Despite continuing debates about appropriate measures of earnings and capital, European insurance outfits are on stable ground. Balance sheets look healthy, and profitability for most groups is good. Ratings in the European insurance sector are predominantly stable.
If industry players can demonstrate the favorable trends are sustainable, more positive ratings outlooks and upgrades across the sector will likely occur during 2006. Of course, risks to these positive rating developments do exist, including acquisitions or failures in the much-improved risk-management frameworks insurers are developing.
GOODBYE, ORGANIC GROWTH? Over the past few months, an increase in M&A activity in the sector has taken place -- Old Mutual has acquired Skandia, Talanx is merging with Gerling, Swiss Re is acquiring GE Insurance Solutions (GE), and Aviva recently approached Prudential (PUK) about exploring a merger. Standard Life is switching from a mutual insurer to a stock ownership format and may turn into a target. In addition, Allianz (AZ) and Generali have both restructured to buy out minority interests in some material subsidiaries.
With capitalization restored, it appears some management teams have switched their strategies from organic growth to growth through acquisitions. Organic growth came about as stronger companies gained market share from weaker players in life insurance, particularly in Britain and Germany, and renewal rights and underwriting teams were acquired in non-life. Management had seemed happy to avoid acquiring legacy issues. So what changed?
Capitalization is stronger after the hard market and recovery in investment markets. Some managers are now tempted to use their perceived excess capital for acquisitive growth, while others are considering share buybacks. Defining excess capital is somewhat difficult, however, because of the nature of insurance liabilities -- accounting and regulatory changes can exacerbate the process.
INTEGRATION RISKS. In some cases, Standard & Poor's Ratings Services can view material acquisitions negatively, especially when the target has a weaker credit profile. Execution risks after acquisitions are high, and capitalization is usually strained in the expectation of revenue and cost synergies. Failure to deliver these synergies leaves the company with weaker financial strength.
Demonstrating a track record of success remains the key way for outfits to mitigate this risk, but any management team is only as good as its last integration. Acquisitions typically result in a negative rating action up front on the acquiring entity. Positive rating actions typically follow, if and when a successful delivery of the planned synergies happens.
Insurers claim they're managing the underwriting cycle more effectively, which should yield more stable results. Similarly, investment risks are being more tightly controlled. S&P notes the emerging risk-management frameworks have yet to undergo full testing by either weak market pricing in non-life markets or adverse investment conditions in bonds, equities, and property.
Risk management of catastrophe exposure found itself severely tested last year due to hurricanes Katrina, Rita, and Wilma, and several companies ended up more exposed than expected. While ratings on European insurers and reinsurers held up, it will be important to see how companies learn from this experience in their risk-management framework. Greater-than-expected underwriting or investment losses in adverse conditions would offset the positive rating trends in the sector.