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Special to Business Insurance

We recently produced some statistics on the stock segment of the property/casualty industry that involved reviewing the growth rates in net premiums written, premiums earned, combined ratios (after policyholder dividends), net investment income and operating margins. We went back over a 25-year period and calculated average growth rates in five-year increments. For example, over the period from 1972 to 1997 (using estimated figures for 1997), net written premiums increased at an average 8.4% rate.

For the 20 years from 1977 to 1997, growth slowed to 7.5%. The time frame from 1982 to 1997 showed an average growth rate of 7%, while the 10-year period of 1987 to 1997 dropped to a snail's pace of 3.5%. The growth rate recorded for the last five years, 1992 to 1997, which was somewhat distorted by a 7% rise in 1993, did a little better, increasing to 4.7%. During the past four years, however, premium growth has run at a 4.1% pace.

We are at a point now in the infamous underwriting cycle where there is virtually no organic growth. This, together with an ongoing spate of pricing pressures, creates a very interesting and difficult environment for insurers.

A similar diminishing growth pattern over the various time frames also was exhibited by net premiums earned. Net investment income growth, which moved along at a 12.1% clip for the past 25 years, slowed to a 4% rate for the period from 1992 to 1997.

This marked reduction in growth relates to a combination of factors that include a downward tilt in the yield curve; diminution in cash flows; and the fact that the bigger the base, the faster you have to run to grow at the same pace.

The combined ratio, at 106.4% for the past five years, is the best number of the five time-frame averages that we reviewed. Likewise, the operating ratio at 90% is also the best. As we have noted many times in this column, we are very skeptical about reported operating results in recent years, as they have appeared to come at the expense of some severe compromising of balance-sheet integrity. The industry -- according to data provided by the Insurance Services Office Inc. -- has been operating at a paid-to-incurred ratio that exceeds 100%. Reserve liquidation can't go on forever.

The aforementioned slowdown in premium growth can be attributed in part to the material increase in pricing competition in recent years and in part to the reduction in inflation and its salutary effect on premium increases. There is, however, another factor that has to be reviewed.

The alternative risk market has been taking on an increasing share of the commercial property/casualty market. In fact, it is often argued that the better business has been gravitating to the self-insured market.

The most obvious vehicle used has been the captive insurance company. Originally, captives were set up to take advantage of the tax deductibility of insurance premiums paid for self-insurance mechanisms. Today, the main attraction captives hold is their ability to control the cost of insurance protection vis-a-vis the purchase of more traditional coverage.

Furthermore, captive programs can be more neatly tailored to meet the specific needs of a client. In the early 1980s, it was estimated that captives had taken on about one-third of the commercial insurance market. Today, the numbers appear to be closer to the 50% mark.

Clearly, captives have come of age. They can and are used for virtually any form of insurance and have become a standard tool for risk managers worldwide.

In addition to the single captive, we see more and more groups and associations forming captives and smaller companies making use of "rent-a-captive" plans. As a result, fewer commercial premium dollars are flowing through the traditional insurance mechanisms.

As if this were not enough, there are other methodologies on the horizon that could siphon off more premium dollars and introduce -- believe it or not -- smaller profit margins to the business. The changing dynamics of the insurance business are resulting in a greater focus on financial products and offshoots and less on traditional coverage.

Clients are seeking balance-sheet protection, insulation from earnings volatility and various types of "risk solution" coverages. For example, there are approaches that appear to be in the wings that involve derivatives and/or hedge transactions; these provide coverage for corporations that could have a legal liability if certain events or combination of events were to occur. A liquid or semi-liquid asset could be used as collateral in such a transaction, which in essence end-runs the insurance process, as an insurance purveyor may not have to be directly involved.

The key to all of this is that the capital markets are introducing the discipline of low transaction costs. The appearance of such market fee parameters, and/or "banking spreads," in the traditional insurance business presents a material challenge to the insurers that toil in that marketplace. This concept is not likely to disappear any time soon.

It portends not only margin compression for those that cannot compete effectively but also presents a potentially formidable form of premium disintermediation for both primary insurers and reinsurers.

Myron M. Picoult is a director and senior insurance analyst at Wasserstein Perella Securities Inc. in New York. He is the past president of the Assn. of Insurance & Financial Analysts and a member of the New York Society of Security Analysts.

An online archive of Mr. Picoult's columns can be viewed on the World Wide Web at headlines.html.