Reinsurance as a strategic ally in M&A and divestitures

The tremors of ongoing economic uncertainty are being felt in many markets around the world.

From skyrocketing (continually high) inflation and credit spreads in Europe to energy price spikes and general concern about the potential for a recession, a prolonged period of turbulent economic conditions has driven strategic portfolio re-evaluation efforts among many insurers.  

Indeed, there has been an increase in industry divestitures and mergers and acquisitions (M&A) activity in the past 18-24 months, where we’ve seen a flurry of activities that have made headlines, a few selected examples being:

• January 2021: Catalina Holdings divested Glacier Re.
• February 2021: Aéma Groupe acquired Aviva France.
• August 2021: HSBC acquired AXA Singapore.
• September 2021: MACIF acquired Aviva France.
• November 2021: Allianz acquired Aviva Poland.

The drivers behind these divestitures of course differ on a case-by-case basis. M&As are transformational situations which entail significant changes to funding and risk transfer needs. There is heightened investor scrutiny of the quality of the acquired portfolio, as well as execution risk on successfully integrating an acquired entity.

However, there are several key and common factors that we’ve seen emerging as trends.

First, in general the insurance industry faces several challenges. Extreme weather events are driving higher frequency and severity of both primary and secondary perils, as well as mass sociodemographic changes. We’re also seeing social inflation with so called "nuclear verdicts" – defined as awards in excess of $10 million – in some jurisdictions, while economic inflation is amplifying loss trends and impacting volatile yield curves and capital markets.

At the same time, the industry is coming under pressure to advance the digital customer experience and simplify and standardise product offerings – innovations that will likely require hundreds of millions to be spent on IT migration and restructuring sales teams.

Further, companies also require capital to make the most of market opportunities. Critically, with overall compressed economics and price-to-book (P/B) value, some buyers with both spare capital and growth ambitions are able to invest in growing pockets of business that are performing well (organic growth) and seizing opportunities to acquire new portfolios (inorganic growth).

With that said, amidst current economic uncertainty, many insurers and reinsurers are having to work to ensure that their balance sheets are looking strong and healthy to cover increased CAT exposures, reserve risk and investment risks (market risks, interest rate risks, credit risk). For listed companies, that has meant evaluating back books and selling off subsidiaries and divisions that are either not strategic, or up to scale. Capital is then extracted and upstreamed to strengthen the group's financial flexibility, while enabling management attention and operational efficiency to be focused on desired areas.

Regardless of the initial drivers – be it making the most of market opportunities, ensuring balance sheets are in good order, or a combination of the two – many organisations are actively restructuring, selling off certain arms and acquiring others.

In either case, capital is typically required – either to invest in expanding promising business areas, or to acquire existing businesses. However, if existing capital is tied up to a major extent in CAT retentions, especially with reinsurance covers attaching at higher points, and taking account of reserve risks and investment risk, market players need to find alternative ways of freeing up funds to maximise opportunities.

So, how exactly are insurers able to free up the additional capital that they crave?

In the case of some mid-sized companies or family-owned entities, owners may be prepared to raise equity when market conditions are good. However, for listed companies, issuing shares is not a particularly promising avenue at present, with the stock market critically compressed.

Some may alternatively explore loans (subordinated debt), but amidst current economic uncertainty credit spreads are high, making loans expensive.

Fortunately, if these options aren’t available to the desired extent, there are several reinsurance levers that can be pulled to facilitate the freeing up of capital. Specifically, there are three structured solutions that can work as strategic support mechanisms:

1 – Renaissance of structured quota shares

Quota shares are a simple and common avenue we see utilised at present, particularly in high growth markets. This is a pro-rata reinsurance contract in which the insurer and reinsurer share premiums and losses according to a fixed percentage. Quota share reinsurance allows an insurer to retain some risk and premium while sharing the rest with a reinsurer up to a predetermined maximum coverage. These quota shares are oftentimes covering the net retention across major lines and leverage risk mitigants; insurers are comfortable with the base volatility and don't see the need to transfer base volatility (and pay for that portion accordingly). Overall, it is a way for an insurer to increase excess capital by reducing required capital.

2 – Immediate effect with retrospective covers under Solvency II (Loss Portfolio Transfers (LPT) and Adverse Development Covers (ADC))

In Solvency II markets, in our view the most effective reinsurance mechanism is LPT/ADC. Retrospective reinsurance is used to transfer the economic risk of portfolios of losses that have already occurred, whether the losses have fully emerged or not. LPT/ADC is a common retrospective solution, where the insurer cedes liabilities for all emerging unpaid losses associated with a previously incurred insurance liability to the reinsurer. Essentially the reinsurer takes on the uncertainty of reserve development and thereby frees up capital for the insurer. Motivation is efficient capital relief, so structures are used which reduce base volatility and shorten the latency while at the same time being capital efficient tools for more extreme threat scenarios. This is an area where we see more requests from clients. Last year we closed seven LPT/ADC structures and are currently working on several opportunities this year.

3 – Peace of mind with Legal Finality reinsurance

A third example, as was seen in a recent divestitures of a reinsurance company in run-off, is Legal Finality reinsurance. Here, an insurer or reinsurer cedes liabilities usually through a bulk transfer mechanism (such as a Part VII transfer mechanism in the UK, Insurance Business transfer in the US) that ensures that the original policy issuer no longer remains responsible to policy holders, but rather the party to whom the business is transferred.. The transfer usually takes the form of an LPT/ADC without limitation and associated claims handling and operations are handled by the new obligor. This frees up risk capital and management time to ease operational efficiencies. Swiss Re is a partner in select cases; we took over a captive insurer in run-off two years ago and took over a reinsurer in run-off last year. With that said, these tend to be rare, isolated, special cases. It’s a niche focus area for Swiss Re, and requires the right opportunity, market conditions and regulatory environment to pique interest.

It is becoming increasingly clear that a key challenge among insurers is unlocking and upstreaming capital. Indeed, we’re witnessing many insurers adopting LPT/ADC arrangements, with particular upticks seen in London, Europe, Australia and Singapore.

Today's market environment is more volatile and competitive than ever. The changing market outlook is putting pressure on balance sheets as well as risk and capital strategies.

Thankfully, reinsurers can help, standing shoulder to shoulder with you on those strategic decisions that you make. Structured solutions can become the bedrock of successful partnerships between insurers and reinsurers that work towards the long-term strategic objectives of the former.

Swiss Re's local teams of structuring experts draw on global experience and expertise and a strong financial position to deliver carefully tailored structured solutions that support clients looking for more efficient risk protection and to optimise capital structures. The structuring experts are fully embedded in client facing underwriting units of Swiss Re.

By optimising an insurer's capital structure, we can achieve a broader set of financial objectives, support clients by releasing trapped or redundant capital to help seize market opportunities and grow, and/or lifting return on equity (ROE).