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DEAL STRENGTHENS ZURICH

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LONDON-Zurich Insurance Group's drive to expand its financial services in the United States is seen as the catalyst for its merger with the British American Financial Services unit of B.A.T Industries P.L.C.

The new Zurich-based entity will be called Zurich Financial Services Group and will wholly own Zurich's existing insurance and reinsurance companies and asset management units, as well as B.A.T's insurance and financial services operations.

The ZF Group is not expected to conduct business as a consolidated entity before late 1998, though, because of the time needed to obtain approval from regulators, including the 29 state regulators where BAFS' principal U.S. insurance unit-Farmers Group Inc.-operates.

Zurich shareholders will own 55% of ZF Group and B.A.T will hold 45%, with ZF Group paying B.A.T 500 million pounds ($811.7 million) in cash and assuming 800 million pounds ($1.3 billion) of debt for the BAFS operation.

The two parties say that ZF Group will be one of the largest insurance and asset management companies in the world, with gross premium volume of $40 billion, including reinsurance, and $341.8 billion in assets under management, based on a pro forma combination of the two companies' 1996 figures.

But the primary motivation behind the merger is not to become larger but for Zurich to achieve greater U.S. market penetration for its financial services business, analysts say.

For B.A.T, the deal provides an opportunity to separate its diverse tobacco and financial services operations, which the company says should provide greater returns for B.A.T and its shareholders.

In the United States, ZF Group's main insurance units will be: Farmers Group Inc.; Zurich Kemper Life Insurance; Universal Underwriters Group, a Zurich unit that specializes in insuring auto dealers and marketing coverages via dealerships; and all companies that currently comprise Zurich Insurance Co.-U.S., including Zurich-American Insurance Group, Maryland Insurance Group and Fidelity & Deposit Group.

In the United Kingdom, ZF Group's insurance holdings will comprise: Allied Dunbar Assurance P.L.C., one of the largest U.K. life insurance and pension companies; Eagle Star Holdings P.L.C., a leading U.K. multiline insurer; Zurich Municipal, a leading insurer of municipal authorities; and existing U.K. units of Zurich Insurance.

All Zurich Insurance subsidiaries based in Switzerland and elsewhere in the world also fall under the ZF Group umbrella.

ZF Group will also include all members of Zurich Re-one of the largest reinsurance groups in the world, including Centre Reinsurance Holdings Ltd., Zurich Reinsurance Centre among others-and Eagle Star Reinsurance Co. Ltd.

The asset management units of ZF Group will be: Chicago-based Zurich Kemper Investments Inc.; New York-based asset manager Scudder, Stevens & Clark Inc., which is being acquired by Zurich; and B.A.T's London-based Threadneedle Asset Management unit.

Zurich already has a significant presence in the U.S. commercial insurance market, so the merger initially will have little effect in the U.S. commercial market because of Farmers' concentration on personal lines, according to Rob Jones, an insurance analyst with Standard & Poor's Corp. in London.

However, Mr. Jones said the merger will significantly enhance Zurich's position in the U.K. commercial insurance market.

Allied Dunbar is "pretty strong" in personal and commercial life insurance, while Eagle Star has a "very strong" commercial lines portfolio, and is a market leader in U.K. employers liability business, Mr. Jones said.

The deal not only gives Zurich a better-balanced insurance portfolio-with Farmers' personal lines market business complementing Zurich's existing commercial and industrial business-but also provides a better geographic spread, with Farmers West Coast presence complementing Zurich's Midwest and East Coast presence, analysts say.

Trevor Petch, European insurance analyst at Robert Fleming Securities in London, said that ZF Group will be well positioned to offer integrated financial services in the United States.

Between Zurich Kemper, which specializes in bonds and money market funds for individual investors, and Scudder, which is a highly skilled designer of equity funds distributed to institutions, "there's a lot of possible opportunities."

Mutual funds are a real growth area in the United States, for which Los Angeles-based Farmers Insurance Co. would "offer an excellent distribution channel," Mr. Petch said.

ZF Group's asset management business will provide a buffer to the traditionally more volatile insurance operations, he added.

Mr. Petch noted that the U.K. fund management operations of Threadneedle could be significantly expanded throughout Europe as a result of the deal.

The merger is "definitely" U.S.-led, however, said Mr. Petch.

Farmers Insurance, with a network of 14,000 captive agents, would make an "excellent mechanism" for Zurich to distribute its savings and mutual fund products.

This could prove especially important for Zurich, which last year acquired Chicago-based asset manager Kemper Corp., and is acquiring New York-based Scudder, Stevens & Clark.

