Steve Wevodau

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 in 2009. 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. The Industry’s statutory capital levels have fallen sharply in 2008 and some companies are trying to raise capital through the Troubled Assets Relief Program (TARP). We are not sure whether the lawmakers will allow the insurers access to TARP money. Further, many life insurers have substantial exposure to commercial-real-estate-backed securities, which will result in further losses during FY09.

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 this 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 in the coming quarters. Also, losses in the investment portfolios since the beginning of 2008 have significantly reduced the capital adequacy of most insurers. 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 FY08. Further, during 2H08, the underwriting profits were severely hurt by the Hurricanes Ike and Gustav. However, the pricing has improved recently, which will benefit 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 in FY09. Reinsurers could benefit from improved pricing while losses from the investment portfolio will continue to hurt the earnings.

OPPORTUNITIES

We recently initiated coverage on Amerisafe, Inc. (NasdaqGS: AMSF - News) a specialist in providing workers compensation insurance. Since our initiation, the stock has already appreciated by about 42.5%, and we expect it to continue to outperform the market due to its sound capital position, solid investment portfolio and strong financial strength rating. We also cite its addition to S&P SmallCap 600 index after the close of trading on December 31, 2008.

We are also positive on reinsurer PartnerRe Ltd. (NYSE: PRE - News) 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 recommendations on mortgage insurer PMI Group (NYSE: PMI - News), which will remain exposed to further losses from the decline in housing values, though the demand and new business quality have improved in recent months.

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

We are also bearish on Hartford Financial Services Group (NYSE: HIG - News), as we suspect that the company will face higher losses on the investment portfolio and its variable annuity business.