In the last one week, weakness among insurers has kept the financial sector from performing in-line with the broader market. Even though, AIG posted a positive earnings surprise in the third quarter, the company fell heavily on November 6, shedding all the gains made till that day in the week. In such a scenario, one is forced to ask should I reconsider investing in the sector. To answer a question or two, I am picking the winners and losers in the sector.

First half suggests inflexion

The life insurance industry is showing some signs of improvement. The industry's net gain (in the second quarter) from operations totaled $36 billion, a 30.7% increase over last year's $27.5 billion. Capital and surplus for the life insurance industry showed a slight increase of 1.7%, and separate account assets, which had seen the worst losses, increased 4.3%. Coming to property/casualty (P/C) industry - policyholders' surplus (the industry's primary measure of capacity—akin to net worth in other industries) increased by $25.9 billion or 5.9% to $463.0 billion during the second quarter from $437.1 at the end of the first quarter. The reversal is both important and timely. Property/casualty insurance industry capacity had plunged by an alarming $84.7 billion or 16.2% over the previous five quarters (ending second quarter of 2009) from the pre-crisis peak of $521.8 at the end of the second quarter of 2007. Despite the turnaround during the second quarter, industry capacity remains 11.2% below its 2007 peak. However, capacity should improve as we progress into the final quarter of 2009.

Third quarter - a benign period for the insurers

Third-quarter earnings season has been benign for insurers. Though I have not consolidated all the available quarterly results from insurance companies, however, the trend seems to be positive for the insurers. I think the continued improvement in the equity and credit markets since the end of June seems to have provided capital relief and boosted earnings for most insurers.

Life insurers likely to do well in the coming periods

From a valuation perspective, I believe there is still upside left in the group despite the strong rally in life insurance stock from their lows in early March. Currently, life insurance stocks (as a group) are trading at about 1.2 times trailing twelve month price-to-book (excluding accumulated other comprehensive income), still below the industry historical average of 1.6 times and its previous trough of 1.2 times seen in 2002 following the previous bear market. For much for the past decade, it was not uncommon for an insurer to produce a return on equity (ROE) in excess of 15%. In my view, the difficult macro condition will make it unlikely for most life insurers to see their ROE exceed the single digits in 2009 and into 2010.

With credit spreads narrowing considerably in the third-quarter, book values (excluding accumulated other comprehensive income) are likely to increase in the double-digits for most insurers. Following the significant rebound in the financial markets in 2009, the overall capital adequacy of the industry today differs substantially from capitalization levels seen earlier in the year. For the most of companies I follow, I believe capital adequacy is not a major concern. While I expect fixed income impairments to trend down in the third quarter, I believe losses will remain elevated versus historical levels. I believe many companies will continue to see adverse credit migration weigh on their statutory financial positions, reflecting downgrades of securities in insurers' investment portfolios from the rating agencies.

In terms of operating fundamentals, I expect the group to benefit from a number of tailwinds in the third quarter. Rising equity markets are likely to bring considerable earnings and capital relief, through higher asset-based fee income, improved sales and flows of most equity-linked products (I believe this will be especially apparent in the better capitalized names), lower DAC (deferred acquisition costs) amortization, reduced variable annuity rider costs, and lower equity-related statutory pressure.

I expect the steepening yield curve from earlier in the year to help boost profits for insurers' interest sensitive product portfolios. Since early January through September 30, the spread between the two-year and the ten-year treasury increased 78 basis points, widening insurers' operating margins. Although the yield curve has not steepened since the end of the second-quarter, the current low interest rate environment has adversely impacted investment income for the industry. This is because insurers generally invest new money inflows and proceeds from maturing or liquidated portfolio assets at rates of return that are lower than existing investments; putting pressure on portfolio yields. However, this has been partially offset by most insurers gradually reducing defensive liquidity positions and putting new money to work in the capital markets.

I believe sales results will be good in the fourth quarter as the economy is just beginning to show signs of stabilization. In my view, this recession clearly demonstrates a change in consumer behavior toward life insurance, an area that was once thought of as fairly defensive during bad economic times. However, I believe sales of fixed annuities will remain robust since wealth preservation products remain in demand in the wake of the financial crisis. I also anticipate strong sales and flows of 401k plans, mutual funds, and other equity linked products due to the strong equity markets in the quarter. I expect sales of variable annuities to rebound from depressed levels seen earlier in the year, although recent pricing increases and product redesigns should temper growth.