COUNTRY PROFILE: Germany

Germany's motor market is recovering and its earnings performance is improving. Standard & Poor's explains why it maintains a negative outlook on the German non-life insurance market.

Non-LIFE INSURANCE RATING OUTLOOK
Standard & Poor's is maintaining its negative outlook on the German property/casualty insurance industry through 2001.

This reflects the view that operating conditions will remain difficult, despite continued recovery in the German motor market and evidence of rates firming in the highly competitive industrial lines sector.

Persistent overcapacity combined with anaemic growth in insurance demand will make it difficult for companies to implement the necessary price increases and will hinder a swift uplift in underwriting results. At the same time, market participants face an investment environment characterised by low interest rates and weak stock markets, putting further pressure on bottom line results. In addition, the industry continues to go through significant structural changes, calling into question companies' long-term competitive muscle. As a result, Standard & Poor's expects downgrades to outnumber upgrades in 2001.

Rating distribution
Despite the difficult operating environment, the financial profile of the industry has been fairly stable, benefiting mainly from the sector's very strong capitalisation. As of 29 August, Standard & Poor's had financial strength ratings on 75 non-life primary insurers operating in Germany.

Of these, 12 were interactively rated, meaning Standard & Poor's regularly meets with senior management and is privy to confidential information. A review of Standard & Poor's insurer rating distribution indicates the strength of the market. The number of companies in the AAA band account for

3% of all definitive ratings, AA for 24%, A for 39%, BBB for 27%, BB for 6% and B for 1% (as of 29 August). Standard & Poor's insurer financial strength ratings can be found at: www.standardandpoors.com/RatingsActions/RatingsLists/Insurance/InsuranceStrengthRatings.html.

Factors affecting the outlook on the property/casualty sector
An improvement in the outlook on the property/casualty sector will remain dependent on a number of factors.

Among these are the sustainability of rate increases in the important motor insurance market and the ongoing commitment of industrial and commercial lines writers to re-underwrite their portfolio.

Given the poor performance and limited growth prospects of the German property/casualty insurance market, the industry's strategic focus has shifted rapidly towards life insurance. As market participants are preoccupied in preparing for the pension reform, a number of companies may lack the necessary discipline to restore the profitability of their property/casualty book, thereby overlooking significant earnings potential.

Restructuring will be the overriding challenge of the German property/casualty industry, as companies need to reposition themselves in a saturated and increasingly unstable competitive environment. The key drivers for future success in the German property/casualty market will be strong competencies in investment management and the ability to offer innovative underwriting and to create new products.

Through the European Monetary Union (EMU), insurers now have the opportunity to significantly broaden the range of investment products. Companies that fail to exploit these opportunities will inevitably fall behind their competitors. While price competition will remain a feature of the market, the industry has reached a stage where sustainable long-term profits can be achieved only through deepening market penetration, product innovation and investments in distribution and higher quality services. Companies with effective risk management in place will benefit from a significant competitive advantage, being able to exploit additional earnings opportunities in order to counter persistent margin pressures while avoiding assuming undue risks.

The outlook for earnings dependson companies' market discipline
Standard & Poor's expects technical results in the German property/casualty market to have stabilised in 2000, with further improvements in operating performance in 2001.

This applies in particular to companies writing predominantly personal lines business, reflecting mainly the increase in motor rates combined with a reducing claims burden.

Fortunes in the commercial lines sector, however, will remain dependent on industrial insurers' continued discipline to raise rates and to ultimately abandon business, where margins continue to be unacceptably thin.

So far the majority of insurers has failed to take advantage of their strong financial resources, competing predominantly on price in order to preserve their market position. A sustained recovery in the sector, however, will require market participants to substantially improve their earnings capabilities, both on the underwriting and asset management side.

In particular, the larger players have started to employ risk-based capital modeling to determine profitability by business units. While this trend should generally lead to a stronger focus on earnings rather than on revenue, it remains to be seen whether companies will ultimately be able to incorporate results in pricing.

Market conditions will force companies to venture into new product areas beyond their traditional markets, requiring strong underwriting skills. At the same time, companies will increasingly exploit all available investment alternatives to enhance revenue streams.

In defending their franchise, insurers' level of prudence and sophistication will vary widely, with companies inevitably being confronted with unforeseen challenges as a result of their relative inexperience in these new areas.

Strong risk controls and disciplined management will therefore be a key consideration of Standard & Poor's when assessing a company's financial strength.

Pressure to improve capital efficiency will increase
Capitalisation continues to be the sector's main strength. The industry's very strong capital resources mitigate some of Standard & Poor's concerns over earnings, providing companies with greater flexibility to undertake the strategic initiatives necessary to adapt to the rapidly changing market environment. However, the residing overcapacity has also strongly contributed to the intense competition and is expected to remain one of the main catalysts for continued pricing pressures.

