Little Relief in Sight.

Financial Outlook: Core reserve margins continue to erode as more insurers enter the "pain phase" of today's soft market conditions.

Intense price competition began catching up with the property/casualty industry in the third quarter of 1999 in the form of more than $500 million in announced reserve actions. A.M. Best believes this is just the beginning as far more companies are expected to recognize reserve shortfalls through 2000. In the long run, results will improve modestly, once expense savings and productivity gains from ongoing technology investments are realized. However, increased competition and shrinking reserve margins within personal lines will not allow for much improvement in the near future.

We expect the industry to report a combined ratio of 107.5 for 1999, up 1.9 points from 1998. At this level of underwriting profitability, the industry is generating an after-tax return on surplus of 7.0%, below expectations of most investors and analysts. Catastrophe losses decreased but remain near historical levels. Catastrophe losses contributed 3.2 points to 1999's combined ratio, compared with 3.6 points in 1998. Asbestos and environmental (A&E) incurred losses also remained consistent because of fewer reported claims and insurers' reluctance to set aside A&E reserves in the midst of soft pricing. Excluding catastrophe and A&E losses, the industry's normalized combined ratio is 103.3, which is also in line with our initial 1999 forecast.

Despite the large number of reserve surprises already announced, we believe reported results continue to be bolstered by unrealistic reserve assumptions in certain markets. Therefore, future earnings will be further depressed by adverse reserve developments. These reserve charges are not expected to affect the industry uniformly. More commercial carriers are expected to report additional reserve charges than are personal lines carriers. Further, few mutual insurers are expected to experience material reverse shortfalls.

In the personal lines market, A.M. Best believes $3 billion to $5 billion of loss reserve redundancies remain, but these are concentrated among a small group of market leaders. Deficiencies are greater and more widespread within the commercial market; A.M. Best estimates that core loss reserve shortfalls are near $25 billion, excluding A&E.

We continue to see fragmented turns in market pricing. Late in 1999, following a year of extreme turmoil brought on by intense competition and problems involving low-level reinsurance, workers' compensation writers began reporting substantial price increases in some markets, particularly in California. However, other workers' compensation markets such as Massachusetts' continue to experience downward rate pressure. A.M. Best expects to see hard cycles in discreet segments but their duration and intensity will be compressed because of overcapacity and improved real-time market information. Demand is also weakening as nontraditional competitors encroach on commodity segments and middle-market customers migrate toward self-insurance. Those factors foster greater market efficiency and less-pronounced pricing swings.

Proactive companies are redirecting their strategies, cutting costs and launching stock-repurchase programs, to name a few. Most recognize the need to focus on and execute core competencies of marketing, underwriting and claims handling. Despite expected expense savings generated by acquisitions and consolidation, the industry's expense ratio continues to drift upward. We expect that ratio to reach 28.1 for 1999, a two-point increase since 1994. Further technology investments will be required to link back-office systems to the Internet. These investments in technology should provide benefits in the long run.

Policyholder dividends decreased in 1999. As personal auto profitability deteriorated, extraordinary dividends paid by State Farm and USAA diminished.

Premium growth, which slowed in 1998 and in the first half of 1999, began to increase in the third quarter of 1999 and is expected to close the year up 2.3%. This increase is modest, but is a pleasant surprise from 1998, and appears to indicate some signs of price firming, particularly in commercial markets. Surplus will finish the year up only 0.5% because of lower operating earnings and moderating appreciation on common-stock holdings. That reflects the blue-chip orientation and underweighting of the technology sector within the industry's collective portfolio.

We expect that underwriting results will continue to deteriorate through 2000. While commercial price levels appear to be improving during the second half of 1999, the effects of inadequate pricing in recent years are expected to dampen underwriting results in 2000. Prior-year reserve redundancies are drying up and will no longer be available to prop up reported results.

Personal auto is not immune to shrinking margins, as evidenced by the higher initial accident-year loss ratios being recorded. Personal auto margins will further erode as market leaders further reduce prices and begin to use the Internet as a low-cost delivery system. Despite slow growth to date, A.M. Best expects Internet usage and insurance e-commerce to rapidly expand over the next five years.

Underwriting Results

During 1999, personal auto showed slowing growth trends as prices continued to fall. This line's underwriting profitability declined to its lowest level in eight years. While personal auto remains profitable, 1999 price levels have not kept pace with loss costs that are modestly rising. Claim frequency remains flat, reflecting safer autos, greater enforcement of speeding laws, fewer drunken drivers, and favorable demographic changes. However, claim severity is rising because of higher medical inflation and auto-repair costs, and more severe accidents associated with sports utility vehicles.

