Insurance Industry Stock Update - Sept. 2012 - Industry Outlook

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The U.S. insurance industry sees no respite from natural catastrophe losses yet again this year. The 2012 Atlantic hurricane season, which officially started on June 1 and will run through November 30, is just a little more than half over and it appears that it is not as mild as was expected earlier. Though insurers are better prepared to withstand significant losses this time, the after effect of this year's hurricane season will play a key role in determining the sector fundamentals for 2013.

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. A dearth of positive catalysts is naturally making it harder for insurers to recover fast.

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 possibilities, rising rates and pricing flexibility stand out.

It can be said that the overall health of the U.S. insurance industry has improved to some extent in 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 first half of 2013. 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 and meeting the challenges of climate change 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 toward growth. 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 portfolios, higher hedging costs, lower income from the variable annuity business and more burdensome capital requirements will continue to restrict earnings growth of the life insurers. Most life insurers have substantial exposure to commercial real estate-backed loans and securities, which will lead to 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 a sluggish economic recovery indicate stability of the U.S. life insurers over the medium term with respect to credit profile and financial prospects. However, higher-than-average asset losses, 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 expand 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.

In mid September, credit-rating agency Moody's -- a wing of Moody's Corp. ( MCO ) -- has revised its outlook for the U.S. life insurance industry to negative from stable. This action was primarily based on the rating agency's expectation of continued pressure on life insurers' earnings due to persistently low interest rates.   

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.

Some life insurers have already gone back to the basics in order to meet demand and escape financial and regulatory difficulties, but this conservative stance 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 insurers such as WellPoint Inc. ( WLP ) and UnitedHealth Group, Inc. ( UNH ).

Unfortunately, these insurance companies utilize a pre-existing condition 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 condition clause and at the same time bring in 32 million more people under coverage by 2019.

However, the legislation has had many detractors who contested several of its stated benefits and considered it another entitlement program that the country can ill afford. Finally, in June 2012, the U.S. Supreme Court ruled in favor of the healthcare reform, rejuvenating the industry by removing major uncertainties.

With respect to the individual mandate, which drew the most attention as it requires all uninsured Americans to purchase a minimum level of health insurance coverage, the Supreme Court ruled that individuals failing to buy health insurance will have to pay a tax fine, but forcing them to buy insurance will be illegal. Employers will also be fined if they fail to provide insurance coverage to their workers.

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 people into the system.

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 August 2012, nonfarm payroll employment inched up just 96,000 and the rate of unemployment marginally edged down to 8.1%.

That said, 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 have been continuously reducing the capital adequacy of most property-casualty insurers since the latest recession. 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. Low interest rates and government bond yields are expected to compress profits in the quarters ahead. However, an expected improvement in casualty rates will partially offset the negatives.

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. This declining trend in premium rates is expected to persist through the first half of 2013, adversely affecting insurer profitability. The key positive trend visible as of now is a slight improvement in some insurance pricing after persistent deterioration for the last three years.

On the other hand, high catastrophe losses, stiff competition and lower reinvestment yields are expected to depress profits for property-casualty insurers.

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. 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 put underwriting profits under pressure. However, in the recent months, reinsurance prices have increased substantially. Also, reinsurers now have the capacity to meet the demand for coverage despite catastrophe losses.

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

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

Insurance companies 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 Ageas SA/NV ( AGESY ), Eastern Insurance Holdings, Inc. ( EIHI ), Ping An Insurance (Group) Co. of China Ltd. ( PNGAY ), Fidelity National Financial, Inc. ( FNF ), First American Financial Corporation ( FAF ), Homeowners Choice, Inc. ( HCII ), ProAssurance Corporation ( PRA ), Stewart Information Services Corporation ( STC ) and United Fire Group, Inc ( UFCS ) 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 ), Assurant Inc. ( AIZ ), Assured Guaranty Ltd. ( AGO ), CNO Financial Group, Inc. ( CNO ), MetLife, Inc. ( MET ), The Allstate Corporation ( ALL ), The Chubb Corporation ( CB ), Everest Re Group Ltd. ( RE ), XL Group plc ( XL ) and HCC Insurance Holdings Inc. ( HCC ).

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. Moreover, the overall industry is vulnerable to the ever-increasing threat of natural disasters.

Among the Zacks covered U.S. insurers, we prefer to stay away from the Zacks #5 Rank (short-term Strong Sell) companies -- Kemper Corporation ( KMPR ), Meadowbrook Insurance Group Inc. ( MIG ), Old Republic International Corp. ( ORI ), American Safety Insurance Holdings Ltd. ( ASI ), EMC Insurance Group Inc. ( EMCI ), Hallmark Financial Services Inc. ( HALL ), Mercury General Corporation ( MCY ), Selective Insurance Group Inc. ( SIGI ), Phoenix Companies Inc. ( PNX ) and StanCorp Financial Group Inc. ( SFG ).


 
(AGESY): ETF Research Reports
 
AMER INTL GRP (AIG): Free Stock Analysis Report
 
ASSURANT INC (AIZ): Free Stock Analysis Report
 
EASTERN INSURNC (EIHI): Free Stock Analysis Report
 
FIRST AMER FINL (FAF): Free Stock Analysis Report
 
FIDELITY NAT FI (FNF): Free Stock Analysis Report
 
HOMEOWNERS CHCE (HCII): Free Stock Analysis Report
 
(PNGAY): ETF Research Reports
 
PROASSURANCE CP (PRA): Free Stock Analysis Report
 
STEWART INFO SV (STC): Free Stock Analysis Report
 
UNITED FIRE GRP (UFCS): Free Stock Analysis Report
 
UNITEDHEALTH GP (UNH): Free Stock Analysis Report
 
WELLPOINT INC (WLP): 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: AGESY , AIG , AIZ , EIHI , FAF

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