For the next year or two, we believe that ratings downgrades, low investment returns, balance sheet concerns, withdrawals from the market, shareholder pressure, and a new generation of financially sophisticated senior-management teams argue for a stable operating environment.

Not that there arent grounds to be cynical (skeptical sounds better) about the current cycle and valuations of insurance stocks: Improving results, strong cash flows, the build-up of capital and heightened competition suggest the cycle is nearer the end than the beginning.

From an investors perspective, valuations of specialty stocks have not been this high in years. Further, because they are dial-up companies in a wireless world, insurance stocks tend to underperform when the tech-heavy Nasdaq market does well, which has been the recent case.

But consider being skeptical of the skeptics. In general, the glass-half-empty drumbeat surrounding the insurance operating environment and insurance stocks in the second half of 2003 proved too clever by half.

Renewals went better than expected, and specialty insurance stocks significantly outperformed the broader S&P 500 index through the first quarter of 2004, rising 12.3 percent during the quarter, versus a 1.3 percent gain posted by S&P 500.

Following several years of robust top-line growth, we see 2004 premium volume slowing to the single-digit or low-double-digit level for many specialty insurers. We also anticipate terrific earnings reports and strong book value growth for the majority of companies.

Further, specialty insurance stocks are off to a good start and may again prove to be among the most attractive segments of the p-c insurance market in 2004, considering the overall marketplace landscape.

Property premiums, which make up perhaps 20 percent of all commercial lines p-c volume, are already declining, albeit to still-adequate levels. Here, recent underwriting profitability, a lack of reserve issues and new capital formations are exerting a real-time influence on rates. Additionally, bolstered by reinsurance support, a few larger insurers are now offering property limits not seen since before the 9/11 attacks.

The casualty market, by far the largest segment of the commercial insurance market, remains firm. Buyers of casualty coverage face single-digit rate increases for many lines, and larger increases for tougher lines, such as professional and products liability. Remember that these increases are on top of three or four prior rounds of larger hikes, resulting in a significant cumulative effect.

The longer-tailed casualty market responds slower than the property market to changing conditions. While pricing has finally gotten in front of loss costs, unpleasant memories of devastated balance sheets, rating downgrades and the juggernaut of higher lawsuit costs remain fresh in underwriters collective memories. The result is a sellers market that should persist into 2005.

Approximately 60 percent of the p-c marketthe heavily commoditized private passenger auto, homeowners and workers compensation segmentsmay soon face political and regulatory resistance to continued rate increases. That is because of the perception of excess profitability in auto and homeowners and the inability of customers to bear additional premium hikes in workers comp.

Consequently, its no surprise that the specialty (non-commodity) commercial segment of the p-c insurance market has attracted investment capital. Currently, several of the leading stocks in this category trade at book-value multiples of twice or better, compared with one-and-a-half times book value, or less, for many standard-market insurers.

What are specialty insurers?

First, well start with what they are not. If you are an average or plain-vanilla risk, then a standard market company rather than a specialty carrier probably covers your business. Over time, the premiums you pay dont cover the insurers losses and expenses. In effect, those insurers are handing their excess capital over to you.

If you require unusual or hard-to-underwrite coverage for risks such as professional liability, earthquakes, vacant buildings, environmental or construction, you are likely to be a customer of a specialty insurer. And the insurer makes money off you. It has to, over time, in order to pay your occasionally large directors & officers coverage, earthquake, fire, or similar claim.

Specialty insurance companies have historically produced far better underwriting results and better returns on equity than their standard-market counterparts. Not surprisingly, the result has been bigger stock price gains.

As shown in the accompanying graph, the leading specialty insurers have produced superb results in the past decade, trumping both the S&P 500 Index and the S&P 500 Insurance Index by wide margins.

Included in our specialty insurance group are HCC Insurance Holdings, Penn-America Group, Philadelphia Consolidated, Markel Corp., RLI Corp. and W.R. Berkley Corp.

But the $64,000 question is, how will their stock prices hold up in the slowing top-line environment that we expect? We do not expect expansion of book-value multiples from current levels, despite the observation that they remain below the nearly three-times or better level seen in 1997-1998.

Instead, a likely scenario would be for multiples to remain constant or decline only modestly throughout this year, offset by a healthy increase in book values. In what looks to be an increasingly volatile stock market, that may be welcome news even for a cynic.

John Keefe is senior vice president at Ferris, Baker Watts Inc., a retail brokerage and investment bank headquartered in Baltimore.

Reproduced from National Underwriter Edition, April 23, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.