Taking Strides.

Munich Re dominates reinsurance-but it keeps one foot in the primary side of the business.

While much of the reinsurance industry has been waiting for underwriting profits to return, Munich Re has gone looking for them, and its travels have taken it places few of its peers have dared to go.

A look at Munich Re's income statements can be startling. The most striking feature is that the world's largest reinsurer has a nearly equal amount of primary insurance premiums. Quietly Munich Re has become a force in direct property/casualty, life and health insurance, with strong positions in Germany and designs on the rest of Europe. Other companies have discovered the virtues of spreading risk across primary and reinsurance business, but Munich Re was uniquely positioned to start the journey from the reinsurance side.

Munich Re also has taken a fundamental back-office function of reinsurance--asset management--and turned its expertise into a marketable service, launching a separate subsidiary to manage the investment portfolios of Munich Re companies and third parties. The strategy of diversification has helped Munich Re to prosper through a relentlessly difficult time in its core business of reinsurance.

Still, Munich Re hasn't been known for making rapid changes, and the perception of a somewhat sleepy organization remains. "They profess to be changing, but to date it's been at a pretty slow pace," said Brian Shea, an analyst with Salomon Smith Barney in London.

Now, a new wave of change may be coming, as unexpectedly drastic changes are proposed in Germany's tax code--"a huge external shock to the system," Shea said. In December, the government proposed eliminating or sharply reducing the draconian capital gains taxes now imposed on publicly traded corporations, a move that would allow the country's big insurers and other companies to untangle vast and sometimes unprofitable cross-shareholdings with one another. Such a change would release the excess capital that investors have long criticized in German companies and create new currency--in both cash and reinvigorated stock prices--for acquisitions and other ventures.

No Surrender

Munich Re has worked to hedge its exposure to the competitive pressures in its core business, but it hasn't surrendered to reinsurance market forces. The company began rethinking its approach to the business even before the current soft market became entrenched. The period 1989-1992 brought some hard lessons for the insurance and reinsurance industries, and the instructors were named Hugo and Andrew--the hurricanes that laid bare the accumulation of property exposures in catastrophe-prone regions around the world. The year Andrew struck, 1992, was Munich Re's worst ever.

Those events suggested a new way to think about underwriting, one that Munich Re's peers first dismissed, then quietly adopted, said Karl Wittmann, Munich Re's board member in charge of North America, the United Kingdom and Asia/Australasia. Rather than looking solely at the claims history of a given risk, Munich Re began looking at the exposure.

"It doesn't matter what we call it, it is the way we underwrite," Wittmann said in a recent interview. The results have been good, even yielding underwriting profits in some years, Wittmann said.

Munich Re's reinsurance business, with a presence in more than 60 countries, is organized on one hand by region and on the other by line of business, said Rainer Kuppers, the company's chief spokesman. Regional managers mainly play a marketing role, staying in touch with client companies, while line managers primarily cultivate technical expertise. There is a continuous dialogue between the two.

In Turkey, for example, the regional managers saw a facultative market for major risks, but the line managers balked and prevailed. When a massive earthquake rocked northern Turkey last year, Munich Re's exposure was mitigated, though not eliminated.

Munich Re also strictly adheres to a philosophy that while a business segment from a client may be unprofitable, the overall relationship has to be profitable. Losses won't be tolerated indefinitely. "We cannot have, in the medium to long term, unprofitable client relationships," Wittmann said.

Still, this reinsurance market has battered even the best underwriters, and Munich Re is no exception. For the first six months of 1999, Munich Re's underwriting losses in reinsurance ballooned to 312 million euro (about $302.8 million) from 56 million euro a year earlier. That's where the risk spreading of Munich Re's aggressive foray into direct insurance comes into play. That business turned an underwriting profit of 337 million euro, up from 295 million euro a year earlier.

The offsetting primary results cushioned the blow of the reinsurance losses, and Munich Re turned a six-month profit of 316 million euro, down from 390 million euro the year before but better than it might have been.

Hedging Bets

The primary insurance operations collectively are known as the Ergo Insurance Group, and they include Victoria and Hamburg-Mannheimer, both of which write property/casualty and life business; D.A.S., Germany's leading legal-expenses insurer; and DKV, Europe's largest private health insurer with about 16% of the German market. Ergo is the country's No. 2 life insurer after Allianz. All of the Ergo units have subsidiaries and branches around Europe, although 90% of premiums come from Germany. But Kuppers said Ergo is "set to go into Euro land," with DKV and D.A.S., in particular, representing "a wonderful franchise to expand."

