Brazilian insurance firms feel the squeeze

Brazil’s tightly-regulated, fast growing and generally well-capitalised insurance market looks doubly attractive in the wake of the pounding insurers have been subjected to in more loosely regulated markets, epitomized by the nationalization of AIG. For foreign insurers, tightening solvency regulations and gummed up credit markets mean smaller insurers are finding it tough to get access to credit. That is likely to create a rare chance to enter the market at a decent price. But it will be a brave move given massive global uncertainty. Instead, it may be better-capitalised Brazilian banks that further consolidate the concentrated market.

On paper, the Brazilian insurance market looks vibrant. Economic growth of over 5%, a raft of new products sold to an emerging middle class, long-starved of even basic products, new channels of distribution and a slow legislative thaw are already generating strong revenues.

The market has been growing in double digits and is expected to continue to grow some 15% per annum until 2012, according to the Federação Nacional das Empresas de Seguros Privados e de Capitalização (FENASEG), the industry body association. In five years, the outstanding in billed premiums will double from R$30 billion and assets in the industry will reach R$400 billion, adds Samuel Monteiro dos Santos Júnior, CFO of Rio de Janeiro-based Grupo Bradesco de Seguros e Previdência, the country’s largest insurer.

Compared to insurance in developed markets, the industry in Brazil remains a relative minnow, representing just 3% of GDP, notes José Tadeu Mota, head of investor relations at independent insurer Porto Seguros in São Paulo.

Typically, the relation between GDP and the size of the insurance market are tightly correlated as is the case in the US, UK and Japan, notes Monteiro dos Santos Júnior. The BRIC markets are completely out of alignment, he says. While China is the fourth economy in the world in GDP but it ranks a lowly 14th position in insurance. Brazil has the world’s 10th largest economy in GDP terms, but comes 19th, he points out.

Product Push

There’s plenty of pent-up demand for insurance products, says Monteiro dos Santos Júnior. Just one quarter of the vehicle fleet is covered by more than obligatory insurance and just 16% of homes are insured. At the same time, there has been an enormous transition of Brazilians into the middle class which now represents more than 50% of the population.

For this emerging middle class, one of the buzzwords is consumer protection, says Rogério Alves, vice president of Aon Affinity in São Paulo. Fast growth in consumer spending is driving the market for car insurance, credit protection (covering against default in the case of illness or unemployment) and extended warranties for purchases, he notes.

The traditional problem of distribution for such a mass market product has been ingeniously circumvented thanks to tie-ups with utilities. Aon has a partnership with electric utility AES Eletropaulo, whereby the later tacks on the insurance tab clients run up with Aon when it bills for electricity consumption, says Alves. The difficulty with this model is that utilities make any such deal extremely expensive, say competitors.

For wealthier Brazilians, home insurance and longer-term insurance, including life policies, retirement funds and health coverage are becoming must-haves; while companies are increasingly rolling out similar benefits for senior employees, says Monteiro dos Santos Júnior. The emerging middle class, which are for the most part completely uninsured, are crying out for small ticket life and disability coverage, he adds.

Fast-growing corporate insurance will get a further boost from the government’s ambitious infrastructure plans, adds Rodolfo Nobrega, analyst at Moody’s in São Paulo. Unibanco AIG is leading the insurance for the Santo Antônio hydroelectric plant on the Rio Madeira which is being built at a cost of close to $6 billion, he notes. Engineering, property and civil construction are all niches in this area, adds Andrés Holownia, President of the Brazilian Association of Risk Management. Finally, environmental guarantees are in fashion and growing fast, says Monteiro dos Santos Júnior.

The corporate sector has, however, been a tougher nut to crack thanks to very competitive margins, which shrunk as competition heated up, says Monteiro dos Santos Júnior. That may be changing as insurers look afresh at their risk profiles in the wake of the credit crunch. Since May, pressures on margins have eased as credit markets have seized up and insurers become more cautious on underwriting, believes Tadeu Mota. “There is no miracle here. The biggest players are having to go back to charging what they were before,” he says. Still, the Brazilian market is not facing the difficulties that many insurers are now confronting in developed markets, in large part thanks to strict regulations.

