Insurance Industry Outlook - Industry Outlook

After enduring stress with respect to pricing pressure and reduced insured exposure through mid-2009, the overall health of the U.S. insurance industry has started improving. Though the market turmoil forced many companies to take immense write-downs, the worst of the crisis appears to be now behind us.

The soft market conditions, along with legislative changes, remain the chief causes for concern for the overall industry at this point. The industry continues to be challenged by the regulatory uncertainties and massive health care restructuring.

Though there are signs of economic recovery, its sluggish pace is expected to continue at least through the first half of 2011. Also, structural economies of scale have pushed the industry toward consolidation. Moving forward, maintaining profitability after complying with the regulatory requirements is not expected to be a painless task.

While enormous financial support from the government helped rescue

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) from collapse, many other firms remain under tremendous pressure or have fallen by the wayside. Competition within the segments of the industry has reduced, which is consolidating through mergers and acquisitions. This has increased market shares of the largest firms.

We expect static growth with persistent soft market conditions, resulting in further consolidation in the industry. However, we expect overall conditions to improve in the second half of 2011, should the economy turn to growth post-recovery.

Losses in the investment portfolio and lower income from the variable annuity business will continue to hurt earnings of life insurers. Most life insurers have substantial exposure to commercial real estate-backed loans and securities, which will result in further losses in the coming quarters.

As the industry's statutory capital levels fell sharply during the recession, life insurance companies will need to optimize their capital levels to address continuing challenges. In the short term, traditional sources of capital are expected to fulfill most of the needs of life insurers to stay in good shape. However, non-traditional sources of capital will take years to help them strengthen financials.

Though the economic recovery is expected to remain sluggish, the underlying trends indicate stability of U.S. life insurers over the medium-term with respect to credit profile and financial prospects. However, higher-than-average asset losses for life insurers, primarily as a result of their real estate exposure, will remain a major concern in 2011.

Though some life insurers are trying to go back to providing only basic services to escape from financial and regulatory difficulties, taking shelter from the icy winds may not be sufficient for optimal operations and profitability. Life insurance companies have to be more proactive to weather the situation.

The U.S. health care system is significantly dependent on private health insurance, which is the primary source of coverage for most Americans. Approximately 58% of Americans have private health insurance. Unfortunately, these insurance companies utilize a pre-existing exemption clause in order to control costs and maximize profit.

The newly passed historic healthcare legislation prevents private insurance companies from using the pre-existing condition clause, but at the same time brings in more than 30 million additional people under coverage. The legislation pledges access to medical insurance for tens of millions of Americans and would subsidize coverage for the low- and middle-income groups.

While the legislative overhaul brings more regulatory scrutiny for private insurance companies, the net negative effect is far softer than was initially feared. Also, the removal of this uncertainty is a net positive in its own right.

However, the healthcare reform legislation will mar the overall profitability of the health insurance industry in the long run as the negative impact of Medicare Advantage payment cuts, industry taxes and restrictions on underwriting practices will more than offset the benefits of covering more than 30 million additional people.

Major catastrophe losses in 2008 resulted in significant deterioration of companies' underwriting results. Steep losses in the investment portfolios since the beginning of 2008 have significantly reduced the capital adequacy of most insurers.

During 2009, the seizure of credit markets and rising concerns over defaults pushed down bond prices sharply, causing significant realized and unrealized capital losses on insurer portfolios. Holding two-thirds of the invested assets in the form of bonds, the capacity of the Property & Casualty insurers is highly sensitive to changes in credit market conditions.

While the ongoing recovery in the credit and equity markets is leading to a reduction in the unrealized investment losses, the premium rates continued to decline, though at a slower pace.

Reduced financial flexibility and weak underwriting and reserves have further added to their woes. The positive trend visible as of now is a slight improvement in some insurance pricing after continued deterioration during the last couple of years.

Also, in September 2010, Fitch Ratings revised the rating outlook on the U.S. Property & Casualty industry to Stable from Negative. The rating agency took this action as the industry endured the recent financial crisis better than the other financial services sectors. The rating agency also noticed that access to capital has improved over the last few quarters as a result of issuance of securities by many insurers.

The recent quarters have been witnessing increasing rebound in claims-paying capacity (as measured by policyholders' surplus), which reflects the industry's resilience over the prior-year.

Losses from the investment portfolios of reinsurance companies have surged during the last few quarters. In the second half of 2008, the underwriting profits were severely hurt by Hurricanes Ike and Gustav. However, the pricing improved in 2009 and 2010. We expect pricing to remain firm going forward.

With the signs of recovery in the capital market (though still weak by any means), the concerns related to reinsurers' ability to access the capital markets on reasonable terms have sufficiently eased.

However, diminishing new business and rising expense ratios are major concerns for reinsurers at this point. The higher rate of unemployment is primarily responsible for the lower business production. Also, due to increased levels of price competition among insurers, market premium volumes continue to shrink.

We expect slightly lower favorable reserve development trends in the upcoming quarters, as there are lingering concerns about the overall economy.

We remain positive on

(

) Infinity Property and

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) with a Zacks #1 Rank (Strong Buy).

Other insurers that we like with a Zacks #2 Rank (Buy) include

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),

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),

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),

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),

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),

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),

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),

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),

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) and

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).

We expect continued pressure on investment portfolios and lower income from the variable annuity business will restrict the earnings growth rate of life insurers. Also, reduced financial flexibility and weak underwriting will hurt earnings of Property & Casualty Insurers.

We remain negative on AIG with a Zacks #5 Rank (Strong Sell) as its vigorous asset disposals to eliminate significant debt to the government are not only reducing its global market share but are also heavily weighing on its operating earnings.

We are also concerned about AIG's significant exposure to the subprime market than other P&C insurers and its dependence on partnership income. The company is significantly exposed to residential and commercial mortgage backed securities, which have been facing headwinds since the recession started in mid-2007.

Other insurers that we like with a Zacks #5 Rank include

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),

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).

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