Alexander Roth, global head of M&A and CEO Europe at DARAG, on the impacts of the current inflationary environment and how DARAG is well prepared to withstand unpredictable market developments.
Insurers, captives, reinsurers and legacy specialists are facing similar pressures and opportunities in a market characterised by surging prices and rising investment yields. On the one hand, accelerating inflation – at or near 40-year highs in the US and the UK and at record levels in the Eurozone – is driving up claims costs.
On the other hand, rising bond yields triggered by higher central bank rates has ended what Swiss Re’s Sigma calls “the negative interest rates experiment”, offering a silver lining for insurers as bond portfolios mature and roll over into more favourable yields.
Claims inflation is being felt acutely in lines ranging from motor, property and liability, and surging prices are giving risk carriers sleepless nights. The problem is, the finest economic brains in the world can’t agree on how far prices will rise and for how long. In the UK, the Bank of England now predicts an October inflation peak of 11%, with the rate staying above 10% for several months after that.
That’s well down on expectations before the UK government’s energy market intervention when Goldman Sachs in August made headlines with a mammoth 22% forecast. Fast-shifting government responses worldwide and differing outlooks among economists recall the confusion about the landscape at the start of Covid-19 and a divergent approach to reserving is one manifestation of this uncertainty.
In terms of the macro environment’s impact on captive deals, the situation is complex. Captive deals have typically been driven by capital considerations, or in the case of smaller captives, operational efficiency. Right now, smaller captives will be feeling the pinch from market-to-market losses as bond prices plunge and collateral requests, which they may be unable or unwilling to fund, will encourage disposals, particularly of longer tail books such as workers’ compensation.
Owners of longer tail books will also be keen to take advantage of the brighter investment income outlook. As an example, 10-year US Treasuries now yield about 4%. That’s a rise of about 2.4 percentage points in a year. However, with a range of views prevalent on the inflation outlook, price agreement on the more sizeable deals may be harder to forge. At DARAG, we have done detailed assessments of our portfolio and consider ourselves in good shape to withstand inflationary pressures based on our current view of market development.
Of course, with just one chance to get the pricing right, deal discipline and operational excellence are paramount, a combination PwC highlighted recently in its annual run-off surveys. At DARAG, we’re investing in robotic process automation and machine learning to view claims fi les and portfolios of claims in order to improve our due diligence. We have also partnered on this with start-ups and are in the process to tie with German universities.
In terms of portfolios, we’re currently avoiding lines impacted by social infl ation in the US, such as commercial motor and some parts of general liability as well as large, less mature portfolios exposed to uncertain longer-term trends in inflation. We are, however, keen on more mature workers’ comp in the US and European motor liability portfolios.
We have a diverse range of deals, and central to our whole expansion growth plan in both the US and Europe are captives. In 2022 alone we have struck four captive deals and, with a strong pipeline of captive opportunities, we hope to do more before the year is out. The captive market is ripe with opportunity globally. In the US, deals tend to entail portfolios involving old underwriting years where the sellers are seeking collateral release.
Operational considerations – both time and cost – are certainly a major theme on my side of the Atlantic. For larger captives still handling claims, collateral discussions and reinsurance renewals are part and parcel of owning a captive and, even with a captive manager, the captive owner will still need to spend a considerable amount of time on the operation. For those captives in run-off in particular, money spent on the captive manager, claims handling systems, actuarial expertise and all the rest could be better spent elsewhere. Big corporations with captives are often blithely unaware of these outgoings but, when they start drilling down, they quickly realise there is a massive mismatch between costs and what value they bring to the business.
Cost myopia at captive owners is one barrier to captive disposals taking place, compounded by the simple fact that (at-large companies in particular) these operations won’t necessarily be on the C-suite radar. But there are also psychological barriers, given the sensitive nature of portfolios such as employers’ liabilities for existing staff.
Reputational worries – the ‘what ifs’ when claims handling is transferred to a third party – can also prompt captive owners to stick with the status quo. But DARAG is ideally placed to allay those worries. With 57 closed transactions in 21 jurisdictions and €1.7bn ($1.66bn) of reserves assumed, we provide certainty of closure. We engage early in the process with regulators and have never had a transaction blocked.
Central to our reputation is also our professional and fair claims handling, which we consider to be a core competency. Our reputation was an absolute driver of our deal for captive Thames Water Insurance Company, which we bought to serve as a Guernsey consolidator for certain non-EEA legacy deals, including captive purchases.
The Thames Water captive provided coverage for risks including public and employers’ liability, personal accident, business interruption and property damage, and it was of utmost importance that the deal was managed in the seller’s best interest and that there was absolutely no reputational risk.
Our Guernsey captive consolidator is just one vehicle through which we can provide deal counterparties with legal and economic finality. As a company with risk-carrying entities across North America, Europe and the UK, and as a service provider too, our organisational and geographical scope means we can massively decrease the cost burden for numerous types of carrier.
Our solutions include captive and company acquisitions, portfolio transfers and the provision of reinsurance through adverse development covers or loss portfolio transfers. I took on the role of global M&A head in June to join up our dealmaking across all jurisdictions and this strategy is already bearing fruit.
Captive and legacy dealmaking is transactional in nature but DARAG strives to be a reliable, enduring partner that can provide certainty to sellers while maintaining the highest standards of service for their former policyholders. We plan to share our tech know-how around claims due diligence with deal counterparties as we believe transactions work best when information is pooled.
Notwithstanding our improving techpowered intelligence, it’s true to say that a large degree of data discrepancy remains between potential sellers and buyers in the captive and legacy market. It’s therefore vital that sellers – and their brokers – are as transparent as possible to ensure that deals represent a win-win situation for both parties and to keep all interests aligned. As stressed at the start, reinsurers, captive and legacy book acquirers face almost identical inflationary pressures as primary carriers.
Unrealistic seller expectations about inflation will often scotch deals in the embryonic stages and the fact several EU legacy deals have been left on the table recently is sign of a maturing, more discerning market, which DARAG welcomes. Those sellers still bent on obtaining the best price at any cost may celebrate when a deal comes to fruition but it could come back to bite the industry as a whole.
Captive owners, more than anyone, with their employers’ liability-focused books and awareness of the importance – and fragility – of corporate reputations, will certainly make finding a responsible deal partner a priority as they mull their options in today’s inflationary environment. In this, DARAG stands, as always, ready to help.
