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Strictly private & confidential. Reinsurance Capital: Predictions for the Near Term. Brian Moon Director Deutsche Bank Securities Inc. June 7, 2004 .

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Presentation Transcript
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Strictly private & confidential

Reinsurance Capital:

Predictions for the Near Term

Brian Moon

Director

Deutsche Bank Securities Inc.

June 7, 2004

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“IMPORTANT: This presentation has been prepared by members of our investment banking department. Statements and opinions regarding the company's investment case, positioning and valuation are not, and should not be construed as, an indication that Deutsche Bank will provide favorable research coverage of the Company or publish research containing any particular rating or price target for the Company's common stock. This presentation speaks only as of the date it is given, and the views expressed are subject to change based upon a number of factors, including market conditions and the Company's business and prospects.”
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Significant number of M&A deals in the “softer” part of the last cycle

Question: Will we see significant M&A activity in Bermuda soon?

Paragon catastrophe price index

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?

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There are a number of potential catalysts that suggest that the answer is “yes”

  • Maturing P&C pricing cycle and lower growth and returns
  • Maturing growth of start-ups
  • Future inability to reach ROE and growth expectations of the market
  • Private equity investors “want out”
  • Potential strategic imperatives
    • penetrate top reinsurer/ insurer ranks
    • diversify further into primary or other businesses (e.g., ACE and XL model)
    • geographic diversification/extension to include U.S., Bermuda, London, continental Europe, Asia and Latin America
    • diversify distribution to include both direct and broker (directs expand broker channel in U.S. and Bermuda)

M&A?

slide5

But, hopefully, we learned that buying other people’s problems can be expensive…

Acquiring other people’s problems persisted through the soft part of the cycle

  • M&A actually added fuel to the soft cycle as investors demanded to see growth from the high-premium acquisitions
  • This growth came at exactly the wrong time!
  • Solutions:

i) Reserve guarantee or risk sharing structures

ii) Renewal rights transactions

iii) Acquire shorter tail businesses

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…and insurance M&A in the news today indicates very little interest

“No bubble boys here: P&C execs eschew M&A”

“…this time, with a greater deal of unanimity and in more resounding tones, [insurance] industry leaders spoke out against that other great vestige of the late-90s P&C industry: mergers and acquisitions.”

– SNL Insurance daily, 5/3/04

“ACE, XL Capital looking to internal growth rather than deals”

“XL does not want to deploy any capital for a major acquisition. …[an XL executive’s] comments echoed those of ACE. ACE also plans to stay away from acquisitions [according to a company executive]...”

– SNL Insurance Weekly P&C Edition, 12/8/03

slide7

Accounting issues lead to ROE dilution

Illustrative acquisition and ROE dilution

Only weaker franchises have lower ROEs

(1) Pro forma calculations assume no change to seller’s earnings from synergies or purchase accounting adjustments

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…and difficult EPS accretion

Illustrative acquisition and EPS accretion/ (dilution)

Without improvement of earnings, it is difficult to argue the merits of the transaction

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All you are left with is an increase in book value per share, offsetting ROE dilution

Value map: P/B vs. ROE regression

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Evolving M&A environment

  • “Bigger is better”
  • Growth in market share imperative
  • Fear of being acquired/ taken over
  • Pooling accounting
  • Europe, ACE and XL as buyers

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Rapid consolidation slowed through the late 90’s

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Evolving M&A environment(continued)

  • “Bigger is better” – rating agency driven
  • Rate adequacy vs. market share goals
  • Risk of being acquired/ taken over non-existent
  • Few buyers
  • No pooling accounting
  • Amortization of reserve discount – purchase accounting issue
  • Nimble is better

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New cycle; same mistakes?

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  • Excess capital used to acquire at a premium and buy the reserve mistakes of others
  • Companies chase growth and market share driving a steep downturn

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Evolving M&A environment(continued)

Current M&A strategies: primarily “don’t”

Potential M&A strategies

  • Recruit underwriting teams
  • Renewal rights transfers (e.g., Hart Re, CNA re, LaSalle Re)
  • Merger of equals
  • Bolt-on whole company acquisitions with limited to no reserve risk
  • Transforming/diversifying acquisitions (e.g., ACE/CIGNA)

Issues with traditional M&A

  • Management distraction
  • Difficulty integrating business (i.e., systems, culture, retention of key employees, etc.)
  • Negative revenue synergies
  • Lack of significant cost savings
  • Target reserve adequacy
  • ROE dilution from goodwill (premium to book paid)
  • Accounting changes – dilution from amortization of loss reserve discount
  • Limited track records of successful M&A execution
slide14

Private equity is patient, not “hot”

“Class of ’93” equity investors waited at least six years to completely exit

Paragon catastrophe price index

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Warburg Pincus got out in Q1’00

Almost 7 years

RenRe

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More than 7 years

LaSalle Re

Sold to Trenwick in an all-stock deal in 9/00, creating liquidity for private equity to exit in the open market

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More than 6 years

MidOcean

Sold to Exel in an all-stock deal in 8/98, creating liquidity for private equity to exit in the open market

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Conclusion: Recent IPOs and secondaries provide liquidity in the post-9/11 start-ups but only smaller investors have been able to exit a majority of their position (e.g., Lightyear and Vestar)

slide15

…and if M&A is questionable as a capital management tool today, what else can we do?

