Premium volumes, according to KBW's analysis, could be even lower than expected as competitive pressures worsen and buyer budgets remain tight.

It further estimated that loss ratios could deteriorate as weather normalizes, reserve releases decline and soft rates flow into results.

KBW foresees that expense ratios may rise as premium volumes fall and management teams invest into new platforms.

Investment yields are falling and "income will be weak in 2010," in KBW's view. Its analysts also expect that share buybacks may disappoint and the firm noted that balance sheet risks include weakening reserve positions and the potential of a "double dip" recession hitting investment portfolios.

The firm said the chance of meeting the 9-to-11 percent ROE expectation is low, while the odds of disappointment are high and in either case, it believes valuation expansion is unlikely.

On the positive side, it found valuations are near all-time lows, well below book value, and barring a major catastrophe, another round of credit market losses, or a spike in loss cost inflation, book values are unlikely to decline. The group could tread water. KBW said it focuses its recommendations on companies with sound long-term growth strategies including ACE, Allied World Assurance Company Holdings Ltd. and Hanover Insurance Group.

A portion of the equity analysts' 56-page report says that with the sector having a "not great but not too terrible" fundamental outlook, many investors reach the false conclusion the stocks are "cheap," trading below book value, which may not be possible because overall premium volume decline may be worse than 5 percent.

The study said that the industry's combined ratio, excluding Bermuda-based insurers, is "deteriorating but not terrible for an estimated level of 99 this year and better than 105 for 2010--better than the historical average over the last 40 years.

Regarding merger activity, KBW said it expects that the most likely acquisition targets are still small-to-midcap specialty players with strong niche-market positions, and if improved market conditions create more deals, it is highlighting "names such as American Safety (ASI), Eastern Insurance (EIHI), Navigators Group (NAVG), SeaBright Insurance (SBX) and The Hanover Insurance Group (THG) as potential candidates to be involved.