Last year's most notable transactions represented sales by a highly motivated seller, as General Electric sold its medical malpractice operations to Berkshire Hathaway and its reinsurance operations to Swiss Re.

While there may be a modest increase in M&A in 2006, Fitch Ratings does not anticipate a return to the merger frenzy experienced in the market in the late 1990s, and does not believe that any one material transaction would create a new trend by adding pressure on other insurers to find merger partners. Reasons for Fitch's view include the following:

o Favorable underlying profitability and capital trends that results in fewer sellers.

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

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

The p-c insurance market exhibited strong resiliency in 2005 as the market posted only a modest underwriting loss despite enduring the worst hurricane season on record in terms of insured losses.

In looking at accident-year results by business line, pricing remains adequate in many areas despite recent trends of declining insurance rates.

These market conditions, coupled with significant improvement in balance sheets and capital positions over the last two years, are encouraging individual insurers to continue to develop their internal business plans and not seek acquisition partners.

Another factor that is inhibiting acquisition activity at the lower end of the market is the greater access to capital that midsized insurers have today with the development of the insurance collateralized debt obligation (CDO) market. Capital constrained organizations that may have been forced to merge in the past now are flush with capital to pursue independent growth opportunities.

Small insurers with as little as $25 million in surplus that previously had limited access to capital markets are now able to issue long maturity debt and trust preferred securities in increments of as little as $3-to-$5 million through pooled CDO transactions. Fitch estimates that insurers have issued approximately $5 billion of securities in CDO pools over the last four years. (For more on CDOs, see NU, July 21, 2003, page 19 and related graphic, “More on CDOs.”)

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

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

Regarding diversification efforts, there is also a greater appreciation today that insurers are better off focusing on underwriting in segments where they have appropriate skill and expertise, and that it is difficult to compete and succeed in new product segments. Unfortunately, history reveals that institutional memories are short, and sentiment is likely to revert to prior form at some point.

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

Most acquisitions in this period were characterized by overpayment as post-purchase reserve deficiencies materialized, particularly in longer-tailed casualty lines. Three notable examples of this trend were Berkshire Hathaway's acquisition of General Reinsurance Corp., XL Capital's purchase of NAC Re, and CNA Financial's purchase of Continental Insurance.

While the industry's reserve position has improved considerably in the last few years, and recent accident years are generally exhibiting favorable development trends, risks related to inadequate reserves are inherent to any p-c insurer acquisition.

Execution risks are also inherent to p-c acquisitions as effectively combining disparate operations requires tremendous efforts and anticipated cost savings and business synergies do not always materialize. Furthermore, integration efforts may distract management focus from core underwriting operations.

For these reasons, Fitch believes that a significant increase in p-c insurance company merger and acquisition activity is not imminent.

Given the industry's past track record, and the innate risks related to acquisitions, companies whose growth strategies emphasize acquisitions will continue to be viewed more cautiously in the rating process.

More On CDOs

Back in July 2003, Fitch Senior Director James Auden first explained collateralized debt obligations to NU readers in his article, “CDOs: A New Source Of Insurer Capital,” noting that the securities backed by insurance company senior debt, surplus notes and trust preferred securities created unique opportunities for smaller 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 whose rating and risk are a function of their priority of payment.

o Various asset classes have been used across many industries to create CDOs including mortgage-backed securities, bonds, bank loans, trust preferred securities (and surplus notes for mutual insurers).

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

o Surplus notes are debt securities that regulators allow insurers, typically mutuals, to issue at the insurance company level. These obligations are treated as surplus for regulatory and the National Association of Insurance Commissioners risk-based-capital purposes, and as debt under Generally Accepted Accounting Principles accounting.