Nick Bunker, an analyst at HSBC Securities in London, said Munich Re's move into direct business was less of a stretch than it might appear, because Munich Re started in 1880 as what amounted to a pooling mechanism for small German insurers, writing traditional, proportional reinsurance coverage. It wasn't until after World War II that more exotic, excess-of-loss business entered the portfolio. Now, Bunker said, consolidation among primary insurers is cutting in the market for old-fashioned proportional business and tilting the mix toward more volatile types of reinsurance. Munich Re's move into primary business amounts to a pragmatic step in search of more stable results, he said,

One of the few comparable moves by a reinsurer was Swiss Reinsurance Co.'s venture into primary business in the 1980s, from which it later retreated, Bunker said.

"A lot of people were skeptical" of Munich Re's move toward primary business, said Shea from Salomon Smith Barney, but the strategy seems to be paying off. "The primary operations are helping to smooth out their earnings," he said.

Bunker, for one, finds the publicly traded Ergo a more attractive investment than its 58% owner. In an October report, Bunker cited Ergo's stable, low-risk book of business, strong valuation reserves in its life business diverse distribution system and prospects for restructuring under the group's chief executive, Lothar Meyer, who joined Ergo last year from Aachener und Munchener Beteiligungs AG. Bunker says Ergo is in a position to acquire weaker competitors in the life sector in Germany.

But the same report also cited some question marks surrounding Ergo. These included uncertainty over the tax treatment of traditional life insurance in Germany; weak underwriting results in German automobile business; unfinished business in reforming the country's health-care system; and the vagueness of plans for cross-border expansion, which is seen as critical to Ergo's continued growth.

Some of those clouds may be lifting, however. The prospects for a proposal to end favorable tax treatment of "endowment," or whole life, policies is uncertain; some observers think it may be watered down or deferred indefinitely. And cutting or eliminating capital gains taxes could energize the group as an acquirer.

Waiting for the Windfall

A separate report by Bunker on the tax change predicted that it would add as much as 50% to the net asset value per share of German insurers' stocks and free the companies to invest for greater returns, buy back shares and pursue mergers and acquisitions more easily. Munich Re hasn't been a voracious acquirer, but it has made some high-impact moves. Its 1996 purchase of American Re Corp., Princeton, NJ., was the biggest such transaction ever for a German company.

Major cross-shareholdings currently include the 25% stakes that Munich Re and Allianz AG Holding own in each other. Salomon's Shea called it a "large and expensive use of capital" that Munich Re's management historically hasn't viewed with the same level of concern as investors. Munich Re and Allianz, which started business in 1890, had the same founders.

Bunker wouldn't hazard a guess as to how Munich Re would treat the tax break, noting that the government's announcement in December caught the country's businesses by surprise. "Nobody expected anything like what we've actually seen," he said.

"The reaction was surprised but positive," Kuppers said of the government proposal that was quietly put forward just before Christmas. It is now embodied in legislation that might be enacted by this summer. Kuppers indicated that the change wouldn't lead to a wholesale liquidation of portfolios, as some of the holdings are part of strategic relationships. "Here, tax is not the decisive factor," he said.

Munich Re has a new structure in place to manage what could suddenly be a much more liquid portfolio with the proposed tax changes. Munich Ergo AssetManagement GmbH, known as MEAG, was launched in December and is now handling more than 200 billion marks (about $102.62 billion) of assets on behalf of the group's reinsurance and primary operations. It also will offer its services to third parties.

As the group's asset manager, MEAG will economize on a key back-office operation, giving the group more clout as an investor. While pooling the group's assets, it will attend to asset/liability management for each member's needs, seeking to have assets match liabilities for each currency in which the group does business. As a retail business, MEAG's services will include providing investment vehicles for life insurance payouts and managing pension funds.

In managing its diverse operations, Munich Re takes an approach similar to that of its close neighbor, Allianz, giving considerable autonomy to the various business units. "We do not interfere in the day-to-day transactions of the Ergo insurance companies...and we will not interfere in the day-to-day business of the asset-management company," Kuppers said. Even the far-flung reinsurance business operates with a high degree of independence.

Also like Allianz, Munich Re is reluctant to jettison well-established brands when it makes acquisitions. American Re and Geneva-based New Re, for example, have kept their identities. "Why destroy that?" Kuppers said. "They are successful."

                     Munich Re Group Financial Report
                    Summarized profit and loss account
                          (in millions of euros)
                          First    First
                       6 months 6 months
                        of 1999  of 1998
Gross premiums written   13,397   12,657
  Reinsurers              6,714    6,276
  Direct insurers         6,683    6,381
Underwriting result          25      239
  Reinsurers               -312      -56
  Direct insurers           337      295
Investment result         1,066      990
Operating result            809      748
Tax                        -493     -358
Profit for the year         316      390
Source: Company report