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Strong upward movement in the markets from the March 2009 low has been led by the financials, and insurers have benefited as investment portfolios have regained some positive momentum. Now the question is whether the rest of the year will play out as 'sell in May and go away', or ride a summer rally.

While many will argue that valuations are still attractive by historical standards, there remain reasons to be cautious on the insurance sector.

  • Hurricane season will soon begin, and this year is forecast to be an active season. Already in the first quarter, catastrophe losses were above normal. The Icelandic volcano, several earthquakes, bad winter storms, and spring flooding, all presage a potentially turbulent season.

  • Competition remains fierce as demand for commercial coverage has fallen due to economic recession, and industry rates have declined. Insurers will be hard pressed to produce increased profits if demand remains sluggish amid a weak economy and prices drop further. According to the Property Casualty Insurers Association of America, U.S. property-casualty insurance sales last year fell by 3.7%, the most in five decades. Industry rates for U.S. commercial insurance fell 5.3% in the first quarter. Rates have fallen each quarter since 2004, according to the Council of Insurance Agents and Brokers.

  • Reserve redundancies, which boosted insurer earnings in some recent years, are not as likely to boost future results. While inflation remains low, claim costs are rising in many areas as premium rates fall. Just last week, the Insurance Information Institute issued a press release stating that New York no-fault auto claim payouts reached their second-highest rate in years, in the fourth quarter of 2009, due to fraud and abuse.

  • Losses from new and emerging risks continue to threaten the industry, although many believe current exclusions provide protection. In particular, insured loss emanating from cell tower RF radiation is on the verge of development into a costly issue. Such antennas are proliferating as telecom moves from 3G to 4G. Insurance industry risk exposure to third-party worker claims is significant. Also, there is a simple no-cost solution available, but the industry has not yet recognized that a problem exists.

  • Financial reform is still working its way through Congress. Tucked into Sen. Christopher Dodd’s bill is a provision that would help companies preempt state rules that govern reinsurers by creating a U.S. Treasury Department office to negotiate international regulations. That would be considered positive by the global reinsurers that are currently required to post higher collateral than domestic firms. However, financial reform may also come along with higher reserve requirements that would hit financial statements, as well as with a possible global financial services tax.

  • Healthcare reform will require $409.2 billion in higher taxes according to an analysis by the Congressional Joint Committee on Taxation. High income investors will pay 3.8% in Medicare taxes, and tax breaks for out-of-pocket medical deductions will be curtailed. The new healthcare reform measure will also charge employers with 50 or more workers a tax of $2,000 per worker if they don’t offer health insurance. While these tax measures are designed to cut the budget deficit, they will also cut into net disposable income. Some of these taxes won’t go into effect for several years, but large employers are nonetheless likely to reduce existing health insurance offerings, and to cut pension benefits further, perhaps offsetting the positive from inclusion of a greater number of participants. There has also been talk of health insurance premium price controls.

  • If the economy continues to improve, as appears to be the case currently, then the Federal Reserve may soon have to begin raising interest rates. That would take some steam out of the financials and the markets. Already, the government programs which have provided the economic boost are being cut back, and it is not yet clear that the private sector can sustain growth on its own without government support.

Overall, insurance stocks can be expected to move with the market in the near term, as investment income will drive earnings results. At the moment, there is no catalyst for rate hikes and there is little reason to expect significantly higher demand. Some good news in recent months helped the sector – AIG’s (NYSE:AIG) pending sale of two major units for prices well above the amounts expected a year ago, and Hartford Financial Services’ (NYSE:HIG) quick repayment of its TARP money. However, high catastrophe losses, rising claims costs, increased taxes, emerging risks, and other factors, could all cast a shadow over future stock performance.

Editor's note: The following stocks could be affected by this: Unitedhealth Group (NYSE:UNH), WellPoint (WLP), Aetna (NYSE:AET), CIGNA (NYSE:CI), Humana (NYSE:HUM) and the Healthcare Providers ETF (NYSEARCA:IHF)

Disclosure: No positions

Source: Insurance Stocks: More Smooth Sailing or Storms Ahead?