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MUNICH, Germany-Munich Reinsurance Co., the world's largest reinsurer, is set to become Germany's second largest primary insurer.

By merging two Munich Re subsidiaries with Victoria Holding A.G., in which Munich Re has a minority shareholding, the reinsurer will become a majority shareholder in the new ERGO Insurance Group, with gross premiums written of 21 billion deutsche marks ($11.92 billion).

Upon completion of the merger, which requires no cash payment by Munich Re, primary insurance revenues will almost match the group's reinsurance revenues.

Munich Re's strategy of increasing its involvement in the primary market directly contrasts other major reinsurers such as Swiss Re, which in 1994 sold its primary insurance companies to Allianz A.G., Germany's largest insurer.

Munich Re's share price leapt 8% when the announcement was made on July 3. By last Thursday, the share price had reached 5,550 deutsche marks ($3,151), up from 4,890 deutsche marks ($2,777).

Munich Re said in a statement that strengthening its presence in the personal insurance market "will improve the risk balance in the Munich Re Group," providing additional security and stability for its reinsurance clients.

If approved by shareholders and regulators, the merger will leave "Munich Re prepared for further globalization and the ongoing consolidation process worldwide," said German insurance analyst Sylvia Wurl-Aydilec.

Ms. Wurl-Aydilec, who works with Dresdner Kleinwort Benson in Frankfurt, said, however, that the merger "surprised everyone because we were expecting Victoria would be bought by a foreign company. It was astonishing because Munich Re has always said that reinsurance would remain its core business."

She noted that the merger was logical if Munich Re wants to remain a primary underwriter.

Under the proposal, Hamburg-Mannheimer A.G., in which Munich Re has an 80% shareholding, and DKV A.G., in which Munich has a 60% shareholding, will be merged with Victoria Holding A.G., in which Munich Re has a 23.5% shareholding. Victoria shareholders will receive shares in the new group, to be named ERGO. According to provisional valuations, Munich Re will have a majority 55-60% shareholding in ERGO.

Victoria, which underwrites mainly personal lines insurance and small-business insurance, and its sister company DAS, which specializes in legal-assistance insurance, wrote gross premiums of 9 billion DM ($5.1 million) in 1996.

Hamburg, which specializes in life insurance, and Cologne-based DKV A.G., Germany's largest health insurer, had combined gross revenues of 12 billion deutsche marks ($6.8 billion) for 1996, according to Munich Re.

The inclusion of Victoria in Munich Re's group accounts will increase gross consolidated premiums written by some 8.4 billion DM ($4.8 billion) to about 46.6 billion DM ($26.5 billion), according to a statement from Munich Re.

"This means that reinsurance and direct insurance will contribute approximately equally to the group's premium" revenues, said the company.

ERGO will write about 8% of the overall German market but it will have a higher share in the areas in which it specializes, said a Munich Re spokesman.

For example, ERGO will have 17% of the German private health insurance market; 19% of the legal assistance market; 11% of the accident market; and 9% of the life insurance market, he said.

Together with Munich Re's other direct insurance shareholdings, the entire Munich group will hold about 10% of the German direct insurance market, analysts say.

Units of ERGO will continue to operate as separate insurers under their existing trading names. ERGO's board of management will include senior management of the individual companies, said the Munich Re spokesman. ERGO will be headed by Edgar Jannott, currently chief executive of Victoria.

In a market well known for its complex cross-shareholdings, Munich Re has held significant shareholdings in Hamburg and Victoria for decades. "We have simply regrouped our participations to form a new holding company," said the Munich Re spokesman.

The German insurance market "is in a process of consolidation. The market share of most leading companies in Germany is not as high as in other European markets," he noted.

Most stock analysts agree that the merger makes sense in the face of likely further consolidation in the German insurance market.

"It is a sensible transaction. Victoria was not a top tier company and this move catapults both companies up to No. 2 on a combined basis," said Tim Dawson, an insurance analyst with ABN-AMRO Hoare Govett in London.

"It is a natural fit the way the shareholdings are structured," he said, noting that the deal could not have come about without "a string of deals done in the last five years" building up Munich's shareholdings.

"This is the culmination of five years of restructuring and all the pieces in the jigsaw falling into place," he commented.

As a result, Mr. Dawson does not predict an immediate response by other companies to further consolidate.

However, in the long term, "as other knotty shareholdings (in the German market) start to unwind, such consolidation might take place," he said.

"With the trend in European insurance toward consolidation, it makes sense for Munich Re to increase its mass of operation if it is serious about direct business," said Jonathan Lawlor, an insurance analyst with HSBC James Capel in London.

The creation of ERGO allows Munich Re to maximize its yield from Victoria and Hamburg, he noted.

The German market is the most fragmented market in Europe and is likely to consolidate further, said Mr. Lawlor.

The creation of ERGO likely will force other German insurers to look for partners or decide to focus as niche players, said Ms. Wurl-Aydilec.

One company German insurance analysts are watching closely is AMB Aachener & Muenchener Beteiligungs, which will be pushed out of its No. 2 spot in German insurance rankings to No. 3.

Paris-based Assurances Generales de France has a 33.5% stake in Aachener but is unlikely to be able to increase that further, said Ms. Wurl-Aydilec. The two companies, meanwhile, have a standstill agreement that AGF will not sell its stake before 1999 without Aachener's agreement, she added.

Another point of interest for observers is the long standing relationship between Munich Re and Allianz. Each has a 25% cross shareholding in the other. As Germany's largest insurer, Allianz also is Munich Re's largest reinsurance customer. Now ERGO will be Allianz' largest domestic insurance competitor.

"There has been a sea change in the relationship between the two companies. They are now each other's major competitor," Mr. Dawson said.

"I don't think anything will happen too quickly" to change their shareholdings, he said, adding, however, that in five years such a cross-share arrangement will be unlikely.

Mr. Lawlor does not see the creation of ERGO as "a prelude of competition between Munich Re and Allianz. Allianz still is Munich Re's

primary reinsurance customer. It is inconceivable that Munich would act against Allianz," he said.