Insurance industry observers were surprised recently by apage-one Wall Street Journal article describing a rumored mergerbetween Zurich Financial Services and St. Paul Travelers Corp.

This would have been a blockbuster deal, representing thecombination of the fourth and fifth largest property-casualtyinsurers in the United States based on net written premium, and theuncommon union of a European and a U.S.-based insurer.

Both organizations quickly swept aside these notions and therehas been no further information on the matter.

However, this story has raised questions as to whether the p-cinsurance market, which remains highly fragmented and whose revenueconcentration has remained materially unchanged in recent years, isin line for an increase in merger and acquisition activity. Suchactivity has been modest in recent years, and 2005 was noexception.

Last year's most notable transactions represented sales by ahighly motivated seller, as General Electric sold its medicalmalpractice operations to Berkshire Hathaway and its reinsuranceoperations to Swiss Re.

While there may be a modest increase in M&A in 2006, FitchRatings does not anticipate a return to the merger frenzyexperienced in the market in the late 1990s, and does not believethat any one material transaction would create a new trend byadding pressure on other insurers to find merger partners. Reasonsfor Fitch's view include the following:

o Favorable underlying profitability and capital trends thatresults in fewer sellers.

o Insurers are facing less pressure to grow the top line and todiversify.

o There is less strategic interest in M&A due to pastdisappointments.

The p-c insurance market exhibited strong resiliency in 2005 asthe market posted only a modest underwriting loss despite enduringthe worst hurricane season on record in terms of insuredlosses.

In looking at accident-year results by business line, pricingremains adequate in many areas despite recent trends of declininginsurance rates.

These market conditions, coupled with significant improvement inbalance sheets and capital positions over the last two years, areencouraging individual insurers to continue to develop theirinternal business plans and not seek acquisition partners.

Another factor that is inhibiting acquisition activity at thelower end of the market is the greater access to capital thatmidsized insurers have today with the development of the insurancecollateralized debt obligation (CDO) market. Capital constrainedorganizations that may have been forced to merge in the past noware flush with capital to pursue independent growthopportunities.

Small insurers with as little as $25 million in surplus thatpreviously had limited access to capital markets are now able toissue long maturity debt and trust preferred securities inincrements of as little as $3-to-$5 million through pooled CDOtransactions. Fitch estimates that insurers have issuedapproximately $5 billion of securities in CDO pools over the lastfour years. (For more on CDOs, see NU, July 21, 2003, page 19 andrelated graphic, “More on CDOs.”)

A primary catalyst behind the merger wave of the late 1990s wasa demand for better revenue growth and diversification ofoperations and earnings from equity analysts, investors and otherconstituencies. While we are again in a period of slower premiumgrowth, pressure for top-line growth is not yet evident. For thetime being, the market appreciates that underwriting profits aremore important than growth, and rapidly expanding premium revenuein a softening price environment is not prudent.

However, this attitude may change as competitive pricingpressure rises and underwriting profit opportunities diminish.

Regarding diversification efforts, there is also a greaterappreciation today that insurers are better off focusing onunderwriting in segments where they have appropriate skill andexpertise, and that it is difficult to compete and succeed in newproduct segments. Unfortunately, history reveals that institutionalmemories are short, and sentiment is likely to revert to prior format some point.

The greatest inhibitor to p-c merger activity today is the poortrack record exhibited by the acquisitions completed in the late1990s. Given the difficulty in estimating loss reserve liabilities,insurance company sellers have significant information advantagesin valuing an organization relative to buyers. The late 1990srepresented a period of rampant underpricing, unexpected sharp losscost growth and chronic underreserving.

Most acquisitions in this period were characterized byoverpayment as post-purchase reserve deficiencies materialized,particularly in longer-tailed casualty lines. Three notableexamples of this trend were Berkshire Hathaway's acquisition ofGeneral Reinsurance Corp., XL Capital's purchase of NAC Re, and CNAFinancial's purchase of Continental Insurance.

While the industry's reserve position has improved considerablyin the last few years, and recent accident years are generallyexhibiting favorable development trends, risks related toinadequate reserves are inherent to any p-c insureracquisition.

Execution risks are also inherent to p-c acquisitions aseffectively combining disparate operations requires tremendousefforts and anticipated cost savings and business synergies do notalways materialize. Furthermore, integration efforts may distractmanagement focus from core underwriting operations.

For these reasons, Fitch believes that a significant increase inp-c insurance company merger and acquisition activity is notimminent.

Given the industry's past track record, and the innate risksrelated to acquisitions, companies whose growth strategiesemphasize acquisitions will continue to be viewed more cautiouslyin the rating process.

More On CDOs

Back in July 2003, Fitch Senior Director James Auden firstexplained collateralized debt obligations to NU readers in hisarticle, “CDOs: A New Source Of Insurer Capital,” noting that thesecurities backed by insurance company senior debt, surplus notesand trust preferred securities created unique opportunities forsmaller and mutual insurers to raise new capital.

o CDOs are structured securities that pool collateral (debt)from a number of issuers.

o The pool of funds is organized into a series of classes whoserating and risk are a function of their priority of payment.

o Various asset classes have been used across many industries tocreate CDOs including mortgage-backed securities, bonds, bankloans, trust preferred securities (and surplus notes for mutualinsurers).

o Trust preferreds are attractive for insurers, since ratingagencies give considerable equity credit to them due to theirhybrid nature. The hybrid nature is illustrated by a trustpreferred with a maturity of 30 years or more, and the ability ofthe issuer to defer interest payments.

o Surplus notes are debt securities that regulators allowinsurers, typically mutuals, to issue at the insurance companylevel. These obligations are treated as surplus for regulatory andthe National Association of Insurance Commissionersrisk-based-capital purposes, and as debt under Generally AcceptedAccounting Principles accounting.