Private equity eyes insurance: investments in the insurance industry are booming as investors flush with capital look for new ways to invest it.
"It might be a fairer statement to say that there's an explosion of private equity growth worldwide in many industries, and the insurance industry is just one of them," said Robert Hartwig, chief economist for the Insurance Information Institute.
Because private equity favors investments in areas where a market has been displaced, the property/casualty market has been a popular investment choice in recent years.
In the wake of the Sept. 11, 2001, terrorist attacks, private equity invested billions into the Bermuda market to finance new property/casualty efforts. Montpelier Re, Endurance Speciality, DaVinci Re, Axis Speciality, Allied World and Arch Capital all were either formed in part or helped to expand their businesses by private-equity' funding.
"There's been a lot more private equity interest in insurance," said John Waller, managing director for Cochran Caronia Waller, a Chicago-based investment bank. "Going back to Sept. 11, private equity saw a need for more capital in the industry. As more private equity did due diligence, and got more comfortable with the industry, more investments were made. Most have gone to property catastrophe insurance, where clearly there's an opportunity for significant profits if the wind doesn't blow."
So, too, "after hurricanes Katrina, Rita and Wilma struck in 2005, private equity again flowed into new Bermuda insurance ventures, including Ariel Reinsurance, Arrow Reinsurance, Flagstone Re, New Castle Re and Palidus Re.
"When the market turns soft, no new equity comes into the market," said Rob Bredahl, president of Benfield Inc. "It goes in cycles. But in the last two years, it has been busier than usual for the entire industry."
The most important thing private equity investors look for when investing in an insurance company is the quality of the management team, said Bead Cooper, a partner with Capital Z Financial Services Partners.
"This is not an industry that has a surplus of high quality management, but it is an industry that has a surplus of complicated issues," Cooper said.
For example, Capital Z recently backed the start-up of Lancashire Insurance in Bermuda, which was launched with $1 billion in capital.
At the helm of Lancashire is Richard Brindle, a leading underwriter from the Lloyd's marketplace. Brindle "served as chief underwriting officer in John Charman's highly successful Lloyd's Syndicate 488 and 2488 (Charman Underwriting Agencies) in the 1990s. Richard Brindle has a strong underwriting track record in the Lloyd's marketplace and is well-positioned to capitalize on the current opportunity in the property, insurance and reinsurance marketplaces," according to the Cypress Group, another private equity firm involved in capitalizing Lancashire.
Cooper said Capital Z is very familiar with Brindle and his work. Capital Z became one of the first to infuse Lloyd's with corporate capital in 1994 by investing in Charman Underwriting. Capital Z owned Charman for five years before selling it to Ace and was impressed with Brindle's work with the company.
Brindle "was very successful before, so we sought him out and backed him in the formation of Lancashire," Cooper said. "When hurricanes Katrina, Rita and Wilma hit, we identified an opportunity in specific lines of business. We knew Richard was the perfect guy to go to."
This would also seem to be the case with Ariel Reinsurance Ltd., which was incorporated in 2005 and launched with $1 billion in capital. The company is being led by former Ace executive Don Kramer, and investors include the Blackstone Group, Texas Pacific Group, Thomas H. Lee Partners, Oak Hill Capital Partners, Olympus Partners, affiliates of Bain Capital, SAB Capital and Eton Park Capital Management. The company took over the infrastructure and offices of reinsurer Rosemont Re, which was owned by U.K. parent Goshawk Insurance Holdings, which is in run-off.
Room for Growth
Private equity also tends to seek out sectors where there's been some disruption, said John Waller, managing director of Cochran, Caronia Waller.
"The disruption can come from different areas: regulatory issues, rating issues or market disruption from the weather. If they see a market disruption with a reputable management team, they're looking for excess return" Waller said.
Also important to private equity is an exit strategy. "They want to know there's going to be access to the public markets or some sort of strategic buyer," Waller said.
Bredahl explained private equity investors want to make money while they own the investment in an operating company--as the company turns a quarterly profit--and also want to make a profit when they sell that interest.
