Merrill analyst modestly negative on insurance credits but notes spread widening

By Ronda Fears

Nashville, Tenn., Sept. 3 - Merrill Lynch high-grade bond analyst Angelo Graci is still mostly negative on insurance credits but noted that spread widening in the sector is creating substantial relative value that is making the group more attractive.

Featured in the report, among others, are convertible issuers ACE Ltd., MetLife Inc. and The St. Paul Cos. Also mentioned are convertible issuers Prudential Financial Inc., RenaissanceRe Holdings Ltd. and Travelers Property Casualty Corp.

"The insurance sector certainly looks more attractive on a relative basis than it did during the first six months of the year," Graci said in a report.

"In intermediate maturities, investors can now pick up 46 bps on average relative to banks, compared to 11 bps six months ago and 4 bps in early July. We believe this spread differential represents historically high value. While we still recommend an underweight overall in the insurance sector, the rather substantial relative value is testing our limit."

Compared to industrials, the change in the spread differential is much more pronounced, he said. On average, intermediate insurance bonds offer 39 bps of additional spread relative to industrials, compared to a give up of 10 bps six months ago and 4 bps in early July.

"Investors turned on a dime in July, and drove insurance credit spreads from historically tight levels to historically wide levels in a matter of weeks," Graci said.

"Intermediate single-A insurance bonds are now at their widest levels during the past six month period, essentially erasing all the gains since Sept. 11 and then some."

Intermediate insurance spreads widened 30 basis points over the past six months to 161 bps over, 55 bps wider than 106 bps in mid-June, he said, and clearly represents underperformance relative to banks and industrials, which tightened an average of 5 and 19 bps respectively over the last six months. Since mid-June, banks and industrials have widened by only an average of 18 and 19 bps, respectively.

Long A-rated insurance bonds widened 55 bps on average over the past six months and are off by 61 bps from tights reached in mid-June, he said, noting over the last six months long insurance paper lagged other sectors, like long bank bonds that widened 10 bps on average and long industrial bonds that narrowed 11 bps on average. Since mid-June, long bank and industrial bonds widened by an average of 32 and 29 bps, respectively.

Overall, Merrill Lynch has a modestly negative credit outlook for the life insurance sector.

"The life insurance sector should show operating earnings growth in FY02, although the disparity between net and operating earnings will likely remain wide. We expect credit losses to extend into 2H02, but we also expect losses to remain manageable within operating earnings," Graci said.

"Exposure to the equity markets is also a concern for those companies weighted in variable products. Dents in the investment portfolios have weakened capital levels, which still remain strong, in our view."

In general, Merrill Lynch has a stable credit outlook for the property and casualty insurance sector.

"The property and casualty insurance sector should show strong operating earnings growth in FY02. However, asbestos grabbed the spotlight in 2Q02 and we expect additional news to come out in 2H02," Graci said.

"Lingering concerns regarding general loss reserve adequacy, troubled business lines, exposure to catastrophe losses and weak investment results also pose a threat to the sector's earnings growth potential."

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