Consolidation barriers add to risk of default for GCC insurers: S&P

A small number of well-established insurers are reaping the benefits of the fast-growing insurance markets in the Gulf Cooperation Council (GCC) region, Standard & Poor’s Ratings Services said in a review.

Meanwhile, inflated valuations and a reluctance to relinquish control are preventing smaller insurers from consolidating. In trying to avoid reporting losses, we believe revenue-starved insurers could distort market pricing for all.

Insurance in the GCC region continues to benefit from generally robust economic growth because the considerable hydrocarbon wealth of the GCC states sustains their expanding economies. Real GDP growth in the region was nearly 6% in 2012, and we expect this growth momentum to continue in 2013 and beyond.

The GCC insurance sector grew to nearly US$16 billion in terms of gross premium written and we observed growth rates of over 10% in the region’s largest insurance markets in 2012. Ample capital is available within the industry to back the growth in insurance premiums.

Both regional and international investors are looking for a slice of the business because of the growth potential. This creates a highly competitive marketplace in which all companies are contending for profitable business. The ensuing competition puts pressure on margins.

PROFITS ARE HIGHLY CONCENTRATED WITHIN THE INDUSTRY

Although we estimate that the GCC markets are profitable as a whole, the profits tend to be concentrated at larger and more-established entities. For example, in Saudi Arabia, the three largest companies reported 80% of all profits in 2012; meanwhile, nearly a third of Saudi insurers reported losses.

We observed a similar trend in the United Arab Emirates (UAE)–again, the three largest companies reported over 80% of the market’s profits in 2012. Even if we exclude takaful companies, this figure is still over 50%. Results for UAE takaful companies were significantly skewed by losses at Salama/Islamic Arab Insurance Co. (P.S.C.).

Many UAE-based insurance companies established in the past few years are struggling to deliver sustainable levels of performance, despite acceptable reported loss ratios.

In our view, inadequate profitability is more pronounced at the lower end of the market because smaller companies lack economies of scale. Many of them lack the critical mass–sufficient business volumes–to cover their operating expenses.

Over time, a lack of profitability erodes capital, leaving some companies with little prospect of finding a profitable niche. In our view, it is just a matter of time before these companies start to run out of capital and face a risk of default.

Therefore, for some companies, consolidation makes economic sense. If companies merge, it could improve their economies of scale and offer them cost efficiencies. Acquirers tend to be more successful entities, indicating that they are better-managed or that they have larger resources at their disposal. Consequently, an acquired entity may benefit from the resources, know-how, and technical expertise of its new management team.

THREE REASONS WHY FIRMS RESIST CONSOLIDATION

In our view, several factors prevent companies from consolidating:
•In many cases, public stock market valuations do not reflect economic fundamentals, causing a significant valuation gap.
•Existing shareholders and incumbent management teams are reluctant to relinquish control because their positions and status could be diminished or eradicated within the larger entities.
•The risk of business churn is significant.

Valuation gaps are particularly pronounced in Saudi Arabia, where nearly all insurance companies on the Riyadh-based Tadawul exchange are trading at a significant premium to their book value (source: Bloomberg).

We estimate that the average market valuation is between three and four times its book value for an insurance company in Saudi Arabia. Existing shareholders look to the market valuations when contemplating a sale of their shareholding, but buyers find such prices difficult to justify on an economic basis.

Integrating an acquired entity carries execution risk. Because most of the risks written in the region have a relatively short claims tail, acquirers have few concerns regarding whether sufficient reserves have been set aside to cover old business. However, retaining new business post-acquisition also carries significant risk. Business relationships often affect who wins insurance business; there is a risk that insureds may not maintain their relationship with the acquired entity.

LACK OF CONSOLIDATION HAS CREDIT IMPLICATIONS

The reluctance to consolidate could have credit implications. We anticipate that some smaller companies at the lower end of the market will see their creditworthiness diminished as continued losses cause their capital bases to deteriorate. This could encourage some companies to abandon sensible underwriting, in a last-ditch attempt to bring in much-needed revenues to cover their expenses.

By doing so, they would further erode their profitability and distort pricing in the wider market, reducing profitability for other market participants. In our view, the pricing developments, exacerbated by a failure to consolidate, enhance overall insurance industry risks across the GCC region.