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Solvency II sounds like the title of an unimaginative Hollywood movie sequel. But this insurance industry EU directive, due in 2012, promises some interesting plot twists — including a big rise in M&A activity, surprising in today's turmoil.
Tim Burke, CFO Europe Magazine
April 7, 2008
When Swiss insurer Helvetia announced in March that it would buy Italy's Padana Assicurazioni, a small company providing private insurance policies for employees of energy group ENI, formerly its parent, the deal must have been a relief to management and investors alike. Last year, chief executive Stefan Loacker had told reporters that Helvetia wanted to be a player in industry M&A, but that a lack of willing sellers was dampening deal flow. And make no mistake, Helvetia wants — and needs — to grow.
"The clear message that we get from analysts and investors is 'You've delivered some nice results in the last few years. We need to see the growth story now — either that or you give capital back to the shareholders,'" says Paul Norton, Helvetia's CFO since July. "There's clearly an increase in the pressure from a couple of different sides, which leads us to say that we do need to grow."
Investors are one big reason why insurers such as Helvetia are feeling the pressure to build and branch out. Brussels is another. What lies behind this is Solvency II, a European Commission directive due in 2012, which will overhaul the legislative supervision of Europe's insurers for the first time in more than 30 years. Though still at draft stage, the new directive looks set to favour insurers that have diversified their business by requiring them to hold less capital to cover their range of risks. Ratings agency Standard & Poor's reckons that more than a quarter of Europe's 5,000 insurers will face "major strategic decisions" once the new rules are introduced, including whether to get involved in industry M&A.
As it happens, plenty of insurers have already been brushing up on their deal-making expertise as part of overall growth plans. (See "Big Buys" at the end of this article.) Some are targetting emerging markets. Others are branching out into product distribution. But all are being cautious in a quintessentially risky business. The burning question their CFOs are now asking is how to manage M&A strategies at a time when market conditions are making any kind of deal-making so difficult.
While few European insurers have had to announce significant writedowns as a result of exposure to America's subprime crisis, investors seem to have treated insurance much the same as any other financial-services stock — when German bank Sal Oppenheim published a study of insurance consolidation in December 2007, it noted that valuations were close to a ten-year low. The fact is that "every insurance company in the world is getting hammered by the developments in the financial markets," says Joseph Streppel, CFO of Aegon, a Dutch life insurer with revenue-generating assets of €371 billion.
So even though Streppel expects Solvency II to drive deal activity, the current environment for public companies such as Aegon is that "it's pretty difficult to stick our necks out and do a large acquisition," he says. Issuing shares would be tough and few investors would be happy to see the board use surplus cash — Aegon has more than €1 billion — to pay a premium. That said, standing still won't be an option for long as Solvency II approaches.
Root and Branch
One of the main proposals of Solvency II focuses on companies' solvency capital requirements, which will be worked out with a risk-based model, rather than the mathematical formula of Solvency I. If a company underwrites businesses in areas unlikely to run into a crisis at the same time — say, car insurance in the UK and home insurance in the US — Solvency II should require it to hold less capital to cover the combined risks than for either individually.
The beneficiaries are expected to be large, diversified insurers with good risk management processes. Smaller companies with fewer business lines may suffer. "That is bound to lead to some sort of pressure for M&A activity across Europe," says Ian Dilks, global insurance leader of PricewaterhouseCoopers. "Either for big companies taking advantage [of the new regulation] or smaller ones finding that they have to sell out because they're just not going anywhere."
Yet don't expect big-ticket M&A in an environment where it's hard to borrow money "whether you're trying to buy a house or a £7 billion insurance company," says Matt Lilley, an insurance analyst at Lehman Brothers. Rather than encouraging deals between large players that are "obsessed by staying independent," he says current insurance consolidation is likely to involve smaller transactions — lesser players merging or larger companies acquiring smaller businesses as bolt-on buys.
Indeed, at Aegon, bolt-ons are currently all that's on the table. But Streppel says that's not a concern. Despite several acquisitions in the past — the largest being its $9.7 billion takeover of Transamerica in the US in 1999 — the company today focuses on organic growth in its core markets of the US, the Netherlands and the UK. There's now a limit to the synergies that can be achieved by growing through M&A in these markets, Streppel says. "We don't need to expand scale there because our unit costs will probably not be much lower if we double the size of those companies."
