As the 2009 hurricane season gets off to a mild start, all eyes in the reinsurance sector are free to focus on which companies are merging. Two recent deals may herald a new wave of consolidation. Meanwhile, reinsurers were encouraged by a judgment from the House of Lords, made on its swansong day.
Period clause ruling makes history
On 30 July the UK’s House of Lords ruled in favour of reinsurers in a judgment that was historic for more than one reason. It was the last day that the House of Lords acted as the highest appeal court in the UK. From 1 October, the Supreme Court of the United Kingdom assumes jurisdiction on points of law for all civil law cases in the UK and all criminal cases in England and Wales and Northern Ireland.
But the Lords’ judgment in Wasa and AGF v Lexington also made history for the insurance industry. The issue was whether reinsurers Wasa and AGF had to follow the reinsured’s (Lexington’s) settlement of $103m (£62.5m) with aluminum giant Alcoa for insurance of environmental liabilities.
Before the case reached the Lords, the Court of Appeal had held that reinsurers were obliged – under a “follow the settlements” clause in the reinsurance policy – to follow the misfortunes of the primary insurer. The US courts had ruled that the primary insurer, Lexington, had to indemnify Alcoa against pollution damage that had taken place before and after the three-year period (from July 1977) specified in the policy.
The damage arose from failures by Alcoa in dealing with waste products and pollutants. These failures first began causing damage in 1942 and continued until at least 1986.
But the House of Lords overturned the Court of Appeal’s judgment, and found instead in favour of Wasa and AGF. Delivering the verdict, Lord Collins said: “This is not a case where the reinsurers are relying on a technicality to avoid payment.”
The judgment is important because it clarifies that, as a matter of English law, a period clause is fundamental to a reinsurance contract. The inclusion in the contract of a “follow the settlements” clause does not bind reinsurers to provide coverage for losses that fall outside the period clause.
So, the reinsurer is not unconditionally “lashed to the wreckage of the insurer’s coverage vehicle, but has an independent escape module – in the plain and natural meaning of the words of his own contract,” said Peter Taylor, partner in the insurance and reinsurance practice at Lovells.
The wording of each reinsurance contract, rather than matters of principle, is key.
“It is time to start putting proper wording into contracts of reinsurance to postpone the running of time until a convenient and logical date,” Taylor said.
Brokers and underwriters love to use techie terms such as “back-to-back” cover, “full reinsurance clause” or “as original”. But Taylor warns that such shorthand is “of no avail and [does] not trump the words of the contract where the law of the insurance is different from the law of the reinsurance”.
In the wake of the judgment, lawyers are working on how to amend the wordings of reinsurance contracts.
Ian McKenna, partner in Mayer Brown International, said: “Insurers of multi-jurisdictional risks, without express choice of law clauses to rely on, should, in light of the decision in Wasa, consider whether they will be able to rely on the presumption of back-to-back cover in the event that they need to claim under their outwards reinsurance.”
Survival spirit breeds merger mania
Two mergers have gripped the attention of the reinsurance sector recently, and there are whispers of more to come.
PartnerRe’s $2bn deal to acquire Paris Re in a stock-for-stock transaction creates the world’s fourth-largest reinsurer, bringing shareholders’ equity to about $6bn. Meanwhile, the board of IPC agreed to a sweetened offer from fellow Bermudian Validus, having earlier rejected Validus’s approach. At that time, the IPC board preferred an offer from Max Capital. However, IPC shareholders then disagreed with their board, and the Max deal was set aside.
In the wake of these two mergers, the discussion centres on how much consolidation is still to come. The calculation relies on unknowns, such as the speed with which the financial markets continue to stabilise, the availability of capital and the severity of the 2009 Atlantic hurricane season (which has begun mildly enough).
But it also relies, to an equal but less knowable degree, on the personality match between potential acquirers and their targets. Buying a company, the example of IPC notwithstanding, is easy enough to do. Buying the right company – merging cultures, personalities and reinsurance books – is not so easy.
Larger profits are not the single driving force. Survival is also key for those mid-sized companies most likely to feature in the forthcoming war of attrition. Improving the bottom line is never unwelcome, but having a bottom line to improve is far more important.
Industry consolidation is a classic feature of insurance cycles. In simple terms, a hard market, when reinsurance rates are high, offers opportunities to grow new franchises, and the soft markets that follow offer the best-managed (and perhaps luckiest) companies the chance to invest some of their organically-produced earnings in further growth through acquisition.
So it has been in Bermuda, at least since the market took off in 1993-94 with the introduction of $4bn of property catastrophe capital. The eight companies that propelled Bermuda into the big leagues were soon enough reduced to three as the hard market that spawned them gave way to over-supply. Within five years, ACE and XL Capital had bought four of the companies, using the accumulated earnings from their first decade in Bermuda. One more, LaSalle Re, experienced problems, and the other three survived to reach their 15th birthdays in 2008.
The cycle is a constant; timing is not. Just because the “class of 1993” lasted five years before being reduced to a rump did not mean that the “class of 2001” would automatically follow the same pattern. Indeed, it didn’t. Almost eight years since their formation, although a couple have recently evaporated, not one of the dozen majors formed in the 90 days after 9/11 has yet been acquired.
Why? Because every cycle is different, and because these seven years have been the most tumultuous in insurance history. Because most of them operated a new model, combining insurance and reinsurance under the same parent, making themselves more attractive to rating agencies but less attractive to specialist reinsurers. Because their owners have been satisfied with their performance and the non-correlated risk the books of business bring to their balance sheets. And, lately, because softening markets have been affected by liquidity constraints in the capital markets.
Nevertheless, it seems likely that the IPC dogfight has sounded the opening bell for a bout of consolidation in the Bermuda market, both for acquirers and acquired. Who will the likely candidates be? The same names potentially appear on either side of the equation. A confused stock market undervalues insurers and reinsurers at present, which is a key condition for a wave of mergers and acquisitions. How much more attractive might a marginal candidate for acquisition look if it could be had for less than book value?
The cases of IPC and Paris Re show that the likeliest acquirees would have capital and surplus somewhere between $1bn and $2bn. In IPC’s case, the potential buyers fell into the same category, although PartnerRe shows that few companies would object to strengthening their balance sheet through a sensible acquisition, regardless of their existing scale.
Which Bermuda companies meet the size requirements? In alphabetical order: AEGIS, Argo Group International Holdings, Ariel Reinsurance, Flagstone Reinsurance Holdings, Hiscox, IPC Holdings, Lancashire Holdings, Max Capital Group, Montpelier Re Holdings, OIL Insurance, Platinum Underwriters Holdings, Tokio Millennium Re and Validus Holdings.
Assume for these purposes that Validus completes its deal with IPC, and that both companies are therefore already spoken for. Exclude AEGIS and OIL, which are essentially special purpose vehicles owned by their customers. Assume that Tokio Millennium Re’s single parent is unlikely to want to sell one of the sector’s star performers. That leaves eight medium-sized companies for consideration. Some of these are led by personalities – Don Kramer at Ariel Re, and Richard Brindle at Lancashire – unlikely at this stage of their career to enjoy working for someone else. So that leaves our speculative list of six potential merger targets (see below). IT