Innovating and Executing.

Strategic Management: Successful strategies will depend upon innovation, flexibility, adding value and properly gauging customer preferences.

Three market forces--deregulation, Internet transparency and the impact of globalization--are transforming the competitive landscape of financial services. Property/casualty insurers must assess their companies' core competencies and operational capabilities to determine their ability to develop innovative products, services and delivery in the face of formidable competitors. Overnight, the list of competitors has widened to include banks and securities firms, as well as new entrants such as Internet "attackers." These new competitors are not burdened with legacy systems or agency systems, have innovative ideas, strong management and a focus on execution.

Strategic management in the 21st century will require all companies to constantly innovate--a difficult task for the historically staid property/casualty industry. Innovation requires changing--and sometimes destroying--outdated business models, often accessing external expertise through outsourcing, alliances, joint ventures, and through mergers and acquisitions.

Insurers are in various phases of executing strategic business plans. Market leaders such as American International Group and Travelers continue to sustain competitive advantages and operate at peak performance. They continue to foster innovation by expanding their capabilities in financial services, online and throughout the world.

AIG is active on all three fronts. It formed a banking alliance with Wells Fargo, an online partnership with aggregator site Autobytel and acquired SunAmerica to cross-sell Sun's annuity products through AIG's vast international network. Travelers is part of the merger that created Citigroup which ranks as the largest financial-service organization in the world. It is also part of Citigroup's integrated broad-based consumer-finance website citi [f/i.sup.SM]; its global marketing alliance with Winterthur Swiss will help both parties service multinational clients throughout the world.

Meanwhile, much of the industry has been relatively quiet on these three fronts. Many have had to rationalize lackluster operating performance, modest organic growth and inefficiency. Some have yet to roll out defensible market strategies. Others have resorted to under-pricing to secure market share. For many in this category; the financial and strategic strength of their competitors has greatly reduced their prospects for success and market viability.

Behold the Internet Era

Morgan Stanley Dean Witter projects "conservative" growth of at least 34% for consumer financial services on the Internet over the next four years. Insurance appears poised to be transformed by the Internet. One area ripe for e-commerce is personal auto, where insurance policies are relatively standardized and more than $100 billion of business could be up for grabs each year because of annual or six-month renewals.

Many banks have developed strategic plans to deliver products and services online, but the insurance industry has lagged. Insurers served fewer than 10,000 customers online in 1997, compared with 3.6 million by banks and 2.7 million by the brokerage industry. A survey by Booz-Allen & Hamilton found that most insurance companies spend less than $500,000 per year on Internet-related activities, with most of that invested in customer-service efforts and marketing, rather than in direct sales. This may partly result from the complicated regulatory system that requires brokers and agents to be licensed in all 50 states in order to sell insurance over the Internet, as well as insurers' fear of channel conflict. However, these two obstacles are expected to be gradually overcome.

Insurers have been developing broader, but limited uses for their Web sites as an information conduit. In instances where insurers put more-sophisticated online technology to use, it is usually to generate price quotes so consumers can comparison shop. Only 20% of insurers' Web sites allow customers to research a quote or purchase a policy. To date, sales remain off-line for most insurers.

Clear and Present Danger

The agency-distribution model-both captive and independent-still dominates the property/casualty industry; but e-commerce poses greater opportunities and threats to insurance carriers than ever before.

New Internet-based competitors are developing business models that take on the industry and exploit areas of inefficiency. Insurance marketplaces such as InsWeb and Quicken's site act as online front-ends facilitating insurance shopping services. Many Internet players still require an agent to close the insurance transaction but the e-commerce model is moving toward a new insurance marketplace. That could be in the form of an end-to-end virtual insurance carrier such as eCoverage or to a financial-services superstore such as Merrill Lynch Co. or Charles Schwab, which adds insurance to their product line.

Meanwhile, other new entrants aim to unlock economic improvements within the insurance value chain. Collectively, these well-funded and nimble attackers are expected to generate cost savings and capture the attention of insureds renewing insurance policies. New players include InsurQuote, a company that leverages technology for enhanced underwriting, and AdjustNET, CyberSettle and PRO-Claims, which aim to improve claims effectiveness.

Most insurers have established their own closed-architecture Web sites, but not strayed far beyond that model. Best-of-breed insurers known for features such as service (USAA) or strong branding (Allstate) or product innovation (Progressive) may be best-positioned to exploit portal-based opportunities on the Internet and form financial-service alliances. Organizations like these recognize that the Internet is not a technology fad, but rather a serious environment in which winners are redefining delivery systems and leveraging information to forge valueadded relationships with customers.

Buy, Partner or Outsource

For U.S. insurers, the demise of the Glass-Steagall Act will accelerate convergence in financial services, intensify competition, spur innovation in the application of technology and lead to the development of new products and services. It also will accelerate the erosion of inefficient practices, particularly as state regulation is streamlined and standardized in the wake of commercial lines deregulation.

