A fixed income analyst specializing in the property/casualty insurance sector is growing uncomfortable with a potential trend he sees developing in the M&A landscape—interest in insurance company acquisition targets from nonfinancial firms.

Without specifically revealing the identities of such buyers, Robert Hauff, managing director of Wells Fargo Securities LLC, hinted at unwelcome activity that is making him wary of the objectives of a possible new class of investors in the insurance space. Speaking during a session of the Standard & Poor’s annual insurance conference earlier this month, Hauff seemed to agree with co-panelist Jay Cohen, an equity research analyst and managing director for Bank of America Merrill Lynch, who said he doesn’t see any big wave of deals on the horizon.

Hauff, however, reporting evidence of more “activity and rumblings under the surface” than last year, said that he has definitely included a bit of an uptick in insurance- and reinsurance-related deals in his base-case scenario for industry activity this year. “The thing that I’m watching closely is [whether] you are going to have these alternative buyers come in. That makes me a little squirrelly—[wondering] just what the intent is with these companies. Certainly as creditors, we have to live with an owner for a very long period of time. So we need to be careful.”

Earlier in the session, Hauff clearly defined these alternative buyers as “nonfinancial-type” firms or “industrial” firms that seek to buy into the insurance sector. “I think all of us in this room can remember that the last industrial firm that had insurance operations was GE,” he said to the audience of insurance executives and analysts. “And those weren’t the best businesses,” he added. (Editor’s Note: Insurance and reinsurance businesses owned by General Electric in the last decade included, among others, GE Insurance Solutions; Employers Reinsurance Corp., sold to Swiss Re in 2005; and Genworth Financial, spun off in 2004.)

“So I think we need to keep an eye on it, watch it very closely,” he said.

The discussion of M&A activity coincidentally came on the same day that a more comfortable insurer-insurer deal was announced—when Japan’s Tokio Marine Holdings revealed its intent to acquire HCC Insurance Holdings for $7.5 billion through a wholly owned subsidiary, Tokio Marine & Nichido Fire Insurance Co. Ltd. (TMNF). Taking a cue from that deal announcement, S&P Director Tracy Dolin-Benguigui linked the news to last month’s report that Chinese conglomerate Fosun International is planning a $1.8 billion merger with Bermuda-based insurer Ironshore.

“We do think that’s something we’ll see a little bit more of—some interest abroad, particularly in the Asia market, to acquire some primary writers,” she said.

“The bigger concern for me on the fixed income side has been some of these nonfinancial-like firms coming in and showing interest in our insurance companies,” Hauff said, following Dolin-Benguigui’s prediction. “It makes me think, ‘What’s your true intent in holding this thing?'” he said.

(Editor’s Note: Fosun has investments in steel, mining, pharma and energy, in addition to insurance and asset management. EXOR, which is currently involved in a bidding war with AXIS Capital for reinsurer PartnerRe, also has investments in industrial firms, including car-maker FIAT and CNH Industrial, a producer and seller of agricultural and construction equipment.)

Later, Dolin-Benguigui noted the high value that Tokio Marine is paying for HCC, at 1.9-times the book value per share. “It could be that new classes of investors are more agnostic about actual [lower] valuations because they view those particular [target] entities as having a higher intrinsic value.”

Panel moderator Laline Carvalho, a director for S&P Rating Services, asked BOA Merrill Lynch’s Cohen whether current valuations of insurers are conducive to M&A activity. She noted that companies are trading at higher price-to-book ratios on the primary insurance side than on the reinsurance side.

Cohen, who said that average price-to-book multiples for companies he covers are in the 1.15-1.20 range, also said he doesn’t see a groundswell of primary insurer deals in the near future. “There’s not enough pressure. There’s no one out there that’s really suffering or where ROEs are down below acceptable levels, where the boards are demanding them to sell,” he said.

“When you get some inflation or you get some reserve issues, that’s when you start to see it. I’m not expecting that much right now.

“There might be some individual companies where there’s a management transition or a reinsurance company that really wants to be in the insurance business,” he said, citing the deal announced by Validus Holdings to acquire specialty insurer Western World last year. But beyond that, Cohen said a wave of deals is unlikely.

‘A Deal That Makes Strategic Sense’

At a later session focused on specialty insurance, Tokio Marine’s latest expansion into the U.S. specialty insurance market came up again. S&P Director John Iten, adding this year’s XL-Catlin tie-up to the specialty deal list that includes Tokio-HCC and Fosun-Ironshore, asked panelist Michael Schell, chief executive officer of Houston Casualty Co., the main operating company of HCC, to comment on the forces driving M&A activity in the specialty insurance space.

“We’re very excited that HCC is going to be part of a wonderful world-class group, Tokio Marine,” he said, declining to make too many other comments specific to the deal involving his publicly traded company. “This is a great day for my colleagues and me,” he said. “It’s good for the shareholders, employees and potentially the customers.”

Addressing Iten’s question more generally, Schell said: “It’s a good thing to have a good-quality balance sheet and a high S&P rating. It’s a better thing to have a good-quality balance and a high S&P rating, and the balance sheet be a lot bigger. It gives you more potential for operating flexibility in running your business.”

