14. Project Swiss Flashcards
Walk me through Project Swiss.
We were retained by a $25 billion insurer / reinsurer to evaluate alternatives to create shareholder value, including a $9.4 billion acquisition opportunity that would diversify and enhance its presence in new markets and ultimately grow its commercial insurance segment.
Our client is a global provider of reinsurance and insurance products for insurance companies and multinational corporations. The target is primarily a property and casualty insurer with half of its business in North America and the other half in Europe.
Synergies
A potential acquisition of the target could be financially attractive to our client as well as strategically sensible and could generate significant operating synergies.
-Reduction of combined corporate expenses as well as selected underwriting/operating expenses
-Reorganization of non-core operations (lower ROE segments)
-Partial offset of reducing overlapping peak zone exposures could be managed through portfolio reshaping during the next renewal cycle
Valuation
The target has weathered the storm of the financial crisis and is showing health performance with a strong outlook; however, it is trading at a discount to book value and lower than its peers mainly due to its low ROE and investor scrutiny. Although the target’s management has made progress in repositioning the business since saving the company in 2008, we believe the company needs catalysts to address issues in its global P&C insurance business and run-off life operations
Our client has outperformed its peers in recent months and has a strong purchasing power with better than average valuation and a solid capital position
Deploying some of the capital in an accretive and growth oriented acquisition could provide the company with meaningful potential upside.
Timing
Consolidation in Bermuda and the broader market is squeezing the target from its historical dominance in the space, which may call for a strategic play
The P&C industry is anticipating a positive turn in rates after several years of a soft market. This could present an opportunity to enhance market position at the bottom of the cycle
Debt and equity markets are open and available particularly for acquisition financing
Underwriting and Diversity Balance
Balanced pro forma portfolio
Standalone: 57% Property / 43% Casualty, 11% Insurance / 89% Reinsurance
Pro Forma: 51% Property / 49% Casualty, 23% Insurance / 77% Reinsurance
Each company will benefit from greater diversification in terms of geography and business lines.
Acquirer could benefit from the leading specialized catastrophe reinsurance platform and XL’s capabilities in other specialty lines of business
Risks:
(1) Revenue cannibalization
(2) Managing pro forma peak zone aggregates
(3) Shareholder flow-back
(4) Deep underwriting / management bench mitigates risk of losing talent
Task: describe the challenges and expectations (i.e. scope of engagement)
We were expected to evaluate various alternatives to create shareholder value, specifically looking at a potential acquisition opportunity
Action: elaborate on your specific action in response
(1) Analyzed historical performance of target, trading multiples of comparable companies and precedent transactions
(2) Built dynamic merger model to analyze financial implications on book value, tangible book value and EPS basis
(3) Performed combination analysis to assess pro-forma impact on business portfolio and geographic mix
Results: explain the results of your efforts both qualitatively and quantitatively
The acquisition opportunity proved to be both financially attractive and strategically sensible. However, given the economic uncertainty at the tail end of 2012 and the general lack of an M&A appetite for large insurers, our client decided to hold off on a potential engagement and instead chose to deploy capital in the form of a special dividend.
What was the strategic rationale for the investment?
A potential acquisition of the target could be financially attractive to our client as well as strategically sensible and could generate significant operating synergies. The potential acquisition would diversify and enhance the acquirer’s presence in new markets and ultimately grow its commercial insurance segment
What are the five most notable merits of the deal?
(1) Undervalued: target is trading at a discount to book and lower than its peers mainly due to low ROE and investor scrutiny
(2) Significant operating synergies
- Reduction of combined corporate expenses as well as selected underwriting/operating expenses
- Reorganization of non-core operations (lower ROE segments)
- Partial offset of reducing overlapping peak zone exposures could be managed through portfolio reshaping during the next renewal cycle
(3) Accretive and growth oriented acquisition could provide the company with significant potential upside
(4) Opportunity to enhance market position at bottom of the cycle
(5) Diversification in terms of geography and business lines
What are the potential risks and pitfalls?
(1) Internal:
- potential for revenue cannibalization (overlapping customers?)
- systems integration can be challenging (much more diligence is needed)
- limited history of M&A success means investor community would be very skeptical of such a large acquisition
(2) External:
- uncertain macroeconomic environment with looming US presidential elections and fiscal cliff
- European sovereign debt crisis
- depressed valuations limiting deal activity (sellers would prefer not to sell their companies below book and buyers are content buying back shares at historically depressed valuations)
Describe the P&C insurance industry.
In the US, P&C insurance is a fragmented, mature industry. There are about 2,700 players, the largest being State Farm. The top ten insurance carriers control just over 50% of the industry’s premiums ($439 billion)
In general, premium growth is modest across a cycle. Total industry premiums grew 3% in 2011 and were up 4% in 2012. Premium growth has average -0.6% over the past five years and 3.4% over the last fifteen years.
Improving pricing could help premium comparisons over the next several years and economic growth could also provide a tailwind.
Personal auto (liability and physical damage combined) is the industry’s most important, followed by homeowner insurance and other liability
What is the size of the market and its growth prospects?