In central and eastern Europe, however, acquisitions have helped the company enter new markets and, adds Streppel, expand "a little bit faster" than it could have if it were starting a business from scratch. Earlier this year, for example, it used the acquisition of Ankara Emeklilik, a life insurer and pension provider with €35m of assets under management, to enter Turkey. Such small deals are a necessary step in global diversification, Streppel says, and bode well for future organic growth. "In 10, 15 years from now, countries such as Hungary [could be] comparable to Belgium," he says. "To build up a position now in Hungary, the Czech Republic, Slovakia, Poland and Romania is a good thing. So we spend money there on small acquisitions, and we have capital available to grow pretty fast in those countries."
Not all insurers are so keen to branch out into new markets, even if they want to flex their acquisitive muscles. In Switzerland, Norton of Helvetia says, "we're not going into eastern Europe, we're not going to go into emerging markets — Asia, India or whatever." As he sees it, the company has neither the infrastructure nor the people to crack new markets for now. Instead, Helvetia is focusing on core markets of Switzerland, Spain, Italy, Germany and Austria. The company's gross written premiums of SFr5.5 billion (€3.5 billion) are fairly evenly split, with SFr2.9 billion from its life-insurance business and SFr2.6 billion from non-life. But the life business is concentrated in Switzerland, and Norton wants to rebalance this.
Like others, Norton sees a chance for more M&A in the sector. As fixed costs increase, he says, smaller players may have to boost business volumes. "Infrastructure costs have been driven up by regulation in the last couple of years, and it will get worse — you have Solvency II coming along the line, you have much stronger regulation in most territories," he says. "In Germany, the myriad small mutuals with tiny premium volumes, when they're forced to do Solvency II and have all these regulations that come out, [they] are going to find that their cost structure increases considerably. Unless they can at least create their own capital from profits, they're going to have to do some kind of deal."
It's not a situation that Norton believes Helvetia is likely to face. He reckons the company's international units could "probably have a certain amount more premium without having more fixed costs." But the pressure from analysts and investors to present a compelling growth story remains, as does the knowledge that the company's balance between life and non-life business needs adjusting. "We need to get the balance if we want to be a full service provider on a service basis," Norton says. "In the life business, we'll have to develop that or rethink our strategy."
Putting itself up for sale is unlikely, the finance chief adds. The company values its independence and sees "no reason" to sell itself, while mergers of equals are difficult to pull off. Instead, organic growth and smaller deals are the preferred strategy, which may include acquiring a distribution business. "Our aim is to look for stuff that is basically below the radar screens," Norton says. "It's large enough for us but it's probably too small for the big boys to worry about because it doesn't really add anything to them. And we are seeing opportunities like that around."
Better to Bolt On
Other insurers are being more aggressive in pushing ahead with their M&A strategies, despite the ongoing financial turmoil. Some are repositioning themselves in new parts of the value chain, such as distribution. Others are entering new markets. In the former camp is AXA UK, the British arm of the French insurer, which has £74 billion (€94 billion) of invested assets. During the past 18 months, group finance director Philippe Maso y Guell Rivet and his colleagues have been buying up brokers and other distribution firms.
"Clearly one of the difficulties we had in the UK was distribution," says Maso y Guell Rivet, finance director of the British business since 2003. "We operated 80% through intermediaries — on the life side with independent financial advisers, on the property and causal side with brokers, be it for personal lines or commercial lines." This meant the business model was overly reliant on channels that didn't allow AXA to get close to its customers.
The decision to move into distribution led to a raft of acquisitions starting in early 2007, including non-life takeovers of brokers Stuart Alexander, Layton Blackham, Smart & Cook and SBJ. Some 20 other targets have been snapped up behind those four pivotal acquisitions. The team also decided to move into direct distribution with the acquisition of Swiftcover.com, a website offering car, pet and travel insurance based on technology that the CFO says could eventually be used in other international AXA businesses. These deals give AXA UK an initial foothold in the distribution sector, and Maso y Guell Rivet adds that "this is a journey" along which the company still has further to go.
