MONTE CARLO, Monaco -- The reinsurance industry is being transformed by consolidation and an increasing emphasis on specialization, a reinsurance executive says.

"The shape of the food chain has changed radically" as a result of consolidation, said Michael A. Butt, a director of X.L. Mid Ocean Reinsurance Co. Ltd. of Hamilton, Bermuda. X.L. Mid Ocean Re itself is the product of EXEL Ltd.'s purchase of Mid Ocean, which was completed last month (BI, Aug. 31).

The consolidation trend is driven by multiple factors, which vary by company and can change in prominence over time, he said.

Speaking at a presentation on "Consolidation and Specialism," sponsored by Pricewaterhouse-Coopers during the Rendez-Vous de Septembre, Mr. Butt reviewed some of the leading factors behind the consolidation trend, as well as pressures on reinsurers to become specialists rather than generalists.

The forces behind reinsurance consolidation include:

* Underwriting cycles.

"This, in my view, is the strongest driver of consolidation and will remain a strong factor until pricing changes," Mr. Butt said.

* '"Gaining reach," the process of moving to a global from a regional position in reinsurance.

"It's interesting that our business took as long as it did to go from regional to global," Mr. Butt remarked, pointing to earlier globalization efforts by other financial services industries.

One early impetus for reinsurers' global expansion was a desire for "counter-cyclicality," or offsetting soft conditions in one part of the world with firmer pricing in other regions. "But for those of us who took this approach, seeking balance in our books via a global reach, we found that the world had passed us by and there were no longer many regional differences," he said.

* A desire to achieve greater scale and spread of business.

The drive for size, in part a response to cedents' "flight to quality," has been a consistent factor behind reinsurer consolidation. As mergers create fewer and larger corporations, such as the recent mergers of British Petroleum Co. P.L.C. and Amoco Corp., or Chrysler Corp. and Daimler-Benz A.G., that will drive further consolidation among their insurance services providers, Mr. Butt said.

Also fueling this trend is a move among reinsurers to write more excess-of-loss business, as well as higher retentions by ceding companies, he added. "It is ironic that in our industry, historic trends show increased retentions just before a market turn," he said.

* Desire for additional means of distribution.

"Very few reinsurers today are only at one end of the distribution chain," Mr. Butt noted. He pointed to direct writer Employers Reinsurance Corp., which recently acquired broker market reinsurer Kemper Reinsurance Co., as an illustration of a company that has gained multiple means of distribution.

* Responding to investor demands.

This factor is becoming more prevalent as capitalism expands globally, according to Mr. Butt. In Europe, he noted, there has been an adjustment to "Wall Street-style thinking." Because a significant portion of the industry's capital has come from Wall Street, it is natural that those investors' demands will be felt, he said.

* Lowering volatility.

"Historically, especially at Lloyd's, this has been done by buying cheap retrocessional cover. (Lloyd's) is doing so again, hopefully this time without the spiral," said Mr. Butt, referring to the London market excess-of-loss spiral in the 1980s, in which many Lloyd's syndicates wound up assuming risks they thought they had ceded.

Increasingly, mergers and acquisitions will be seen as a means to lower volatility in particular lines. Mr. Butt pointed to American International Group Inc.'s proposed $18 billion acquisition of SunAmerica Inc. (BI, Aug. 24), which will bring AIG diversification via new capabilities in asset management and retirement services and products.

* Capital markets risk financing.

To many in the reinsurance industry, it is not yet clear whether the capital markets represent competition or a new partner for sharing risks.

"I no longer believe it to be ancillary, but instead a fundamental part of our business," Mr. Butt said. "Those who do not participate are at risk."

Asked why he expects the capital markets to become a key part of reinsurance, Mr. Butt replied, "The business we are in is only a financial service; we exaggerate the differences."

For reinsurance companies to enter this new risk financing arena requires significant capital, which is not difficult to attain, he said.

"But the skills to deploy that capital are harder to develop," he added.

"If you believe convergence is taking place, you can't just look within our business but must also look at companies at the fringe," he said.

At the same time that these various forces are driving consolidation, the reinsurance industry also is coming under pressure to become more specialized, according to Mr. Butt.

"Analysts didn't like generalists, so we all became specialists," he quipped.

To Mr. Butt, this trend means adopting greater underwriting discipline for a given reinsurance specialty.

"I'm horrified by intuitive pricing in our market, especially in London," he said. The reinsurance industry must apply more technical skills to underwriting, rather than relying on intuition about risks, he said.

Other elements of specialization, he said, include differentiating among products; providing added value to products; product innovation; and offering different skill mixes.