In the wake of the deal between Max Capital and Harbor Point, Seb Kafetz looks at whether bigger is really better in Bermuda.
The merger of Max Capital and Harbor Point took the market by surprise. In a close-knit community that is subject to constant rumours, the management teams of both companies and their respective advisors did a good job of tying up the deal before it hit the newswires. What was less of a surprise was the fact that insurance companies in Bermuda were getting together. Indeed, ever since a new wave of companies was established in 2005, the industry has been talking about the prospects of consolidation.
In their literature to accompany the proposed merger published to the market, Max and Harbor state that their combination should enhance their market profile across four factors. Firstly, greater size and scale, which in turn should enhance their valuation and ratings profile, as well as provide greater financial flexibility; secondly, enhanced positions for clients and brokers alike; thirdly, allowing access to multiple platforms; and finally, providing the ability to manage resources well through creating excess capital.
Over the last decade, the price of entry into the Bermudan insurance market has increased. The wave of companies that started up post-2001 could write business with an A-rating and $500m of capital. After 2005, the majority of entrants started with over $1bn of capital and ever since the price of entry has increased.
Larger capital bases bring benefits for firms, including opportunities to enhance ratings, more stock liquidity, entry into greater numbers of funds and greater line sizes for clients. There is also a correlation between size and market value with, to a large extent, increased price-to-book multiples for the Bermudans with larger balance sheets. Raising equity to increase the size of the balance sheet is dilutive in a market that is predominantly trading just below book value, hence entering into a merger is another way to achieve benefits of scale.
As companies mature from the start-up phase, they are looking increasingly to diversify from their home markets through operating platforms in other jurisdictions. This has been played out in Bermuda where the majority of firms on the island have looked to acquire underwriters from Lloyd's, as well as set up operations in the US and Europe. This allows access to business that does not come to Bermuda and also lets firms provide worldwide support for their clients.
Many companies operating in Bermuda have taken differing strategies in their platform approach, although the majority of growth has come from acquisitions. Setting up new platforms organically can be a relatively slow process and acquisitions are difficult in the current market due to a mismatch in pricing expectations. This could therefore be a contributing factor to a merger of equals, with companies looking to find a partner that offers a complementary platform approach.
The larger the firm, the more options it has in managing its capital. Larger public companies have full access to the debt and equity capital markets and can use these as tools to enhance return on equity.
A clear example of this is the continued share buyback programmes operated by the larger clients such as those recently announced by Partner Re and Arch. At the same time, firms continue to make use of the debt markets with a recent flurry of issuance in March, including Axis, Ren Re and Endurance. While the majority of recent issuance has been of shorter maturities than previous issues (usually 10-year rather than 30) it locks in gearing into the balance sheet (typically sub-20%) and enhances the returns available to investors.
It is more difficult for smaller, privately owned companies to take advantage of these capital instruments, as they are limited to utilising bank debt or accessing investor debt through bespoke private placements, products which continue to be in limited supply, albeit on improving trends. This will accelerate the desire for scale and hence market access, in particular for those firms that continue to be either privately owned or where the original private equity owners continue to hold a large proportion of the stock.
With valuation multiples continuing to trade close to book value, it remains difficult for the owners of these businesses to float the shares on the market, so engaging in M&A remains the more likely way that they will attempt to realise value.
While these factors above provide a strong argument that larger companies are more likely to be successful in both delivering for investors and serving clients, there remain a number of issues that act as a counterweight to that position. These include an increasing focus on counterparty risk, which means that some clients are limiting the line sizes they are willing to take from each insurer.
In turn, this may require an insurer to utilise surplus capital to write additional business, with the risk that this becomes underpriced in order to gain the necessary volume. Additional issues of scale could arise from greater market scrutiny, the ability to manage staff in multiple jurisdictions and the ability to manage expectations in a softening market.
Max Capital and Harbor Point appear to have been successful in agreeing a mutually beneficial merger, but much of the merger activity rumoured never comes to fruition.
While the two issues of personalities and management positions are often cited as strong factors, the dominant issue is always likely to be the respective valuations of each company, and hence the proportion of ownership of the new entity. The majority of deals collapse at this stage as investors of both firms look to enhance their positions going into the deal, rather than allowing the positive influences to come to fruition and provide value post-completion.
Perhaps this is an indication that the short-term investor valuation view continues to dominate the belief that bigger is better.
Seb Kafetz is a relationship director for insurance clients at Lloyds TSB Corporate Markets.
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