M&A Fireworks

Anyone who has seen a homemade fireworks display knows the disappointment of watching the “burning schoolhouse.”
After all of the promise and anticipation associated with watching exploding, screaming, whistling and colourful thunderbangers, watching the burning schoolhouse has the same impact as watching a candle flame slowly consume a small cardboard box. The effect is underwhelming, to say the least.

Contrast this with the story of consolidation in the Canadian property and casualty insurance industry.
Between 2005 and 2007, analysts routinely predicted an exciting explosion of mergers and acquisitions activity in the fragmented Canadian P&C market. Companies were amassing capital in the relatively benign catastrophe years of that period, and many proclaimed the capital would ultimately be used for acquisitions that would change the face of the Canadian market. Despite these many predictions, not much happened.

And then the financial crisis hit in 2008. For two years during the crisis, companies were all but silent about M&A. Seemingly, they preferred to “keep their powder dry,” conserving their capital to offset the effects of the contracting financial markets and depressed investment portfolios.

Suddenly, the predicted M&A fireworks occurred in 2010-11. In 18 short months, several major deals were announced. Among them, RSA Canada bought GCAN Insurance Company from the Ontario Teachers’ Pension Plan Board for $420 million. This deal, along with RSA’s acquisition of Canadian Northern Shield (CNS) for $75 million in 2007, vaulted RSA from Canada’s sixth-largest insurer to Canada’s fourth-largest. Then Economical Mutual Insurance Company, Canada’s 10th-largest private insurance company announced its plans to demutualize, pending a new regulatory framework for P&C demutualizations. The Economical’s plan includes either an initial public offering or a “sponsored demutualization,” in which like-minded partners might acquire all or parts of the mutual insurer. Then came a granddaddy merger in 2011: Canada’s Number 1 insurer, Intact Insurance Company, announced its plan to acquire AXA Canada, the country’s eighth-largest insurer in terms of premium volume in 2010. The deal would give Intact a 16% market share in the country, dwarfing that of its closest competitor Aviva Canada, which had a 7.95% market share in 2010.

After hearing all of these loud noises in M&A activity in the marketplace, the obvious question arises. Does all of this consolidation activity mean the fireworks show has finally started? Or is all of this just sound and fury, signifying a prelude to little more than another prolonged burning schoolhouse display?

Consolidation by Numbers

First, a note on definitions: as sources for this story point out, “consolidation” can take two forms. It can occur by means of M&A activity, or it can happen when insurers simply exit the Canadian market. Most observe that if consolidation includes the long-term attrition of insurers exiting the Canadian market over time, consolidation has been slow and steady for several decades. Data from the Office of the Superintendent of Financial Institutions (OSFI) bears out this observation.

According to OSFI, back in March 1998, there were a total of 214 federally incorporated insurers – 98 Canadian and 116 foreign – with assets totaling just over $50 billion. As of March 2005, those numbers had dwindled to 187 federally incorporated insurers (90 Canadian and 97 foreign). As of last year, in March 2010, Canada still had 187 federally incorporated insurers (95 Canadian and 92 foreign), with assets exceeding $123.6 billion.

These numbers paint just a partial picture, as they exclude provincially licensed insurers. In a July 2011 paper presented to Canada’s Department of Finance, the Insurance Brokers Association of Canada (IBAC) notes there are currently 316 property and casualty insurers in the country. In comparison, a Statistics Canada report in 2002 says there were 395 licensed P&C insurers in Canada (both federally and provincially licensed) at that time.

The data above show the overall number of P&C insurers is slowly dropping. Still, Canada remains a very fragmented market compared to other property and casualty insurance markets around the world. “Yes, the Canadian market is very fragmented,” says Phillip Cook, CEO of Omega General Insurance Company. “In a country where the population is circa 35 million, having approximately 300 insurers/reinsurers means there is almost one insurer or reinsurer for every 100,000 of the population. That is a very over-serviced market.”

This market does not feature dominant players, as does the banking industry, for example. Eighty-five per cent of all P&C insurance companies in Canada have less than a 1% market share, Cook says.

Conversely, “the Canadian market seems similar to the U.S. one insofar as that the top 10 or so companies command about 60% of the market, while many smaller companies have the rest of the market,” says Joel Baker, president and CEO of MSA Research Inc.