Going forward, companies will find it increasingly difficult to maintain the current level of capital strength. Weaker earnings levels combined with insurers' increasing pursuit of longer-term capital efficiency are likely to result in declining capital positions. This trend will be further accelerated by rapidly declining asset value reserves as a result of the weak stock markets.

Faced with mounting shareholder pressure, companies seek to deploy capital as efficiently as possible in order to improve their return on equity. As a result, Standard & Poor's expects companies to become increasingly active in restructuring their capital base, including the issuance of hybrid capital and debt.

The effect on an individual company's rating will depend on its ability to achieve greater capital efficiency while maintaining a level of capital that comfortably allows it to fund future business growth and to cushion potential earnings volatilities as well as external shocks.

THE INSURANCE MARKET
The German primary non-life insurance market is the largest in Europe in terms of gross premium income, with 25.6% of the total premium provided by the EU member countries in 1999.

At year-end 2000, the Federal Supervisory Office for Insurance, or Bundesaufsichtsamt für das Versicherungswesen (BAV), supervised 254 property casualty insurers.

The top ten non-life insurers in Germany as measured by gross premium in 1999 are shown above.

The ranking of the biggest property/casualty insurers has been fairly constant since 1995. The AXA Colonia insurance group continues to be the only foreign-controlled group to have a property/casualty insurer in the top ten. With the top ten commanding a combined market share of only 38%, the concentration in the industry is still comparatively low by European standards.

Growth prospects remain subdued
Revenue dynamics of the industry - traditionally a strong growth market - have been weakening since 1996, with total premiums declining by 2.6% to DM93bn (£29.5bn) in 1999. In 2000, the German property/casualty market returned to modest growth, recording a rise in premium volume of 1.5%. Growth prospects, however, will remain subdued, with an estimated 2% increase in 2001.

The gradual recovery in the German economy has so far largely failed to ignite significant demand for non-life insurance.

Competitive pricing is likely to remain one of the prime measures in companies' battle to maintain market presence as too many overcapitalised players attempt to offer traditional products in a stagnating market.

Non-life premium distribution by line of business
In terms of portfolio composition, motor insurance remains the most important line of business, accounting for 40% of gross premiums written in 1999. Pricing pressures have been most explicit in this segment of the market, which is considered key to entering other lines of business. The trend towards an increasingly fine differentiation of rates, initiated in 1995, has now established itself, with preferred risk being granted significant discounts.

Between 1995 and 1999 premiums in third-party motor liability dropped by 10.6% to DM23.8bn (£7.5bn). Combined with a rapid increase in the claims burden this has led to a sharp deterioration in underwriting results since 1997. Rising claims amounts finally led to price increases in 1999 and 2000, which are expected to have started feeding through in 2000 underwriting results.

The downward trend in commercial lines business continued in 1999 and 2000, reflecting unabated price competition. Between 1994 and 1999 gross premiums written in fire insurance almost halved, plummeting to DM3.7 bn (£1.2bn) from DM7bn (£2.2bn).

Industrial fire has been one of the lines to suffer most from soft market conditions, with premiums reducing by a further 16% in 2000 to DM1.9bn, after a fall of 19% in 1999.

Although the claims burden in industrial fire is expected to have also reduced by 16% in 2000, underwriting results continue to remain deep in the red. In 1999, the industry reported a fire insurance loss ratio of close to 90% on a gross basis

Although the main industrial lines players have started to re-underwrite poorly performing business, price increases implemented to date are not seen as sufficient to bring rates back to adequate levels.

In certain cases, underwriters' desire to maintain high profile accounts will further hinder the market's recovery. Overcapacity, an increasingly sophisticated risk management of large corporate clients and the growing importance of alternative risk solutions will call into question whether industrial lines writers will be able to achieve and sustain the necessary rate increases in what has become a contracting market.

Distribution - a key success factor
Companies with well-focused distribution networks that allow them to target customer segments in a cost-efficient manner will enjoy a competitive edge over their peers.

Tied agents continue to dominate distribution, both in the German life and property/casualty sectors, generating an estimated 70% to 75% of the industry's total premium income.

Traditionally the dominance of tied agents has provided an efficient barrier against foreign players entering the German market. However, their prominent position has also rendered companies cautious in developing alternative distribution channels, carefully trying to avoid any potential ambiguities with their sales forces.

Notwithstanding this, a number of market players have started to push quite aggressively for other forms of distribution. As competition remains intense, market participants increasingly seek access to cost-effective distribution networks in order to increase the depth of customer penetration and gain access to different customer segments.

In particular, in light of the German pension reform companies aim to achieve additional sales power, allowing them to compete effectively for their share in the fiercely contested pension market.

Bancassurance (Allfinanz) - which is estimated to account for 20% of new life business generation in Germany - has once again become an industry focus, with the merger between Allianz, Germany's largest insurer and Dresdner Bank, the country's third-largest banking group, being the most prominent example.

