At the half-way stage in the second-quarter earnings reporting season, the big question was this: Are the good times over in auto insurance? Jay Cohen reports.

For the past several years, auto insurance has been the place to be for an insurance carrier in the US. Underwriting margins have continuously improved - widening to head scratching levels - helped by sector and demographic trends, modest medical cost inflation and stricter loss cost controls at individual company level. At the same time, premium growth rates for a number of speciality carriers accelerated well above the industry average.

As a result of these good times, the stocks of those companies heavily weighted in auto insurance have performed very well. These stocks broke the old rules of insurance company valuations, reaching new highs on price-to-book and price-to-earnings multiples.

When Progressive (PGR) reported its second quarter earnings, a lower than expected loss ratio allowed it to exceed easily earnings expectations. However, the real surprise was PGR's premium growth which at 13%, was its slowest in 23 quarters.

Also, Mercury General, whose premium growth slowed dramatically to 3% in the second quarter, even though its bottom line number was okay. The slower growth was a function of the intensifying competitive environment in California. Mercury reduced its own rates by 7%, but in an environment where most drivers are seeing lower rates, it should be more difficult to continue taking market share.

Price pressure does exist in selected markets. However, the lower prices are largely a function of lower losses (helped in California by favourable legislation such as the passage of proposition 213). While the favourable claims environment will not, of course, last forever, there is nothing on the horizon that suggests that claims costs will suddenly spike up.

While pricing should become more competitive, we do not expect it to become irrational among the large players (those that can really influence pricing). In other words, we do not expect a price war. We note that about five insurers control about one-half of the market for auto insurance, providing better price leadership than in the more fragmented commercial lines arena. In addition, it is much easier for an insurance company to get approval from insurance commissioners for a rate reduction than for an increase, so they tend to lower prices in a more gradual fashion.

Premium growth will be driven by expanding distribution channels (direct responsive for PGR and AIG, independent agents for Allstate's non-standard business, Primerica Financial Services and Citibank for Travelers Property/Casualty) and geographic expansion (Mercury General's moves into Florida and Texas). For example, we expect to see Allstate's non-standard business begin to grow at a faster pace after slowing down to 6.6% in the first quarter of 1998.

More generally, while nearly all insurers complained of the continued competitive market conditions when announcing their second quarter results, several discussed their efforts to raise prices in certain segments. Hartford noted it would begin raising rates for some risks in its middle-market business, although the management seemed uncertain how these prices would stick. Allmerica Financial said it had been implementing price increases in commercial lines business dominated by small accounts, and the company's growth rate did pick up in the quarter.

The company is also achieving a higher average price for its homeowners' book, a trend we have seen from other writers in the sector, and SAFECO stated that it has raised premium rates by a cumulative 18% over the past year for some California workers' compensation risks.

Are these scattered efforts to raise premium rates the beginning of a broad-based turn in market conditions? We believe such a conclusion is premature. While the pressure certainly appears to be increasing in commercial lines, we note that underwriting margins are still generally good, and those results would have to deteriorate further before overall premium rates moved up meaningfully. Capital levels (ie supply) remain at all time highs in the property/casualty industry.

In reinsurance, the pace of consolidation in the sector accelerated with three M&A deals. Gerling is acquiring Constitution Re from EXOR Group for $700 million in cash, which is 130% of book value. Constitution Re writes mainly short and medium tail lines with a focus on regional and speciality carriers, and Swiss Reinsurance Company is to buy Life Re at a price of $95 per share in cash or roughly $1.8 billion.

Third, GE Capital announced the planned acquisition of Kemper Re, the most significant effect of which will be to move GE more aggressively into the brokered reinsurance market (GE's main reinsurance company, ERC, deals directly with primary companies). The price for the deal was undisclosed. With the very competitive market conditions in reinsurance, other direct writers may copy GE's move into a different distribution channel.

Jay Cohen is an insurance analyst with Merrill Lynch, New York. Tel: +1 (212) 449 5206. Fax:+1 (212) 449 0209. E-mail: Jay_A_Cohen@ml.com