During 1999, loss reserve releases enhanced personal auto earnings again. With only an estimated $3 billion to $5 billion of reserve redundancies remaining, future reported earnings are expected to be less favorable. As a result, we believe personal auto underwriting results will continue to decline as remaining reserve redundancies are used and higher accident-year results emerge.

Over the past several years, premium growth in commercial lines has been anemic, as loss-cost savings of the early 1990s were outpaced by premium reductions. These losscost savings largely benefited workers' comp, where improved claims management, managed-care techniques and benefit reforms lowered workers' comp costs in some cases by up to 50%. As these savings were realized, reserves proved redundant and helped reduce the calendar-year combined ratio by six to 10 points per year in recent years.

As these cost savings have been reflected in premium rates, commercial lines have grown minimally and lossreserve adequacy has deteriorated. During 1998, accident year 1997 developed adversely for workers' comp. This is the first time this occurred since 1992, before most loss-cost savings were apparent. This trend is expected to continue through 2000 and is similar for most commercial lines. Those companies that do not have historical loss-reserve redundancies to offset this adverse development will face significant earnings pressure.

Workers' comp is not the only line affected by substantial competition in the past few years. Deteriorating rates have existed across the commercial market segment, with commercial automobile finishing a distant second to workers' comp. Although commercial pricing levels have recently improved, prior-year reserve development will continue to undermine calendar-year profitability.

Expense levels continued to increase in 1999 and reflect roughly two points for Year 2000 system-remediation costs. In addition, industry commission expenses remain elevated as many regional insurers have motivated their independentagents through full-commission structures.

In the longer term, we expect companies to continue to explore alternative-distribution opportunities in an effort to reduce production costs. Many companies will have to lower their expenses to remain competitive, particularly in personal lines and small commercial accounts. In these sectors, where the average premium per policy is low, proactive expense management, automation, efficient distribution and effective risk selection are keys to long-term viability and growth.

Catastrophe Losses

Catastrophe losses will be in line with our initial expectations for 1999, adding 3.2 basis points to the combined ratio for the year. In recent years, A.M. Best has included 3.0 points within its industry forecast for expected catastrophe losses. Since Hurricane Andrew in 1992, catastrophe modeling has gained considerable acceptance and facilitated improved catastrophe-mitigation by many companies. Strategies include securing specialized reinsurance arrangements, securitizing risk and focusing on annual aggregate losses. Many companies are becoming more effective in quantifying and managing the earnings impact of catastrophe losses.

Mass Tort Liabilities

Incurred-loss activity linked to asbestos and environmental (A&E) coverage has remained low over the past three years. A&E losses contributed about one point to the industry's 1999 combined ratio. Most of the adverse development relates to a few remaining carriers maintaining a pay-as-yougo funding approach to A&E losses. Other mass-tort liabilities loom on the horizon, including claims tied to electromagnetic fields, latex, lead, silicon breast implants and tobacco. To date, the industry has seen limited claim activity in these areas.

On the other hand, Year-2000-related computer problems present an immediate mass tort exposure to the industry. Property/casualty insurers may be required to cover losses triggered by computer failures or malfunctioning products related to Y2K problems. While it is impossible to estimate potential Y2K losses at this time, there will clearly be claims and defense costs related to Y2K. Given the uncertainties and for legal reasons, we are not aware of any carrier establishing explicit Y2K reserves in 1999.

The plaintiff's bar has invested several years of research into Y2K-related legal issues and is prepared to act quickly as losses occur. Already, some Y2K-related lawsuits have been filed against insurers. In addition to product or professional-liability lawsuits, some of the most recent suits have alleged insurance coverage for Y2K remediation expenses under the "sue and labor" and "preserve and protect" provisions in insurance contracts. These suits assert that insurers should be responsible for all costs associated with computer repairs that prevent future losses. A high court ruling against insurers in these cases would set a costly precedent for the industry.

Normalized Losses

To facilitate our analysis of industry trends, we continue to normalize underwriting results by excluding catastrophe and A&E losses. On this basis, we project a normalized combined ratio of 103.3 for 1999. This is the highest level in eight years and 2.3 points higher than 1998. This deterioration is in line with what we forecast last year. Despite reserve strengthening in the third and fourth quarters of 1999, we believe many insurers have yet to recognize growing reserve deficiencies.

Personal auto competition is intensifying; loss severity has increased modestly in recent years after receding in the mid-1990s. Recent reports show a trend toward increased medical and auto-repair costs but frequency trends remain modest. As a result, we expect personal auto loss costs to increase marginally.

