Budding concerns about loss emergence is building enough momentum for the U.S. property/casualty (P/C) insurance industry to find religion once again on pricing. We characterize this hardening rate cycle as loss-cost driven rather than capital-replenishment driven, as we saw in prior cycles. The sector's capital keeps reaching new heights partly because of asset appreciation and dwindling share buyback activity.

The sector's capital redundancy helps provide a buffer against severity shocks such as catastrophe activity and latent liabilities. And although capital is ample, P/C insurers are still demonstrating restraint by withdrawing underwriting capacity in underperforming business lines, raising attachment points, and reducing limits and asymmetrical re-pricing efforts where it is needed the most. We think the sector is strategically holding onto more capital as a matter of prudence over growth opportunities. We also believe enterprise risk management programs are effective and investment strategies are conservative. These factors support our continued stable outlook on the U.S. P/C insurance sector.

S&P Global Ratings has been watching pricing complacency over the last few years, as mentioned in our prior sector outlooks. The industry started increasing pricing in 2018, but we viewed those low single-digit increases as subpar and as a bleak market correction. Starting in 2019, the magnitude of pricing increases rose to 6% on a composite basis and even to double digits in some business lines. To harden rates, there has to be an impetus, and in this case it is social inflation, a trend we saw more clearly in the 1970s. It may take time to completely attribute loss trends to a rise in social inflation, but from our standpoint it may be more of a matter of prolonged pricing complacency.

Another long standing issue is possible reserving complacency. From 2006 to Sept. 30, 2019, in aggregate the P/C sector released a striking $133.7 billion of reserves, which translates to 16% of the industry's $822.4 billion surplus. We're still pessimistic regarding the available reserve cushion and believe that the amount of favorable reserve development will likely dampen and could reverse course.

The U.S. Economic Outlook

After a prolonged expansion, our economists are predicting the risk of recession 12 months out at 25%-30%, as of November 2019. We have moderated our views from August 2019, when we pegged the risk of recession at 30%-35%, reflecting improvements in economic conditions, namely escalation in trade talks between the U.S. and China as evidenced by signing of the Phase 1 of a trade deal, reduced concerns about the manufacturing sector, and a more accommodative monetary policy. Nevertheless, uncertainty remains, and the dispute could still have longer-term consequences on global supply chains and business sentiment.

It feels like déjà vu all over again, as the Fed has instituted an abrupt change in its monetary policy by reducing rates three times in 2019. These rate cuts act as insurance against risks from tariffs and slower foreign growth on balance with subdued inflation. Although we anticipate no further rate cuts in 2020, these actions have put a lid on the slowly rising interest rate momentum we have seen between 2014 and 2018. Simply put, interest rates will remain low for the foreseeable future. We believe 10-year Treasuries will slowly rise and remain range bound between 2%-2.5% through 2022. We also pay attention to the term spread (10-year minus three-month Treasury rates), which had been negative since late May but reversed its trajectory to become positive in mid-October. The "un-inverting" of the yield curve is a potential sign of easing concerns about an upcoming recession.

Under our baseline forecast, we expect core inflation to drift higher in 2020 but not break out above the 2% targeted by the Fed. Inflation can raise claims costs faster than P/C insurers can adjust premium rates. While the consumer price index (CPI) is the standard inflationary indicator, we pay more attention to medical inflation and litigation trends to assess lost costs.

Under our base case, we forecast real GDP growth transitioning back to longer-run growth potential of 1.9%-1.8% starting in 2020 through 2022 from 2.3% in 2019. Growth in P/C direct premiums written (DPW) has generally paralleled that of nominal GDP, with the notable exceptions during hard P/C pricing cycles. The gap between DPW growth and nominal GDP closed in 2018, and DPW is set to outpace nominal GDP due to firming pricing.

Chart 1

Long Overdue Pricing Actions: Asymmetrical Movements

After a prolonged period of pricing remaining too low for too long in many product lines, things began to change in 2018, though by subpar single digits. We view 2019 as an inflection point as pricing momentum significantly accelerated and is finally keeping pace with loss cost trends, although pricing adequacy is a mixed story depending on the line of business. On a composite basis, pricing (except workers' compensation [WC]) was up in the mid- to high-single digits during 2019. There are several lines where pricing actions reflect long-overdue pricing corrections, such as commercial auto, large account property, financial, and professional lines. We are seeing steeper rate increases in those lines placed in the excess and surplus market after AIG, Lloyds, and Swiss Re Corporate Solutions withdrew underwriting capacity. We are optimistic about the continuation of rate increases into 2020 (see chart 2).

Chart 2

It is not all about headline pricing actions--we couple pricing with re-underwriting. In particular, insurers who write larger account sizes have been reducing limits, raising attachment points, and redefining their underwriting appetites. Ultimately these coverages have migrated from a single carrier to a co-shared or layered basis among various carriers. There is more gravitation to market clearing limit sizes rather than outsized limit variation by insurer.

We are seeing cross-line subsidization to compensate for underpricing in vulnerable business lines. For instance, commercial auto is becoming the enabling product for commercial multi-peril packages policies with the same client. This is a shift from years ago when WC was unprofitable and this line was the enabling product. Given rate adequacy variability by line of business, we also look at insurers' business mixes to assess competitive strengths.

Is Social Inflation Just Inflation?

Social inflation is the new-again buzzword in the P/C sector. While there's no single definition, insurers generally use the term "social inflation" to describe the increased propensity for plaintiffs to sue and be awarded higher noneconomic damages spurred by social factors including the rise in litigation financing firms, political temperament of judges, and possibly Millennial influence within juries.