As a result, Allianz will have exclusive access to Dresdner Bank's retail bank network and fund management subsidiary, Deutscher Investment Trust, which previously had also been selling the products of ERGO, Munich Re's primary insurance operation. Munich Re will also benefit from the transaction: as a result of a swap of shareholdings with Allianz, Munich Re will acquire Allianz's stake in HypoVereinsbank, Germany's second-biggest bank. As a consequence, ERGO will be able to sell its products exclusively through HypoVereinsbank. While the net effect of the bank's branch capacity controlled by Allianz and Munich Re will be broadly neutral, the insurer's ability to fully control their banking partners could boost productivity.

Two different bancassurance models are evolving as a result of the shareholdings swap. While Allianz and Dresdner Bank are set to become a fully integrated financial services supermarket, Munich Re and HypoVereinsbank have opted for a strategic union, underpinned by cross-shareholdings. Which combination will prove more successful, and whether the bancassurance model will generate the expected revenue synergies, remains to be seen.

The deal is expected to put further pressure on other financial services players. The Aachener und Münchener insurance group, which is 65% owned by Italian insurer Generali, has already begun strengthening its strategic ties with Commerzbank and could become another serious market contender.

In addition, there are already a number of well-established players in the market, such as R+V insurance group or the public law insurers, which have been historically associated with banks.

Direct marketing so far has had little success in Germany, accounting for less than 5% of total premium income. This mainly reflects the success of a number of well-established low cost providers, which through a tight reign on distribution costs benefit from an exceptionally low expense structure, thereby more than offsetting the cost advantage of direct marketers from lower distribution costs and selective risk underwriting.

While most German insurance companies have acknowledged the increasing importance of e-business, efforts to pursue the Internet as an alternative distribution method have been limited. So far the majority of initiatives focus on developing the internet as a tool to increase agent productivity and provide product information.

Only very few players, such as Mannheimer (through Mamax) and HuK Coburg (through HuK24), have started to develop the internet as an independent distribution channel. In general, companies with a dependable brand and flexible IT systems should have a competitive advantage against newly established internet insurers.

Standard & Poor's expects online sales to gain importance only gradually in Germany, with the main potential being in the area of commodity products, such as motor insurance. In particular, the life and health insurance sector, where products are more complex, it will be significantly more difficult to sell successfully via the internet. The strong position of tied agents in Germany will further hinder a speedy increase in sales via the internet. Nevertheless, the internet will certainly affect pricing and margins in the insurance industry, thereby further increasing competition.

Independent insurance brokers contribute about 15% of new business in Germany, mainly in the commercial lines sector.

Tax reform - the trigger for long-awaited market consolidation?
In 2000, the German government implemented a number of far-reaching tax changes, which are expected to significantly accelerate consolidation in the insurance industry.

Effective on 1 January, income taxes for joint stock companies in Germany declined from 40% for retained earnings and 30% for distributed earnings to 25% for all earnings. Effective 1 January 2002, if held for longer than one year, the capital gains tax on the sale of shareholdings in other joint stock com-panies will be abolished. The abolition of

capital gains tax will allow German insurers to unwind their traditionally grown cross-shareholdings in other German companies, and realise substantial tax-free gains. While this will enhance insurers' financial flexibility, companies are expected to redeploy a substantial part on acquisitions and restructuring initiatives. Moreover, shareholders are likely to expect to participatevia extraordinary dividend payments.

Competitive pressures have driven and will undoubtedly continue to drive consolidation in the German insurance sector. The elimination of capital gains taxes on German shareholdings is likely to further accelerate this trend, with the main beneficiaries likely to be the very large players, such as Allianz and Munich Re, which have already started to unwind part of their shareholdings.

German pension reform will be another catalyst for consolidation. Given the soft market conditions in property/casualty insurance, companies are increasingly eager to grow in the long-term savings and asset gathering market. Acquisitions and co-operations will be one alternative to safeguard market share. Profitability of the new pension product will be limited and will most likely have an additional adverse effect on alternative pensions products.

A low expense ratio will, therefore, be a key success factor in the fiercely contested pension market. The prospect of efficiency gains and the desire to reach critical mass, in particular in the asset management area, could result in acquisitions becoming even more appealing.

The potential for new business growth in the pension sector will be substantial, putting significant capital strain on companies' balance sheets. Weaker capitalised players with low financial flexibility will either have to restrict the generation of new business or may be forced to look for financially stronger partners. This trend will exert growing pressure on smaller players and speed up the differentiation process among market participants.

If properly managed, Standard & Poor's considers that consolidation may lead to improved financial strength for some players in the industry and a more sustainable level of competition. However, history has shown that mergers and acquisitions are certainly not a guarantee of success.

The key lies in implementation and management's capability to successfully leverage potential synergies.

GENERAL
Standard & Poor's sovereign ratings
Publication Date: 29 May 2001

Analysts:
Moritz Kraemer, London, 020 7847 7114 Konrad Reuss, London, 020 7847 7102

Credit rating:
AAA/Stable/A-1+

Rationale

The ratings on the Federal Republic of Germany are supported by: