Hard Times, Hardening Markets?

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This article is part of our Rising Star Portfolios series.

I purchased shares of AON (NYSE: AON  ) and W.R. Berkley (NYSE: WRB  ) for my Rising Stars Portfolio because I think underwriting markets will harden. A host of woes are now draining insurers' capital reserves, which can only push rates higher. But a more subtle factor could further harden the market without any push from additional disasters.

A mean, miserable market
Insurers have slogged through years of dour conditions, and net premiums written have been soft for seven years straight. Measured against GDP growth and inflation, that spells bad news and eventual losses for insurers. The industry just can't sustain that.

Worse yet, industrywide losses from the Japanese and New Zealand earthquakes, Australian flooding, and U.S. flooding and tornadoes, as estimated by Munich Re and NatCatSERVICE, came in at $9.5 billion, the most costly first quarter in 10 years.

In addition, AIG (NYSE: AIG  ) CEO Robert Benmosche recently acknowledged that for too long, AIG competed too aggressively on price. Now, it'll have to take additional loss reserves, reducing AIG's capacity to compete and write new business. That's bad news for still-prominent AIG, but good for the industry at large.

Now, in addition to all those elements, a bit of new math could give insurers yet another reason to start raising their rates.

RMS 11: This time, it's mathematical
More than two decades ago, a Stanford graduate student named Hemant Shah set out to create a computer model that could quantify catastrophic risk. Today, California-based Risk Management Solutions' models have become the accepted standard in catastrophe modeling for insurers and reinsurers the world over. Insurers aren't obliged to obey RMS' directives, but when the company speaks, they most certainly listen.

RMS recently released version 11, which effectively predicts worse times ahead for hurricane-prone areas: more wind damage, increased losses from storm surges, and more. If insurers and reinsurers heed its advice, they'll plan for larger losses -- and require bigger reserves to offset them.

The industry can't make up that projected gap just by writing more business. Instead, it needs to charge more for its insurance policies.

The model student revolts?
Anyone who's worked with models knows they combine judgment, science, and a little special sauce -- making their outputs sometimes dubious. Many industry insiders are skeptical of RMS 11's assumption; others, most notably XL Insurance of XL Capital (NYSE: XL  ) , don't see any impact to their underwriting models. But then again, not every insurer's model is forward-thinking.

I'm willing to bet that insurance rates will rise sooner than later -- and RMS 11, in addition to recent catastrophes, should act as catalysts. That's why I'm catching the tide with AON and Berkley. Join me on my discussion board to talk about it.

Michael Olsen does not own shares of any of the companies mentioned. He would consider himself fortunate to one day live in an area rated "high-risk" by RMS. The Motley Fool owns shares of W.R. Berkley and Aon. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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