James Grennan at A&L Goodbody provides an interesting insight into the movement towards consolidation in the insurance industry.
“…… You better start swimmin’, or you’ll sink like a stone, for the times they are a-changin’ ” Bob Dylan.
Although singing about the social and political upheaval of the 1960s, Dylan’s advice on learning to swim in new tides or risk sinking under them provides a fitting metaphor for insurers 47 years after he recorded ‘The Times They Are a-Changin’.
This article could focus on numerous challenges facing insurers in these changing times. For insurers in the European Union and European Economic Area (EEA), there’s Solvency II, the beginning of centralisation of rule-making at EU-level through the new European Insurance and Occupational Pensions Authority, the challenge of gender equality and many, many more. I’ve chosen to focus on a growing trend towards consolidation in the industry and to highlight some of the tools provided by recent legal changes in the EEA to facilitate consolidation.
Trend towards consolidation
Across the insurance industry we are seeing a trend towards consolidation, both within insurance groups and by way of external mergers and acquisitions.
Consolidation within groups
Consolidation within insurance groups is particularly evident in the EEA. It involves rationalising the number of individually regulated and capitalised subsidiaries by transferring business from those subsidiaries to a single operating platform. Examples are Zurich (using an Irish platform) and Swiss Re (using a Luxembourg platform). This is possible within the EEA because an insurer authorised in one member state (the home member state) is entitled to provide services into and may establish branches in the other member states under the umbrella of its home member state authorisation.
Why consolidate within a group?
There can be many reasons for consolidation within groups but common themes include capital efficiency, reducing the number of regulators supervising group companies (eliminating the need to comply with different and potentially inconsistent prudential supervision obligations in different countries), a clearer structure for financial strength rating purposes, and aligning the governance and legal structures of the group.
Control of capital is a particularly important factor. Many insurance groups, particularly those affected by Solvency II, see significant benefits in controlling capital in a central location. The final Solvency II directive did not include the group support provision that had been included in earlier drafts. This provision would have allowed group capital to be held centrally and provided to individual subsidiaries as required. The result of its removal is that each regulated subsidiary within a group must maintain its own (or ‘solo’) solvency capital.
There are undoubted inefficiencies in maintaining solo solvency capital in subsidiaries, each of which must comply with different investment requirements under local regulatory regimes. However, an effect similar to the group support model can be achieved by consolidating those subsidiaries into a single operating company. All of the assets and liabilities of the subsidiaries are consolidated on a single balance sheet. The infrastructure and personnel of the former subsidiaries become branches of the operating company. EEA branches of an EEA authorised insurer are not obliged to maintain independent reserves or solvency margins. The operating company maintains all reserves and a single solvency margin that covers all of its operations.
This can also help to reduce capital requirements under Solvency II as the insurance risks consolidated into the operating company will generally be more diversified than the risks of any individual subsidiary.
Consolidation within the industry
There is also evidence of increasing consolidation in the insurance industry through sale and acquisition of insurance operations. This is driven by a variety of factors.
Within the EEA, Solvency II is likely to lead to increased capital costs for some insurers and increased compliance costs for all. This is already encouraging some smaller operations to consider whether to go into run-off or merge.
External factors are also relevant. For example, many banks are disposing of productive assets, including insurance operations, either to repair their balance sheets or as a condition for provision of state aid. Insurance operations that have been disproportionately affected by sub-prime exposures, the financial downturn or soft market are also on the market. Certain groups have put peripheral subsidiaries into run-off in order to extract surplus capital required at head office and are looking for buyers for the run-off businesses.
In parallel with this, in recent years, we have seen the emergence of operations that specialise in buying run-off books of business, consolidating those within their operations and benefiting from resulting economies of scale.
For reinsurers, there is a trend towards building critical mass by merger and acquisition. Examples are the mergers of Max Re and Harbor Point, Validus and IPC and Partner Re and Paris Re.
Implementing consolidation creates legal, tax, accounting, operational, systems and cultural challenges but recent legal changes within the EEA have provided tools to make the legal elements of the process easier. In addition, a number of insurance groups have taken the opportunity to create European companies, a new corporate structure available within the EEA.
The remainder of this article describes some of the tools available for consolidating insurance operations, highlights some advantages and disadvantages of each, and addresses some of the interesting features of the European company.