When investing in the insurance sector, private equity tends to favor investing in niche companies.
"They much prefer specialty niches, or some expertise that is hard to gain and not many others have," Bredahl said. The reinsurance market, for instance, has drawn investments from private equity. "They like the reinsurance market because there's complete freedom of rate. It's not regulated as tightly as the primary market. They believe underwriters can get in and out of the market much more easily."
Other recent examples of private equity investing in reinsurance include:
* In April, France's Axa said it received a binding offer for its reinsurance operations from a group of investors led by Stone Point Capital LLC. The offer came from Paris Re Holdings Ltd., a newly created company sponsored by what Axa calls a "consortium of international investors" led by Trident III L.P., a fund managed by Stone Point. Under the proposed transaction, Axa would take a 5% to 10% stake in Paris Re. Other lead investors include Hellman & Friedman, Vestar Capital Partners, Crestview Capital Partners, ABN Amro and New Mountain Capital.
* In a transaction announced in October, the Chubb Corp. sold its reinsurance business, which represents more than $1 billion of Chubb's revenue, to a group of private equity buyers led by Stone Point Capital. Stone Point established a new Bermuda-based global reinsurance company named Harbour Point Ltd. to take the business. It was expected to have an initial capitalization of $1.5 billion.
Private equity has also sought out start-up companies, such Greenlight Re, a Cayman Islands' reinsurer funded by New York City-based private equity firm Greenlight Capital Inc. in November.
In addition to reinsurance, private equity favors excess and surplus lines. For instance, St. Paul Travelers Cos. has completed the sale of its monoline earthquake and E&S surplus personal lines property unit to GeoVera Holdings Inc., a company established by Friedman Fleischer & Lowe LLC and Hellman & Friedman last year.
Perhaps the least attractive insurance sector for private equity is admitted carriers, Bredahl said. "The problem with admitted carriers is it's not always straight forward. They can get tangled in regulations, must file for approval of their rates, and face other risks, such as assessments from state-sponsored cat funds," he said.
Private equity investors also have been active in insurance-related industries, such as claims handlers and brokers. For instance, following the investigations by New York state Attorney General Eliot Spitzer, Marsh Inc. sold its wholesale broking operation, Crump Group Inc., to private equity firm J.C. Flowers & Co., and Aon Corp. sold its wholesale broking operation, Swett & Crawford, to an investor group that includes Hicks, Muse, Tate & Furst Inc., Banc of America Capital Investors and Emerald Capital.
Stone Point Capital also backed the formation of a new New York City-based wholesale broker, Mercator Risk Services, in January.
"It goes back to disruption in the marketplace causes more interest," Waller said of the private equity investments in the wholesale brokerage units. "As private equity investors grow more comfortable and more knowledgeable about the industry, we will see more investments."
Life/Health in the Fast Lane
Although private equity has favored the P/C industry vs. the life insurance industry, Cooper said it's not a result of investors shying away from a potentially longer term investment.
"The life sector has been more active over the years in terms of strategic acquisition activity. It's hard for private equity guys to compete with these acquisitions. There's a lot of interest in life reinsurance among private equity investors," Cooper said.
One example of this is the creation of Wilton Re U.S. Holdings Inc. in December 2004. Its Bermuda-based parent company, Wilton Re Holdings Ltd., raised more than $600 million in capital commitments through a private placement of its common stock. The Wilton Re group was formed in order to provide a new source of life reinsurance capacity to life insurers in response to the continuing consolidation in the U.S. life reinsurance industry. The sponsoring investors are Trident III, a private equity fund managed by MMC Capital Inc., and Chris C. Stroup. Additional capital has been provided by private equity rinds managed by Vestar Capital Partners and Friedman Fleischer & Lowe, among others.
Since September, at least three private equity groups have invested or announced plans to invest in health insurers:
* UICI Group, the parent company of the MEGA Life and Health Insurance Co., the Chesapeake Life Insurance Co. and Mid-West National Life Insurance Company of Tennessee, was purchased by a consortium of private equity firms led by the Blackstone Group in a $1.7 billion transaction.