US P&C market = $667 billion (33% share)
Europe P&C market = $726 billion (36% share)
Global P&C market = $2 trillion
Modest growth prospects (~4%) due to improving pricing and economic growth acting as a tailwind
Discuss the industry outlook and trends.
P&C insurance is a fragmented, mature industry
The industry’s maturity is demonstrated, in part, by its modest premium growth across a cycle
Following a deep recession in the US, insurance premiums began growing again in most lines, which is expected to continue. The US, despite its problems, is currently viewed as a better place to invest than Europe or Japan, although some real values are developing in Europe
Demand for insurance continues to be impacted by sluggish economic conditions, and the Fed is actively signaling that it is determined to keep rates low through late 2014.
In the current low valuation environment, M&A activity often competes with attractive capital management such as share buybacks and special dividends
How will the target company outperform, underperform or be neutral with the industry?
We view the target as one of the best value names in P&C insurance because its balance sheet is strong, its reserve position appears more than adequate, and it should be well positioned to generate profitable growth in a rising P&C price environment
XL’s P&C business has stabilized and its capital position is strengthening. While management’s expectation for substantial ROE improvement from current levels could be overly optimistic, we believe the company’s reserve position is strong, meaningful share buybacks could continue, and the valuation is attractive.
The gradual improvement in commercial insurance pricing and the likelihood of the pricing gains continuing in 2013 leave XL positioned well for further improvement over the next two years, in our view. In addition, a changing business mix and a reducing expense ratio should aid the margins. As the margins and ROE improve, we expect the company’s price/book multiple to improve
Is there fragmentation in the P&C insurance market?
In the US, P&C insurance is a fragmented, mature industry. There are about 2,700 players, the largest being State Farm. The top ten insurance carriers control just over 50% of the industry’s premiums ($439 billion), although certain lines of business, such as personal auto, the concentration is greater. In contrast, the top 10 insurers in the UK control roughly 70% of the market
Is there seasonality / cyclicality?
The Company earns its revenue primarily from net premiums written and earned. The property and casualty insurance and reinsurance markets have historically been cyclical, meaning that based on market conditions, there have been periods where premium rates are high and policy terms and conditions are more favorable to the Company (a “hard market”) and there have been periods where premium rates decline and policy terms and conditions are less favorable to the Company (a “soft market”). Market conditions are driven primarily by competition in the marketplace, the supply of capital in the industry, investment yields and the frequency and severity of loss events.
Is the P&C insurance market attractive?
Relatively unattractive
Intensity of competition: (HIGH) fragmented; difference between one insurance company vs another is not great; insurance has become more like a commodity; insurer with lost cost structure and greater efficiency and better customer service will win out; mature industry with very little growth
Threat of new entrants: (LOW) high capital requirements, strong distribution network required, strong brand names are important, requires economies of scale
Threat of substitutes: (HIGH) plenty of substitutes in the insurance industry
Purchasing power of buyer: (MODERATE) huge number of buyers; product is important to buyer; but there are plenty of substitutes; customer poses little threat in the insurance industry
Purchasing power of supplier: (MODERATE) capital is very important to insurers; but there are plenty of sources of capital; suppliers of capital do not pose a big threat
Note: the industry is highly regulated
Describe the customer.
Insurance is distributed to the customer (individuals and businesses) in three primary ways: independent agents, captive agents or directly to the consumer.
Customer has a very unique need: risk mitigation. He is willing to pay a premium in order to mitigate potentially large downside losses, which results in relative price inelasticity. However, the government strictly regulates the insurance industry to prevent unreasonable premiums
What does your client do? What are its key financial metrics?
Operating in more than 20 countries and with a presence on five continents, our client is one of the world’s largest and most diversified reinsurers, alongside Munich Re and Berkshire Hathaway. With a business split about 50/50 between non-life and life reinsurance and a global platform characterized by a high level of in-house expertise, it can access all classes of risk in all major markets. In addition, it has pioneered the transfer of insurance risk to capital markets and remains a leading player in that space. The group targets an ROE of 700 basis points above the five-year risk-free, 10% average annual EPS growth and 10% average annual economic net worth per share growth.
Describe the business segments of your client.
Our client is predominantly a reinsurer (82% of NPE) with a business that is split about 50/50 between non-life and life reinsurance. It operates out of four main business segments:
(1) P&C Reinsurance (56%) – products comprise reinsurance coverage for property, credit and surety, engineering, aviation, marine, and agriculture; and reinsurance coverage for liability, motor, workers’ compensation, personal accident
(2) Life and Health Reinsurance (36%) – death, annuity and illness and disability coverage; also direct life insurance as well as direct corporate insurance
(3) Corporate Solutions (4%) – insurance for single-line and multi-line programs worldwide
(4) Admin Re (4%) – (run-off) solution through which Swiss Re acquires closed blocks of in-force life and health insurance business, either through reinsurance or corporate acquisition, and typically assumes responsibility for administering the underlying policies
What does the target company do?