Top line premium growth in 1999 benefited from price increases in the commercial lines and reinsurance markets, particularly within commercial property line and certain workers' comp markets. Personal lines pricing trends are not decreasing at the levels A.M. Best initially expected. A.M. Best now believes the personal auto leaders will be less aggressive in reducing premium rates that would otherwise squeeze out high-cost providers, and use some of their margins to invest in technology and Internet delivery systems.

Reported workers' comp results continue to slip and are expected to deteriorate dramatically over the next few years. The National Council on Compensation Insurance has estimated the ultimate accident-year 1998 combined ratio will reach 121, in line with our expectations. As reserve redundancies built up in the early 1990s are used, calendar-year results are expected to catch up and reach the current accident-year levels, and within two years exceed them. The overall impact of increasing reinsurance costs on workers' compensation accident-year results is uncertain.

Investment Results

Operating profitability is highly dependent on investment income, which in the past two years has been reduced by declining interest rates. In the next few years, we expect yields to remain low and underwriting cash flows to remain negative, resulting in decreased investment income. For many in the industry, declining investment earnings is a big problem. We expect investment yields to fall below 5% in 1999, the first time in more than 25 years that yields have dipped below that level. Despite rising interest rates during 1999, lower reported investment-yields will persist as older high-yielding investments mature.

Given poor underwriting fundamentals and depressed investment yields, it is no longer realistic to rely on investment income to offset underwriting losses to produce acceptable operating returns.

Personal Lines

In a mature market, personal-lines leaders are seeking to defend their positions by developing alternative ways of reaching customers, Technology in general, but also greater access to information, has created greater price transparency and more-demanding customers. Sophisticated insurers have taken advantage of information technology to target customers through price differentiation in what has traditionally been considered a commodity segment. As a result, they can comply with regulatory requirements to "take-all-comers", and remove undesirable accounts. Meanwhile, new entrants are trying to differentiate themselves as low-cost distributors. In addition, several monoline property writers have added auto to their product portfolio in efforts to diversify earnings and reduce volatility And, personal-lines insurers have controlled costs through better distribution and "managed care" for car repairs.

The personal lines segment reported disappointing underwriting results, with an estimated combined ratio of 106.0 for 1999, a 1.7-point deterioration from 1998. Personal auto results deteriorated for the second consecutive year; however, lower catastrophe losses and moderate price increases enabled the homeowners' combined ratio to remain relatively flat at 109.

Personal auto generated lackluster results, with a combined ratio of 102.8, aided by 3.5 points of prior-year reserve releases. This benefit is expected to decline further because of deterioration in accident-year underwriting results and eroding prior-year loss-reserve redundancies. Loss costs began to increase as higher severity was reported in the both the liability and the physical damage components of this line.

Increased bodily injury severity was driven by increased medical costs that outpaced managed-care savings. While several market leaders reduced prices during the year, personal auto liability rates became a sensitive political issue in many states such as New Jersey, keeping rates flat and liability premium flat for the year.

Growth in physical damage loss severity was driven by increased repair costs and higher insured values, offset by the impact of managed care in auto. Higher insured values are more common, an effect of the strong economy. On average, insureds own more cars for shorter periods. The widespread use of unibody car design and airbags, both effective in reducing medical costs, has made repairs more costly. Insurers have focused on managing these costs through prenegotiated repair agreements with body-shop networks and encouraging the use of after-market parts. However, the unfavorable verdict against State Farm over the use of after-market parts may limit that option.

Overall, premium growth in the personal auto line decreased to 2.6% in 1999. Slowing top-line growth is expected as market leaders reduce premium rates. However, strong economic conditions suggest that higher vehicle values, shorter ownership spans and more cars per family will enable personal auto premium to grow modestly.

Some rate relief strengthened the homeowners' line, but weather-related losses added 2.8 points to its combined ratio. Many market leaders have reduced their exposure to homeowners' catastrophes through better geographic spread and use of wind-based deductibles. Homeowners' volume increased by 8.4%, again driven by the strong economy. Overall home values are on the rise and insurers are emphasizing insurance-to-value in order to obtain the proper rate for the exposure.

Market Outlook: Several converging issues affect the market outlook for the personal lines sector. Those issues are the effects of financial-services convergence and the impact of technology as a means of creating multiple distribution channels and making operations more efficient. Best's rating outlook is mixed for the personal lines segment. We expect limited upgrades for insurers that recapitalize, address catastrophe issues and emerge as leaders in technology and distribution.

