Runoff specialists are increasingly becoming visible acquirers of ongoing books of business as M&A activity heats up across the insurance industry, according to a consultant from Towers Watson.

Speaking to Carrier Management to discuss highlights of a recent survey of 256 carrier executives about their plans for merger and acquisition activity, Sean P. McDermott, P/C M&A Practice Leader for the Americas at Towers Watson in Philadelphia, noted that the emergence of runoff specialists looking for growth opportunities is a relatively new development in insurance deal dynamics that wasn’t specifically picked up by the carrier survey.

Referring first to a key takeaway from the insurer survey, McDermott noted that three-times more respondents said they are looking buy companies or books of business than to sell them. More precisely, the survey report, which is based on responses of carriers and reinsurers domiciled in the EMEA (Europe, Middle East and Africa region) and global carriers active in the region, reveals that 69 percent plan to make acquisitions in the next three years, while only 20 percent said they plan divestures.

Although the report does not split the results between the P/C and life segments, McDermott said that recent past studies show fairly consistent results for life and P/C. “What’s also consistent is the number of companies looking to sell things. That usually runs about one-third of the looking-to-buy number.”

“That creates an interesting marketplace dynamic, which is one of the reasons we think M&A will continue on going forward,” said McDermott, whose expertise is on the P/C side.

But the survey report, “Surviving the Perfect Storm: The Outlook for Insurance M&A in EMEA,” just counts buyers within the industry—those looking to acquire competitors with complementary books of business or seeking bolt-on acquisitions in new lines and regions. Adding private equity buyers and runoff specialists to the tally creates an even bigger demand-supply imbalance that is helping to fuel insurance deals, he said.

“If you go back a few years—even as few as three years ago—some of the runoff companies were interested in only doing runoff. Now you have runoff companies competing almost at the start on any transaction,” he said, noting that these potential acquirers now reserve the right to put a target into runoff or to operate it on an ongoing basis.

“You have a whole new entrant competing with the ‘normal acquirers’ out there.”

Although McDermott declined to name the runoff specialists he had in mind, earlier this year in a separate report on M&A activity, Conning listed Randall & Quilter, Enstar, Riverstone, and White Mountains Solutions among runoff specialists that were active in acquiring and providing ex it solutions for underperforming legacy books of business in 2012.

More recently, in one of the highest valued deals of 2013, Enstar and Stone Point Capital teamed up on the $692 million acquisition of Torus Holdings, helping Enstar to expand into “live” underwriting and direct sales of coverage. That deal came on the heels of Enstar’s announcement that it would buy Atrium Underwriting Group Limited at Lloyd’s and Arden Reinsurance Company Limited in Bermuda for more than $260 million.

“Our core focus remains on acquiring insurance and reinsurance companies that are in run-off, however we believe Atrium will provide us with a high quality operation at Lloyd’s that includes a skilled underwriting and management team that will help create new opportunities for us to grow and prosper,” said Enstar’s Chief Executive Officer Dominic Silvester in a media statement at the time.

McDermott described a similar evolution for the runoff sector overall.

Going back five or 10 years ago, “they were really going after latent liabilities—asbestos and pollution,” he said, noting that they would acquire the liabilities and then became experts in running them off.

After some big successes, they started to go after other long-tailed liabilities, he said, noting that workers compensation was the next frontier. “Then as they went through those liabilities, they’re still looking for more.”

“By definition, the only way a runoff company can grow is through acquisition and disposition of the liabilities. So they started to look for more things, and that’s when they started to dabble into live companies.”

Providing some more background, McDermott recalled that as recently as three years ago, early media reports of an typical acquisition would list anywhere between two and seven “normal acquirers” that were looking at potential target and then walked away. “Then almost as a last resort, the runoff companies would come in and offer a last-ditch evaluation that would sell the company and make a deal go through.”

More recently, “they’ve stepped up in the chain,” he said, noting that the runoff specialists are now listed among the initial companies looking at a particular property in the first press announcement. “Even though it may be a viable book of business, what they’ll do is to partner with somebody who can fund the company going forward—either a PE firm or even another company—and then use their expertise to take off the old liabilities that can be put into the runoff market. Then [they’ll] work to revalue the company that’s there, bring in new management and start again.”

The trend “is relatively new,” McDermott reports. “We’ve only had about a year or two of runoff companies in that space,” he said, predicting that over time, some new viable companies will emerge that started as runoffs.

McDermott confirmed, however, that it’s not the case that there are more distressed books of business emerging, inviting the specialists to apply their runoff expertise. Instead, they are essentially seeking growth opportunities in the live company space.

“Even in a well-run company that’s up for sale, there’s always a particular book of business that’s part of the portfolio that’s an ideal runoff candidate. So they can bifurcate the good from the bad and then go forward,” he said.

Beyond the runoff acquirers, McDermott discussed PE firms and strategic buyers in the insurance space.

“While P/C PE investors have been active for many many years and quite successful, there’s a lot of money that’s coming due that they have to reinvest or give back,” he said, noting their attraction to sidecars and reinsurers in Bermuda.

As for carriers themselves, they are more attracted to acquisitions because market conditions that are not conducive to organic growth, he noted. “They’ll look to inorganic growth by bolting on acquisitions of types of companies that might make sense to add to an operation that have completely different types of businesses, or by buying competitors that have complementary businesses.”

McDermott said geography also plays into the thinking of U.S. regional carriers looking to expand geographically, and national carriers looking to expand into EMEA or Asia or Africa.

The Towers Watson survey, conducted in conjunction with Mergermarket, documents average carrier responses to questions about acquisition drivers, geographic regions of interest, and deal challenges, with results combined for life and P/C respondents. On the geography question, carriers ranked Asia-Pacific as the most attractive region to pursue for acquisitions, followed by Latin America, and then Central and Eastern Europe.

Valuation Gaps

As for deal challenges, “establishing a valuation that is acceptable to both parties” ranked first.

According to the report, valuation gap challenges are reflected in high minimum return on capital required by respondents. Across all sectors, the results show that acquirers are seeking a global average of about 15 percent return on capital—ranging from approximately 14 percent for deals in Western Europe and the Americas, to roughly 17 percent in Africa and the Middle East.

“It has to be said that this seems to reveal a disconnect between some lofty ambitions and what, in our view, is likely to be achievable in the near- to mid-term,” the Towers Watson report says.

Further pressure on valuations may come from the fact that only one-fifth of respondents said they are planning to divest operations in the next three years, Towers Watson noted in a statement about the report.

Jack Gibson, Towers Watson’s global lead for Insurance M&A, said the combination of fewer planned divestures and increased carrier appetite for acquisitions could fuel a “seller’s market,” going forward. The imbalance might drive competition for assets, “which would reduce target returns and raise valuations,” said Gibson, in the media statement.

About the Survey

Researchers from global intelligence provider Mergermarket canvassed the opinions of 256 senior insurance executives from life, P/C and composite insurers as well as reinsurers regarding their outlook for global M&A in the insurance sector, with an emphasis in EMEA. Of the 256 respondents, 76 described themselves as P/C executives with 78 describing their companies as composite insurers.

The criteria for inclusion in the survey were that respondents worked for an EMEA-domiciled insurance company, or where non-EMEA domiciled, the business had operations in EMEA or were otherwise active in the region. Interviews were carried out in the second and third quarters of 2013.

According to McDermott, senior executives chosen to take part in the survey are those that would typically have a hand in targeting or thinking about M&A within a company before it occurs. Titles of such executives include chief financial officer, chief risk officer, chief strategy officer and corporate development officer, he said.