Insight and Intelligence on the London & International Insurance Markets 19 Feb 2018
XL rumours intensify focus on Bermuda’s future
- 13 February 2018
A three-week period featuring the sale of Validus to AIG , a major profits warning from Aspen and reports that XL is in takeover talks with Allianz has placed the future of the Bermuda market front and centre.
The corporate developments follow disappointingly low rate rises in property lines at 1 January.
They also come hard on the heels of major US tax reform that has diluted the benefits of a Bermuda domicile and posed particular challenges to the island's total return reinsurers.
Given its $9.8bn equity base, it would be a big bet to say that XL does not have an independent future, but if it were to sell out to Allianz or other plausible bidders like a SoftBank-backed Swiss Re, Chubb or Berkshire Hathaway, it would fit into a broader narrative.
The acquisitions of Platinum, Montpelier Re, PartnerRe, Allied World, Endurance and Validus over the last three years mark the direction of travel out unambiguously.
The group of traditional publicly quoted Bermudians will surely shrink still further in the next 12-24 months as the logic of consolidation creates sellers on the island and a steady stream of acquirers for the assets.
Boards have been willing to hand over the keys in part because a structural change in the way the sector is capitalised looks to have reduced secular returns from catastrophe reinsurance.
And with weak underlying accident-year underwriting margins, slowing reserve releases and (for now) depressed interest rates, the specialty (re)insurers of Bermuda are struggling to make returns that exceed their cost of capital.
(Re)insurers have responded to the structural reduction in returns and the cyclical pricing challenge partially through capital-efficient diversification, with Arch's major mortgage insurance acquisition and legacy joint venture making it the poster child for this risk-agnostic approach.
Some Bermudians have also shifted to a model where liabilities are originated and matched up to a variety of sources of capital, often third-party money from either insurance-linked securities investors or high-net-worth individuals.
This has generated fee income and allowed them to access capital with lower return requirements.
But even this new breed of Bermudian is struggling to hit a double-digit return on equity in a normal loss year.
And without a compelling pricing story to tell investors, Bermudian (re)insurers are reliant on the argument that they will be able to retain the benefit of improved interest rates without giving them back to customers in the form of price competition, and that expense reduction programmes are in train.
Otherwise, they can look to a sale, which could generate two to three years of growth overnight - or substantially more if they can command the 40-45 percent premiums to market price that John Charman and Ed Noonan garnered.
Over the shorter term it seems likely that at least Aspen, Axis and RenaissanceRe will be taken out of the public markets, and either run as specialty arms by more mainstream insurers or financial bidders or integrated into their existing specialty operations.
But longer term, the changes to the US tax code raise questions around Bermuda's raison d'être.
Inertial forces are powerful and Bermudians will be reluctant to park capital onshore in the US for regulatory reasons, but with much of the tax arbitrage gone the rationale for basing substantial operations on the island is diminished.
The pool of talent on the island remains as a check on an outflow of capital and headquarters, but questions also have to be asked about the sense of employing so many underwriting staff in such a high-cost location.
There is scope, of course, for Bermuda to sweeten either its tax or regulatory framework.
Bermuda continues to offer diversifying businesses of digestible scale, and that is sure to continue to draw interest whether from Asia, Canadian pension funds, family money, major commercial insurers, or even personal lines-focused carriers seeking geographical expansion.
The specialty (re)insurance sector is fragmented relative to others and there is only so long that personnel issues can hold back the logic of consolidation.
Sources have said that talk about an Allianz approach for XL was circulating in the market ahead of Bloomberg's report that the Bermudian had attracted takeover interest. However, ongoing talks between the two firms have not been confirmed.
When the news broke XL shares were trading at $37.34 - just 0.98x fully diluted trailing book value.
At an $11.5bn-$12.0bn takeout price, the business represents a major acquisition, but at this multiple - and given the firm's huge expense base - there is scope for a synergies-driven deal, with the caveat that XL has just passed through a similar process following the Catlin transaction.
Allianz has the scale to execute a deal at this size and valuation with only modest book value dilution to its shareholders given its scale and trading multiple.
Whether it would want to retain the reinsurance business after a deal is questionable, with the valuation turning on the potential proceeds of a spin-off of this piece.
XL is an attractive prospect to a consolidator such as Allianz because of its high underwriting leverage relative to other Bermudians.
In 2017, the business wrote $14.8bn of gross premiums, derived from more than 100 offices worldwide. That is more than half of the volumes written by Chubb.
At a 20 percent premium to the undisturbed share price, XL would sell for around $11.8bn - around twice the absolute amount AIG is due to pay for Validus.
But the group would bring five times as much business as Validus, with 68 percent of it insurance.
To do the deal Allianz would need to turn off the spigot on its share buyback programme as it moves away from a recent run of far smaller deals.
And it would have to do it all in the full glare of publicity, after suffering a 3.3 percent fall in its share price following news of the potential XL deal.
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