A company can put it in existing lines, start new lines with commensurate talent hires and allocate capital to them, or buy a company to help leapfrog the time and effort required in an organic buildout. The other options are buying back stock, issuing a special dividend, or increasing the common stock dividend. As discussed in that note, P&C insurers are generally not the biggest returners of capital.
One of the challenges when pursuing acquisitions is the asymmetric information challenge or gap when acquiring a long-tailed carrier. This often results in the sum of the parts not being greater than the whole. This is one of the biggest reasons many acquisitions in this space haven’t gone particularly well.
Ask Allianz, which acquired the Fireman’s Fund from American Express in 1991. After multiple divestitures, including selling pieces to ACE, it announced a sale of its middle market and entertainment business, underwritten by Fireman’s Fund subsidiaries, to Arch Capital last week. Allianz will continue focusing on large accounts and specialty businesses.
Under the terms of the deal, Arch will pay $450mn in cash at closing and acquire a $1.7bn gross premium book. Arch will also receive $2bn in loss reserves and will cover any losses after 1/1/2016 through 2023. Arch will provide $1.4bn in capital to support this business, and in the long term, it expects the combined ratios to run in the low 90s.
The timing of the deal is interesting for Arch Capital. It ranks as one of the top value creators in the P&C space, has one of the leading stock multiples, an established franchise, and a well-regarded management team.
Among the various (re)insurance franchises, Arch has demonstrated success in acquiring companies in various sub-sectors and avoided the pain associated with those bets going sideways. Its biggest bet was on the mortgage insurance business, which has paid off handsomely, as discussed later in the note. However, acquisitions on the longer-tailed side have been smaller and fewer.
However, Fireman’s Fund is/was a more troubled franchise than many of the companies Arch has acquired in the past. As our news team reported last year, this book has been on the selling block since October 2023. The reported suitors apart from Arch included Zurich, AIG, The Hartford, Chubb, Tokio Marine, and CNA.
So, the question remains: what did they see as potential remedial actions needed in this block of business to pass it over? After all, half a billion in cash and $1.4bn in capital would not have been that tough to swing by.
The four companies under the Fireman’s Fund pool have gross combined ratios approaching break-even over the past 10 years or so.
Arch expects the acquired business over time to run at low 90s after initial remedial work, which will likely push the combined ratios higher in the near term. Arch will also have to keep an eye on the loss cost inflation and prior period reserve bucket as its turnaround efforts will also coincide with a likely slowdown in the overall cycle. In other words, Arch has its work cut out.
On the other hand, time and again, companies with strong middle market franchises such as Travelers, Chubb, and The Hartford, have built stable and profitable books over time. So, this acquisition makes sense for Arch as it allows it to ‘leapfrog’ into a middle market book without building it from the ground up.
We discuss these points in detail below.
Arch has a successful history of acquisitions, but MI has been the best/biggest bet
Our past notes have often demonstrated a clear link between value creation and stock multiples. Arch is among the leaders, along with franchises such as Progressive, RLI, and WR Berkley. The partial list below shows the acquisitions it has made over time and the bet on mortgage insurance, which has proven serendipitous.
Arch has also found success in acquiring small, longer-tail businesses such as Barbican and segments of Ardonagh, but these were mostly on the Lloyd’s and UK side. Although Arch has been associated with other US franchises over time, Fireman’s Fund is a larger bet focused on the middle market business to date.
Under the terms of the deal, Arch’s reserve exposure does include business written after 2016 through 2023 but not before 2015. Our recent note on industry reserves highlights 2015-2019 as problem years, and we would not be surprised to see Arch revisiting the loss picks of the acquired business.
Revisiting Arch’s record in insurance
As discussed above, Arch’s value creation has ranked higher than most P&C insurance carriers over the past decade or so. Regardless, the business which Arch is acquiring needs some work.
The table below shows Fireman’s Fund's direct combined ratio over time. We would note that intercompany pooling via Allianz does complicate getting a truer picture of the underlying quality of the book. That said, Arch has noted that combined ratios over time will trend in the low 90s in the long run.
This expectation begs the question: How has Arch’s insurance business itself performed over time? The table below shows Arch's segmental combined ratios, growth, underwriting income, and net investment income.
The table also demonstrates mortgage insurance’s substantial contribution to results. Yes, insurance and reinsurance’s net investment income contribution also needs to be factored in, but even after apportioning it to the insurance/reinsurance segment, mortgage insurance returns dwarf P&C results.
This acquisition comes at an interesting time as we head into the first-quarter earnings and get another update on loss cost trends in the commercial insurance space. If trends worsen faster than expected, Arch’s expectation of turning this business around will take longer than desired while creating a potential distraction.
Middle market is the way to go
Market sources suggest that approximately 20%-40% of the US commercial marketplace is middle market business. The middle market business can be a stable book where standardized coverage, scale, and operational efficiencies matter, especially when compared to large accounts that can be sensitive to significant losses and client dependencies.
The pie chart below shows Arch’s insurance proforma business mix post the Allianz book acquisition, which results, in theory, in a more balanced book over time.
The addition of middle market business also allows Arch to jump ahead in the overall commercial insurance rankings. Note the caveat that these are overall numbers, and the proportion of large vs. middle and small differs among these players.
In summary, although Arch has demonstrated a successful record of acquisitions, this would be its first foray into digesting a larger middle market commercial account focused US-domiciled franchise.
Fireman’s lackluster results overall have resulted in an attractive price for Arch but also leave it open to execution risk, particularly if pricing and loss trends worsen faster than expected and the soft market reserves (2015-2019) continue to deteriorate.
On the other hand, a successful execution will allow it to build out a middle market franchise that could deliver stable results over time.
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