Seeking Their Fortune.

Global financial-services firms with their ears to the ground will cater to fast-moving, small commercial clients.

Last year seemed like deja vu for property/casualty insurers. Major factors responsible for the industry's performance in 1998 were essentially the same in 1999: slow premium growth, high catastrophe losses and declining investment income--all this amid intense, competitive pressures, globalization, growth in information technology and continued consolidation.

For a better perspective on this landscape, Best's Review turned to two experts at Ernst & Young's financial-services practice, New York. Peter R. Porrino, national director of insurance industry services, and Beth E. Morrow, senior industry analyst, national insurance group, commented in early November, before President Clinton signed the financial-services reform legislation.

Q. How would you characterize the health of the property/casualty industry during 1999 and what does it portend for the future?

Morrow: The health of the property/casualty industry is the result of trends that have been going on for 30 years and not really short-term events. What we're expecting to emerge in the property/casualty industry will also take time to emerge because the types of things going on are changes in the character of demand for property/casualty insurance in the United States. Things like overcapacity in the property/casualty insurance industry are not going to be fixed overnight and the time frame for them doesn't really change over a one-quarter period.

But this is a really bad time for the industry. A lot of equity investors are suggesting that investors in the property/casualty industry stick to very highly specialized firms that are not big in the property/casualty commercial markets. Even personal lines have been down this year.

Porrino: Reserve releases, which may be the backbone of the property and casualty operating profitability the last couple [of] years, seem to be pretty much capped out. There's going to be a lot of pressure on earnings, on [returns on equity], and the fantastic equity markets and even debt markets are only going to make those numbers look worse, not better. As capital keeps increasing, there's going to be more pressure on justifying the capital that's out there. It's going to be tough to turn in stellar returns.

Q. What about the changes in the character of demand for property/ casualty?

Morrow: That's a very long-term trend. The nature of business in the United States has been changing. For one thing, business is global. There are globalization pressures in the insurance industry that are having an effect on an industry as focused domestically as the United States property/casualty industry, for example, or the life insurance industry, for that matter. The state regulatory system perpetuates that focus. State regulation is inefficient for companies that want to do business in the United States and demands significant investment in administrative and legal costs for licensing and product authorizations. And the difficulties for domestically focused businesses--especially small ones without a deep "bench"--to expand globally are also great. So, when you have a sort of conflict between the regulatory framework--which has kept the industry highly fragmented relative to insurers in other countries--too much capital, and pressures of globalizing businesses that are the industry's customers, it ta kes a longer time for insurers to respond to the changes in demand than for an industry where regulation is more centralized or less of a nuisance. And I think you're seeing that in the U.S. property/casualty industry.

Porrino: Another hypothesis is if you look at the U.S. economy, you see two shifts. It's obvious we've seen a shift from a manufacturing to a service economy, that clearly there is less need for certain types of insurance. If you measure gross national product, more of GNP is composed of service industries today. People tend to look at growth in GNP as a proxy for growth in insurance, but I'm not sure that's exactly appropriate. We believe that as there are more and more smaller companies becoming integral parts of the economy, different insurance-buying habits are an unavoidable result.

Morrow: Also, if you look at the trend toward human capital becoming the assets of a company, think about what kind of insurance you get to insure human capital: You get health and life insurance, you get disability insurance. That's not going to be reflected in the demand in the property/casualty industry.

Q. So despite this great wave of consolidation, you're seeing lots of individual activity out there?

Morrow: There'll be a difference in the way that business is carried on. Business is not going to be carried on as much by the kinds of companies that used to have 20,000 employees. There will be companies with 50,000 employees and companies with 10. That middle range is going to be a little different. The re-engineering of U.S. industry put out of work a number of white-collar employees during the early '90s and late '80s. Yet we have record employment now. A lot of them switched to working for themselves.

There's a real change in the dynamic of where people go to work and what they're working at doing. And that, I think, is contributing to changes in the nature of insurance demand and will still be a factor in the consolidation of the major large players, which will continue. There is also the increased productivity which has resulted from the technological revolution in information and communications, which makes much of the existing capacity less necessary.

Porrino: Why do these blockbuster mergers happen? Let's take Citi-corp's. What is the core cause of that merger? Is it to have more products? Is it to have more distribution? Is it to have a global distribution for Salomon Smith Barney and Travelers? It's probably more of the latter than anything else, and I'm not sure that would be the common sentiment out there.

Morrow: The reason it was such big news was because this was an insurance company buying a bank, even though people characterize it as a bank buying an insurance company. In fact, the insurance part of the transaction is not really the most significant aspect of the attraction of the two companies and probably won't have as much significance in the ultimate outcome of the merger as the securities business of Travelers. What you really had was a big product manufacturing capacity in the investment banks for wholesale products and in the insurance companies for more retail-oriented products. You had Citibank's global distribution capabilities--fairly unique on the retail side--and Citibank didn't have an investment bank or sizable asset-management business. It was one of the big commercial banks that had just never developed the same kind of capital markets production room, for example, in M&A or on the equities side like J.P. Morgan had attempted to do. So it was a perfect match.

Porrino: In the property/casualty industry, it's harder to drive consolidation sometimes because of a couple of factors that differ from the life insurance or banking sectors. One is greater balance sheet risk vs. [that of] a life company or a bank. Also, there are less obvious cost savings when you combine two P/C companies as when you combine two banks, or even two life companies--there is a lower proportion of fixed costs in the expense base. The P/C consolidation, although we clearly have an overcapitalization, is not as clear-cut to me as in other sectors.

Q. Will we see more foreign interests, especially Europeans, investing in the American insurance market?

Porrino: Look at what's happened with Aegon's purchase of Transamerica, ING Group's purchases and Fortis Group's purchase of American Bankers. This year has demonstrated a resurgence of European involvement over here.

Morrow: You have to look at the much more concentrated financial sector over in Europe, especially post-European monetary convergence. If you look at the size of financial institutions in Europe and you look at what they are able to buy over here compared to the regulatory and financial barriers to U.S. consolidation, you get some idea of how likely more European purchases are to become. Wait until the demutualizations on the life side happen and until the period that protects them is over. You'll see the Europeans swooping over here to buy brand names. That will be the beginning of the consolidation of the U.S. insurance sector in a much bigger way.

Q. What are the greatest challenges facing the property/casualty industry?

Porrino: The last five, 10 years have really seen a dramatic reduction in the inflationary claim cycle that we've had, and that has driven huge reserve redundancies. One of the great challenges now is predicting which way that trend is going to go, and I certainly can't do that. But if inflation generally--and claims inflation specifically--comes back with much vengeance, that will be a significant challenge over the next few years.

Morrow: One challenge is to think longer term. A lot of these companies focus on quarter-to-quarter profits and year-to-year profits, in some ways encouraged by the stock market. But I haven't seen a huge amount of strategic planning going on. Reinsurance companies may have a better view of this than other insurers.

U.S. companies need to take a longer and broader view in order to understand their own position vs. competitors in both capital markets and alternative markets. Companies also need to get the discipline of a strategic planning exercise along with internal risk management--and to take those to heart.

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