The target is predominantly a P&C insurer (64% of NPE) and reinsurer (36%) with half of its business in the US/Bermuda and the other half in Europe. It operates out of three main business segments:
(1) P&C Insurance (64%) – primarily commercial insurance including professional casualty lines, other casualty lines, property cat, other property, marine, energy, aviation and satellite, and other specialty lines
(2) P&C Reinsurance (30%) – provides casualty, property risk, property catastrophe, marine, aviation, treaty and other specialty reinsurance on a global basis
(3) Life Operations (6%) – (run-off; not accepting new business) traditional life and annuity business; provided life reinsurance on business written by life insurance companies, principally to help them manage mortality, morbidity, survivorship, investment and lapse risks
What are the company’s competitive advantages?
(1) Commercial P&C insurance underwriting expertise
(2) Broad international mix with consistent access to distribution channels
(3) Financial strength (strong balance sheet)
What the company’s strengths, weaknesses, opportunities, and threats?
Strengths: weathered the storm of the financial crisis (exited survival mode it operated under during the financial crisis) and is showing healthy performance
Weaknesses: low ROE compared to peers; run-off life operations
Opportunities: growing strategic footprint; enhance market position at bottom of the cycle
Threats: consolidation in Bermuda and the broader market is squeezing the target from its historical dominance in the space, which may call for a strategic play
What does the company’s supply chain look like?
There is not a traditional supply chain as with a consumer products company. The company’s business is driven by the amount of capital that is available. Generally, the more capital an insurer has on its balance sheet, the more premiums that a company can write.
Insured = individuals and businesses Insurer = underwrites risk Suppliers = capital (debt and equity) Reinsurer = insurer indemnifies another insurer
How does the company’s competitive advantage improve its position within the industry?
The P&C industry is anticipating a positive turn in rates after several years of a soft market. This could present an opportunity to enhance market position at the bottom of the cycle. The company can leverage its underwriting expertise and financial strength to gain further access to distribution channels internationally.
How does the company make money? (profitability analysis)
The company makes money in three ways: (1) underwriting (2) interest/dividend income (3) realized gains on securities
(1) Underwriting: historically, the industry has on average paid out $1.04 for every $1 earned in premiums, for a $0.04 underwriting loss
a. Collecting premiums: when an insurance company writes a policy, the premium is recorded as gross premiums written
- To help manage their risk and their capital needs, most companies buy reinsurance of some kind, paying ceding premiums to the reinsurer, which leaves us with net premiums written
- Those premiums are earned pro rata over the life of the policy, which leads to net premiums earned (if net premiums written are growing, the earned premiums will lag the written, and if the written premiums are shrinking, the earned will tend to be larger)
- Claims: (Loss and loss adjustment expense) incurred losses can come in two forms – paid claims (cutting a check to the insured) or establishing a loss reserve to pay the claim at some point in the future
a. loss reserve = liability on insurer’s balance sheet - When a claim that has been reserved for is paid, the loss reserve goes down by that amount as does cash
b. Along with actual claim costs, an insurer must also pay for (or reserve for) loss adjustment expenses (LAE), such as legal fees and costs for loss adjustors
c. the tail on the claims reserve, or the average length of time until the claim is reported and then paid, will depend on the business line
- Short Tail: auto, homeowners’ and other property related lines - Long Tail: general liability, medical malpractice (company’s incurred losses in the year are largely an estimate of future claims payments)
- Paying expenses: aside from the claims expenses, an insurer has other underwriting expenses, such as acquisition expenses to bring in premiums (e.g. commissions to agents and brokers)
a. Other underwriting expenses include admin staff, technology, premium taxes and office space
b. Expenses that are paid but not yet run through the income statement become an asset on the balance sheet, called deferred acquisition costs
(2) Investment Income: makes up the bulk of overall earnings for most insurers; between the time the company collects premiums and pays claims and expenses, it will invest those funds in an array of securities and investment vehicles
a. The interest and dividend income that derives from these investments has historically accounted for the bulk of the overall earnings for most insurers
- Those companies with long tail lines of business will hold on to their reserves for a longer period of time, so the funds supporting those reserves will build up faster than a company that focuses on short tail lines
b. Not surprisingly, changes in interest rates have a big impact on an insurer’s net investment income
- Declining interest rates over the past decade have eroded investment income and caused insurers to focus even more on underwriting profitability
(3) Realized Gains: investment income can also come in the form of realized gains due to the sale of securities and credit impairments
a. Although realized gains flow through the income statement and add to retained earnings, we do not include this income operating earnings forecasts due to the unpredictability
What is the most common measure of underwriting profitability?
Combined Ratio = Loss ratio + Expense Ratio
Loss Ratio = Losses & LAE / premiums earned (avg 74%)
Expense Ratio = Underwriting Expenses / premiums earned (avg 27%)
> 100% underwriting loss
< 100% underwriting profit
*Prior to 2004, the overall P&C industry had not made money from underwriting activities since before 1979. Therefore, the industry’s entire net income has come from investment activities