Bermuda's insurance industry is well capitalised, but its companies will face significant challenges during the current phase of the insurance cycle.

That is according to AM Best, which has published a special report on the Island's insurance market, and believes firms must consider the opportunity costs for prematurely deploying capital, which could be grave if a catastrophe occurs or margin compression accelerates.

In the report, set to be published tomorrow, Best said the most pressing concern was the lack of meaningful pricing improvements and the forecast for pricing pressure on January 1, 2010 renewals and beyond.

The ratings agency also expects reserve adequacy to be pressured within the next year to two years, as the country's 2009 results have been bolstered by considerable reserve releases from prior years, masking any meaningful deterioration in recent accident years.

Meanwhile it views large catastrophic events as a major concern for the sector as a whole, while it said the compounding effects of underpriced casualty business and possible significant reserve changes over many years were often overlooked.

In addition, uncertainty over the economy continued as the spectre of inflation affects the demand for and pricing of re/insurance coverages, with claims inflation being compounded by pricing constraints in nearly all classes of property/casualty risks and by severe competition in primary insurance markets.

So far this year, net premiums written were $10 billion below 2008 levels of $45.4 billion and total revenue was $7.5 billion lower, but net income was up at $8.2 billion compared to a net loss of $1.1 billion over the same period, said the report.

"Bermudian property/casualty reinsurers would do well to remember the not-so-distant past, because one year after the global financial crisis crossed paths with Hurricane Ike and created a 'live' stress test, they are touting their position of strength through 2009," read the report.

"Indeed, these companies appear to be rife with capital and generating strong earnings, perhaps taking the edge off the memory of the financial crisis.

"Moreover, the lack of natural catastrophes and the rapid turnaround in the equity markets have propelled the capital positions of the Bermuda market companies to a total shareholders' equity of $76.8 billion as of September 30, 2009.

"Unfortunately for Bermuda market participants, despite the solid 2009 results, a balance sheet represents only a point in time, and AM Best reiterates that current industry fundamentals drive future financial condition."

The report found that despite the likes of Validus and PartnerRe announcing takeover deals for IPC and Paris Re respectively, integration concerns, current valuations and financing have presented significant obstacles to wholesale mergers and acquisitions activity to date. And while liquidity had improved and Bermuda market re/insurers had regained access to the capital markets, the cost of capital remained high.

Elsewhere, total investment income has improved noticeably this year, according to Best, as the values of depressed investment holdings have rebounded and realised capital gains and losses have been largely neutral versus 2008, when asset write-downs generated considerable realised losses of $6.3 billion.

In terms of investment allocation, the Bermuda market was split between fixed maturities (82 percent), cash and cash equivalents (seven percent), short-term investments (six percent), other invested assets (four percent) and equities (one percent) during the third quarter of 2009.

Having reaffirmed its stable rating outlook for the global non-life reinsurance industry in March, which extended to Bermuda property/casualty market re/insurers, the ratings agency said its outlook reflected the sector's strong capital position throughout the financial crisis, demonstrating discipline and improved enterprise risk management practices and frameworks.

But it added that the longer term view of this year was considered to be a disappointment regarding pricing fundamentals, with the overwhelming concern that rates would continue to deteriorate and pressure to compete for market share would become too much for carriers to endure.

"Regulatory issues concerning Bermuda and the potential for the United States to change current tax laws under proposed legislation, such as that sponsored by Rep. Richard Neal, are raising questions about Bermuda's future as a prominent centre for re/insurance," the report concluded. Clearly, any such tax-laws changes would have implications for the Bermuda re/insurance market.

"In the long run, however, AM Best expects that given the creativity, re/insurance innovation, accomplishments and value added to a global economy by the claims-paying ability of the Bermuda market, it will be relevant for years to come."