Commercial Lines

Most commercial insurers have entered the "pain phase". At the same time, advances in technology and the changing competitive landscape are creating additional pressures that have further compressed margins. The burden of excess capital, increased utilization of alternative-risk-transfer mechanisms, cost-reduction initiatives by risk managers and the entrance of new competitors--capital-market providers and reinsurers--have increased competition and kept prices low. Loss costs have also begun to rise again as severity has worsened in workers' compensation, commercial auto and medical malpractice lines. While merger and acquisition activity will continue to eliminate weaker players, the industry remains highly fragmented and pricing remains soft despite modest increases that began in the second half of 1999. A.M. Best expects a gradual price correction as negative cash flows become more widespread.

Reserve strengthening began in earnest during 1999. We estimate this segment will produce a combined ratio of 109.0, a 1.7-point deterioration from the prior year. Catastrophe losses in the commercial package line accounts for some of the deterioration but unfavorable loss development is having a greater impact. Specialty program writers and workers' compensation companies including Orion, Reliance, Fremont, Frontier, MMI, Superior National, Zenith, Acceptance and others reported major reserve charges during the year. Many charges were triggered by a lapse in control or underwriting discipline, combined with the availability of low-level and stop-loss reinsurance.

We expect loss development--which produced a favorable impact on this segment in prior years--to continue to deteriorate. The workers' compensation, medical malpractice and commercial package lines were the worst performers in this segment as continued pricing pressures led to further underwriting deterioration. A. M Best expects significant reserve strengthening to be reported for the fourth quarter of 1999 and in 2000. Thirteen of 20 market leaders are expected to record higher combined ratios in 1999.

Fortunately, there is some evidence of price firming in commercial lines, starting in the second half of 1999, particularly in the commercial auto and workers' compensation lines. However, few would argue that the market has turned. A.M. Best estimates that commercial growth will be less than 1% in 1999, but will rise to 2.1% in 2000.

Commercial auto writers face many market obstacles. Results have deteriorated significantly in recent years because of weaker underwriting discipline. Higher severity in liability and physical damage lines was driven by increased medical and repair costs, as well as higher cargo values, a result of the strong economy However, premium growth in this segment was driven by the physical-damage component, which rose nearly 5% as companies increased the minimum premium per truck in a fleet. Commercial auto liability premiums remain flat.

Workers' compensation writers have benefited from favorable loss-reserve development each year since 1994. This development began to slow in 1998 and A.M. Best believes that 1999 results will incorporate less than four points of this benefit, which will continue to slow over the next few years. Although insurers have been integrating managed-care techniques into workers' compensation claims management, the savings of managed care have varied. In 1998, several California health-care companies found savings more difficult to realize than expected, leading to poor results and adverse reserve development. Increased medical costs have also been a factor. The availability of low-level reinsurance continued to depress prices in 1998 and 1999 as some primary players lost their focus on gross results and cut prices to compete on reinsurance arbitrage. Although insurers in this line have reported pricing improvements in late 1999, premium volume was still down more than 5% for the year.

Medical malpractice results will show dramatic deterioration because of greatly reduced reserve redundancies. Former mono-state insurers have expanded across state lines and managed-care initiatives have forced physicians to consolidate or join larger groups. These competitive issues are expected to produce ultimate loss ratios in the 150% to 200% range. Claim severity is also up approximately 5% for the year due to trends in litigation. State caps on non-economic damages have been revised and income levels have generally risen, causing juries to increase their average award. Large-account business remains underpriced, while growth-oriented companies continue to aggressively compete for business. On the other hand, insurers serving small groups, single practitioners, specialists and primary care physician classes have reported some price increases.

We expect some deterioration in the general liability and CMP lines as competition in these lines remains strong, although we have seen indications of more moderate price decreases. A&E losses will add about 10 points to general liability segment's results in 1999 and 2000. In addition, new issues such as Y2K liability and remediation costs will emerge in 2000 and beyond.

Market Outlook: Our rating outlook is unfavorable for this segment, particularly for undifferentiated middle-market companies and companies that cannot demonstrate reserve stability and underwriting discipline. We are more optimistic about specialty commercial insurers. Difficult market conditions in this sector will limit rating upgrades.

Mergers & Acquisition: Aggressive price competition, expanded policy coverage, high expense levels and weakened reserves will accelerate consolidation in this segment. Financially distressed companies are at risk, while specialty segments such as medical malpractice are ripe for consolidation as evidenced by St. Paul's announced acquisition of MMI. Noncore books of business that fail to meet performance objectives will be jettisoned.

