NEW YORK ( TheStreet) -- Losses in the municipal bond market could be a significant problem for insurers in the New Year.

"You are going to see insurers book values fall because they are heavily invested in municipal bonds," said Paul Newsome, managing director at Sandler O'Neill. " Travelers ( TRV - Get Report) and Chubb ( CB - Get Report) are some of the insurers that have large positions."

Newsome says that almost all U.S.-based property and casualty insurers are likely to be hit hard by muni bond exposure, including Allstate ( ALL - Get Report) which has been trying to trim their position. Allstate CEO Thomas Wilson has been outspoken regarding his concerns that budget deficits and funding shortfalls would cause market-value declines in the municipal bond market.

Newsome recommends that investors stick to Bermuda-based insurers such as ACE ( ACE) or XL Group ( XL), which are not heavily invested in U.S. municipal bonds.

Municipal bonds are down 9% this quarter due to Treasury yields, a surge in issuance, concerns about the end of the Build America Bond program and year-end selling related to broker "window-dressing", wrote Michael Kim, an associate director at Sandler O'Neill + Partners, L.P in a note.

In addition, the outlook for state and municipal defaults is expected to increase. At least 31 states and Puerto Rico area forecasting deficits in excess of $82.1 billion in the next fiscal year, according to the National Conference of State Legislatures.

"The message of the losses so far is that there is no value in a tax free return if the return of your capital is at risk," says Walter Zimmermann, chief technical analyst at United-ICAP in a note.

--Written by Maria Woehr in New York.

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