Relative to the global context, this isn’t a high degree of market concentration. “We looked at the Top 10 corporate groups,” Sharon Ludlow, president and CEO of Swiss Re Canada says. “In Canada, together, they would represent about 60% of the market share, whereas if you look at France and the United Kingdom, it’s more like 70% to 80%. Japan would be 90%. The U.S. is only around 50% or less than 50%.”

Rowan Saunders, president and CEO of RSA Canada, observes the recent deals between RSA-GCAN and Intact-AXA Canada have bumped up those concentration levels by about 5% or so. “If you go back as recently as 2000, the Top 10 insurers had 55% of the market share, and if you now looked, pro forma, with Intact, Axa, RSA and GCAN, it would be closer to 65% at the end of this year. That’s quite a significant movement. I think that will continue.”

But will it continue at its current lively pace? Or is this just a random spike in what has been a very slow development over a period of several decades? “There’s been a fair amount of activity,” IBAC CEO Dan Danyluk says. “I guess the big question is: Do we think that somehow the economic climate has changed, and do we think that is going to lead us to more consolidation?”

Fireworks in the Future

In the context of the big deals announced in Canada over the past 18 months, most sources discussed consolidation with M&A in mind. Those who argue Canada will see more M&A activity in the immediate future cite several factors. Taken together, these factors would allow companies to amass enough capital to pursue future acquisitions.

One is the overall improvement of global financial markets after the credit contraction in 2008-09. In particular, Canada came out of the crisis in relatively strong economic shape, compared to other countries. “Given that Canada was relatively unscathed through the crisis and generally there is good economic certainty…companies I think are feeling a little bit more confident about spending some of their capital than they were a couple of years ago,” says Ludlow.

One feature of recovering economic health is that P&C insurance companies have generally been able to write more premiums, thus bringing in more revenue. “From an underwriting standpoint, it’s been a fairly decent market,” says Jeff Mango, assistant vice president at A.M. Best. “When you have the profitability there, certainly premium is going to be associated with an acquisition.”

But the large number of P&C players means Canada is still a very competitive market. And while premium revenues are increasing as the financial crisis recedes, they might not be increasing enough for some insurers. This leads some to consider growth through acquisition rather than through “organic” growth (i.e. increased premium revenues).

“Companies have been going through various attempts to gain market share via more conventio
nal means (marketing, dedicated broker affiliations, product design, improved service standards and better claims practices etc.),” says Cook. “Most of these activities have been designed to ultimately gain market share. And of course premium rate reductions have been added to the mix over the last five or six years to retain market share in a very competitive marketplace. Having done all of these things, there is little opportunity for further growth unless through acquisition.”

The economic impact of the financial crisis also played a part in insurers considering growth through M&A, Saunders says. “We do have what I would define as a pretty benign growth in the GDP in Canada, and less so around the world,” he says. “That actually is having an impact on insurance. There’s less to insure, true exposures have come out of the market and I think that makes it really hard to grow your business organically. For those organizations that are permitted to build a business in their chosen territories, M&A is actually a better strategy, subject to evaluations, than aggressive pricing to grow your portfolio. That’s why I think you are seeing an interest in companies acquiring either talent or profitable portfolios, as opposed to trying to aggressively build your book of business file by file. That’s likely to continue for the next little while.”

OSFI’s regulatory prudence mandated a solid capital base for Canadian companies. This, too, may be playing a role in current M&A activity, sources say. “Canadian PC insurers have typically been so well capitalized, by statute really, and adverse to risk,” says Jacqalene Catrino Lentz, a senior financial analyst at A.M. Best. “By statute, they’ve had fairly conservative investments in provincial bonds, government bonds. With the exception of companies here and there, they typically did not have crazy assets like derivatives or asset-backed securities, things like that.” This means companies have the financial wherewithal to buy, she concludes.

But some companies, with apologies to George Orwell, have recovered from the financial crisis “more equally than others,” as some sources observe. In other words, some companies have improved their financial position post-crisis, while others have lagged. Some believe this creates opportunities for some well-capitalized companies to acquire others.