* USHealth Group Inc. said it completed a transaction that took the company private. CAA Acquisition Corp. merged with USHealth, resulting in USHealth becoming a subsidiary of Special Situations Holdings Inc., a unit of Credit Suisse First Boston.
* Carlyle Group, a global private-equity firm, said in March it plans to acquire MultiPlan Inc., the largest independent preferred provider organization in the United States. Financial terms of the purchase, expected to close in the second quarter, weren't disclosed.
Poised for Growth
With hedge funds continuing to grow by 20% annually, and private equity overall continuing to grow, industry experts expect private equity will continue to find a home investing in the insurance sector.
"If you had asked me two months ago, I would have said it's probably over for this insurance cycle. But the market has gotten much tighter over the last couple of months. I think there will be additional new companies formed because of how tight the catastrophe market is right now," Bredahl said.
Private equity has played a "favorable role, especially when the market needed capital," Waller said. "There was high quality discerning capital that backed high quality management teams. But some capital also backed management teams that were less than favorable. Maybe there's some management teams that shouldn't have been backed, but time will tell on that."
* Private equity investments in the insurance industry are growing.
* Despite the growth, only 4% of private equity deals involved the financial services sector in the past five years.
* Favorite insurance targets for private equity investors include niche markets, reinsurers, start-up companies and excess and surplus lines writers.
A Few Things That Turn Investors Off
While private equity investments in the insurance industry have increased in recent years, there's still room for growth. Brad Cooper, a partner with Capital Z Financial Services Partners, a private equity firm, estimates that a traditional public stock adviser would suggest an investor allocate 20% of his or her portfolio to the financial services industry. Only 4% of all private equity deals completed in the past five years were in the financial services industry.
Cooper suggested several reasons insurance isn't a more popular investment for private equity:
* Insurance products are not in a warehouse. "Private equity guys like products you can touch and have in inventory," he said.
* Unknown costs. "The insurance industry is the only one where you don't know the final cost of the product until several years "after you've sold it. That's a turn-off for private equity investors."
* It's a complicated industry with statutory and GAAP accounting, actuarial pricing and complicated reserving methodologies. "Private equity guys aren't used to that."
* It's a highly regulated industry. "The rules of the game are changed on a regular basis. That's very frustrating for private equity investors."
But perhaps the biggest reason more private equity investments are not made in the insurance sector is that insurers aren't allowed to carry a ton of debt. Traditionally, private equity firms look to make highly-leveraged plays, borrowing heavily and having as much as a 65% debt-to-capital ratio.
"The insurance industry has the reverse structure. You're only allowed to have a 30% to 35% maximum debt-to-capital ratio. That's the main reason private equity stays out of investing in the insurance business," Cooper said.
Also, insurance, especially the property/casualty industry, is known for volatile returns. Five years ago, private equity investors would say their target return in the investment was 30%. "But with equity markets not doing as well in the last five years, their targets have dropped. Most will accept 20%" said Rob Bredahl, president of Benfield Inc.
The insurance industry's historical return on investment has been less than 10%, Bredahl said.
Bredahl also said the rapid growth in hedge funds, and their interest in the insurance industry, has stepped up competition for private equity investors.
"Traditional private equity players are miserable because there are more players. The entrance of hedge funds has pushed down the return for private equity," Bredahl said.
Cooper disagreed. "Most people view competition as a bad thing, but we tend to focus on the positives. We work very well with private equity and hedge funds" he said.
PRIVATE EQUITY: Investment firms that pool money from wealthy, sophisticated investors, such as pension plans and institutional investors, to invest in companies. Private equity firms offer cash to companies in exchange for an ownership stake. Transactions include those in which managers of a company take it over, or managers from outside take over a company.
PRIVATE PLACEMENT: The private sale of stock or debt to institutional investors, often private equity firms.
VENTURE CAPITAL: Sometimes used interchangeably with private equity, but typically refers to the funding of new business.
HEDGE FUNDS: A type of private equity fund that traditionally offsets potential future losses by buying or selling securities in other areas.
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|Date:||Jun 1, 2006|
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