Regulatory Straitjacket

The Brazilian market has long been seen as one of the most conservatively run in the world. “The market is very regulated and not totally open, yet,” sighs Holownia. And an insurer cannot market new products without prior approval from authorities, he notes. Only gradually are products becoming more accessible and free competition doing its job by driving down prices for consumers.

“Brazil has a system that was created in the 1950s and that has been seen by the whole world as inflexible, but it is much more secure,” adds Monteiro dos Santos Júnior. That clearly looks like a blessing in today’s world.

For investment portfolios, the Superintendency of Private Insurers (SUSEP), the regulator that is part of the Ministry of Finance, applies limits of up to 30% in equities for some products and 8% in real estate. It monitors portfolios closely as well as requiring insurers to gain approval for asset allocation changes. Insurance companies are nowhere near to that upper equity limit, anyway.

Traditionally, Brazil’s extremely high interest rates and chaotic equity markets made insurers deeply conservative when allocating investments. Bradesco invests some 5.5% of its portfolio in equities and the balance in fixed-income, mostly in inflation-linked bonds. For Brazilian insurers that is relatively racey. The rest of the market has a greater concentration in fixed-income, says Nobrega. Given recent whip-sawing markets, there is more likely to be greater concentration still in government securities going forward.

For years, there has been the expectation that falling rates would drive insurers into equities to make sure they were earning the high yields they need to honour their guaranteed products. That was indeed starting to happen, albeit exceptionally slowly, and its acceleration was becoming a popular topic for conferences and the media. Insurance companies had been too undiscriminating in underwriting risk on the basis that they could park assets in extremely high-yielding government bonds went the argument. With interest rates falling to more normal levels, that game looked as if it’s time were up.

Not quite yet. The double whammy of an increasing interest rate cycle, designed to stave off inflation, and a rout in equity markets has derailed that idea, at least for the next couple of years. In September, nominal interest rates stood at 13.75% and real interest rates were close to 7%, giving a highly attractive risk-free return. Meanwhile the equity market posted losses of over 20% year-to-date on September 25. That has made Brazilian insurers’ conservatism look canny.

Longer-term, however, there will be scope for more balanced investments with some re-allocation from these ultra-conservative portfolios. “People are living much longer today in Brazil and insurance firms are going to have to invest more in equities to increase returns over time as their asset-liability profile changes,” says Monteiro dos Santos Júnior. Long-term products, such as life and retirement, will particularly benefit from equity exposure.

Other areas of business operation are similarly restricted. Until the market was opened earlier this year, Brazil shared the dubious distinction of having Latin America’s last monopolistic reinsurance market with Cuba.

Solvency II

The requirements for insurers are about to get more onerous as Brazil puts in place new solvency requirements, in the form of Solvency II, a sort of Basel II for insurers. SUSEP is bringing in new minimum and additional capital provisions, says Alexandre Paraskevopoulos, manager, global corporate reporting at PricewaterhouseCoopers (PWC) in São Paulo. Credit, legal, operational and market risk will follow.

To make life even harder, the industry is also working on the transition to international accounting standards, he points out. Recognising that the solvency deadline was unrealistic, the introduction of the law has been delayed one year til 2011, giving insurers an extra year to raise capital.

The combination of tighter solvency and growth opportunities means that almost all family-owned insurance companies are crying out for funds. On average, insurers will need 50% more capital, believes Nobrega, adding that the exact level various significantly according to the business line.

To reach Solvency II in the next three years as much as R$8 billion will be needed, agrees Monteiro dos Santos Júnior. At the same time, the market is becoming ever more competitive, requiring investment in marketing, systems and product development to keep up, putting an enormous strain on the balance sheet of less capitalised players.

Almost all small- and mid-sized firms need to plan a strategy, thinks Nobrega. Some insurers may look to raise capital in the belief that markets will improve long before the 2011 deadline while others may seek to sell off their business in full, find a parnter for a joint venture, sell a minority stake, or use reinsurance to pass over more risk to other players. The last option would limit losses, but at the cost of losing profitability, says Nobrega.