Tools for Consolidation
The principal legal tools available for consolidating insurance operations are:
• share acquisitions;
• asset transfers (including transfers of portfolios of insurance contracts); and
Share acquisitions and portfolio transfers
These tools are not new. However, they continue to play an important role in insurance industry consolidations.
Under a share acquisition, the acquirer acquires all of the shares in the operation acquired (the target), typically in return for cash, assets, the issue of shares or a combination of these. This does not consolidate the assets and liabilities of the target into the acquirer. The target remains a separate company with separate solvency requirements, internal governance and its own constitution. It remains separately authorised and regulated. If the target is a limited liability vehicle, liabilities remain ring-fenced within the target.
In the EEA, regulatory approval is required for a share acquisition representing (directly or indirectly) 10 per cent or more (or any percentage that gives the acquirer a significant influence) of the capital or voting rights of an insurer and for increasing a holding through 20 per cent, 33 per cent or 50 per cent.
A share acquisition is suitable for acquiring external operations, or for moving group companies into position in advance of consolidating one group company into another, or for acquisitions where the acquirer wants to ring-fence the acquired business.
Under an asset acquisition, the acquirer acquires assets of the target but not the corporate vehicle. The acquirer can acquire all or just some assets.
Under many legal systems, liabilities cannot be transferred without the consent of the person to whom the liability is owed. An exception is liabilities under insurance policies. Since the early 1990s, a transfer of insurance policies, carried out in accordance with processes established under the European Insurance Directives, will be recognised throughout the EEA. These processes include:
• receiving an official approval for the transfer in the home member state of the target;
• notification of the proposed transfer to the authorities in certain other member states affected; and
• issue of a certificate of authorisation and solvency by the authority in the home member state of the acquirer to the authorities in the home member state of the target.
The process for official authorisation varies between Member States. For example, in Ireland and the UK, it requires court approval. The certificate of authorisation and solvency confirms that the acquirer is authorised to conduct the type of insurance business to be transferred and that, following the transfer of the business, the acquirer will have at least the minimum solvency margin required under the European Insurance Directives. Particular advantages of an asset acquisition are that the acquirer can avoid acquiring liabilities, it can acquire part of the business rather than all of the business, the assets acquired are consolidated into the acquirer and the transfer of policies will be recognised throughout the EEA.
If the intention is to wind up the target following the transfer, a disadvantage is that there is no automatic dissolution of the target under the portfolio transfer process. Therefore, depending on the rules in place in the relevant member state, it may be necessary to appoint a liquidator and wind the company up.
Other disadvantages include the fact that liabilities (other than liabilities under insurance policies) may not be capable of transfer without consent, even if the parties want them to transfer. While the exposure this leaves with the target can be addressed by an agreement by the acquirer to discharge those liabilities, it may delay winding up the target and means that the target takes a counterparty risk on the acquirer.
There can also be questions over the validity of the transfer of inward and outward reinsurance as part of a portfolio transfer.
Where policies are governed by the law of a jurisdiction outside the EEA, the portfolio transfer may not be recognised under that law, meaning that the transferring insurer remains liable for payments under the transferred policies. Again, this can be addressed by the acquirer agreeing to make those payments but this issue may delay winding-up and the solution creates a counterparty risk for the transferring insurer.
The cross-border merger is a relatively new concept for many member states, including Ireland and the UK. Under a cross-border merger, the assets, liabilities and undertaking of the target are transferred to the acquirer in return for an issue of shares in the acquirer to the target’s shareholders. If the target is a 100 per cent subsidiary of the acquirer, no share issue is required. Following the transfer, the target is automatically dissolved without liquidation. All assets and liabilities of the target transfer to the acquirer and its business continues within the acquirer.
A cross-border merger between EEA companies is recognised throughout the EEA. The process and documentation involved in a cross-border merger are relatively simple. However, in countries such as Ireland and the UK, the merger requires court approval. Also, in circumstances where employees of one or more of the merging companies are entitled, under their local law, to participate in the board of directors or other management organ of their company, a similar right is extended to all of the employees of the merged company, unless a different arrangement is negotiated with the employees.