In support of this position, sources cite the combined ratios for Canada’s Top 10 private insurers in 2010 ranked by market share. Combined ratios are percentages obtained by dividing claims payments by premiums collected. Numbers below 100% show profitability; those above show a loss. The combined ratios among Canada’s Top 10 insurers in 2010 ranged between a low of 85.2% (Lloyd’s) to a high of 162.84% (State Farm Insurance Company). Similar spreads exist through the rest of the companies in the industry as a whole.

“There certainly seems to be this divergence in performance, where strong companies – well-capitalized, well-managed, good, sensible strategies – appear to be widening the gap in their financial performance compared to other companies,” says Saunders. “And when you look at the Top 10 or Top 15 insurers and the difference in their combined operating ratios, probably it’s never been larger between the successful and less successful players.”

In this respect, Saunders says the Canadian P&C insurance marketplace in 2010 is in a different place than it was when it went through a similarly weak economic cycle in 2000-02. The difference suggests to him an increase in M&A activity in the future.

“If you think about when there were a lot of sellers in the last real downturn, the weak part of the insurance cycle, which was in and around 2000-02, that was a difficult time for most players in the insurance sector,” he says. “So while there were many companies for sale, there really weren’t qualified buyers with a strong enough balance sheet [to buy them]. I think that as you see this divergence in performance occurring and likely to continue [in 2011], there are some strong companies with exceptionally strong balance sheets that this time, I think, will be able to take more advantage of that. And that’s why we believe the M&A trend is going to continue for the next little while.”

Demutualization is another potentially major catalyst for future M&A activity. The Canadian government is currently crafting a regulatory framework that would allow Canadian property and casualty insurers to demutualize. Mutuals share an ownership structure in which mutual policyholders make up the ownership of the company. Currently mutuals, which make up about one-third of the Canadian market, cannot be sold.

The Economical has recently announced its intention to demutualize once the anticipated regulations are in place. The company has a two-pronged strategy. It could demutualize either by way of an initial public offering, in which mutual policies are converted into shares, or through a ‘strategic partnership,’ in which selected companies purchase all or parts of The Economical.

“The pending demutualization regulations in Canada are certainly something that can open the door to more consolidation,” Ludlow says. “That’s obvious. It certainly did on the life industry [when the federal government allowed it to demutualize in 1999]. Five companies literally demutualized once those regs were in place.”

The ‘Burning Schoolhouse’ Argument

Before everyone plugs their ears in anticipation of an M&A explosion in the future, however, people need to remember some mitigating factors.

Several sources note the Canadian marketplace represents a balance between private insurers, public insurers and mutual insurers, with a number of insurers offering niche and specialty products. Or to put it simply, the fragmented market, as it is presently constituted, works for the consumer.

“I think Canada is still well-served,” says Maurice Tulloch, president and CEO of Aviva Canada. “You have a difference of players. You have national players. Clearly there is one less national player after this most recent deal [between Intact and AXA Canada]. You still have some very strong regional players. Some are mutuals, some are not. You have niche players and you have some local players in small geographic areas. For Canadians, the market is still well-served in most jurisdictions.”

Ultimately, Tulloch adds, M&A will be driven by a company’s business strategy. “I think from our standpoint at Aviva, we are always going to be looking at opportunities that make sense for us, and every company is in the same boat,” he says. “They will look at opportunities and see if they fit into their strategy. Is there an opportunity to extract value? If you look at the environment for acquisitions, it’s got to be driven out of the fact that you can ultimately extract value. So it’s back to the old, are you buying low and selling high? And if you’re not, you’d better have a heck of a strategic business case that ultimately you are driving value here.”

Finding that good strategic fit within a myriad of potential partners has been one factor inhibiting consolidation, some sources say. The scarcity of suitable marriage partners drives up the values or “multiples” of those who might be a good fit. Some potential sellers are spread across the country, some are not, some are niche players, others are not, says Ludlow. “So if you are looking for a good block of business to fit with Company A, whoever A might be, the shortlist is maybe 10, not 200,” she says. “The fact that there aren’t that many drives some of that [high valuation]. There’s a premium, because there are relatively fewer in the market than you would find in the United States.”

Ludlow observes that typical insurance company valuations in Canada are in the order of a multiple of 1.8. A “multiple” is a value, usually expressed as a factor, that companies multiply against a business economic benefit to arrive at their business value. The 1.8 multiple in Canada is higher th
an in the United States, where the average is more like 1.2.