For those in the insurance underwriting business, “having increased portfolio diversification and having lower potential correlation of risk results in better potential risk-adjusted returns,” he added, stressing that these were general reasons why consolidations might take place across the industry beyond expense synergies.

Iten, characterizing the Tokio Marine transaction as “interesting,” noted that the Japanese company already owns Philadelphia Consolidated, another specialty insurance holding group. “It will be interesting to see whether there’s any synergy there. I guess it also provides some opportunity for [further] international expansion,” the S&P director said.

“These are all comments from John Iten,” Schell said, unmoved to even nod in agreement to discuss a deal that had just been announced hours earlier.

Co-panelist Mark Lyons, executive vice president and chief financial officer of Arch Capital Group, weighed in instead. “My first blush on it is here’s one [deal] where you don’t scratch your head. It makes strategic sense.

“It’s not just a financial transaction,” he said, noting that beyond Philadelphia Consolidated, Tokio Marine owns Kiln Ltd. in the Lloyd’s market. “They have more of an international specialty expansion strategy. It’s a super-quality organization.”

Suggesting an improved environment for deal-making, Lyons revealed that his company feels no particular compulsion to make an acquisition.

“Eighteen months ago, certainly in Bermuda, you had most of the companies trading below book.” Under such circumstances, it is “pretty hard to get a board to go into an M&A transaction that’s in the best interests of shareholders [but] that has self-corrected over the last 12 months,” he said, noting that boards may be more open to deals today. “You can catch the wave of wanting to do something and rationalizing that scale is important,” he added.

“We did it the hard way. We don’t need to do anything. But not all boards feel that way,” he said.

HCC Ratings on Watch

Despite positive comments about the rationale for the Tokio Marine deal at the S&P conference, the strong S&P financial strength ratings that Schell referred to are actually in jeopardy of falling one notch when the deal closes, according to S&P.

On June 10, the day of the deal announcement, S&P put the “AA” financial strength ratings of HCC’s operating companies on CreditWatch with negative implications. “HCC’s current group credit profile is one notch higher than that of TMNF,” S&P explained. “After the close of the transaction, we could downgrade HCC by no more than one notch depending on our assessment of its strategic relationship to its new parent according to our group rating methodology criteria and our assessment of HCC’s standalone credit profile, including any potential effect regulations and rules could have on its capital prospectively,” S&P said in a ratings announcement.

While noting that HCC operating performance is far better than peers and the P/C industry overall, S&P said: “We believe the acquisition primarily benefits TMNF’s competitive position and prospective earnings profile. However, we also believe any incremental benefits to HCC with regard to its overall credit profile will be modest, with the exception of additional growth opportunities outside the U.S. that will depend largely on its risk appetite.”

Fitch Ratings also put HCC’s insurer financial strength ratings on negative watch on June 10, noting that the ratings could be constrained by Tokio Marine’s lower ratings, which are in turn constrained by the Japanese sovereign rating of “A.” Fitch downgraded the ratings of TMNF and other Japanese insurers in late April in conjunction with the downgrade of Japan’s long-term local currency issuer default rating.

Although the currency action dropped TMNF’s rating to “A+” from “AA,” on June 11, Fitch noted that Tokio Marine’s acquisition of HCC is viewed as a credit positive for TMNF.

Taking the opposite view, Moody’s Investors Service views the deal as a credit negative for Tokio Marine (financial strength Aa3 negative) in the short term and as a credit positive for HCC (Baa1). In an article in Moody’s Credit Outlook report published earlier this week, Moody’s noted that the deal will increase Tokio Marine’s goodwill and underwriting risk and also result in lower capital levels, while HCC will gain the support of a higher-credit-quality parent.

Looking out over the longer term, Moody’s analysts noted the insurance portfolio diversification benefits for Tokio Marine. “With the HCC acquisition, around 40 percent of Tokio Marine’s revenue will be outside of Japan,” compared to 30 percent today. “We consider a further shift in some of Tokio Marine’s geographical exposure to the U.S. and away from Japan positive, given the negative effects of Japan’s aging and shrinking population on the domestic P/C market,” the Moody’s note said.

For HCC, Moody’s said: “We expect HCC’s business strategy and risk profile will remain essentially unchanged. Also, in keeping with Tokio Marine’s past practices with acquisitions, we expect that the current management team and other key employees will remain in place…”

“The transaction would partially address some of HCC’s challenges, which include the company’s modest scale relative to competitors, and its product risk characteristics, which include high loss limits and potential volatility in certain lines of business,” Moody’s said, highlighting the company’s participation in directors and officers insurance, which has exposure to the financial services sector, and in specialty financial products, such as aircraft and real estate residual value and mortgage guarantee, which historically have low loss frequency combined with high potential loss severity. “Tokio Marine could provide support to HCC in a stress scenario in which one or more of HCC’s lines of business experience sizable losses,” Moody’s said.

Separately on June 11, A.M. Best commented that the “A+” ratings of the members for HCC Group and “A++” financial strength rating of TMNF remain unchanged.