The advantages of a cross-border merger include the fact that the transfer of assets and liabilities of the target will be recognised throughout the EEA. There may also be a greater likelihood of recognition of a transfer of liabilities under third-country laws than is the case for an asset acquisition. The target is automatically dissolved on transfer, avoiding the need to go through a winding up process.
Disadvantages include the fact that a cross-border merger is not suitable for a partial transfer. In addition, in countries such as Ireland and the UK, the cross-border merger mechanism does not overcome the need for a compulsory court approval for the portfolio transfer inherent in an insurance merger. However, the court approval process can run in tandem with the approval process for the cross-border merger.
Depending on the laws in the member states of the companies merging, the prospect of extending employee participation rights can be a disincentive to merge.
All liabilities (whether or not the acquirer is aware of those liabilities) are acquired by the acquirer and are not ring-fenced in a limited liability subsidiary.
A cross-border merger is unlikely to transfer an insurance authorisation granted by one member state to another member state. Any necessary authorisation (or extension of an existing authorisation) of the acquirer must be organised in advance.
It is also possible for companies within EEA member states to merge. Under the European Directive on Mergers of Public Limited Companies, public limited companies (plcs) may merge. The acquirer plc acquires all of the assets, liabilities and undertaking of the target plc under a process requiring official sanction. In Ireland, for example, the process involves an application to Court, similar to the process for approving cross border mergers. In return for acquiring the assets, liabilities and undertaking of the target, the acquirer issues shares to the shareholders of the target. The target is dissolved without liquidation.
Under the European Directive on Division of Public Limited Companies, it is also possible to acquire by ‘division’. This occurs where two or more plcs acquire all of the assets, liabilities and undertaking of the target plc in return for an issue of shares to the target’s shareholders.
The advantages of a merger or division of this type is that it is recognised throughout the EEA, the target can be dissolved without liquidation and liabilities can be transferred without consent. The disadvantages are similar to those that apply to a cross-border merger.
It is also possible in some counties to merge domestic private limited companies.
The European company or Societas Europaea (SE) was introduced in late 2004. After a slow start, it has recently been used by a number of high profile insurance operations such as Allianz SE and Swiss Re International SE.
The SE takes the form of a public limited company incorporated in an EEA member state. It is governed by the laws of that member state like a normal public limited company. However, it has one distinguishing feature; it can move its incorporation to another EEA member state. When the member state of incorporation changes, the company’s constitution is amended to reflect the requirements of the new member state and it becomes governed by the laws of that member state.
An SE can be formed by merging two plcs from different member states. It can also be formed by converting an existing plc that has had a subsidiary in another member state for at least two years. Alternatively, a holding SE can be established as a holding company by two or more private or public companies incorporated in different member states or by one company having a subsidiary in another member state for at least two years. Finally, an SE can be established as a subsidiary company by two existing bodies from different member states or by one body that has had a subsidiary or branch in another member state for at
least two years. For insurance groups considering consolidation, an SE can be formed (in one of the ways set out above) as a result of consolidation of existing operations
An insurance authorisation is unlikely to transfer when an SE changes its jurisdiction of incorporation. Therefore, a new authorisation would be required from the supervisory authority of the member state to which the SE is transferring.
The principal advantage of an SE is that it can change its incorporation to another EEA member state. For pan-EU/EEA operations it is also helpful that the SE projects a European, rather than national, identity. There is no need for a portfolio transfer or a merger on migration of the SE from one state to another. Contracts (including reinsurance) remain with the same legal entity. The company law processes for transferring an SE’s incorporation to another member state are relatively straightforward.
However, a potential disadvantage is the need to consult with employees and potentially provide those employees with a right to be involved in the SE’s decision making processes. Before forming an SE, negotiations are required with employees with a view to agreeing the degree of involvement of employees in the SE’s affairs. If there is no agreement, standard rules can apply.
In summary, there is a growing trend towards consolidation. While consolidation won’t be right for every operation, where it is, a helpful range of legal tools are available to facilitate it. The choice of tool will depend on the circumstances. In addition to tax, accounting, commercial and other pertinent considerations, the advantages and disadvantages set out above of various options will be important factors in deciding which tool to use.
I believe that we will continue to see an increased level of portfolio transfers and cross-border mergers in the insurance industry in the next few years. It will also be interesting to see whether other major insurance groups decide to form SEs.