Insurance Industry Stock Update - June 2012 - Industry Outlook

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The U.S. insurance industry will probably breathe a sigh of relief as the 2012 Atlantic hurricane season is expected to be much calmer compared to 2011. This year's hurricane season, which officially started on June 1 and will run through November 30, is expected to be less conducive for tropical storms. In addition, insurers are better prepared to withstand significant losses this time.

However, insurers have yet to recover fully from the impact of last year's series of natural disasters, and the industry continues to reel under economic unrest that thwarts every attempt it makes to grow. The dearth of positive catalysts is naturally making it hard for insurers to recover.

These impediments aside, there are fundamental challenges that are expected to come in the way of insurers' efforts to meet growing investor expectations in the upcoming quarters. Among the possible ways out, rising rates and pricing flexibility are primary.

It can be said that the overall health of the U.S. insurance industry has improved to some extent in the recent quarters, after enduring pricing pressures and reduced insured exposure for quite some time. The market turmoil resulting from the Great Recession of 2008-2009 forced many companies to take immense write-downs, but those are gradually becoming a thing of the past.

That said, continued soft market conditions, shrinking businesses, a still-high unemployment rate, uncertain fiscal policy and legislative challenges are threatening insurers' ability to rebound to the historical growth rate. The industry continues to be challenged by subdued premium volume growth in a perked-up economy as well as a massive healthcare restructuring.

Though there are signs of economic recovery, its sluggish pace and sudden drop offs are expected to continue at least through the end of 2012. Also, structural economies of scale have pushed the industry toward consolidation. As a result, inter-segment competition within the industry has alleviated. Moving forward, maintaining profitability after complying with regulatory requirements could be a painful task.

We expect static growth from persistent soft market conditions to result in further consolidation in the industry. Though there are near-term opportunities for insurers, thanks to rapidly growing sectors such as health care and technology, overall industry conditions are expected to improve beyond 2012, provided the economy turns to growth after recovery. The industry would likely take a couple more years to overcome most industry challenges with the help of an improved market mechanism.

Life Insurers

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 level fell sharply during the recession, life insurance companies will need to optimize their capital levels to address the ensuing challenges. In the short term, traditional sources of capital are expected to fulfill most of what life insurers need in order to stay in good shape. However, non-traditional sources of capital will take years to strengthen financials.

Moreover, regulatory changes under the Dodd-Frank Wall Street Reform are still troubling life insurers as they pose strategic and competitive challenges. In order to address such concerns, life insurers may have to burn some of their financial energy.

The underlying trends amid sluggish economic recovery indicate the stability of U.S. life insurers over the medium term with respect to credit profile and financial prospects. However, higher-than-average asset losses of life insurers, primarily resulting from their real estate exposure, will remain a major concern in the near- to mid-term.

Most importantly, the tardy economic recovery is making it difficult for life insurers to enhance their customer base. In fact, insurers are struggling to even retain their existing clientele. Narrowed disposable income owing to high unemployment and huge credit card debt has made it difficult for Americans to invest in retirement products such as life insurance.

Moreover, the low interest rate environment is one of the major risks for life insurers at this point. Investment income remains weak as life insurers are experiencing low returns on fixed-income instruments. Also, low rates are spoiling life insurers' efforts to grow fixed annuities and universal life insurance sales.    

On the other hand, interest in cheaper products to cover only basic risks has increased. So, returning to providing basic services and reducing operating costs should be the primary course of action for life insurers to realize some profit in the near term.

Some life insurers have already gone back to the basics in order to meet demand and escape financial and regulatory difficulties, but taking shelter from the icy winds will not be adequate for thriving. Life insurance companies have to be more proactive to weather the situation.

Health Insurers

The U.S. healthcare system is significantly dependent on private health insurance, which is the primary source of coverage for most Americans. More than half of the U.S. citizens are covered under private health insurance.

Unfortunately, these insurance companies utilize a pre-existing exemption clause to control costs and maximize profit. The historic healthcare reform legislation, which was passed by Congress in 2010, aims to prevent private insurance companies from using the pre-existing clause and at the same time bring in 32 million more people under coverage by 2019.

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.
 
Though the reform will provide more cross-selling opportunities for health insurers, their overall profitability will be marred 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 adding the extra 32 million.

Growth in nonfarm payroll employment is expected to enhance health insurers' customer base to some extent as these individuals will be insured through their jobs. However, according to the U.S. Bureau of Labor Statistics, in May 2012, nonfarm payroll employment inched up by a disappointing 69,000 and the rate of unemployment unchanged at 8.2%.