It explains why the liberalization of the reinsurance markets is so welcome. It will allow insurers more flexibility in tranching and passing on risk and could bring down prices. The sector is not yet really rumbling into action, but a number of large insurers are seeking or have been approved, ranging from Lloyd's of London, to Munich Re Group and Swiss Reinsurance Company. That could prove a lifeline for many insurers.

The weakness of financial markets is likely to create opportunities to buy firms, agrees Alda Fassbender, a consultant at Towers Perrin in São Paulo. Still, in her work on valuation and due diligence, she has seen more demand than supply. Furthermore, foreigners need to realise that there are many pitfalls when entering the Brazilian market, she notes.

One is the number of claims that wind up in Brazilian court. The creaking judicial system means that a case can take between five and 10 years to resolve. The government imposes extra payment on insurers of inflation plus 1% per month to policyholders, payable when the compensation figure is reached. The system tends to look favourably on policyholders, she adds. That creates a large incentive for customers to litigate and insurance companies typically dedicate 50% of their reserves to judicial cases thanks to the uncertainty of the outcome and high penalties, she says. Attempts by insurers to resolve such cases through arbitration have generally not succeeded, she cautions.

The second hidden danger is a legacy of guaranteed products, offered by most insurers on retirement products, which now look like creating dangerous liabilities long into the future. Typically, these products offered returns of an index inflation plus 6% annually. These will take years to unwind and could become disastrously expensive if real interest rates fall far, preventing insurers from liability matching using what have been until now, but are unlikely to remain indefinitely, very high real rates. Many firms including giants such as Bradesco, Unibanco and Brasil Previdência were large sellers of these products, she says.

Market Form

Even for those foreign insurers not deterred by legacy products and big court awards, the structure and ownership of insuers in Brazil means opportunities are not that easy to come by. The heavy dominance of banks as both owners of insurers and distributors of insurance products means there are very few large, independent insurers.

The total number of insurers in Brazil is close to 120, but if you look at the top 15-20, they hold 80% of premium, points out Nobrega. The top 20 companies are either bank affiliated or subsidiaries of multinationals and they tend to use their local bank or overseas parent as a cash cow, removing any need to tap capital markets.

The banking and insurance industries are heavily inter-twined and inter-dependent. If banks dominate the insurance market, they also depend on their large and profitable insurance arms for much of their bottom line.

Bradesco is a case in point. Brazil’s largest private sector bank distributes products and helps to capitalise Bradesco Seguros and the insurer returns the favour by ratcheting up 40% of overall profits.

These bank insurers are truly massive. Bradesco Seguros has one quarter of the whole insurance market, says Monteiro dos Santos Júnior. It represents some 42% of the sector’s total assets and posts profits that equal 35% of the total profitability of the entire market, he adds.

Monteiro dos Santos Júnior puts the big retail banks dominance down to the heavy penetration of the banking system. “Brazil is one of the most bank-dependent countries in the world. Just look at the fact that pre-dated cheques are widely used as an alternative to money,” he says. The gives Brazilian banks a ready-made distribution channel for insurance and a huge head start over foreigners, who typically create a joint venture with a Brazilian firm that has an insurance broker.

As if private banking domination did not make the market complicated enough, Banco do Brasil, the state banking giant, has also been throwing its weight around in the insurance industry. It has bought out the remaining 30% stake in Aliança do Brasil with which it had a joint venture, notes Fassbender. If it buys the bank Nossa Caixa, as seems likely, it will also gain a 49% stake in Nossa Caixa Mapfre Vida e Previdência, a joint venture with Spanish insurer Mapfre, which holds the balance. Banco do Brasil may end up owning the whole shebang as Mapfre has en exit clause in its contract with Nossa Caixa that allows it to sell its stake at a set price if the bank is sold.

Brazil’s state-owned banks may be painfully slow but they have enormous penetration and there is always the risk that they make non-commercial decisions in a bid to build up market share. Banco do Brasil could decide to focus on its insurance businesses through price cutting, for example. That could reverberate through the industry.

Mid-market Consolidation

The mid-market sector has already been slowly consolidating, pointing the way for future deals. In the last 12 months, there have been three sizeable deals in different sectors. In two cases, the driving force was the need for solvency by a Brazilian firm, says Nobrega.