Despite the fact that AXA UK is one of the few AXA businesses with a dedicated M&A team and that deal-making is "part of the DNA" of the business, Maso y Guell Rivet stands behind group statements insisting that there will be no large deals in the UK. As at Aegon, only bolt-on buys are considered. The group's main fire power will be reserved for emerging markets, as seen in recent acquisitions in Russia, Mexico and Turkey. "Bolt-ons in the distribution sector meet our UK strategy," the CFO says. "We see, even more than a year or two ago, that there is no point in contemplating any big move in the UK market in particular."
While AXA UK uses acquisitions to position itself in new channels, Swiss peer Zurich Financial Services (ZFS) has placed bolt-on M&A at the heart of its international growth strategy. In January, it entered Turkey with the takeover of general insurer TEB Sigorta. The deal was the culmination of a year of small acquisitions, including insurers and insurance intermediaries in the UK, Germany, Spain and Russia.
"Something I really like is that the common market in Europe offers insurers the possibility to build a Europe-wide business and go away from the country-specific locations," says Dieter Wemmer, CFO of the Zurich-based insurer since March 2007. "Traditionally insurers are pretty local, and the opportunities of the common market have not been fully discovered by the insurance industry."
European expansion is a definite driver behind ZFS's recent deals. As at Aegon, organic growth is important in mature markets, but M&A has helped the group get a foothold in emerging economies, says Wemmer. Lucky, then, that he knows his stuff when it comes to deal-making. During a varied 22-year career with the group, he spent the four years from 1999 as ZFS's M&A director. Much of 2002 and 2003 involved a restructuring aimed at focusing the business on specific markets, improving operational efficiency and strengthening its balance sheet. For Wemmer, that meant revisiting businesses the group had bought in the 1990s to see how they had been integrated, offloading any that no longer fitted with the turnaround vision.
That experience gives Wemmer useful insight into the deal-making going on in the sector today. "I had done a lot of disposals for the group in the clean-up phase," he says. "I've certainly lived through complex transactions and probably can still help people with a lot of operational advice and also looking at the risk profiles on what we are doing."
However, Wemmer says he isn't as hands-on with acquisitions as he was. Since January, former CEO of Swiss reinsurer Converium, Inga Beale, has acted as head of M&A. While Wemmer keeps close tabs on deal-making, he's taking a step back to gain perspective on whether a transaction is worth chasing. The finance chief says that the group, which had gross written premiums of $73 billion (€46 billion) last year, will not forsake its return target for an acquisition. "It's a balancing act," he adds. "Of course you want to expand the group and have to be bold about doing transactions and taking risks. But the risk needs to be measured."
Wait and See
Both Wemmer at ZFS and Maso y Guell Rivet at AXA UK say their companies will continue bolstering business with careful bolt-ons, and Lehman's Lilley says the European industry "would benefit from consolidation." Meanwhile, Sal Oppenheim predicts that diversification will "really pay off" for insurers once Solvency II takes hold. But the uncertainty pummelling the financial markets at present means many companies will still be wary of making major moves.
At Aegon, the situation in the financial markets makes life frustratingly uncertain, even though the company isn't entertaining big buys. Does CFO Streppel see investors' perception of insurers changing? "The problem is pretty complicated because the markets only gradually understood that if you only invested in AAA and AA securitisations in the subprime and you have no CDOs at all, the chances are pretty low that you have to take impairments," Streppel says.
"Until that understanding broke through, we were treated exactly the same as the investment banks that kept leveraged positions in BBB subprime structures, so they were hammered down and then the general market thought, 'The insurers do all that stuff as well,' and there we went as well." (For the record, when Aegon announced its fourth-quarter results, it said there was no impairment to its €2.9 billion subprime portfolio.)
All Streppel can do is wait to see when and how the market shifts back and values insurers more fairly — besides, he says, insurance CFOs have plenty of other things to keep them busy. "In the meantime, as CFO you look to your general risk management, defence levels, pricing for assets and products, liquidity, you handle capital as efficiently as possible," he says. "It is a difficult time [but] what you do in practice is set out your strategy, check it once again and be prepared to execute that strategy when the market is better."
Tim Burke is senior staff writer at CFO Europe.