Property/Casualty Insurance Sector Falling Short

It looks like the "mortgage credit" down trade will have run its course for this mid year move (more coming in the second half), and that investors will be wading back into the group albeit slowly in front of earnings. Many of the big commercial and and investment banks (Citibank (C), JPMorgan (JPM), Wells Fargo (WFC), Wachovia (WB), Goldman Sachs (GS) and Bear Stearns (BSC)) are under water year to date, or just about flat.

In the meantime, the financial sector with the worse fundamentals is the property/casualty insurance group, courtesy of a low loss inflationary period (huh). It's the cat with nine lives, enjoying a profit streak long in the tooth, especially considering the notorious cyclicality of the business. In some ways, it mirrors the sub-prime/mortgage world in the sense that underwriting bad policies are somebody else's problem... a few years down the line.

There is absolutely no question that today insurance managements are better stewards of investor capital than in prior cycles. But compounded annual stock returns for some of (what we consider) the more vulnerable mid cap names (Philadelphia Consolidated Holding Corp. (PHLY), W.R. Berkley Corporation (BER) and Argonaut Group, Inc. (AGII)) are well above 20% annually going back some ten years. ROE's will fall from the 20% level to the low double digits if not lower within the next two years, with a chance of money losing operations by 2009.

Cashing in gains before somebody else does it for you (and before second quarter earnings report) and redirecting funds to likely survivors of the mortgage wreckage such as MGIC Investment Corp. (MTG), Freddie Mac (FRE), Countrywide Financial (CFC), Fannie Mae (FNM) and Triad Guaranty (TGIC) will provide considerable alpha going into the second half.