by 20 percentage points within the next 10 years,” Nodine posited.

As larger companies with the financial means to invest in sophisticated data analytics reduce their losses and compete more strenuously on price, they will also invest in technology solutions that reduce their operating expenses, thereby making up some of the difference, profit-wise, caused by the lower premium income.

Smaller insurers, on the other hand, may not have the resources to purchase such systems. Without them, their losses and expenses will be higher, as will the premiums they charge to make up for the shortfall. While the smaller carriers may continue to thrive by focusing on specialty lines of business and service and by employing more customer-focused distribution channels than their competitors, a widening price differential over time may overcome these advantages.

“Large companies with good underwriting, good data, good relationships with brokers and agents, and good pricing increasingly will threaten smaller regional companies that lack these scale-based advantages,” Theodorou said.

Other analysts agreed. “Smaller specialty-type insurers tend to have inefficient operating models,” said Gregory Galeaz, U.S. insurance sector leader at accounting firm PwC. “When they were growing, many of these companies cared little about ballooning expenses. They didn’t invest in systems to reduce expenses, improve distribution and customer relations, and underwrite risks more closely. But, as rates go lower and lower, expenses will become more of an issue.”

Problems Requiring Solutions

Many midsize and smaller carriers are stuck with a tough decision: to invest now in expensive new technology platforms, data analytics systems and operating models to squeeze costs and improve underwriting; to acquire a company that already has these components in place; or to put themselves up for sale.

The latter appears to be increasingly likely. “It’s hard to imagine companies with less than 1 percent market share will find a way to invest in these technologies, putting them at a great disadvantage,” Nodine said. “Without these investments, a merger or acquisition is inevitable. I predict that the number of P/C insurers [in the United States] will be halved within the next 10 years—if not the next five.”

Finding eager acquirers will not be a problem. Several recent transactions indicate a wealth of different kinds of companies willing to plunk down the money to make a deal—reinsurers, large insurers in China and Japan, and private equity all have ponied up to make their bids. At the same time, many midsize and smaller carriers are binging on each other.

For solid reasons. “Two midsize P/C insurance companies or larger joining together can have more powerful analytics because they will now have data from two companies, as opposed to one,” Theodorou said. The greater the volume of data, the better to extrapolate loss causes and patterns, he explained.

With regard to much larger companies the size of ACE and Chubb going on a buying spree, all the observers commented that it was too soon to predict similar sized alignments, indicating (for now) that the giant deal may be an outlier.

With regard to the rest of the P/C market, more deals are likely. “These things tend to happen in waves,” said Theodorou. “It’s the old lemmings theory: If your competitor is doing something, why aren’t you? With all the excess capital sloshing around and interest rates so low, companies are primed to acquire. And they will.”

Some Deals Will Fail

Certainly, in their haste to couple up, there will be winners and losers. Often determining the successful outcome of a merger or acquisition is the effective realization of the combined entity’s planned integration effort.

“The key is knowing what you are buying and how you can go about integrating it—before signing the contract,” said Anthony Diodato, group vice president at insurer rating agency A.M. Best Co. “For instance, the merger of cultures is always a big obstacle. If you can’t put forth a plan to integrate the cultures, you could lose key talent.”

Diodato said most of the M&A deals to date “have been generally prudent, with CEOs attuned to not taking missteps. But a rush to the altar could cause some companies to stumble.”

Is a stampede down the marital aisle inevitable? “When one company in a market acquires, others tend to follow,” said Alessandro Santoni, director and leader of the property/casualty M&A practice at employee benefits consultancy Towers Watson. “We’ve seen this before in the industry when there was excess capital needing to be deployed. [The M&A activity] is not over yet by a long shot. There’s a lot of action going on, with a lot of foreign money coming into the U.S. willing to pay what’s needed.”

Brosnan from Ernst & Young concurred: “There’s definitely room for additional deals.”

As these deals take shape, the onus is on senior management of insurance companies to ensure the M&A due diligence not only introduces the post-transaction integration challenges but also puts forth a plan to do something about them.

Brosnan cited the results of a recent Ernst & Young survey of more than 200 financial services executives affirming the value of a pre-contract-signing integration plan. The plans clearly laid out the integration challenges, how they would be addressed, and the nature and scope of the project management office designated to achieve the goals.

Of the respondents, 29 percent of acquirers that had signed off on a specific integration plan prior to inking the contract later realized a 40 percent reduction in the target’s cost base through the achieved synergies. Only 12 percent of acquirers without a pre-signing plan achieved the same scale of cost synergies.

“Smart companies are no longer waiting to complete their due diligence into a target company before thinking about how the deal will create value,” said Brosnan. “Rather, they’re already planning how to deploy their resources to see the integration effort effectively through to its conclusion.”

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