Two questions ought to keep the managers of listed European insurance companies awake at night, according to Trevor Petch.

For some, the first is this: "How can we continue to produce the levels of earnings and earnings growth which the market has come to expect in the last five years or that we have promised for the future, based on what our competitors have achieved over the last five years?"

The second question is simply: "Where is future growth going to come from?"

The last five years have been as lucky for the insurance industry as the previous five were unlucky. Severe catastrophe losses have been relatively low, and the proportion of insured losses to economic damage was relatively small in the few major natural disasters. Last year was especially benign.

Soft reinsurance rates continue to soften. In most countries, for most lines, primary rates are low and competition severe. Last year also produced statistically low levels of attritional losses in most markets, particularly in the United States.

In 1997, insurers were thrice-blessed, because in addition equity markets produced spectacular returns, at least until October. Unusually, so did bonds. Insurers are, therefore, flush with investment earnings and capital reserves.

In insurance, an abundance of good fortune is no good thing. It causes complacency, the illusion that the fundamentals are sound and the persistence of bad practices. The signs are that the insurance market is at the peak of its earnings cycle. Some investors have lost track of what represents a realistic rate of earnings and earnings growth across the whole underwriting cycle.

Attritional claims already look worse in 1998. Freakish weather, quite possibly linked to the 1997 El Niño, is already apparent in Australia, California, the north-east of North America, and the United Kingdom and Brittany coast. Optimism about the outlook for Atlantic hurricanes is not advised.

Even in the event of more than two huge insured catastrophes, it is unlikely that very large increases in reinsurance pricing would be sustainable for long, given the increased speed of response of the capital markets. The effects of the Asian currency crisis will dampen economic growth globally, depressing the organic growth of premium volume in developed countries as well as in the countries directly affected. The outlook for equities is uncertain. Transition to the single European currency is likelier than not, but not enough to make bonds a one way bet. Insurance exposure is not falling; competition is not abating.

The next three years are, therefore, likely to see increasing divergence in performance between those insurers able to continue to generate something approaching a 15% return on equity, and those whose good returns have been the result of external factors.

Most of the following features will characterise the operations of the successful insurers. Together, they represent the diversification necessary to generate relatively high earnings with comparatively low volatility.

* A significant market share in chosen markets and classes of business with the ability to influence rates.

* A comparatively high proportion of higher margin business relative to purely price-driven, commodity business.

* A significant amount of life and pension business.

* Significant presence in growth classes or markets.

* Access to non-traditional, low cost distribution channels.

* Low costs and economies of scale in fixed investment such as data processing.

* Sufficient capital for flexible response to market conditions, including opportunistic acquisition.

For the largest international insurance groups, three other factors will also be important:

* Wide geographical diversification, including a significant presence in most major markets.

* In terms of branding, a large share or at least a leading position in the home market.

* Asset management operations sufficiently sophisticated to maximise the advantages of the single European currency, and offering the potential to develop products uncorrelated with the non-life underwriting cycle.

Achievement of these goals ought to be the underlying logic of consolidation of the industry both for buyers and targets with the best prices paid for those with the greatest number of key attractions.

To remain independent, companies with more limited ambitions must pursue maximum profitability, allied to an active and efficient capital management strategy which generates above average shareholder returns. They cannot do this if earnings are consistently diluted by underwriting losses.

What will not work is defensive merger merely in pursuit of size. Lower costs are a necessary but not a sufficient condition for relative earnings out-performance. Future cost savings only come after immediate reorganisation costs. Company managements which believe that they have three more years of gratuitous profitability before their performance begins to diverge are being very optimistic.

Trevor Petch is European insurance analyst at Robert Fleming Securities. The views expressed are personal, and should not be taken as reflecting the views of Robert Fleming & Co Limited.