Trevor May, an insurance analyst for Salomon Brothers Inc. in London, agreed that "Farmers is very much a Zurich-type company." Attractions include its agency network, cross-selling opportunities and growth potential, he added.

The merger partners maintain that ZF Group will have leading market positions in the United Kingdom, continental Europe and the United states and will operate in more than 50 countries.

But Mr. May contends that "Europe doesn't figure highly" when it comes to the rationale for the merger. "For Zurich ,it is a growth move," and this means primarily B.A.T's financial interests in the United States and Britain, he said.

John Russell, insurance analyst at Hoare Govett Securities Ltd. in London, said that while Zurich is paying "quite a significant premium" for the B.A.T operations, the acquisition will give ZF Group a better balanced global portfolio and help Zurich better spread its risks both geographically and by product line.

Mr. Russell also said Zurich will provide the "more dedicated and tougher management" that British American Financial Services has been lacking.

He said that with its concentration in tobacco, B.A.T was generally "too slack" in giving direction to its financial services side.

Rolf Hueppi, chairman and chief executive officer of Zurich Group, will hold the same titles in ZF Group.

"The businesses to be combined are high quality, have significant prospects for growth and are highly complementary," Mr. Hueppi said.

He said ZF Group's concentration in key segments of personal, commercial and corporate risk and investment management should enable it "to deliver consistent earnings growth, building upon Zurich's financial strength and market strategies and BAFS' strong market positions in the U.S. and the U.K."

Mr. Hueppi said at a London press briefing that ZF Group would focus on specific types of customers that have been profitable. Past examples in the United States have included automobile dealerships, home builders and car rental agencies.

He added that tax benefits and cost savings, including some elimination of redundancies as a result of the merger, are expected to be worth some $250 million annually within three years. While Mr. Hueppi declined to elaborate on how these savings would be achieved, he did say there would be job losses through natural attrition.

Lord Cairn, chairman of B.A.T Industries, said that the business fit between BAFS and Zurich "will create an outstanding worldwide business positioned for rapid growth."

It will also improve the prospects for capital and income growth as a result of the separation of B.A.T's diverse tobacco and financial services interests, he added.

Analysts say that details so far released about the merger do not make clear whether Zurich will be exposed to the tobacco liabilities of B.A.T.

Mr. Jones at S&P said that if not resolved it is a matter over which the two parties will have to haggle before the deal is consummated.

Both S&P and Moody's Investors Service Inc. said that in merging with BAFS, Zurich Insurance is taking on a weaker partner.

S&P last week placed its AA+ rating of Zurich Insurance on CreditWatch with negative implications because of a potentially weakening effect of its merger with BASF, which has an A+ rating. However, while S&P has kept its rating of Farmers Group on CreditWatch, it has amended it to be a rating with developing implications, meaning it could be raised if the merger is completed or lowered if it is not.

Moody's said that through its merger with BAFS, Zurich Insurance "is becoming affiliated with comparatively weaker companies."

It also contends that Zurich's move in recent years to establish its position in reinsurance, life insurance and fund management-areas requiring substantial capital and management resources-could mean a decline in resources available to support its other core businesses. Accordingly, Moody's last week placed its Aa1 insurance financial strength rating of Zurich Insurance Co., and the debt and financial strength ratings of most of its subsidiaries, under review for a possible downgrade. Since June 30, Moody's has had the ratings on negative outlook because of what it sees as "the increasingly aggressive capital structure" of Zurich Insurance and the expectation it would make further acquisitions.

Eight years ago, B.A.T was in discussions with the late Sir James Goldsmith, a London businessman who had wanted to acquire B.A.T and break up its diversified holdings. Not long afterward, it engaged in talks to possibly merge its financial service interests with London-based insurer Commercial Union P.L.C. Neither of those possibilities came to fruition.

Martin D. Feinstein, Farmers' president and chief executive officer, expressed enthusiasm for the merger and the opportunity it provides Farmers.

"This will provide Farmers with the opportunity to access an expanded menu of new products and services. This joins us with a truly global organization dedicated to insurance, and one which will enhance our future growth plans," he said in a statement.

Mr. Feinstein said that Farmers will bring to this merger its financial strength and distribution network of 14,000 agents.

In return. will gain: the opportunity to accelerate its future strategies, alignment with a global organization dedicated to insurance, an expanded ability to spread risk in the United States and abroad, potential access for agents and customers to new products and services in commercial lines and especially in financial services through Scudder and Kemper, and a partnership with a company with one of the most respected reinsurance operations in the world.