Increasing dividend yields

Share repurchase programs and large repurchases

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But there are problems with capital management

Question: Can I get it back when the cycle turns?

  • Rating agencies view as a fixed charge
  • Limited flexibility: “terrible” things will happen if you cut your dividend
    • post 9/11 no company cut its dividend to fund growth; why not?
    • cutting dividends due to small/ medium sized cat losses hurting earnings and cash flow would be difficult for your stock
  • Special dividends are not fully valued and non-recurring
  • Rising interest rates and subsequently higher required yields to be attractive to investors

Dividends

  • Limited shares to repurchase in the open market
  • Negotiating directly with private equity at a discount to market to repurchase shares will be limited by current valuations
  • In periods of high multiples, difficult to justify

Share repurchases

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2.5

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Zurich

RNR

PTP

RE

CHR

ACGL

Mid Ocean

MXRE

MRH

ACE

IPCR

ENH

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AXS

AHL

XL

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2/21/01

1/1/03

1/1/90

11/10/91

9/18/93

7/28/95

6/6/97

4/15/99

Number of public reinsurers has increased once again

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IPO phase

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Consolidation phase

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Late 1990’s post-consolidation phase

Now

ACE

XL

Partner Re

Berkshire Hathaway

Transatlantic Holdings

Trenwick

RenaissanceRe

IPC Holdings

PXRE

PMA

Everest Re

Berkshire Hathaway

ACE Ltd

XL Capital Ltd

Everest Re Group

AXIS Capital

Transatlantic Holdings

PMA

RenaissanceRe

PartnerRe

Montpelier Re

Endurance Specialty

Converium AG

IPC Holdings

Aspen Ins Holding

Arch Capital

Odyssey Re

Platinum Underwriters

Max Re Capital

PXRE

Total number of public companies: 11

Total number of public companies: 19

slide19

So, where does that leave us today?

  • Turning cycle
  • New accounting challenges to M&A at a premium
  • ACE, XL and Europe potentially not acquisitive
  • Historical issues with returning capital (i.e., can I get it back when I need it?)
  • More efficient capital markets
  • Rate adequacy and returns over market share understood by investors
  • More public companies providing information about rate adequacy

Same mistakes?

slide20

Potential future scenarios

I. Same mistakes

  • Excess capital funds M&A deals at a premium and buying the mistakes by others
  • Companies chasing growth and market share driving a steep downturn

II. Bifurcation of the market between large diversified and nimble/ “professional” reinsurers

  • MOEs among Bermuda post 9/11s to gain size, scale and geographic and business diversification
  • Excess cash used to acquire insurance properties/ markets in the U.S. and Europe
  • If valuations of post-9/11s drop enough and existing large diversifieds maintain valuations, then they may acquire post-9/11s in a financially attractive deal under current accounting and market constraints
  • Active capital management to return capital to shareholders during downturns and raise capital/ cut dividends when market turns again (“believe you can get it back”)
  • Avoid severe price competition without returning capital, still resulting in a decline in ROEs

Large diversified strategies

Nimble/ prof. reinsurer strategies

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Bio

Brian Moon is a Director in the Financial Institutions Group at Deutsche Bank. He joined the group in September 2003 from Morgan Stanley. Mr. Moon has executed a broad range of advisory and capital raising assignments for Bermuda-based reinsurers, as well as property-casualty and life insurance and reinsurance companies and asset management companies globally. A few noteworthy assignments include Montpelier Re and AXIS IPOs and secondary offerings; People’s Insurance Company of China’s IPO; Partner Re strategic work and PEPS offering; and numerous reinsurance sellside transactions, including Allstate Re, Constitution Re, Axa Re, and CNA Re. Prior to rejoining Morgan Stanley as an associate, Mr. Moon spent two years as the director of finance reporting to the Chief Financial Officer of Constitution Reinsurance and several months at EXOR America (parent company of Constitution) where he assisted in the execution of the sale of Constitution. Mr. Moon has a B.A. with honors from University of California, Berkeley.