Alternative-Risk Market

Despite extremely soft market conditions, new capital emerged to fund alternatives to commercial insurance. Many new U.S.-sponsored single-parent and group captives were formed. Two states, Maine and Rhode Island, licensed their first captives in 1999. Other new captive domiciles emerged after long gestation periods, including Lloyd's of London. More agent-owned and small captives, or "rent-a-captive" formations have been registered, some in the form of protected-cell companies in Guernsey or segregated-portfolio companies in Cayman. The number of worldwide captives continues to grow unabated, particularly in Bermuda, Cayman and Vermont.

Consolidation among broker-managers continued. This has left two mega-managers, J&H Marsh & MeLennan and Aon, with management control of nearly one-third of the worldwide captive business. The merger of International Advisory Services into Mutual Risk Management had the most impact on the Bermuda market.

Through its newly acquired publication, the Captive Insurance Company Directory, A.M. Best estimates that worldwide premium volume devoted to alternative markets grew modestly in 1999. Since commercial insurance rates appear to have bottomed out in 1999, interest in captive arrangements will likely accelerate, should prices begin to increase.

Self-insured pools, which make up the other half of the alternative market and are predominantly focused on workers' compensation coverage, have seen minimal growth in the past few years. Private pools have faced the same competitive pressures as traditional workers' compensation writers.

Market Outlook: We expect captives will write more third-party business, especially employee benefits and personal lines coverage. A financial-strength rating has become an important marketing tool for insureds concerned about the background and financial security of these entities. Also, many companies are upgrading their captive facilities from financing vehicles to profit centers, and require a rating for internal as well as external benchmarking needs. Tate & Lyle and Western General are such single-parent captives that have diversified such that 70% of their revenues is derived from third-party business.

As captives evolve, we expect their roles will migrate from acting solely as a reinsurer to writing directly as well. To compete effectively direct-writing captives need validation in the marketplace.

Most captives are focusing on specialty business rather than traditional property/casualty lines. Generally these specialty lines do not require fronting arrangements with traditional carriers, thereby pushing captives into direct writing and the public eye.

Ratings on alternative-market entities have historically been clustered in the lower half of Best's Secure range (B+ to A++). Typically, a minimal spread of risk and lack of diversffication have suppressed their ratings. Over time, ratings should migrate upwards as alternative market entities successfully diversify their earnings.

Mergers & Acquisitions: As commercial insureds consolidate to become more efficient and effective, so will their captives. A recent example is the combination of British Petroleum and Amoco, in which several of their captives around the world are being consolidated into one super-captive with surplus that exceeds that of many regional domestic carriers.

Risk-retention groups and private pools also face competitive and financial pressures that are causing them to consider mergers and alliances to ensure their viability.

Reinsurance

Reinsurers are redefining their role in the global market and positioning themselves as well-capitalized financial-services organizations. In the past five years, a host of trends have thinned the ranks of reinsurers, increased the size and global nature of the survivors, trimmed profit margins, broadened the range of available products and increased the breadth of competitors. The pressure to maintain profitability in a tougher pricing environment is forcing companies to embrace technology as a means of expanding distribution, and to view service alternatives as a means to control costs and enhance efficiency.

In 1999, premium volume for the domestic reinsurance market rallied to show positive growth on the heels of weaker earnings. While premium rates declined through 1998, property losses and inadequately priced liability exposures led to loss reserve inadequacies early in the year. For 1999, this segment is expected to report a combined ratio of 111. This represents a 5.4-point deterioration from 1998. It's largely because of competitive pricing within this segment, which has resulted in a deterioration of current accident-year loss ratios and an erosion of prior-year loss-reserve redundancies. Catastrophes throughout the world, including hailstorms in Australia, wind storms in the United States, and earthquakes in Greece, Thrkey and Taiwan, contributed to these poor results, accounting for 9.1 points of the combined ratio.

Accident-year underwriting results have been steadily deteriorating for five years. In 1998 and 1999, prior-year reserve redundancies were used to prop up calendar-year reported results. A.M. Best believes that accident-year combined ratios will continue to rise as losses develop more fully and the effects of inadequate pricing are realized.

Losses from Y2K-related systems failures, as well as sue-and-labor claims in all-risk policies or preserve-and-protect claims from general liability policies will undoubtedly affect reinsurers' 2000 combined ratio. In addition, several primary companies lowered their net retentions in selected lines of business--most notably workers' compensation--because of inexpensive pricing. Many reinsurers are now unraveling these reinsurance treaties to better understand the full extent of their retained exposure.