On the other hand, reducing government employment (down 13,000 in May) will partially offset this benefit. Moreover, growth in industry revenue is expected to decline until 2015 as insurers will be forced to adjust the benefits to comply with the healthcare legislation. Among others, providing coverage to everyone regardless of whether they had an expensive pre-existing condition would put their top lines at stake.

Property & Casualty Insurers

Steep losses in the investment portfolios since the beginning of 2008 have significantly reduced the capital adequacy of most Property & Casualty insurers. The seizure of credit markets and rising concerns over defaults have pushed down bond prices sharply since then, causing significant realized and unrealized capital losses on these insurers' portfolios. As Property & Casualty insurers hold about two-thirds of the invested assets in the form of bonds, their capacity 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 unrealized investment losses, the premium rates continue to decline, though at a slower pace.

Reduced financial flexibility and weak underwriting and reserves have added to insurer woes. The only positive trend visible as of now is a slight improvement in some insurance pricing after persistent deterioration for two years since 2008.

Though premium rates are showing signs of stabilization in the recent quarters, loss trends are rising at a faster pace. This will ultimately lead to underwriting margins compression.

On the other hand, catastrophe losses, competition, lower reinvestment yields and economic uncertainty will remain the headwinds for Property & Casualty insurers' operating performance in the near- to mid-term.

However, the Property & Casualty industry endured the latest financial crisis better than the other financial service sectors. Once the economic recovery gains momentum, insurance volume will grow rapidly.

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

Property & Casualty insurers started 2012 with positive net income, aided by premium growth and lower catastrophe losses. Strong capital adequacy and conservative investment strategies will keep these insurers on solid financial footing in the upcoming quarters.

Reinsurers

Losses from the investment portfolios of reinsurance companies have gotten worse during the last few quarters. The deterioration resulted from the supply-demand imbalance in reinsurance coverage due to intense competition that kept pricing soft over the last few years.

Also, catastrophic events like Hurricanes Ike and Gustav were the major culprits that pressure on underwriting profits. However, in the recent months, reinsurance prices have increased substantially. In fact, rising rates are expected to be more than sufficient to offset 2011 catastrophe losses. Also, reinsurers now have the capacity to meet the demand for coverage despite catastrophe losses.

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

However, lesser new business and rising expense ratios are major concerns for reinsurers at this point. An increased level of price competition also may hurt top lines in the upcoming quarters.

Moreover, reinsurance market capital levels are expected to be down for reinsurers with huge exposure to the European sovereign debt crisis.

OPPORTUNITIES

Insurers are suffering from the ongoing economic uncertainty and challenges related to natural disasters. However, this tough period brings opportunities for many large industry participants to grow by attracting new customers and taking market share away from weak rivals. The industry has been undertaking several structural changes that will make underwriting and pricing schemes even more attractive to consumers.

We remain positive on Everest Re Group Ltd. ( RE ), ProAssurance Corporation ( PRA ), Allied World Assurance Company Holdings ( AWH ), CNA Financial Corporation ( CNA ), Greenlight Capital Re, Ltd. ( GLRE ), Markel Corp. ( MKL ), White Mountains Insurance Group, Ltd. ( WTM ), Amerisafe, Inc. ( AMSF ), Eastern Insurance Holdings, Inc. ( EIHI ), Loews Corporation ( L ) and Symetra Financial Corporation ( SYA ) with a Zacks #1 Rank (short-term Strong Buy).

Other insurers that we like with a Zacks #2 Rank (short-term Buy) include American International Group, Inc. ( AIG ), The Allstate Corporation ( ALL ), The Chubb Corporation ( CB ), Cincinnati Financial Corp. ( CINF ), RenaissanceRe Holdings Ltd. ( RNR ), Fidelity National Financial, Inc. ( FNF ), American Financial Group Inc. ( AFG ), Seabright Holdings ( SBX ), Prudential plc ( PUK ) and Protective Life Corporation ( PL ).

WEAKNESSES

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

Among the Zacks covered U.S. insurers, we prefer to stay away from the Zacks #5 Rank (short-term Strong Sell) companies -- Platinum Underwriters Holdings Ltd. ( PTP ), State Auto Financial Corp. ( STFC ), Assured Guaranty Ltd. ( AGO ), Meadowbrook Insurance Group Inc. ( MIG ), Allianz SE ( AZSEY ) and Genworth Financial Inc. ( GNW ).


 
ALLIED WORLD AS (AWH): Free Stock Analysis Report
 
CNA FINL CORP (CNA): Free Stock Analysis Report
 
GREENLIGHT CAP (GLRE): Free Stock Analysis Report
 
PROASSURANCE CP (PRA): Free Stock Analysis Report
 
EVEREST RE LTD (RE): Free Stock Analysis Report
 
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Business , Investing Ideas , Stocks

Referenced Stocks: AWH , CNA , GLRE , PRA , RE

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