Those high multiples may be impeding further consolidation in Canada. “Why is that an impediment?” says Ludlow. “Well, obviously because the acquirers have been looking at those valuations and saying, ‘No, that’s too expensive.'”

Baker says the spread between what buyers want to pay and what acquirers want to receive is still too large to support anything more than sporadic M&A activity in the future. Prior to the market crisis, there was “no real shortage of buyers,” he says. “The only impediment was the bid/ask spread between what buyers wanted to pay and what sellers thought that they could command. This largely remains the case now. Neither the GCAN nor the AXA acquisitions were bargains by any stretch. I would argue that both of these events were one-offs insofar that each deal had its motivations that cannot automatically be extrapolated to the rest of the market.”

If sellers’ multiples remain high, the most recent signs of volatility in the market, in addition to other challenges – including huge catastrophe losses in 2011 – may constrain capital, thereby curtailing future M&A activity. In support of this observation, sources note the recent Standard & Poor’s downgrade of the U.S. credit rating and some of the sovereign debt issues facing Greece and other European countries. All of these events suggest the re-emergence of a potential financial downturn, potentially affecting buyers’ capital positions.

At this point, it is impossible to know whether the recent market downturn in August is a trend, or a temporary blip on the radar screen. “I guess if we go down the path of an 08-09, we probably could see some sort of lag in M&A activity,” Mango says. “Again, whether a week makes a trend I highly doubt, but we will just wait and see from that perspective.”

Should an extended market downturn emerge once again in the near future, that could depress valuations, affecting M&A activity in the same way the 2008-09 crisis affected multiples and mergers. “The financial crisis experienced from 2008 through 2010 was an impediment to industry consolidation,” says Mark Tullis, chief financial officer at Intact Financial Corporation. “As valuations declined during that period, potential sellers were reluctant to trade at what they view as discounted book values.”

Some believe that even if the Canadian economy continues to improve, growth through acquisition may no longer represent an attractive growth strategy. “Ironically, if the economy were to get significantly better, it would probably tend to slow down M&A activity, as the larger companies would see premium growth from existing business and ‘sellers’ would see more inherent value in their own businesses and demand more for them,” Cook says.

Saunders makes a counterargument, noting that economic downturns have sometimes triggered consolidation activity and not necessarily suppressed it. “If you think about the last significant downturn, it did create corporate activity,” he says. “One example was ING. Given the challenges the parent company of ING faced, they ended up exiting non-core or non-banking lines, and that’s how come ING Canada completely went public through an IPO [resulting in the current incarnation of Intact]. I do think whenever there is an economic downturn, companies have challenges, either in their own markets or their core lines….I do think some of that facilitates people thinking and open to M&A.”

Proponents of M&A have argued that in response to Canada’s market fragmentation, companies may opt to merge in order to take advantage of economies of scale. But does size matter? There are many skeptics.

A Stats Can report authored by Christine Hinchley examined this position in 2002 and concluded that “evidence for economies of scale (or size advantages) across all product lines in the current Canadian P&C insurance industry is not strong.” If the argument were true, Hinchley writes, more insurance firms in Canada would be large. However, she noted in 2002, “there is a widespread distribution of firms by size according to market share of net premiums written (NPW). The largest licensed insurers serve more than 2% of the market each, the smallest serve less than 0.01% and there is a range of insurer sizes in between.”

About a decade later, each of Canada’s Top 10 P&C insurers serves between 4% and 8% of the market. Most insurers still serve less than 1% of the market each. Thus, while some may argue that having a large, financially strong carrier is a benefit in Canada, others aren’t quite so sure.

“I don’t think consolidation is necessarily inevitable,” says Danyluk. “And I’m not sure that larger means more efficient. I’m not sure larger means more effective. I’m not sure that larger means more choice.”

Ultimately, says Danyluk, echoing Tulloch’s point, M&A activity in the future will be determined by whether or not there is an appropriate strategic fit between the cultures of two distinct business partners. “I think that scale may be something that’s overrated,” he says. “It strikes me that the critical issues are cultures, and that if you are going to get married, it might behoove you not to marry a tree, because your relationship isn’t going to work.”