Premium volume grew 4.1% in 1999. Finite reinsurance and other alternative risk-transfer business remain the strongest sources of growth for domestic property/casualty reinsurers. Nine of the 15 largest domestic reinsurers experienced premium growth, compared with only four in 1998. At renewal time, reinsurers noted some price firming, particularly in property lines. That has prompted an increased interest in multiyear coverages as primary companies sought to temper "shock" price increases. Many market leaders report that rate levels at July 1 renewals held or even increased in some lines. This trend appears to have advanced for the Jan. 1,2000 renewal season. In fact, rates in the primary commercial business, particularly property, auto and some liability lines, have also risen. More importantly, companies are beginning to walk away from business where they have not been able to maintain or increase rates. The contraction of capacity in the U.K. facultative reinsurance market--created in part by the exit of AIG's Lexington and AIU Re, New Cap Re and GIO Re--has also helped prices firm.

We expect surplus to decline 1.8% for the year. Premiums-to-surplus ratio of 0.3 (0.7 times excluding National Indemnity) remains extremely low. The decline in surplus in 1999 reflects the deterioration in underwriting results as well as depreciation in large stock holdings.

Market Outlook: Since capital strength is not an issue for this segment, reinsurers' ratings tend to be stratified based on their competitive-market position, product and service capabilities, and earnings stability. The world's 35 largest reinsurers handle roughly three-quarters of the world's reinsurance business. Given their dominant positions in the market, unquestioned financial security, and generally strong overall performance, these largest reinsurers also command A.M. Best's highest ratings. The gap between top-tier reinsurers and remaining market players will continue to widen as market leaders utilize their excess capacity to grow through acquisition.

Competitive market conditions will limit rating upgrades; however, flight-to-quality trends already have reduced the number of reinsurers. That has resulted in a more top-heavy rating distribution than the primary insurance market with 90% rated "Excellent" or "Superior." A.M. Best believes that there will be few rating changes in this sector.

Mergers & Acquisitions: The field of domestic reinsurers has shrunk by roughly two-thirds from a decade ago. Surviving reinsurers are extremely well-capitalized and produce good results. We believe the flight-to-quality movement is in its final stages in the reinsurance sector, with middle-market reinsurerss I most at risk of losing operating autonomy. This was demonstrated recently by Swiss Re's announced acquisition of Underwriters Re and Trenwick's completed merger with Chartwell and announced merger with LaSalle Re. Reinsurers continue to compensate for weak growth in mature markets by targeting other regions such as Asia and Latin America, which provide opportunities for further global expansion. In addition, they continue to strengthen their presence in emerging markets, often through joint ventures with local insurers.

The reinsurance industry is poised for rapid change over the next decade. Fewer reinsurers will survive this final consolidation phase. Those that lack tremendous financial flexibility, strategic and operating agility and innovative risk-management skills will fall short.

Rating Trends

In the next year, A.M. Best expects downgrades to outpace upgrades, while most ratings will be affirmed on the basis of insurers' excess capital positions. Intense competition and reduced profit margins will fuel more consolidation, particularly among companies rated Excellent or Very Good, or whose ratings are downgraded because of poor operating results and unstable reserve trends. These factors and Best's wait-and see posture has generally slowed the number of upgrades in the industry.

We expect some lower-rated companies to buck the negative-rating trends as they are acquired by stronger strategic buyers, or are able to recapitalize their balance sheets, reduce earnings volatility, and expand market positions profitably. Above-average performance and growth, as well as sustainable competitive advantages derived from innovative products, distribution, service, brand, and low-cost operations will generally drive rating upgrades among higher-rated insurers.

We believe consolidation will continue to thin out weaker and lower rated companies, particularly those that are rated within our Vuinerable category (B to D). Our rating distribution supports this view. The percentage of Secure-rated (B+ to A++) companies has increased gradually over the past few years, and now accounts for 89.6% of Best's comprehensive ratings coverage in the United States. "Secure" percentage will increase further as consumers become more discerning and aware of Best's ratings available on the Internet.

We believe flight-to-quality trends are beginning to take hold in most primary segments, driven by value-added agents, brokers, and financial service partners. Consolidation and flight-to-quality trends within the primary insurance marketplace is roughly five to seven years behind the reinsurance segment which saw its domestic ranks thinned by two-thirds over the past decade. After an extended shakeout period, we expect that the rating distribution of primary companies will improve and align more closely with the more "top-heavy" distribution shown for the reinsurance segment.

