2018 marked the 13th consecutive year the U.S. insurance industry saw reserve releases. More than $10.7 billion of favorable prior-year reserve development bolstered calendar-year underwriting margins. Workers' compensation (WC) and short-tail lines accounted for $12.6 billion, which was $2 billion higher than the total amount the industry released (see chart 1). The biggest culprits for the $2 billion in unfavorable development were other liability and commercial auto liability. There are still significant levels of reserves related to asbestos and environmental (A&E) litigation subject to elevated levels of reserve volatility. And notwithstanding substantial rate increases, the commercial auto industry can't seem to catch up to loss trends. This is in contrast to the personal auto liability industry's relatively quick return to profitability amid similar loss trends.

Chart 1

U.S. P/C Reserves Remain Adequate Overall

S&P Global Ratings believes that overall reserves are adequate for the near term. Since 2007, the U.S. property/casualty (P/C) insurance industry has averaged about $10 billion in reserve releases per year (see chart 2). Although there certainly are lines of business that need support (such as commercial auto and other liability), our opinion is supported by the steady reserve releases in short-tailed lines and the large reserve releases from WC.

Chart 2

Although the WC line has released significant reserves the past two years, on an undiscounted basis, reserves could appear inadequate in a simple schedule P reserve study. Using schedule P data for a long-tailed line like WC can be insufficient to assess reserves properly given the lack of granularity (exposure classes, limit and retention profiles) and limited tail data. Thus, we don't believe these reserve releases are sustainable at this magnitude despite the significant reduction in frequency the sector has experienced.

Why Are Loss Reserves Important In The Credit Rating Process?

Loss-reserves affect several areas of our credit analysis, including capital and earnings projections, risk position (incorporating additional sources of capital and earnings volatility that are not addressed by our risk-based capital adequacy model), and enterprise risk management (ERM). Loss-reserve adequacy is a key driver when assessing a P/C insurer's creditworthiness, because loss and loss-adjustment expense reserves are the largest liability on P/C insurance companies' balance sheets. As of year-end 2018, the industry held about $660 billion in reserves for all lines excluding mortgage and financial guaranty (see chart 3). To put the magnitude of this liability into perspective, if the industry were to experience a 5% adverse swing in reserves, this would cause a $33 billion dollar pretax hit to earnings and would raise combined ratios by approximately 11 points. Furthermore, these liabilities are management's best estimates from analyses that incorporate numerous assumptions and actuarial methodologies, which can leave them subject to increased volatility and uncertainty. Given the size and nature of these liabilities, when assessing the volatility of reserves, the effectiveness of an insurer's ERM and reserve risk controls influences our opinion. Companies with robust reserve controls tend to be able to identify trends earlier and take swift action to address an issues, which are positive factors to reduce uncertainty in reserve development and our view of capital adequacy overall.

Chart 3

As a result, we leverage a reserve volatility measure using a heat map targeted at key lines of business that have experienced historical uncertainties in terms of prior-year reserve developments. Recognizing that there are other methods and techniques to measure volatility, we selected two volatility metrics, namely "Frequency of Adverse Reserve Development during 1999-2018" and "Reserve Volatility." The "Frequency of Adverse Reserve Development" assesses the number of times a line of business experienced adverse reserve developments in the past 20 years. "Reserve Volatility" is defined as the standard deviation of prior-year reserve developments for the past 20 years divided by average reserve development during the same period. For a given line of business, we scored reserve volatility on a scale of one to 10 with 10 being the worst. In addition, the size of each bubble is based on the ratio of its total reserves to the average of the past five years of earned premiums, normalized for total reserve size (see chart 4). The analysis suggests that the three riskiest lines of business are commercial auto liability, WC, and special property. Material underestimation of reserves has, and could again, lead to downgrades or even company insolvencies.

Chart 4

Personal Lines Reserves: Private Auto Liability Back To Reserve Releases Though Competition Will Pressure Sustainability

Personal-lines reserve releases have been mostly positive since 2003, with the exception of 2016, when frequency trends spiked in personal auto liability (see chart 5). The majority of the releases stem from the proportion of auto physical damage assigned to personal lines, but historically homeowners insurance has provided consistent reserve releases. Suppressed property pricing and recent adverse development from catastrophes has reduced these levels and led to a modest strengthening in 2018 ($84 million).

