Buy-side value: Strategy for mergers and acquisitions

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By Urban E. Leimkuhler | 01 May 2008

Following a classic hard market — in which it was difficult for most insurers not to make money—property and casualty prices have been declining markedly for the past few years. And as this soft market deepens, it will become even more difficult for property/casualty insurance companies to grow organically. Value buyers will perceive opportunities in pursuing acquisitions of companies and books of business, and some insurers may be forced to seek assistance from buyers in order to shore up their inadequate levels of capital. Separating the real opportunities from potential money pits will require a strong approach to analyzing company fundamentals, including due diligence.

Investing in property/casualty insurers can be fraught with peril. Chronically underperforming companies with inherent underwriting, claims, and other operational weaknesses can present major post-deal challenges to buyers. On another level, hidden claims and exposures, such as multiple-year construction defect claims, long-tail liability exposures, or catastrophe-prone property, can present devastating potential liabilities to a buyer. But for the savvy buyer who can identify value pockets and avoid pitfalls, a deal can offer substantial returns.

Avoiding the stampede

In a high-stakes arena where sellers can have a distinct information advantage, a sound buy-side business strategy can help to level the playing field. It can enable buyers to rationally decide whether a deal makes sense, and once comfortable with an initial top-level review, how to systematically assess and value the target's operations. It can also help buyers avoid critical mistakes that typically lead to poor decisions.

All too often, poor decisions result from abbreviated due diligence and a rush to make arbitrary deadlines. Buyers often take shortcuts by focusing on historical data made available by the target without systematically assessing the dynamic nature of property/casualty operations—underwriting, pricing, distribution management, claims, reserving, reinsurance, etc. and the interaction among these key functions—and carefully examining balance sheet risks that may lurk in corners of the business. Shortcuts in data collection and examination—the cornerstone of due diligence—almost invariably return to haunt buyers, who can find themselves ill-prepared to manage unexpected setbacks after the deal closes. Most unwelcome surprises can be prevented by a well-thought-out strategy and action plan for due diligence.

Done properly, due diligence equips buyers with the needed information to effectively assess the target's operations and identify weaknesses as well as strengths, providing leverage that can be used to the buyer's advantage in negotiating price, conditions, or carve-outs in a deal. Armed with this information, buyers can gain an advantage in the negotiating process. Sellers themselves may lack an awareness of inherent weaknesses in their operations or the significance of these weaknesses.

Uncovering these opportunities requires the use of a professional due diligence team that can thoroughly evaluate the insurer's core functions, including the following:

  • Business strategy - Is the core business strategy fundamentally sound? Does it contemplate a strong product/service offering, a viable overall market, and a dominant company position in the market?
  • Underwriting - What classes of business is the target insurer writing, and where? What is the profit potential and the downside for each? What market position does the insurer enjoy? What processes does the target use to capture and evaluate individual risk underwriting information so as to ensure good risk-selection decisions? How is the insurance coverage constructed? Does it open the door to problematic claims activity? How is underwriting performance monitored? Is the target insurer’s catastrophic exposure reasonable, or should exposures in some markets be pared back or eliminated?
  • Product pricing - Have products been priced properly? Is pricing aligned with exposure? What, if any, level of market pricing power does the insurer enjoy? How reliable and valid is actuarial data used in pricing? Does pricing take into consideration prospective trends, such as an increase in hurricane activity, for which historical data does not take account? Have year-over-year pricing changes been monitored in order to facilitate a more comprehensive actuarial review of results?
  • Distribution management - How strong is the target's network of agents with respect to the product and geographic objectives? Do agents value the company as a specialized market or do they see it as a commodity player? How have agents been managed and incentivized to achieve underwriting profitability? Does the target rely on managing general agents who report incomplete or delayed results that may cloud true profitability?
  • Claims - Is claims service perceived by agents and customers as a strength or as a weakness? Are adjusters assigned claims at their level of experience or training, or beyond this? Are staff levels adequate for the volume of claims? Are there inconsistencies and/or changes in the target’s methodology for reserving claims? Do the target's claims practices inadvertently promote inadequate loss reserving?
  • Actuarial loss reserving - Have proper loss reserving techniques been applied? How agile are reserving practices in reflecting changes in the book of business or claims trends? Do loss-ratio forecasts lag changes in rates and terms?
  • Ceded reinsurance - Is the target missing profit opportunities by reinsuring too much of its business or assuming exposures beyond its capital capacity? Has the business been reinsured with well-capitalized reinsurers? Have reinsurers and brokers provided value-added partnership services?
  • Financial and information technology - Are financial controls continually evaluated and maintained for adequacy? How adequate are systems that support core functions such as under-writing, policy processing, claims processing, actuarial analysis, reinsurance, and financial/statistical reporting? What management data has supported ongoing performance monitoring and decision making?
  • Human resources - How capable are the target's management and staff? How are managers and staff held accountable or rewarded for results? What training and development needs have been identified and what programs have been designed to meet these needs?

Performing such detailed analysis also helps bring rationality and perspective to negotiations. Enthusiastic buyers who make the fundamental mistake of shortchanging due diligence cede a major advantage to the seller.

A done deal?

The substantial upside potential of a well-vetted deal can be lost because the buyer fails to hit the ground running and diligently follow through in implementing fundamental improvements uncovered during due diligence. In many cases, buyers behave as if closing the deal means the deal is done. On the contrary, it is just the beginning. Execution of the workout stage is critical to success of a deal and requires buy-side plans and timetables for post-sale, strategic change. In the post-deal stage, the buyer should separately address operational problems that easily can be fixed to yield quick returns and systemic deficiencies that require an investment of time and resources to produce results.

The soft market can be expected to present buyers with a wide range of opportunities for investment. Inherent in all property/casualty insurance transactions are issues that represent potential value creation and value destruction. Only with an effective strategic and analytical framework can a potential buyer navigate successfully from target identification through the due diligence stage to post-sale implementation. This is often the difference between a good deal and one that fails to deliver the expected value.

Urb Leimkuhler is a manager and senior consultant with the Princeton, N.J., office of Milliman. His experience includes company-wide executive responsibility for personal lines business, commercial lines underwriting, and actuarial operations; development of property and casualty business planning and underwriting models; and management of major due diligence reviews related to mergers and acquisitions.