                     P/C Industry Financial Indicators
                                  Actual                         Estimate
                                                                 Original
                                    1994  1995  1996  1997  1998     1999
Change in NPW(%)                     3.7   3.6   3.4   2.9   1.8      1.4
Change in Surplus(%)                 6.1  19.0  11.1  20.7   8.1      0.3
Combined Ratio(Reported)           108.4 106.4 105.8 101.6 105.6    106.8
Less: Catastrophe Losses             6.4   3.3   2.8   1.0   3.6      3.0
Less: A&E Losses                     1.9   4.1   2.1   0.7   1.0      0.5
Combined Ratio(Normalized)         100.1  99.0 100.9  99.9 101.0    103.3
AY Combined Ratio(Normalized) [*]  100.8 100.4 103.1 102.3 103.5    105.9
Change in Net Inv. income (%)        3.2   9.3   3.1   9.3 (3.8)    (3.1)
Investment Yield (%)                 5.7   5.9   5.6   5.8   5.2      4.7
Pretax Return on NPE (%)             4.7   7.7   7.9  13.1   8.4      6.3
After-tax Return on Surplus (%)      5.8   9.7  10.1  13.1   9.6      5.7
NPW to Surplus                       1.3   1.1   1.1   0.9   0.8      0.8
                                  Revised
                                     1999  2000
Change in NPW(%)                      2.3   3.7
Change in Surplus(%)                  0.5  (2.4)
Combined Ratio(Reported)            107.5 108.5
Less: Catastrophe Losses              3.2   3.0
Less: A&E Losses                      1.0   1.0
Combined Ratio(Normalized)          103.3 104.5
AY Combined Ratio(Normalized) [*]   104.9 105.8
Change in Net Inv. income (%)       (2.3) (1.3)
Investment Yield (%)                  4.9   4.8
Pretax Return on NPE (%)              5.5   3.9
After-tax Return on Surplus (%)       7.0   5.0
NPW to Surplus                        0.9   0.9
(*.)A.M. Best's estimate of reported accident year combined
ratios through 1999, excluding catastrophes and A&E.
                    Industry Surplus Trends ($billions)
                                Actual                      Estimate
                                  1995   1996   1997   1998     1999
Beginning Balance Jan. 1        $193.3 $230.0 $255.5 $308.5   $333.3
Net Underwriting Loss           (17.7) (16.7)  (5.8) (16.8)   (22.6)
Net Investment Income             36.8   38.0   41.5   39.9     39.0
Other Income/(Expense)             0.3  (0.4)  (0.2)  (0.2)    (0.9)
  Pretax Operating Income         19.5   20.8   35.5   23.4     15.5
Realized Capital Gains             6.0    9.2   10.8   18.0     15.0
Federal Income Taxes             (4.9)  (5.6)  (9.5) (10.6)    (7.0)
  Net Income                      20.6   24.4   36.8   30.8     23.5
Unrealized Capital Gains          21.7   13.3   29.0   10.2      1.0 [*]
Contributed Capital                6.9    3.6    4.4    3.8    (1.0)
Stockholder Dividends            (8.1)  (8.7) (11.3) (13.6)   (15.0)
Other Changes                    (4.4)  (7.1)  (5.9)  (6.3)    (6.8)
  Total Surplus Change            36.7   25.5   53.0   24.8      1.7
Ending Balance Dec. 31          $230.0 $255.5 $308.5 $333.3   $335.0
Key Surplus Indicators
Surplus Growth(%)                 19.0   11.1   20.7    8.1      0.5
NPW to Surplus                     1.1    1.1    0.9    0.8      0.9
ROE % (Incl. Realized Gains)       9.7   10.1   13.1    9.6      7.0
ROE % (Incl. All Capital Gains)   20.0   15.5   23.3   12.8      7.3
                                  2000
Beginning Balance Jan. 1        $335.0
Net Underwriting Loss           (26.6)
Net Investment Income             38.5
Other Income/(Expense)           (0.4)
  Pretax Operating Income         11.5
Realized Capital Gains            10.0
Federal Income Taxes             (5.0)
  Net income                      16.5
Unrealized Capital Gains         (7.0)
Contributed Capital                1.0
Stockholder Dividends           (12.0)
Other Changes                    (6.5)
  Total Surplus Change           (8.0)
Ending Balance Dec. 31          $327.0
Key Surplus Indicators
Surplus Growth(%)                (2.8)
NPW to Surplus                     0.9
ROE % (Incl. Realized Gains)       5.0
ROE % (Incl. All Capital Gains)    2.9
(*.)1999 based on stock market level in early Dec. 1999.
                     P/C Segment Financial Indicators
                                 Personal Lines
                                      1998       1999   2000
Change in NPW (%)                     3.6         3.2    4.6
Change in Surplus (%)                 9.4         2.7  (3.1)
Combined Ratio                      104.3       106.0  107.0
