While the region goes is growing tremendously, the insurance industry is facing a major challenge related to its profitability, but, if well managed, can put the industry at the forefront of financial services in the regional economy. Driving top line growth is relatively easy considering the economic boom — the challenge for shareholders and managers of insurance companies is driving the bottom line at the same time.
By its very nature an insurance policy is a contract relying on inverse pricing, meaning the selling price of the policy is set well before the final cost is known to the insurer. On this basis an aggressive growth strategy can destroy the bottom line rather than enhance it. So to grow, an insurer must push away price competition and differentiate itself through products, services, focus and market reach. The insurer must develop new products, improve service, cross-sell and enhance distribution networks, while also balancing increased efficiency with cost controls through better operations, enabling them to better manage claims, reach and retain customers, improve underwriting capabilities and strengthen reporting and monitoring. Human resources are scarce in the industry though, with a growing number of insurance companies and the structural under investment in talent throughout the region.
So how would an insurance company shareholder or would-be shareholder of a new company improve his return? They both can growing organically or merge and acquire. Would-be shareholders can set up a brand new company or acquire an existing operation. So the question is when and how. First, let us define the investor; is he coming from the insurance industry and looking to expand in the region or coming from outside the industry and looking to add insurance to the activities of the conglomerate. When the insurer is experienced in the insurance market and the country’s environment, an acquisition would be preferred, as it provides an advantage of faster entry, reducing the opportunity cost of wasting time while the market is growing rapidly. Governmental barriers must be considered — can the investor get a new license or are acquisitions encouraged. When the partners are from outside the industry an acquisition is difficult to handle because of the equity price the investor will pay when they don’t know whether this price is for real, considering the intrinsic valuation difficulties of the insurance business. Not any company is a good target considering poor corporate governance and enterprise risk management of some companies. More preferable for an outside investor is to go for a joint venture with a market player looking for entry into the specific territory. No doubt that joint ventures will be preferred if the industry is concentrated or when it is used as a mechanism to reduce transaction costs incurred when acquiring other firms.
Considering the above, why go through M&A. On the macro level, we are undergoing a change scope by moving from national markets to a regional market and soon enough a worldwide one. As competition increases companies will have to grow rapidly to stay competitive. But how can one grow aggressively when bottom line does not follow the top? Shareholders will have to think of M&A. During a growth period it is always the case that many new companies are founded however with the atomization of the market, the outlook for growth and survival of start-ups becomes negative. With new regulations in the region, companies will face heavy financing needs with reducing returns on equity due to the weaknesses in managing the competitive forces, which, in the end, will push major groups to move out of the industry.
On the micro level, companies that go through M&A are looking for a level of efficiency, productivity and profitability. The acquirer has to be first a very efficient and well managed company and once this level is reached the acquirer looks to improve his bottom line even further through economies of scale on the structure, IT, marketing, creation of products and risk management. They improve bargaining power in purchasing reinsurance and advertisement. The acquirer can benefit from synergies and complementarities in terms of markets, territories, products and distribution networks. The larger size can reduce the effect of economic downturns and softness in the insurance cycle. Finally improve margins by improving market share because of the leadership position.
When 50% of M&As around the world do not succeed, the insurance industry has to manage challenges of its own to make an M&A operation a success. Firstly the valuation challenges and listed among others, the long duration of liabilities, the art of loss reserving, the cyclical nature of the business, the impact of reinsurance, the impact of statutory accounting, regulations and finally interest rates and capital market fluctuations. The value of an insurance company is broken down into several distinct parts. The adjusted book value (ABV) must be assessed carefully considering on one hand the hidden capital gains and on the other the difficulty in assessing liabilities and reserves for outstanding claims, incurred but not reported claims etc. To the ABV must be added on one hand the best estimate of the embedded value, which is the value of in force business and on the other the value of future business and other items such as goodwill etc. Secondly, to run an insurance business you are running risks, underwriting and technical, related to the pricing of products and again reserving, credit risks related to the reinsurance, clients and counterparty recoverable, market risks related to investments and finally, operational risks. Thirdly, the biggest challenge of all is integration of the labor forces and the digestible assets.
The learning curve has its costs whether it is a joint venture, merger or acquisition but the most important thing to keep in mind is shareholder’s return.
Farid Chedid is managing director of Chedid
