Moody's Investors Service announced it has revised its outlook for the U.S. commercial lines insurance sector to negative, from stable, citing carriers’ stressed investment portfolios and weak capital adequacy.

The New York-based rating firm’s report also mentioned capital market turmoil, together with continued cyclical weakening of underwriting.

In addition to above-average catastrophe losses in 2008 and the increasing severity of investment losses through year-end and the first quarter of 2009, Moody's said it expects that these pressures will likely  continue to expose commercial property-casualty insurers to a degree of credit erosion over the medium term.

Moody’s said it sees this outlook for the coming 12-18 months.

The firm noted that further deterioration in investment portfolios, outsized catastrophe losses, and the potential for significant litigation costs relating to corporate bankruptcies and the sub-prime mortgage crisis all could place additional strain on the sector over the intermediate term, particularly if capital market access remains frozen for a prolonged period.

Alan Murray, the Moody’s vice president, who wrote the report, said there are several factors counterbalancing strains on the sector.

He mentioned “a stabilizing-to-modestly improving underwriting environment, sound capital levels, and an expectation of reduced inflation trends affecting claim severity, at least in the near term."

Commercial insurers Moody’s noted are also considerably less exposed to the ongoing economic and financial market turmoil than other financial institutions are largely reflecting their relatively modest exposures to the most troubled asset classes.

 Also limiting exposure is the commercial lines emphasis on high-grade corporate and municipal bonds, as well as their comparatively lower asset leverage relative to capital, the firm said.

"Moody's currently believes that commercial insurers hold adequate overall reserves for their expected ultimate policy liabilities," Mr. Murray said in a statement.

"However, we also believe that the redundancy margin has thinned to a level at which earnings could soon cease to benefit from reserve releases, thereby adding significant pressure to insurers' underwriting margins," he added.

In Mr. Murray’s view, "Macroeconomic stress and contraction will likely reduce business volume over the intermediate term, and will continue to pressure insurers' asset quality and capital strength. The impact of these pressures, however, should be muted somewhat by reduced exposure levels, given a smaller employed workforce and lower levels of commercial activity."

The analyst said that, "Together the combined multi-year trends of weakened pricing and depleted reserve redundancies, as well as recent catastrophe losses and ongoing investment-related strains, have compressed commercial insurers' risk-adjusted capitalization in 2008. Looking ahead, ongoing strain on investment valuations, reserve margins, and embedded underwriting profits will likely continue to pressure risk-adjusted capital levels through 2009."

His report is titled "U.S. Property & Casualty Commercial Lines Insurance Industry Outlook."

Moody’s said it will hold a discussion of the commercial insurers’ outlook during a Tuesday teleconference. It said registration and more information about the event is available at www.moodys.com/events.

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