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Zacks Analyst Interviews

The impact of a series of natural disasters in 2011 and the ongoing economic uncertainty is still quite palpable in the performance of U.S. insurers. These impediments aside, there are fundamental challenges that are expected to come in the way insurers’ efforts to meet growing investor expectations in the upcoming quarters. Among the possible way outs of such difficulties, rising rates and pricing flexibility are primary.

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 forced many companies to take immense write-downs, but those memories are fast 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 is expected to continue at least through the first half 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, braced by some rapidly growing sectors such as health care and technology, overall industry conditions are expected to improve beyond the first half of 2012, should the economy turn to growth post-recovery. Probably, the industry would take a couple of 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 of the insurers.

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 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 2012.

Most importantly, the tardy economic recovery is making it difficult for life insurers to enhance their customer base. In fact, the 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.    

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. health care system is significantly dependent on private health insurance, 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 health care legislation, which was passed by Congress in 2010, aims to prevent private insurance companies from using the pre-existing clause, but at the same time claims to 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.

The recent growth in nonfarm payroll employment is expected to enhance health insurers’ customer base to some extent as these people are getting insured through their jobs. According to the U.S. Bureau of Labor Statistics, in January, total nonfarm payroll employment rose by 243,000 and the rate of unemployment decreased to 8.3%.

However, reduced government employment will partially offset this benefit. Moreover, growth in industry revenue is expected to decline till 2015 as insurers will be forced to adjust the benefits to comply with the health care legislation. Among others, providing coverage to everyone regardless of whether they had an expensive pre-existing condition would put their top line 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’ surplus), 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 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.

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

We remain positive on Phoenix Companies, Inc. (PNX - Snapshot Report) and ProAssurance Corporation (PRA - Analyst Report) with a Zacks #1 Rank (short-term Strong Buy).

Other insurers that we like with a Zacks #2 Rank (short-term Buy) include AMERISAFE, Inc. (AMSF), Manulife Financial Corporation (MFC - Analyst Report), Ace Limited (ACE), Markel Corporation (MKL - Snapshot Report), OneBeacon Insurance Group, Ltd. (OB - Snapshot Report), Progressive Corporation (PGR - Analyst Report), RenaissanceRe Holdings Ltd. (RNR - Analyst Report), Prudential Financial, Inc. (PRU - Analyst Report), Horace Mann Educators Corporation (HMN - Snapshot Report) and MetLife, Inc. (MET - Analyst Report).

American International Group Inc. (AIG) currently retains a Zacks #3 Rank which translates into a short-term Hold rating.

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 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 –– Axis Capital Holdings Limited (AXS), Cincinnati Financial Corporation (CINF - Analyst Report), Loews Corporation (L - Analyst Report), Endurance Specialty Holdings (ENH), Kemper Corporation (KMPR), Meadowbrook Insurance Group (MIG) and MGIC Investment Corporation (MTG).

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