A subsidiary of Liberty Mutual bought Indiana Seguros, a veteran 65-year-old provider of car insurance last year for an undisclosed sum. And in July this year, Zurich Financial Services announced it was paying up to $241 million to buy two Brazilian companies, just over 87% of Companhia de Seguros Minas Brasil and all of Minas Brasil Seguradora Vida e Previdência from Banco Mercantil do Brasil, adding to a string of recent smaller acquisitions.

Other firms had already looked to capital markets to raise funds. Before equity markets become unreceptive to IPOs at the beginning of the year, equity fund raising was just starting to become more popular with insurers. Equity markets are so nascent in Brazil, with the first company listed on the new more credible Novo Mercado segment of the stock market only in 2004, that there was only a three-year window for insurers to come to market.

Indeed, just two independent Brazilian insurers, Porto Seguro and SulAmérica, are listed on the Brazilian stock market. Porto Seguro went public in 2004 raising R$377 million and then tapped the equity markets again in 2006 for R$201 million. SulAmérica, which has a partnership with Dutch ING raised R$775 million through an IPO last year.

Others were starting to get bitten by Brazil’s IPO fever, but attempts to list ran into the volatility and subsequent rapid deterioration of equity markets. Marítima Seguros, and Minas Brasil had registered with the market regulator last year to raise money through IPOs on the exchange and there had been rumours that IRB Brasil Re, the only reinsurer at the time, would tap the market too. None of these deals have taken place. Minas Brasil has been bought while Marítima has just obtained permission from Susep to offer more shares to raise up to R$69 million although when that might happen is anyone’s guess.

Subordinated debt issues, which have been another common form of financing for insurers worldwide, has been limited in Brazil although SulAmérica did sell $200 million of five-year senior unsecured notes early last year. The dollar debt market for Brazilian companies was considered exotic even before the credit crunch, particularly for firms without dollar revenue streams, and for now is not viable.

Cashing Out?

If mid-sized Brazilian firms are starved of cash and might consider being acquired, the problem for insurers in developed countries is an abrupt transition to conservatism and wait-and-see. The big bet for potential acquirers is just how bad things will get before they get any better.

Indeed, some foreign firms may want to get out of the Brazilian market themselves to cover pressing problems at home. The credit crunch has been acute in the US and Spain, two of the biggest investors in Brazil, notes Holownia. “This means the crisis is likely to affect us. Housing difficulties have been common and the spill-over could have an effect on capital markets and insurance markets here,” he says.

The third consolidation in the Brazilian market took place last year when giant Spanish insurer Mapfre snapped up life insurer Vida Seguradora from Nationwide Mutual Insurance Company of the US for an undisclosed sum late last year. The US firm had announced its intention to get out of the Brazilian market back in 2005 when it unwound its joint venture with Marítima Seguros. Mapfre gained a firm with a portfolio of R$70 million in assets and 870 brokers but will need to help the company to reach solvency standards.

The next deal may come from a Brazilian bank buying out an American insurer. Unibanco, the country’s third largest private retail bank, has 52% of a joint venture with AIG, the newly-nationalised US giant.

José Rudge, President of the unit, said Unibanco has the right of first refusal in any sale, but declined to comment on whether AIG inclined to sell in a conference call with analysts. The firm posted R$5.6 billion in revenues last year. Unibanco AIG declined to be interviewed or comment further.

The problem is that the volatility of capital markets could also snarl up negotiations on price. Ricardo Lacerda, managing director and head of investment banking Brazil and co-head of investment banking Latin America at Citigroup in São Paulo, says that while both sides often want to close a deal in difficult maket conditions, the seller believes the price should be at the recent tops of the market while the buyer is looking for a heavy discount. That means the M&A market can get gummed up like the credit market in times of turbulence.

Facing Solvency issues and a gummed up credit market, mid-sized Brazilian insurers face a squeeze. Meanwihle, foreigners are anxiously eyeing home markets. It is perhaps only the bank-owned insurers that are going great guns in Brazil. That’s a shame as more competition would be welcome.

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