THE fortunes of the European insurance sector are linked to the performance of equity markets.

The industry directs investment funds into equities and, as a result, tends to be one of the hardest hit in the event of a downturn but i s a trail-blazer when the markets rally. And while some analysts are less optimistic about its prospects than they were last year, most insist there are opportunities for investors.

On a positive note the sector is still seen as a hotbed for consolidation. It also stands to benefit from the considerable growth in long-term savings, while a low interest rate environment should help to enhance the sector's valuation levels.

These factors are somewhat counterbalanced by the fact that the insurance sector is now highly valued. Sustained low interest rates could undermine life insurance earnings growth as insurance companies are forced to adjust to changed circumstances and the millennium will also introduce an element of the unknown to non-life operations.

Looking ahead, Merrill Lynch stockbrokers cautions that investors will need to take their cue from the market as to when to buy and sell insurance stocks. Merrill Lynch says its clear preference in 1999 is for stocks with strong balance sheets which can provide relative security and cushion against equity market volatility.

Life assurance and long-term savings in general are likely to remain one of the key growth areas across Europe with demographic pressures sufficiently strong to sustain expansion for some years to come. And while low bond yields are likely to depress traditional life insurance profit, this should not cause any lasting damage unless yields stay low for a period of up to seven years, according to Merrill Lynch.

As in the banking sector, consolidation is the watchword in the European insurance sector.

It took a grip of the British market in 1998 with the formation of CGU from a merger between Commercial Union and General Accident. This year it was the turn of French insurer AXA which is buying Britain's , Generali.

The largest insurance stocks quoted on the main European stock indices are the Dutch groups AEGON and ING, Allianz, AXA and Generali.

Merrill Lynch's buy recommendations for investors are ING, Munich Re and CGU. It states that ING's shares are close to the "best value" to be found across Europe's insurance industry. Munich Re, which is the world's largest reinsurance company, has considerable potential. "Its hidden value may only come to light if Munich Re adopts a higher public profile and makes concerted efforts to look more shareholder friendly." And the brokers suggest that CGU is inexpensive within a European context and is the highest quality British non-life insurer. Other stocks deemed to be attractive in the longer term are Dutch group, Fortis, and Italian insurer Generali.

Non-life performances across Europe have been mixed, with analysts now predicting a more benign claims outlook and pointing to the more positive features in the reinsurance sector. The introduction of the euro has fuelled consolidation in most sectors, though some analysts believe that European insurance companies will have to wait for some time before they see much benefit at an operational level from integration.

A single insurance market is not really on the agenda and cannot be seriously considered until there is uniform tax treatment across Europe and uniformity in contract law. To achieve this it would be necessary to ensure that state pension provisions across the member-states were put on an equal footing. "We find it impossible to envisage how this could occur unless there were a common definition of corporate profit and a realignment of social security systems. If this happened, it would provide a major fillip to the life insurance, pensions and long-term savings industry. We believe these potential developments are exceedingly long term and will probably not come into play until well beyond even the most patient investor's time horizons," says Merrill Lynch.

With 5,000 insurance companies in Europe and the prospect of further industry liberalisation and the emergence of ever-larger players in the financial services industry, consolidation should continue apace.

The primary movers and shakers according to the experts will be AEGON, Allianz, CGU, Fortis and Generali.

AEGON is expected to be much more selective than other insurers in making acquisitions. Allianz has a keen appetite for acquisitions, with the stated desire to purchase an Anglo-Saxon asset manager as well as to expand into Asia. It is always looking to expand its overall capabilities and would particularly welcome the chance to gain leadership in specific markets and has made no secret of its desire to expand in Britain and the US.

CGU management is focused on the merger of the non-life insurance operations, so any acquisitions are likely to be small. It would probably like to buy a medium-sized mutual life insurer and also strengthen its European life operations.

Fortis is proactive on acquisitions. At the moment its focus will be on adding a life insurance company. With the recent acquisition of Generale Bank, Fortis is deemed to have its hands full when it comes to banking, though its long-term aim is to enhance its position in retail banking in Europe.

Generali has made it clear it wants to expand in Britain and France. Its current long-term focus is expansion in life insurance and savings in southern Europe.

ING is looking at buying a large US life insurance company costing up to €5 billion (£3.94 billion). After that it has its sights set on buying the outstanding shares of German bank BHF and also purchasing a French bank.

Munich Re's future acquisitions are likely to be small and aimed at filling gaps in the reinsurance portfolio.

Consolidation is being fuelled by the surge in sales of life assurance, pensions and other long-term savings products as people become generally more aware of making provisions for their retirement. The interest in these products seems to be occurring at the expense of short-term savings and has whetted the banks' appetites to get into this market, with life and health insurance proving to be one of the few genuine growth areas. Across the sector, insurance companies seem to be worried that they could end up without the size and pricing power they need to vie for business against newly enlarged rivals. In this environment, further consolidation can be assured.