PRINT THIS PAGE Private Equity Backed Insurance Investments 05/12/2007. Source: Boekel De Nerée. Rogier Dahmen
Unlike the USA and some countries in the EU, the insurance industry in the Netherlands has not yet seen large scale private equity backed investment activity. An important reason often heard for the reluctance of private equity investors to step into the insurance market arena relates to alleged challenges caused by the regulatory environment applicable to insurance companies, which is believed to be more complex that the comparable industries such as banking. This article sets out some of the main features of investments in insurance companies in the Netherlands, possible solutions for the challenging regulatory framework for the private equity industry, as well as recent trends that could provide windows of opportunity. The Issues
Apart from a few examples, predominantly in the UK, there are not many private equity investments nor is there any large scale attention for insurance related lines of business within the EU. Possibly reluctance of private equity industry to invest in insurance assets is caused by complexity issues affecting insurance companies, such as supervision and the solvency requirements. Also in the Netherlands, in spite of the presence of a well recognized and mature life and non-life industry, the private equity industry has almost completely closed its eye to the sector.
Apart from financial supervision and restrictions in combination with the fairly complex regulatory framework, complicating factors most often heard are the following:
- complexity of the insurance industry itself and its business models
- limited possibilities of outsourcing business activities
- potential of tainted insurance portfolios and hidden liabilities
- unknown (future) costs
- claim handling backlogs
It seems, however, that private equity investors are overlooking opportunities that in spite of these complicating factors could well meet the requirements of their investment policies.
Insurance Industry Reform
Examples of possible opportunities for the private equity industry are those that could arise from current industry reforms in the Netherlands. As private equity funds are getting larger and more focused on particular types of business, some of them may be very well positioned to overcome the challenges that the insurance industry is faced with in light of the industry reforms that are taking place.
Regulatory changes may open windows of opportunities. For example: new rules on financial product and costs transparency and disclosure rules are expected to cause consumers to look more critically at levels of premium and the remunerations paid to intermediaries. This could lead to a trend of rationalization of the policy distribution channels, which may, for example, boost the ‘direct insurance’ business model.
Another trend seen in the regulatory environment is that the rules and supervision are becoming increasingly complex. It is believed that smaller market parties will as a result withdraw from the market and that the economies of scale will become important in respect of their ability to comply with requirements.
Finally, the present environment of fierce premium competition in most product lines throughout the industry could have a reducing effect on acquisition prices which will be in support of investment opportunities on the assumption that the climate will change once the premium cycle evolves into more beneficial circumstances.
Companies that are in the forefront of implementing new business models that are capable of using the trends described above for the company’s own benefit will be the winners of the future. In the fairly conservative line of business as far as the Netherlands is concerned, private equity investors could, when using the right tools, play an important role to help companies tailor their businesses in order to successfully meet the challenges ahead and thus create shareholder value and corresponding returns.
Introduction of Solvency II
One of the alleged main disadvantages of the industry sector compared with non-regulated sectors relates to the solvency requirements imposed on insurance companies. It is true that solvency requirements reduce shareholder distribution capacities. The solvency requirements are generally believed to limit the possibility to finance acquisitions with an attractive mix of debt and equity. However, changes in the solvency regime that are expected under the upcoming EU Solvency II Directive are expected to result in potentially attractive and more capital efficient insolvency rules. An important feature of Solvency II is the shift from volume based solvency requirements to a more sophisticated set of rules and risk assessments. As a result the solvency requirements will not be based only on insurance portfolio volumes, as is the case at present to a large extent. For larger portfolios it is expected that the new Solvency II rules will lead to more efficient, lower levels of reserves. With the right approach, the hidden value attached to Solvency II could be unleashed.
There is little doubt that investors, including private equity firms, could benefit from the implementation of Solvency II in the years ahead of us as the proposed changes could release part of existing reserves for the benefit of shareholders.
Supervision
The acquisition of a 10% interest in an insurance undertaking or the intention to increase the participation by certain thresholds must be notified to the Dutch Central Bank (‘DNB’), which is entrusted with the credential supervision of insurance companies under the Financial Supervision Act (‘FSA’). For any such holding a declaration of non-objection must be obtained from DNB. This applies to both direct and indirect holdings, which must be taken into account when setting up an insurance company acquisition structure, together with the financing issues described below.
DNB will test whether the holding does not jeopardize the proper conduct of business by the insurance company or its integrity. In addition, the holding must not lead to an insufficient level of transparency of the governance structure or, more generally, undesirable developments in the financial sector as a whole. The later could be the case e.g. if financial groups emerge that, as far as the structure and activities are concerned, form a potential risk for the stability of the financial sector.
Absent many examples, it is difficult to predict how DNB will treat applications by private equity investors to invest in regulated insurance companies in the Netherlands. However, at the face of it there are no specific rules preventing private equity investors from making insurance investments in the Netherlands. By comparison, a good example is JC Flowers, which invested in NIBC, a bank under the supervision of DNB.
Financing and structure of the acquisition
As is always the case, private equity investors will wish to finance the insurance investment with a mix of equity, mezzanine and debt financing that meets their own investment requirements. Although DNB will most likely carefully consider the financing structure of the holding company and the structure used for the purpose of the insurance acquisition, there are no rules that prevent the relevant acquisition vehicle from adopting a leveraged financing structure at its own level. In principle, solvency requirements of the target insurance company do not affect the possibility of use of debt instruments by the acquiring entity, apart from possible other restrictions applicable to any other investments.
However, for the purpose of calculating solvency levels and depending on the actual acquisition structure, the acquisition vehicles and the target insurer’s accounts may need to be considered on a consolidated basis, as a result of which relatively high levels of equity capital requirements are required. The negative effects for the private equity investor could be minimized by the use of long term subordinated debt or mezzanine type of financing may provide solutions and help to provide for investment return levels that are appropriate for the purpose of private equity fund investments.
Financial Assistance
It will in principle not be possible for an insurance undertaking to provide financial assistance in the form of security over its assets in favor of the financing bank. However, to the extent the use of mezzanine financing as described above does not have the desired effect, freely distributable reserves can be unleashed as a means of financing of the transaction. In this respect, the conservative approach and existing conservative levels of reserves can be used for the purpose of financing the acquisition and the effects of Solvency II may underpin financing structures and future dividend capacities upon implementation of the Solvency II rules.
Also, unlike other jurisdictions there are possibilities to combine the target and the acquisition vehicle in an income tax unity, allowing debt interest payment deductions from target profits for the purpose of calculating profit for income tax purposes. This is a main feature that depending on the exact structure could be used just like investments in any other industries.
Final Observations
There can be no doubt that the insurance industry offers windows of opportunities for the private equity industry. However, to be able to unleash value, thorough industry knowledge and analysis will be key, combined with a full understanding of the regulatory framework affecting the operations. Without any examples in the Netherlands it is difficult to estimate the manner in which DNB will treat applications by the private equity investors in relation to investments in insurance companies. A well planned approach will be fundamental for a successful execution of investments. Interested investors must therefore take into account sufficient time to liaise with DNB once the transaction is submitted and make sure that they understand the issues that they will be faced with during the process. However, in essence this is not materially different from other investments.
If you have nay queries, please contact rogier.dahmen@bdn.nl Rogier Dahmen is a lawyer specializing in corporate / M&A and private equity at Boekel De Nerée N.V. - Amsterdam, the Netherlands
Boekel De Nerée is a full service business law firm covering all areas of the law. The firm offers full bilingual, cross-cultural specialist services to clients from English- and German-speaking countries. www.bdn.nl
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