Chart 5

Taking a closer look at personal auto liability, we observed that companies reacted relatively quickly to the frequency spike in 2016 by taking underwriting actions to refine the risks they were willing to write, and increasing rates to price risks more accurately. This, coupled with the fact that most polices are written on a six-month basis, enabled multiple rate increases to be implemented more quickly. After three years of reserve strengthening, in 2018 the line benefited from nearly $850 million of releases as the industry has caught up to loss trends. It also saw the benefits from safety enhancements, which are becoming common in cars and are starting to reduce claims frequency. Although frequency has declined, severity (which is determined by paid losses 12 months after inception divided by closed claims as of 12 months) continues to grow, driven by increased litigation and rising costs for repairs (see chart 6). With a combined ratio below 100% for 2018, given the competitive nature of personal auto we would expect rates to decrease. Combined with increasing severity costs that accelerated in 2018, this could hurt future development.

Chart 6

Commercial Lines Reserves: Short-Tailed Lines Provide Steady Support, But WC Is Driving The Gravy Train

We separated commercial lines into three broad categories based on the duration of their loss payment patterns: short-, medium-, and long-tail. Accordingly, we view WC, other liability-occurrence, medical malpractice-occurrence, nonproportional reinsurance liability, and product liability-occurrence as long-tail lines. Short-tail lines are those that have condensed two years of historical loss reporting in Schedule P. The medium-tail lines account for all other commercial lines (see chart 7).

Chart 7

Short-tail lines have consistently released reserves since 2003 and during that time have release about $6.4 billion per year on average. The past two years have seen a dip in releases, likely driven by adverse development related to recent catastrophes.

Medium-tailed lines have been under pressure in recent years. Commercial auto insurance has led the pack as significant reserve strengthening led to unfavorable underwriting performance, a combined ratio of over 111% in 2018, and a five-year average combined ratio around 110.6%. Despite multiple rate increases over the past few years, pricing is still lagging loss trends. Also affecting medium-tail reserves has been reduced releases for claims from medical malpractice. Price decreases over a number of years have reduced the amount of reserves released as a percentage of prior-year reserves consistently year over year (see chart 8).

Chart 8

For long-tailed lines, the significant WC releases ($7.1 billion) have more than outweighed the strengthening seen in both other liability occurrence ($2.1 billion) and product liability occurrence ($490 million). Reserve strengthening for long-tailed lines spiked dramatically from 2001 through 2005, driven by a huge increase in asbestos claims, strengthening of reserves for underpriced business written in the soft market years of 1997-2000, and the terrorist attack on the World Trade Center in 2001. Although A&E claims should contribute less to the volatility of results as coverage has been excluded for some time, other liability is still subject to increased litigation risk. The biggest change in fortune relates to recent large WC releases, which have benefited significantly from previous pricing increases and a significant secular trend of decreased frequency through enhanced workplace safety. Occupational Safety and Health Administration (OSHA) and other workplace safety programs have become more standard practice, leading to a significant reduction in claims activity, which has continued to hold up even with the U.S. economy nearing full employment and the percentage of less-experienced employees in the workforce increasing. Looking at claims reported 12 months after inception as a percentage of net earned premium, this ratio has dropped tremendously. Although we have seen modest increases in average severity of claims closed at 12 months, the decrease in frequency far outweighs that growth (see chart 9).

Chart 9

Nevertheless, this trend can't last forever and there are signs that these large reserve releases can't be counted on to the same degree. Firstly, we are seeing significant rate reductions to reflect these trends. In 2018, despite low levels of unemployment, states like California saw direct written premiums decrease, highlighting that rate changes have begun to outpace exposure growth. Secondly, we are seeing a stabilizing of initial loss-pick selections the past three years after consistent declines (see chart 10). Although these earlier years with higher initial loss picks are still seeing releases at more-mature evaluations, the data suggest that these more-immature years won't have the same levels of releases seen in later development periods. Barring a significant shock to the system, such as a mass tort change or torts stemming from the opioid crisis, we don't see the pattern of reserve releases reversing course, but rather tapering down.

Chart 10

2019 Outlook: The Ride Continues, But Just Coasting

We expect overall reserve development for the industry to remain favorable given the steady positions for short-tailed lines and favorable WC secular trends. Although the industry will remain challenged by commercial auto and long-tailed casualty lines with the potential for additional pressures in personal auto given severity trends, we don't see the reserve release gravy train getting derailed in 2019.