Only the doublethinkers of Wall Street would choose this year to become bullish on insurance stocks. Consider: Eight of the 10 most expensive disasters in the history of America have happened in the past four years. And according to the chief economist of the Insurance Information Institute, Robert Hartwig, “2005 will be by far the worst year ever for insured catastrophe losses in the U.S. at more than twice 2004’s record.”

Can that really bode well for insurance stocks?

Peter Strait thinks so. According to Mr. Strait, an insurance analyst for Williams Capital Management, the horrific losses resulting from Katrina, Rita, and Wilma will result in property and casualty (P/C) insurance industry losses of some $80 billion pre-tax, or about 13% of American industry capital at year-end 2004. In effect, losses will effectively wipe out this year’s earnings.

However, losses typically lead to substantial increases in insurance and reinsurance rates, which in turn can boost profitability and returns. Accordingly, Mr. Strait is bullish on most of the stocks in the group. He acknowledges, though, that those who predict such things are forecasting an ongoing major storm cycle, which may mean the industry’s losses this year could be repeated in years to come.

Reviewing a history of catastrophic storms since 1900 indicates how benign the last few decades have been. In the 1970s, for example, there were only four storms rated “category 3 or above.” By contrast, in the last five years we have already suffered 10 such storms. This astonishing figure harks back to the decades of the 1930s, ’40s, and ’50s, during each of which eight or more major tropical storms took place.

Many analysts and investors are positive on insurance stocks because they expect history to repeat itself. One of the best and worst events for insurers was the terrorist attacks of September 11, 2001. Property and casualty income and returns for the industry leading up to that event had been in decline. After hitting a high of $36.8 billion in 1997, income in 2000 had shrunk to $20.6 billion. The losses incurred by the World Trade Center attacks threw the industry into red ink but simultaneously caused an instant firming in prices.

By 2004 profits for the P/C business had reached the record level of $38.7 billion. Mr. Strait and others expect the recent large losses will result in a similar pattern. “Before the hurricanes, it looked like property rates were going to be down 10%-15% in 2006,” Mr. Strait says. “Now we are forecasting they will be up 5%-10%. Rates for reinsurance may rise as much as 20%-40%.”

In this sort of environment, insurance companies can return to the high end of their returns cycle. Another factor influencing Mr. Strait’s recommendations is the overhang of accounting and legal issues on two large companies – AIG (AIG $67) and Marsh & McLennan (MMC $29). Mr. Strait is especially keen on those stocks, because of the potential of price/earnings multiple expansion as their accounting and legal issues recede.

Specifically, AIG, which has historically sold at a premium to the group because of above-average returns and its widely diversified business portfolio, is currently selling at roughly 10 times earnings. Mr. Strait thinks the stock could reasonably sell at 14 or 15 times next year’s earnings, which are forecast at $6.05. Thus, his target price for the stock is $90.

The case for Marsh & McClellan, the largest insurance broker, is similar. In this case, Mr. Strait is looking at earnings in 2007, by which point he thinks the company will have put its legal issues behind it. The stock is selling at around 10 times 2007 projected earnings of $2.60; Mr. Strait thinks a more appropriate valuation would be 14 or 15 times, leading to a target price close to $40.

Despite the probable rate surge, not everyone is positive on the insurance stocks. Mr. Hedwig confirms that there are low barriers to entry in some sectors of the insurance business such as commercial lines and reinsurance, which have assuredly contributed to the mediocre returns earned by the industry in the past. Mr. Hedwig also notes that “this industry has two major players – stock companies and mutual companies, which operate with lower returns.”

Mr. Hartwig’s work shows that industry-wide return on equity during the 2001-04 period was on the rise, but the numbers are still below the average of most industries, and ranged from a loss in 2001 to 10.5% in 2004. In the first half of this year, industry ROE totaled 15.3%, but then came the hurricanes.

In fact, comparing P/C companies to all American industries going back to 1987, the insurers have steadily underperformed. Mr. Hartwig says American P/C companies “missed their cost of capital by an average of 6.3 points from 1991 to 2003.” Not a sterling record.

And yet as of last week, according to Mr. Hartwig, 15 insurance companies had announced plans to raise $6.3 billion in new capital. In addition, there were five new companies starting up, with expectations of raising another $5.2 billion.

New entrants are attracted by the prospect of charging higher rates, while not having any liability for the storms just passed. Several private equity firms and a former chief executive of Marsh & McClellan, Jeff Greenberg, are among those rushing to set up shop.

Another risk is that encountered by any regulated industry. Consumers will not be happy with higher insurance premiums, and voters won’t like claims being disputed by insurance companies.

Numerous lawsuits have already been filed, questioning whether water pushed by winds constitutes wind or flood damage, or whether a barge puncturing a levee is responsible for damages rather than the resulting flood. Mr. Hedwig notes that the American Tort Reform Association describes New Orleans as a “judicial hellhole.” More bad news for insurers.

On balance, there may be a trading opportunity in some stocks in the group, but the case for the industry overall is unconvincing.