In the early stages of the deregulated environment, few U.S. property/casualty insurers will seek to buy banks, nor will there be a rush by banks to acquire insurers. Few U.S. insurers have sufficient capital to buy banks. It's also unlikely that banks will aggressively pursue property/casualty insurers, unless they exhibit strong and predictable earnings, sustainable competitive advantages and a well-controlled risk profile. That's a tall order for most insurers. The rapid growth of Internet access and e-commerce has shifted the "bancassurance" paradigm from one in which banks buy insurers to an environment in which banks partner with insurers in the establishment of high-traffic financial-service portals offering a wide choice of products.

Citigroup remains an exception to the new market alliances. Formed last year through the merger of Travelers and Citicorp, Citigroup is well-positioned to leverage cross-sector opportunities that will emerge in a deregulated environment. Already, it has demonstrated strong cross-selling among its various financial groups.

Insurers need to adopt a flexible strategic plan that leverages their organization's core competencies and embraces a forward-looking business model that may involve increased business partnering.

Forming successful strategic partnerships is a skill that requires the same care as executing an effective merger or acquisition. Central to forming an alliance are selecting best-of-breed partners and understanding their operations and the value they add. The permanence of a strategic partnership is determined by the compatibility of the respective partners' evolving strategies and minimizing the risk of being replaced by a more formidable competitor.

Meanwhile, financial-services companies in the United States and United Kingdom have shown a greater acceptance of outsourcing as a strategy, particularly on the asset-management side as insurers seek to improve investment earnings. Outsourcing of this function to thirdparty asset managers will expand as competitors move to keep pace with insurers that are leveraging greater overall investment performance while reducing overall enterprise risk.

Outsourcing of back-office functions can also help insurers remain competitive without increasing their size. Well-conceived outsourcing can offer insurers an opportunity to grow and create "virtual critical mass" because of reduced cost and lead time requirements.

A Global Perspective

The evolution of the world's capital markets has served as a catalyst for globalization across industry sectors. The world economy is undergoing a long-term transformation from a multitude of local industries confined by national economies to a set of integrated industries that operate across geographic boundaries.

The changing dynamics of risk management brought about by deregulation is further driving globalization. U.S. regulatory reform is expected to spark competition among financial-services companies and create a broader choice of products. At the same time, it provides new opportunities for foreign companies to expand their asset-management platforms into the United States. Many of the large European financial-services giants will likely emerge as competitors in the scramble to acquire or form joint ventures with U.S. asset managers or banks. For example, Allianz' announced plan to acquire a 70% stake in California-based Pimco Advisors would make Allianz the sixth-largest asset manager in the world. Other likely competitors include ING, the Dutch insurance and banking giant; Zurich Financial Services, Switzerland; Axa, France; and Generali, the large Italian insurer, all of which have well-developed bancassurance capabilities in Europe.

Many European companies are also preparing for globalization in several ways:

* By adopting International Accounting Standards to provide financial transparency and better comparability to eventually tap the U.S capital markets.

* By increasing public awareness through worldwide advertising and branding programs.

* By changing their management style to foster the flow of ideas throughout the organization.

Many of these groups also have multiple stock-market listings and are in the process of becoming listed on the most prestigious exchange, the New York Stock Exchange. This would provide organizations with greater financial flexibility to pursue U.S. acquisitions.

The December meeting of the World Trade Organization gathered insurance-industry representatives to address regulatory reform on a global basis. Obtaining transparent regulation across world markets would increase competition by removing costly restrictions.

The convergence of the insurance, reinsurance and capital markets continues. Reinsurers recognized these emerging market trends earlier. They have ignored the boundaries of the past and adopted a more holistic view toward risk financing. This has resulted in significant consolidation within this sector as reinsurers create new platforms to access and service the ultimate client. As a result, few U.S.-only reinsurers exist today. Recent transactions have taken on an increasingly cross-market flavor as top-tier reinsurers expand their global positions.

Financial service and commercial lines deregulation is a powerful combination that will accelerate change in the U.S. insurance marketplace. Under proposed commercial lines deregulation, Fortune 500 policyholders could be exempt from long-standing consumer-protection-oriented regulations, freeing insurers from regulatory oversight and giving them greater ability to create customized coverages and pricing that better suits organizations' risk-management needs. As regulatory constraints are removed and pricing becomes increasingly transparent, opportunities to globalize products and relationships are increasing.

Competition remains intense for larger accounts. Roughly one-third of the commercial market is handled through alternative-market programs. However, these programs are concentrated among larger accounts, with greater than three-fourths of all national accounts using some form of alternative risk transfer. Despite prolonged soft pricing, there has been little return to the traditional insurance market among groups. New capital-market-oriented units such as Arrow Re and Lehman Re are placing pressure on the industry to increase competitive efficiency.

