Rating agencies look at many factors in assigning ratings, of course, but their primary concern is protecting bondholders. Therefore, they want companies to have a diversified earnings stream so that difficulties in one business can be offset by positive trends elsewhere, mitigating concentration risk.

Diversification allows management to shift capital from a poorly performing business to a better-performing one, ensuring that bondholders will get paid. Other things being equal, a diversified insurer typically is assigned a higher rating than a highly-concentrated insurer, resulting in a lower debt cost of capital, and keeping borrowing costs low.

Equity investors, in contrast, seem to value specialization. They are looking for the best performance they can get, and the record shows that its difficult for companies to operate efficiently across many businesseswith companies like American International Group and GE being notable exceptions.

Investors preference for specialization also was highlighted in a separate Ernst & Young analysis of 50 large financial services companies representing all segments of the industry. Our research found that companies with a more specialized strategic focus generally are rewarded with higher market valuations.

Why? Because involvement in fewer businesses provides greater operating leverage and efficiency, encourages customer focus and better allocation of scarce resources, and promotes more effective risk management.

Specialization therefore leads to a lower cost of equity, creating a higher stock multiple that enables companies to make cost-effective acquisitions.

How can property-casualty insurers reconcile these conflicting viewpoints in planning their strategies?

Each company has to make its own decision about where it fits along the diversification/specialization spectrum. Some insurers may decide that the ability to move capital around among businesses is of paramount importance. Others may be comfortable with concentrating on a single business where they have demonstrated excellence over a long period.

The trade-off is between execution and flexibility, and between lower equity costs and lower debt costs.

That being said, it is also true that in the current environment, investors are exerting tremendous pressure on companies to perform. The slightest bad news can cause rapid evaporation of a companys stock price, putting its survival in jeopardy. And ultimately, the rating agencies, too, reward the better-performing companies.

These realities make it difficult for companies to downplay investors preferences as they weigh their strategic options.

Peter Porrino, [email protected], is national director of Insurance Industry Services for Ernst & Young LLP.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, July 22, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.