Change in Net Inv.Income (%)        (6.2)       (1.9)  (1.2)
Investment Yield                      5.1         4.8    4.6
After-tax Return on Surplus (%)       8.4         6.5    3.8
Pretax Operating Income ($ bil.)      8.9         5.5    3.0
Capital Gains ($ bil.)               13.5         9.1    1.0
NPW to Surplus (Ratio)                1.1         1.1    1.1
(excl. National Indemnity)
                                 Commercial Lines             Reinsurance
                                      1998         1999  2000    1998
Change in NPW (%)                      0.1          0.7   2.1   (3.9)
Change in Surplus (%)                  8.2        (0.6) (2.1)     3.4
Combined Ratio                       107.3        109.0 110.5   105.6
Change in Net Inv. Income (%)        (3.1)        (2.4) (1.3)     3.6
Investment Yield                       5.6          5.4   5.3     4.2
After-tax Return on Surplus (%)       11.0          8.7   6.6     9.6
Pretax Operating Income ($ bil.)      11.6          9.0   6.8     3.3
Capital Gains ($ bil.)                 9.9          5.5   1.0     4.4
NPW to Surplus (Ratio)                 0.9          0.9   0.9     0.3
(excl. National Indemnity)                                         0.6
                                  1999   2000
Change in NPW (%)                  4.1    6.0
Change in Surplus (%)            (1.8)  (0.8)
Combined Ratio                   111.0  109.0
Change in Net Inv. Income (%)    (3.2)  (1.4)
Investment Yield                   3.9    3.9
After-tax Return on Surplus (%)    4.9    4.6
Pretax Operating Income ($ bil.)   1.3    2.0
Capital Gains ($ bil.)             1.1    0.5
NPW to Surplus (Ratio)             0.3    0.3
(excl. National Indemnity)         0.7    0.7
                        Underwriting Trends By-line
                              % of   % Chg Combined Ratio
                              1999  in NPW
Lines of Business              NPW in 1999       1994      1995  1996  1997
Personal Auto                 41.8     2.6      101.3     101.3 101.0  99.5
Homeowners                    10.9     8.4      118.4     112.7 121.7 101.0
Workers' Compensation          7.6   (5.6)      101.4      97.0  99.7 100.7
Commercial Package             6.7     1.4      118.8     112.5 118.3 111.1
Commercial Auto                6.4     1.3      104.7     108.1 110.2 110.9
General & Products Liability   6.2   (5.6)      125.5     143.6 123.5 110.6
Fire & Allied Lines            3.3     5.5      166.4     105.7  96.4  93.1
Inland Marine                  2.2    10.4      100.8      91.9  97.3  95.7
Medical Malpractice            1.8   (1.7)       97.6      99.7 106.0 107.9
All Other Lines               13.2     4.8      102.9     103.1  98.9  97.3
Total All Lines              100.0     2.3      108.4     106.4 105.8 101.6
                                    Est.  Est.
Lines of Business             1998  1999  2000
PersonalAuto                 101.1 102.8 104.0
Homeowners                   109.4 109.0 109.0
Workers' Compensation        107.6 113.5 117.0
Commercial Package           119.7 123.0 123.0
Commercial Auto              113.8 115.4 114.0
General & Products Liability 114.5 118.0 119.0
Fire & Allied Lines          106.9 101.3 102.0
Inland Marine                 97.1  95.5  96.0
Medical Malpractice          115.7 124.5 130.0
All Other Lines               99.2 101.5 102.5
Total All Lines              105.6 107.5 108.5
                       Industry Underwriting Summary
                     NPW                       P/H
              NPW Growth  Loss   LAE Expense  Div. Combined U/W Loss
Year      ($bil.)      % Ratio Ratio   Ratio Ratio    Ratio  ($bil.)
1994        250.7    3.8  68.1  13.0    26.0   1.3    108.4   (22.4)
1995        259.8    3.6  65.7  13.2    26.1   1.4    106.4   (17.7)
1996        268.7    3.4  65.4  12.9    26.3   1.1    105.8   (16.7)
1997        276.6    2.8  60.3  12.5    27.1   1.7    101.6    (5.8)
1998        281.6    1.8  63.1  13.1    27.6   1.7    105.6   (16.6)
Est. 1999   288.0    2.3  64.8  13.5    28.1   1.1    107.5   (22.6)
Est. 2000   298.7    3.7  65.4  13.7    28.3   1.1    108.5   (26.6)
1995-1999 1,347.7   14.9  63.8  13.2    27.5   1.3    105.9   (88.4)
                    P/C Industry Rating Distribution (%)
                         Primary
Rating Category          Insurers Reinsurers
Superior (A++, A+)          11        39
Excellent (A, A-)           50        51
Very Good (B++, B+)         29        10
Secure (A++ through B+)     90       100
Vulnerable (B through D)    10        -
Total Ratings Opinions     100       100