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Valuation of Insurance Organizations

The M&A Market for P&C Insurers: 2019

Jeff Balcombe | March 1, 2019

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This article provides an update regarding the mergers and acquisitions (M&A) environment for the property and casualty (P&C) insurance industry (prior article dated August 2017). This article discusses the M&A market for P&C insurers and other key factors, including macroeconomic conditions, political developments, and other trends that may impact the outlook for the industry.

M&A activity in the P&C insurance industry was characterized by megadeals (i.e., transactions over $1.0 billion in total invested capital) in 2018. Although total announced transactions declined from 53 in 2017 to 43 in 2018, the total announced deal value increased from $8.2 billion to $31.0 billion. 1 A significant portion of the total deal value for 2018 occurred in the first quarter of 2018 with AXA's $15.4 billion acquisition of XL Group and AIG's $5.5 billion acquisition of Validus Holdings.

Economic Factors

As the US economy has recovered and unemployment and inflation statistics are near their congressionally established targets, the US Federal Reserve has begun enacting more restrictive monetary policy to offset anticipated inflation from economic growth. 2 Consequently, the Federal Reserve began increasing the federal funds rate in 2015 from its all-time low of 0.25 percent through a series of periodic rate increases. During December 2018, the Federal Reserve raised the target federal funds rate from 2.25 percent to 2.50 percent and communicated that further increases were expected in 2019. However, due to the significant market volatility that occurred in 2018 and sensitivity of the capital markets to borrowing costs, the Federal Reserve signaled a cautious outlook regarding future rate increases and indicated that the federal funds rate may be approaching a long-term equilibrium rate (i.e., the rate that will allow the economy to maintain stable employment and inflation), so the timing and magnitude of future increases remained uncertain.

A key driver of financial performance for P&C insurers is the return on fixed income securities. Insurers charge premiums to their policyholders and generally invest those funds in fixed income securities to earn investment income. Consequently, as interest rates increase, higher investment returns may provide companies within the P&C industry with additional capital and may spur acquisition activity. However, despite the potential increases, interest rates remained near historic lows and continued to reduce investment income of P&C insurers.

After an average annual gross domestic product (GDP) growth of 2.3 percent over the past 5 years in the United States, the Federal Reserve forecasts real GDP growth to decrease from 3.0 percent in 2018 to 1.8 percent in 2021. 3 While increases in the federal funds rate have led to higher yields on shorter-term bonds, yields on longer-term bonds have grown at a slower rate during the past 18 months due, in part, to investors' long-term expectations regarding the prospects for the economy as a whole. This reduction in growth is expected to impact the P&C industry as well. After experiencing 2.2 percent annual growth on average between 2013 and 2018, the P&C industry is expected to see growth fall to 1.4 percent annually between 2018 and 2023. The prospect of reduced long-term economic growth could encourage M&A activity as organic growth opportunities become more limited.

Political Factors

The Tax Cuts and Jobs Act of 2017 reduced the effective corporate income tax rates of P&C insurers and improved profitability. Additionally, it introduced a deemed repatriation provision that would allow companies to bring capital back to the United States from foreign subsidiaries at relatively low tax rates. The additional capital generated from lower corporate income taxes and repatriation of cash from foreign subsidiaries might be used for acquisitions and other strategic initiatives.

Ongoing trade disputes between the United States and China, in addition to other nations, over tariffs and trade rules resulted in higher market volatility in 2018 with an increased likelihood of a recession if a resolution can't be reached. 4 Additionally, as of the writing of this article, the government is in the middle of a 3-week respite from the government shutdown which, if not resolved, could harm the economy and reduce consumer and investor confidence. 5

Industry Trends

P&C markets continue to exhibit "soft rates" (i.e., lower insurance premiums), and despite the recent increases to the federal funds rate, interest rates remain near historically low levels. The foregoing factors have adversely impacted revenue and profitability of P&C insurers, which could encourage consolidation among larger P&C insurers due to diminished opportunities for organic growth. 6

An abnormally high frequency of severe natural disasters in 2017 and 2018, such as Hurricanes Harvey, Maria, Irma, and Michael, and West Coast wildfires, resulted in significant underwriting losses associated with policy payouts and adversely impacted profitability and reserves. 7 Notwithstanding these catastrophic events, P&C insurers had an excess of available capital reserves in 2017, which dampened the impact of these events on the pricing cycle. 8

The frequency and severity of major catastrophic events also impact the financial performance and M&A activity among P&C insurers. Increased frequency and severity of these events adversely impacts capitalization and, in turn, investment proceeds and liquidity. 9 The occurrence of catastrophic events in the United States spiked in 2017 and 2018. Accounting for inflation, 3 of the top 5 costliest hurricanes since 1900 occurred during 2017, with Hurricanes Harvey, Maria, and Irma each doing damage in excess of $50 billion. 10 As a result, P&C insurers are expected to set aside more reserves as a precaution against future catastrophic losses, which may adversely impact profitability and reduce M&A activity. 11

Public Company Multiples

Valuation is a key driver of M&A activity. When considering an acquisition or sale of a business, it is common to assess the multiples of publicly traded companies operating within the business' industry. Figure 1 12, as shown below, graphically presents the average monthly forward price-to-earnings (P/E) multiples of domestic, publicly traded companies operating in the P&C industry.

Figure 1: Average Forward P/E Multiples

Average Forward P-E Multiples - Balcombe - March 2019

At the beginning of 2017, P/E multiples peaked as the economic outlook was positive, unemployment was reaching historic lows, and more businesses and investors anticipated a higher growth environment driven by infrastructure spending, deregulation, and the possibility of tax cuts. However, in 2018, trade tensions, growth concerns, and regulatory uncertainty led to a broader market correction and an accompanying contraction of P&C insurers' multiples. However, multiples expanded as markets recovered in the fourth quarter of 2018 and January 2019 and forward P/E multiples remained considerably above their 5-year trailing average. Continued growth in valuations could make acquisition targets less attractive to potential buyers and dampen M&A activity. 13 Additionally, larger private insurers may be encouraged to pursue an initial public offering rather than a strategic merger or sale.

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1 Financial Services/Insurance Deals Insights: Year-End 2018, PwC, 2018, page 8 (for 2018 figures) and 2019 Insurance Industry Outlook, Deloitte, 2019, page 11 (for 2017 figures).
2 Greg Ip, "Real Time Economics: Powell Follows the Data, Not the Market," Wall Street Journal, December 19, 2018.
3 Federal Open Market Committee press release, December 19, 2018.
4 2019 Insurance Industry Outlook, page 3.
5 Michael Sasso and Andrew Mayeda, "From Craft Brews to Car Bills, Shutdown Hits American Confidence," Bloomberg, January 19, 2019.
6 2019 Insurance Industry Outlook, page 12.
8 2018 Insurance M&A Outlook, Deloitte, 2018, page 12.
9 IBISWorld Industry Report 52412, page 6.
10 "Costliest U.S. Tropical Cyclones Tables Updated," National Hurricane Center, January 26, 2018, Table 3a.
11 IBISWorld Industry Report 52412, page 6.
12 Data obtained from Standard and Poor's Capital IQ. Negative multiples and multiples greater than 50x not considered.

2018 Insurance M&A Outlook, page 10.