5 Potential Takeover Targets: RSA Insurance Group plc, Amlin plc, Hiscox Ltd, Lancashire Holdings Limited and Beazley plc

The insurance industry is seeing a wave of consolidation activity, as many insurers seek to bulk up in the light of intensifying competition and low investment returns. Friends Life was acquired by Aviva (LSE: AV) late last year, whilst Catlin and Brit were acquired by North American insurers this year.

Zurich is said to be considering a bid for RSA (LSE: RSA), the UK’s second largest general insurer. Rumour have been spreading that Zurich intends to price RSA at 525 pence a share, but a much better than expected set of results for the first half of 2015 means RSA shareholders are likely to reject a bid that values its shares at less than 600 pence. Operating profit rose 84% to £259 million, which was more than £50 million higher than analysts’ expectations, and shows the insurer’s recovery is firmly embedded.

Further consolidation in the insurance industry is likely as insurers seek to benefit from scale economies and greater efficiency. Lowering costs and greater diversification are particularly important as Europe’s stricter Solvency II capital rules are set to take effect at the start of 2016.

Takeover targets

Market conditions are conducive to takeovers, as insurance stocks benefit from low price-to-earnings and price-to-book valuations, and low interest rates mean the cost of financing acquisitions is cheap. Although competition is intensifying, profitability amongst many insurers, particular those underwriting speciality lines, are still relatively high when compared to historical averages. Consolidation will likely lead to a withdrawal of capacity in the market and have a positive effect on premiums and profitability in the industry.

Lloyds of London and Bermuda-based insurers are the most attractive takeover targets, because of their focus on speciality lines of insurance. The unique nature of the risks they underwrite should mean that they will benefit more from diversification and scale. As part of a larger firm, they can carry less capital, and have better opportunities to expand their product lines and underwriting capabilities.

Here are four Lloyds of London insurers:

Amlin (LSE: AML) has fared relatively resiliently with softening market conditions. There are initial signs that its claims ratio is improving and it continues to benefit from a paucity of major catastrophe losses. Renewal retention rates are near 90%, which underscores its loyal customer base and its focus on long term risks.

Hiscox (LSE: HSX) is the most expensive of the four on a forward P/E basis. Its forward P/E is 15.0 and it currently yields only 2.7%. But, because of its fast growing retail speciality insurance business, the insurer’s earnings growth is likely to outpace its competitors.

Lancashire Holdings (LSE: LRE) is a particularly attractive takeover target because of its industry-leading underwriting profitability. Its combined ratio, which is the percentage of premiums earned used for settling claims and paying operating costs, was 75.1% for the first half of 2015.

Although Lancashire’s combined ratios have worsened recently, they remain well above many of its peers. Strong free cash flow generation and healthy solvency ratios means a potential bidder would have little to worry about the increase in debt needed to fund the acquisition.

Beazley (LSE: BEZ) has been offsetting the decline in profitability from its Lloyds insurance syndicate by growing premiums in its locally underwritten US business. In contrast to many of its peers, the insurer is expecting to achieve moderate growth over the next few years.

It’s difficult to tell which insurer will be taken over, but with valuations so low, these insurance stocks are worth buying even in the absence of a potential takeover bid.

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Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended Beazley. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.