Why Aviva may regret making its £17bn move on recovering Prudential

Insurers' shares rise on hopes of industry consolidation; Aviva may face rivals in Pru bid war
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The Independent Online

The London market was awash with rumours of consolidation in the UK life insurance sector yesterday, as Aviva's £17bn unofficial offer for Prudential left traders salivating at the prospect of a wave of merger and acquisition activity.

By mid-morning, shares in Prudential had broken through four-year highs of 760p, more than 8 per cent above the value of Aviva's tabled proposal. Given that Prudential had already issued a stern rejection of the approach - claiming it was "unsolicited and unwelcome" - investors were seemingly banking on a bidding war, with the likes of AIG and AXA topping the list of potential acquirers.

Meanwhile, shares in Legal & General and Friends Provident - two other FTSE 100 life insurers - were also soaring, rising more than 5 per cent in early trade before slowly drifting back down across the rest of the day.

The market's excitement was understandable. Having been ripped apart by the equity bear market between 2000 and 2003, the UK life insurance sector has spent the past three years replenishing its reserves and attempting to restore confidence among investors.

As a result, the last wave of M&A activity was nearly five years ago, ending in summer 2001 when Royal London bought Scottish Life, and Abbey National snapped up Scottish Provident.

But with the balance sheets of the largest UK insurers beginning to look robust, the case for a wave of industry-wide consolidation is more compelling than it has been for several years.

In a recent note on the sector, analysts at Fox-Pitt Kelton were among the first to point out that the industry's period of recuperation is coming to an end, with investors beginning to raise pressure on insurers to cut their costs and increase profitability.

For companies that have been dependent on the UK - a market which an increasing number of analysts believe has stopped growing - this has left no choice but to chase scale at home and seek markets with better margins and growth potential abroad.

"We believe UK life insurance went ex-growth a few years ago," Ned Cazalet, a life insurance industry analyst, said. "Most of the UK money flowing into insurance companies is actually just transfers from other insurers."

For the FPK analysts, this is why Aviva had little choice but to table its proposal for Prudential. With the group trading at a premium rating of about 1.6 times last year's embedded value, it required a major acquisition to sustain such a price. Not only would Prudential give it the scale in the UK from it which it could squeeze cost savings and raise its margins, but it would also give it a major foothold in the US and Asian markets, where it is very weak.

While Richard Harvey, the chief executive of Aviva, claimed he was shocked that his merger proposal had been leaked to the market so quickly, the City's conspiracy theorists believe the leak may have come from Aviva.

Given that Prudential's chief executive, Mark Tucker, has had his feet under the table for less than a year, his immediate rejection of the offer is no surprise. With his company having reported better-than-expected results last week -when he boasted it had met its internal growth targets two years ahead of schedule - investors have increased faith in his ability to complete the turnaround of the business.

As a result, it was always in Aviva's interest to get its offer out into the open and hope that an active debate would impress shareholders enough to ignore the Prudential board's rejection.

But by the end of yesterday's trading, Prudential investors looked unlikely to budge, with some claiming the bid had backfired. Roman Cizdyn, an analyst at Oriel Securities, said the Aviva bid had exposed its weakness and left it more vulnerable than Prudential. "Aviva has put itself into play by indicating it has gone ex-growth. That is why its share price has held up rather better than one might have expected."

Although Mr Cizdyn said an appreciation in Aviva's share price over the coming weeks could help persuade Prudential investors to take its offer - a trick which helped Old Mutual acquire Skandia this year - Aviva shares ended down after rallying in the morning.

By the end of the day, an increasing number of analysts and investors had become sceptical that the Aviva/Prudential story would turn out to be anything more than a storm in a teacup.

While buying Friends Provident and Legal & General would give any global life insurance company a firm foothold in the UK, they would not provide the likes of Aviva with the expansion in other global markets which it is seeking. Furthermore, the UK market's uncertain future holds little attraction for foreign players not already here.

Mr Cazalet said while there has been no major M&A activity in the UK for several years, this does not mean there has not been consolidation. "What you've ended up with is a growing closed life book sector - which means there are fewer players writing new business. If you look back to the end of the 1990s, we had Guardian Assurance, Royal SunAlliance, NPI, London Life - all these are closed now. So consolidation has been taking place."

The worry for Aviva is where it goes if its Prudential bid fails. With there are few other companies in the world within its price range, providing the right scale and exposure in the right markets, it may have no choice but to go hostile for Prudential.

Analysts and investors divided over merits of a merger

Aviva received a mixed reaction to its bid for Prudential, with investors and analysts disagreeing over its merits.

Although a merger would create a £37bn giant with a major presence in the UK, Asia, US and continental Europe, the substantial overlap in the insurers' home market would require a potentially messy merger.

Ned Cazalet, an insurance industry analyst, said: "If you look at the two companies' UK businesses, it's striking how different their business models are. There's a real clash on fundamentals."

With Prudential shares racing past the 708p which Aviva's offer is approximately worth, it became clear it would need to come up with a better deal to seduce Prudential shareholders.

However, Richard Harvey was clear there was no cash available. Roman Cizdyn, an analyst at Oriel Securities, warned that sweetening the terms of the all-share offer would be difficult, "robbing Peter to pay Paul" and depriving Aviva investors of full value from the deal.

One institutional investor who has major holdings in Prudential and Aviva said there is considerable overlap between the two's shareholder bases. "It's a deal that makes quite a lot of sense if it can be done on the appropriate terms. But the attraction of a deal depends on whether you're an Aviva shareholder or a Prudential shareholder, and most people are both. It's a difficult balancing act."

Although many predicted talk of a potential bidding war for Prudential, attention shifted to Aviva by the end of the day. Guy de Blonay, at New Star Asset Management, said: "Given that Aviva has flagged that it does not intend to launch a hostile bid, a counter bid for Prudential seems likely. But there must be a possibility that Aviva has put itself into play."

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