U.S. Insurance Industry

Ongoing turmoil in the financial markets has resulted in a highly challenging environment for the U.S. insurance industry -- a trend that is expected to continue at least through the end of the current year. We also expect further consolidation in the industry.

Life Insurers

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

The Industry’s statutory capital levels have fallen sharply and some companies are trying to raise capital through the Troubled Assets Relief Program (TARP). Treasury has stated that some of the life insurers may qualify for TARP because of their Bank Holding Company status.

Property & Casualty Insurers

Insurers' losses from natural disasters surged in 2008, with maximum losses resulting from Hurricane Ike (insured losses of approximately $15 billion). Six named storms -- Dolly, Edouard, Fay, Gustav, Hanna and Ike hit the U.S. coast last year, after two years of benign activity.

Significant catastrophe losses of 2008, coupled with decline in the investment income and sizable investment losses resulting from the ongoing turmoil in credit and equity markets will continue to affect earnings. Also, losses in the investment portfolios since the beginning of 2008 have significantly reduced the capital adequacy of most insurers.

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

Reinsurers

Losses from the investment portfolio of the reinsurance companies have surged during the last few quarters. Further, during 2H08, the underwriting profits were severely hurt by the Hurricanes Ike and Gustav. However, the pricing has improved recently, which benefited these companies during the January renewals.

Also, one of the reasons to hit profits was the increased tendency by the clients for risk retention. With insurers’ balance sheets constrained and reduced financial flexibility in the current capital markets, risk retention by primary insurers is less likely to impact growth during the current year. Reinsurers could benefit from improved pricing, while losses from the investment portfolio will continue to hurt the earnings.

OPPORTUNITIES

We remain positive on reinsurer PartnerRe Ltd. (PRE - Analyst Report) due to its excellent underwriting abilities, strong capitalization, solid ratings and reputation in the market, which will enable it to take advantage of the stronger demand and better pricing being witnessed currently.

WEAKNESSES

We have Sell recommendation on Hartford Financial Services Group (HIG - Analyst Report), as we suspect that the company will face higher losses on the investment portfolio and its variable annuity business.

Primus Guaranty (PRS - Analyst Report), a seller of credit default swaps, will face increased losses from its exposure to some of the failed/troubles institutions.

We recently upgraded our recommendation on PMI Group (PMI - Analyst Report) from Sell to Hold as the shares had already yielded more than a 99% return since we recommended them as a Sell in September 2007, and we think that the downside potential is rather limited now.