Fortune 1000 companies have historically led insurers into major changes, from the adoption of paid loss retros in the 1970s to the globalization of the 1990s. Companies such as AIG, Allianz and many reinsurers operate almost as entrepreneurs and are quick to adapt strategies and capitalize on emerging needs. Their willingness to assume risk through innovative insurance products, to provide purely financial solutions to their Fortune 1000 clients and their global presence distinguishes them in the marketplace and places them in a league of their own. While many companies continue to provide capacity for traditional risk-transfer products, insurers are increasingly developing customized solutions designed to manage enterprise risks.

Competitors such as Cigna, Travelers and Liberty Mutual also adapt well to change, but in a more systematic fashion. They focus on building service capabilities and follow a strategy of acquiring, merging or aligning with other companies to achieve global stature. ACE's recent merger with Cigna, Travelers' strategic alliance with Winterthur Swiss and Liberty Mutual's ongoing acquisition of prominent insurers in non-U.S. domiciles illustrate this point.

Remaining commercial insurers such as CNA and Chubb have reduced their emphasis on the Fortune 1000 market-in-favor-of national and middle-market accounts. These market segments need the sophisticated underwriting and risk-financing expertise that these companies can offer, as well as some multinational presence. However, this market segment remains very price-sensitive. As national and middle-market companies redefine their business models to compete in an ever-increasing global economy and as their needs--and insurance dollars--shift to insurers that are also global in nature, national-account and middle-market-oriented insurers will come under pressure. Any significant hardening in pricing will drive part of this segment into the alternative markets. Past experience shows that once risks move to alternative markets they are unlikely to return to traditional insurance. Accordingly, many property/casualty insurers serving this market segment are likely to become part of the consolidation wave.

The U.S. nonlife insurance industry has yet to experience the widespread consolidation that is reshaping the life insurance and banking industries. A number of smaller, more nimble competitors likely will continue to operate profitably by virtue of their strong local brands or because they are attacking inefficiencies in traditional domestic markets.

New World, New Rules

Financial-services deregulation paves the way for the convergence of banks, investment firms and insurance companies to manufacture, market and distribute a broad range of products, either through cross-ownership or by forming marketing alliances. Market shifts are inevitable. A.M. Best believes that organizations that focus on core strengths, leverage best-in-class specialty insurance products and service and access external expertise through partnering, outsourcing and through mergers and acquisitions are most likely to "stay ahead of the curve."

To succeed in this new period of "controlled chaos" insurers must adopt flexible business models that respond to more-sophisticated and empowered customers. In commodity-like segments such as personal lines and small commercial coverage, insurers will have to respond to consumers and small-business owners' increased demands for service, low-cost and convenience. The greater price transparency and wealth of information made available by the Internet will fuel these demands.

In the mid-to-large commercial segments, insurers will have to respond to risk managers' requirements for financial security and innovative products. Those range from alternative-risk-financing options, to integrated insurance and capital market products, to highly individualized business risk solutions.

In the final analysis, the successful organizations will be those that are innovative, flexible, add value and properly gauge customer preferences.

                     Online Financial Services Revenue
($billions)                       Compound
Segment              1998E  2003E   Growth
Consumer Banking      24.0  235.0      58%
Brokerage              2.5   32.0      67%
Term Life Insurance    0.0    0.7     181%
Auto Insurance         1.0   18.0      78%
Mortgages             75.0  147.2      14%
Credit Card            0.1    3.5     104%
Total               $102.6 $436.4      34%
Source: Morgan Stanley Dean
Witter Equity  Research

Customized Solutions

As corporations adopt a holistic approach to managing enterprise risk, the new risk manager is seeking a partner that can provide cost-effective and innovative risk-management solutions, superior and timely service, and stable long-term capacity. Enterprise risks can encompass potential losses arising from fire, litigation, interest-rate fluctuations, computer-virus invasions or political risk. Commerce is becoming more global, finding new venues online and creating exposures that never existed previously. These new exposures create opportunities for financial-services organizations that possess the intellectual capital to craft integrated risk solutions that effectively meet the customer's demands.

Insurer, reinsurer, guarantor, counterparty, investor--these terms can be used interchangeably to describe the emerging financial-services company. Already, insurance organizations such as Centre Re Solutions, part of Zurich Financial Services; XL Capital; AIG and Munich-American Risk Partners are responding to the challenge to create unconventional products that address customers' unique objectives and circumstances.

Integrated-risk solutions blend standard insurable risks with traditional noninsurable risks such as business and financial risks. In addition, structured-finance products such as residual-value guarantees, financial guarantees and credit wraps have been developed to respond to particular risk challenges. Risk securitization in the form of insurance bonds or derivative transactions, contingent capital and counterparty credit are other new financial products that have emerged.

These nontraditional products help corporations manage critical business risks, protect balance sheets and income statements from unforeseen events, and remove unwanted liabilities thereby imporving their market value.