The Surge of Mergers & Acquisitions

Mergers in the Canadian insurance industry have been trending upwards since 2009 as companies try to increase market share and gain economies of scale in this mature market. There are indications that 2012 merger activity will be as strong or even stronger than 2011.

The route to profitable growth is volume and if total volume is flat, then the only way to grow volume is through acquisitions.

According to Standard & Poor’s Capital IQ, 29 insurance deals were announced in 2011 compared to 21 in 2010 and just 12 in 2009. The large majority of the deal activity in 2011 was driven by the brokerage and managing general agents (MGAs) sector, which accounted for 23 acquisitions in 2011 compared to 11 in 2010. The announced deal value surged to more than $3 billion from $1.3 billion in 2010 and $329 million in 2009.

This spark of activity was ignited by the acquisition of Western Financial Group by Desjardins Group in December 2010. Desjardins then went on to announce six more acquisitions last year.

Another serial acquirer, Hub International, made three brokerage acquisitions of its own in 2011.

However, the big story of the year was AXA’s exit from the Canadian marketplace. Beginning with the sale of multi-line operations to Intact Financial this past May for $2.7 billion and continuing with the sale of its life insurance operations to SSQ Financial Group in September, AXA’s departure drove almost all of the $3 billion announced deal value for Canadian insurance M&A in 2011. This was similar to 2010, where just a few transactions drove most of the $1.3 billion announced deal value.

The pricing surrounding AXA’s departure indicates the pent-up demand for quality insurance targets in Canada. Strong balance sheets, surplus capacity and an appetite to build scale is increasing demand for premium volume from domestic insurers.

However, there is still a lack of willing sellers among carriers. Indeed, last year saw carriers looking for deals along the value chain, driving activity in the brokerage sector as they looked to capture premium volume from the companies they acquired. This was seen again in 2012 with Intact’s $530-million deal to buy Jevco Insurance Company from The Westaim Corporation.

Transactions in the insurance brokerage and MGA space will continually be made as smart entrepreneurs and aging owner-managers exit while the seller’s market continues.

VALUATIONS

Demand for quality assets has increased both competition and pricing. While valuation metrics vary between different sub-sectors, valuation multiples have been trending higher across the board over the last five years.

Pricing is partially a function of the nature of the acquirer and its ability to drive value from the deal. For example, a carrier can generally attain greater synergies from the acquisition of an MGA than another broker or MGA could. As a result, the carrier is usually able to offer a higher valuation because of these stronger synergies.

Demand for premium volume and scale from both brokers and carriers has pushed valuation multiples for insurance brokers to an all-time high. Many brokers have been priced out of broker-to-broker acquisitions because of competition from large domestic carriers. The average transaction multiples for insurance carriers is 1.5 to 2 times book value, 2 to 3 times revenue for MGAs, and 3 to 4 times revenue for insurance brokers.

Other company-specific, controllable factors will also affect the saleability and valuation of a company in a transaction, including the quality of historical earnings, strong underwriting results, consistently low loss ratios, critical mass, a strong niche and proprietary technology or analytics.

If performed early enough, vendor due diligence, where the prospective seller hires a third party to perform a business review as a buyer would, will help the seller identify and mitigate factors that could decrease the value during a sale and/or emphasize those factors that will drive stronger pricing and demand for their company.

BUY CANADIAN

Interestingly, five of the top six announced Canadian insurance deals by value in the past two years were to domestic buyers. The only exception was the sale of Sun Life’s reinsurance operations to Berkshire Hathaway. (While RSA Canada’s parent company is based in the United Kingdom, given that RSA Canada is a major player here, we considered this as a Canadian consolidation play.)

The relative strength of the balance sheets of Canadian financial services companies, the strong Canadian dollar and the fact that the key driver is local market consolidation appear to have kept foreign buyers from going after many of the big deals.

ISSUES AFFECTING M&A

We expect a number of issues will impact deal activity in the industry in 2012, including the following:

• Solvency II – Solvency II may increase the amount of capital European insurance and reinsurance are required to hold, making it more challenging for them to compete in Canada. Interest in the Canadian market by European investors appears to be on the decline partially as a result of the uncertainty around whether or not Solvency II will have an effect on the capital they will

be required to hold at their foreign subsidiaries, an issue compounded by the current strength of the Canadian dollar versus the euro.

• Low yields – The low-interest rate environment is likely to continue through this year and probably next year. Low yields will likely impact the pricing considerations for many insurers that rely on investment results to drive returns. Insurers will be evaluating their pricing and growth strategies, which may lead some companies to sell lower-margin or capital-intensive businesses.

• Catastrophe-related losses and pricing – Excess capacity and low catastrophe-related losses have softened property and casualty rates over the last few years. A change in rates might not take place until adverse development on reserves from catastrophic events in 2011 are realized, which is likely to occur over the next quarter and into 2013.

• P&C demutualization – Economical Insurance’s proposed demutualization could lead to opportunities for private equity players to deploy capital. While there have been many life insurance demutualizations in Canada over the past 20 years, there is currently no legislative framework here for the demutualization of a property and casualty firm. Economical is working with the Office of the Superintendent of Financial Institutions to build that process. Once the framework is finalized, other companies might demutualize and there could be increased demand for capital and additional consolidation in the property and casualty market.

• U.S. insurers – Many of the U.S. and foreign insurance companies have recapitalized over the last several years and begun to return excess capital to shareholders. Insurers will evaluate whether or not they should continue with that strategy or deploy excess capital in another way, such as expanding their core business through M&A.

• Regulatory and legislation uncertainty – U.S. buyers are reluctant to make deals because of changes in federal regulations. The impact of health care reform is far from over and the oversight of the Federal Insurance Office is expected to have further implications on life insurance operations and costs in the U.S.

OUTLOOK

We expect M&A deal volume in the Canadian insurance sector to continue to strengthen this year. Generally, there appear to be more buyers looking to add scale and enter new markets than there are willing sellers.

With investment yields likely to stay low and premium rates stagnating and continuing to put pressure on margins, this phenomenon will probably continue for the rest of the year. Outside of potentially market-changing events, such as the demutualization of property and casualty carriers, activity will lik
ely continue to be driven by the brokerage and MGA sectors. The key is finding sellers seeking to exit at historically high multiples, which should not be too onerous a task.