Should the Captive Markets Consider Mergers and Acquisitions?

We recently looked at the state of the insurance and reinsurance markets and the impact on captive insurers in " Where Things Stand—Insurance, Reinsurance, and Alternative Capital." As a follow-up, we thought it would be interesting to look at the mergers and acquisitions (M&A) environment and whether there is any role for captive insurers. Should captive markets consider M&A?

A search on completed M&A deals in 2017 reveals the following data.

Optis Partners, in its " Agent & Broker 2017 Merger & Acquisition Update" reports that "a whopping 604 transactions were announced in the US & Canada, a 31 percent increase over the 461 deals in 2016." Of these transactions, 301 represented agencies engaged in property/casualty reinsurance.

Willis Towers Watson (WTW) issued a press release, "Value of Global Insurance M&A Deals Soar in 2017." Some of the key elements in the press release include the following.

• Fewer deals were completed in 2017; however, those that were completed were of higher value than in 2016.
• Seven out of ten respondents (68 percent) said that brand strength will be the main driver of M&A in the next 3 years, reflecting the transition to digital sales, which require a strong, recognizable brand.
• Fergal O'Shea, EMEA life insurance M&A leader, is quoted in the press release as follows. "M&A in the insurance industry will be driven by the need to create synergies, build brands, and tackle technological advances. However, as our survey shows, companies will be searching for quality over quantity."

Further confirmation of the changes driving M&A can be found in a recently released EY white paper, " Global insurance M&A themes, 2018." The report outlines seven key takeaways from the research.

• Portfolio optimization continued through 2017, with a number of major insurers simplifying and streamlining their businesses, often as a critical step in creating future business models.
• The question of buy or build has become central to many insurance M&A decisions and will continue to underpin consolidation as well as targeted acquisition of capabilities.
• Insurers continue to invest into insurtech businesses, partly as a response to the ongoing question of buy or build but also, increasingly, as a way of accessing and operating in emerging "digital ecosystems."
• The drive to access and create sustainable revenue models from such ecosystems will lead to new types of partnership and joint venture arrangements.
• For insurers, new digital ecosystems are both a massive opportunity and an existential threat as such ecosystems will also be a route for sector convergence, with players from outside of the insurance sector competing for roles in the value chain.
• Such convergence may result in a number of the "wow" moments in 2018 and beyond.
• Successful M&A will come from insurers combining the talent developing in centers of innovation with the deep experience and knowledge across their existing organizations to create diverse teams addressing fast-changing opportunities.

A potential inference that could be drawn from these reports is that the "transition to digital sales" referenced in the WTW press release and the "digital ecosystems" discussed by EY could be drivers of the increased M&A activity in the insurance agency sector.

While it is true that many owners of smaller insurance agencies belong to the baby boom generation and therefore are reaching retirement age, the M&A activity suggests the need to build bigger agencies. Size brings additional capital, enabling the investment in technology, and, to some extent, mitigating the changes from the switch to digital insurance acquisition suggested in the WTW report.

For captive and public entity pools that use an agency distribution model, this suggests the need to revisit how that model may undergo changes and the implications for the captive or pool as a result. Will larger agencies be as willing to participate with the alternative market segment?

As reported in February, nowhere has the impact of M&A activity been more pronounced than in the reinsurance sector. The article " Fitch Believes M&A Can Benefit Re/insurers by Increasing Resilience" says "the combination of continued competitive pressures, the effects of US tax reform, and catastrophe losses in 2017 is leading to speculation of more mergers and acquisitions (M&A) among re/insurers in 2018, especially in the Bermuda market, says Fitch Ratings. Increasing scale and diversification resulting from mergers could increase the resilience of firms to market challenges, including intense price competition and low investment yields. However, merger execution and integration risks could pose risks to profitability."

So where does this leave the captive insurance market? For single-parent captives, the question becomes what is the most cost-effective option to mitigate risk? As the capital markets, through cat bonds and insurance-linked securities, become a bigger part of the equation, corporations will presumably look to determine the optimal way to finance their cost of risk. For many corporations used to issuing debt to generate capital for operations and growth, the move to using these same markets to offset risk exposure will come naturally. Most will look to involve their captive operations in come fashion, but risk managers should be sure to play a constructive role in making this happen.

The question for group captives, risk retention groups, and public entity pools is different. The pressures they face come from multiple directions—talent acquisition, soft market conditions, changes in technology, and simple demographics. For this subset of the captive market, serious consideration of either a merger or a partnership is warranted. Size, while it has its pros and cons, does seem to be the direction toward which the financial services environment is evolving.

For group captives, mergers or consolidations can provide a number of benefits as follows.

• An increase in gross written premiums
• Increased visibility and negotiating strength in the reinsurance markets
• If done properly, the ability to spread fixed costs over a larger base
• Potential increased capital, allowing for investments in necessary technology
• Ability to attract better talent

However, M&A will not be a natural avenue for group captives to pursue. For those that understand the tensions that exist in most groups, any avenue that looks to expand the group also brings additional potential sources of conflict. This will be compounded by the fact that most group captives use external vendors for a majority of their professional services. These vendors will also add potential intransigence since a merger could result in an existing vendor's contract being lost to another provider.

Given these dynamics, it will take strong management and board leadership for group captives to discuss the possibilities of M&A.