Europe's property and casualty insurers will be challenged to increase profitability for the remainder of this year, reinforcing the negative outlook Moody's Investors Service has on the sector.

“Moody's considers that European insurers' [first-half] 2010 results represent a period of contrasting quarters, at least for the investment markets,” noted David Masters, an analyst in Moody's London office, in a report on the state of the market.

He noted that the first quarter “generated generally positive investment results, which were offset by significant market volatility [in the second quarter].”

In a report authored by Mr. Masters–”European Insurers' H1 2010 Results: Capital and Earnings Stabilize but Market Conditions Remain Challenging”–he warns that European p&c insurer results will remain challenging over the near term due to generally flat combined ratios for primary insurers in the first half of this year, plus deteriorating results for reinsurers following unusually heavy natural catastrophe losses.

However, this picture is not uniform across markets, according to Mr. Masters, who pointed out that some markets are witnessing significant premium-rate increases, such as in the United Kingdom and Ireland. Others remain soft, such as the German motor sector, despite meaningful levels of claims inflation, he noted.

Moody's said life insurance margins showed a slight worsening for the first half of the year, despite increased sales volume. The report noted that the deterioration was caused primarily by changes in insurers' business mix rather than by deterioration in underlying profitability.

The report goes on to note that insurers' ability to issue debt “remains subdued” despite better access to capital markets, compared to the same period last year when only the largest insurers were able to access the markets.

The ability to issue debt will increase over the coming quarters as Solvency II–the new financial regulations for the European Union going into effect toward the end of 2012–evolves and further industry consolidation occurs, the report suggests.

In a separate report, Moody's said that European insurer exposure to certain heavily indebted countries within the euro zone is not expected to weigh down the credit profiles of those carriers.

“Crucially, while gross euro zone sovereign debt exposures remain significant for many European insurers, the insurance sector's net exposures–after policyholder participations, tax and minority interests–remains manageable, particularly given the general ability of insurers to hold assets to maturity,” said Mr. Masters.

In the report, Moody's also said it does not expect European insurers to be forced to crystallize the current levels of loss-to-par suggested by the market value of some of these assets, due to European insurers' continued strong liquidity.

Equally, Moody's noted that during the 2010 first half, European insurers have, in aggregate, witnessed reductions in the value of their Greek sovereign debt, driven by both spread-widening and active net-selling.

Mr. Masters said that while certain euro zone countries clearly face a number of challenges, “sovereign ratings for these countries, other than Greece, all remain investment-grade, reflecting medium-term credit fundamentals.”

He added that the relative ratings (“Aaa” to “A1″) are based on each country's economic vitality, government financial strength going into the crisis, and the intensity and likely success of fiscal adjustments to stabilize debt metrics.

“These ratings remain higher than the majority of European insurers' corporate bond portfolios,” Mr. Masters noted.

He cautioned, however, that while the current risk remains manageable, if European insurers suffered meaningful investment or operational losses in the euro zone due to a worsening of the economic climate, “it could trigger negative rating actions on individual insurers.”

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European Insurers&#039; Struggle Warrants &#039;Negative&#039; Outlook

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