In our research, we found that social inflation is not a new buzzword--it has been referenced since the 1970s--it is just gaining popularity again. In fact, tort-reform laws have been implemented across many states over the last few decades for the exact purpose of reducing litigation and damages. On the contrary, we have also seen limited evidence of liberalization of the tort system expanding the size of the litigation economy as some states had expanded the statute of limitations (i.e., reviver cases). If social inflation is leading to a rise in exaggerated damages, then perhaps a more appropriate way to characterize tort reform is tort lethargy.

Furthermore, we also observed greater losses within the excess casualty layers. Typically maximum limits for commercial general liability policies are $1 million per occurrence and $2 million aggregate. These limits have not changed in many decades, at least dating as far back as the 1985 liability crisis. Perhaps the fact that losses are now piercing the excess casualty layer is more of a function of general inflationary loss experience rather than rising social inflation.

Favorable Reserve Development: The Ride Continues, But Just Coasting

We continue to be surprised about the consistency of sizable reserve releases during the past 14 years. While we believe the industry's reserve position is adequate, reserve cushion from more mature accident years is running out. Of note, the sector released $4.6 billion of combined reserves for accident-year 2018 alone during the first nine months of 2019, which was 67% of the total $6.9 billion of reserve releases for the period, according to S&P Market Intelligence. We are cautious of this trend because it could take more time for the 2018 accident year to season to warrant a release of this magnitude.

The latest availability of reserve development by business line is as of calendar-year 2018. During this period, more than $10.7 billion of favorable prior-year reserve development bolstered calendar-year underwriting margins. WC and short-tail lines accounted for $12.6 billion, which was $2 billion higher than the total amount the industry released (see chart 3). 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 line's relatively quick return to profitability amid similar loss trends.

Chart 3

Prospectively, we are cautiously optimistic that overall reserve development for the industry will remain favorable given the steady positions for short-tailed lines and improving WC loss emergence, albeit somewhat offset by a 40% cumulative rate decrease for this line (for private carriers) since 2003, according to National Council on Compensation Insurance (NCCI). We don't expect 2020 will be the inflection point where reserve development will become unfavorable. Instead we expect to see more reserve strengthening for vulnerable business lines including commercial auto and long-tailed casualty lines.

Price Firming Hasn't Expanded Underwriting Income Yet

Based on S&P Global Market Intelligence data, the industry's statutory combined ratio (including policyholders' dividends) of 97.9% in the first nine months of 2019 was modestly up from 97.5% during the same period in 2018. Underwriting performance through the first nine months of 2019 compared favorably with the average 2014-2018 year-end combined ratio of 99.8%. Prior-year favorable reserve development remained robust but dipped to $6.9 billion for the first nine months of 2019 compared with approximately $11.1 billion for the same period in 2018. We anticipate this reduction in favorable reserve development was offset with lower catastrophe losses during the first nine months of 2019 compared to the same period the previous year.

By segment, commercial lines' direct incurred loss ratio modestly deteriorated to 56% in the first nine months of 2019 from 55% during the same period the prior year; however, it is worthwhile pointing out some moving parts. Some underwriting improvements in property exposed lines offset deterioration in casualty exposed lines, with the exception of commercial auto (modest 1% direct incurred loss ratio improvement). These trends suggest possibly improved catastrophe experience in comparable periods. WC (for private carriers) is still having a good run since it became profitable in 2014. In fact, according to NCCI, private carriers are poised to report an 87% combined ratio for WC in 2019, which is very strong despite a notable increase from 83.2% in 2018, the second-best performance since the 1950s, and is a part of a string of combined ratios below 100% over the last six years. Nevertheless, we expect WC profitability at current margins to continue to narrow, especially given the single-digit rate declines. As long as WC remains this profitable it skews aggregate commercial lines results given its 16% proportion of premiums within the overall commercial lines segment.

Personal lines recorded a 64% direct incurred loss ratio in the first nine months of 2019 compared with 63% for the same period in 2018 due to improved homeowners loss experience offset by a modest uptick in personal auto losses.

Capital Keeps Reaching Record Heights

The industry's very strong capitalization is the cornerstone of our stable outlook. We estimate that rated U.S. P/C insurers have a 20% risk-based capital buffer at the 'AA' level per our capital analysis as of 2018, significantly up from a 9.5% buffer in 2017. As capital increases, it becomes less of a ratings differentiator.

We expect the industry to continue to demonstrate capital strength; overall industry surplus levels peaked again at $822.4 billion as of Sept. 30, 2019 (according to S&P Market Intelligence) compared with $756.9 billion as of year-end 2018. While the sector produced strong earnings, capital growth is more aptly attributed to unrealized gains of $50 billion as equity market recoveries more than replaced the $45 billion unrealized loss experienced in 2018.

The U.S. P/C sector has maintained subdued share-buyback activity during 2019 relative to the prior year (see chart 4). Specifically, the sector repurchased approximately $4.1 billion of shares during the first nine months of 2019 compared with $4.8 billion for the same period last year and $11.7 billion in 2017. In addition to absolute share-buyback levels falling, share repurchases as a percentage of earnings have remained modest, below 30% during the first nine months of 2019 for the second consecutive year compared with 100% during the same period in 2017.

Chart 4

Management sentiment appears to be similar in 2019 as 2018 with share buybacks no longer the preferred capital-deployment measure. Chubb, Travelers, and Allstate led the pack, as each repurchased $1.2 billion, $1.1 billion, and $0.9 billion of shares, respectively, during the first nine months of 2019, in line with levels repurchased the prior year. AIG has significantly curtailed its share repurchases relative to historical levels, leaving more capital for merger and acquisition (M&A) deals and other capital-management actions.

Insurers also are retaining a larger proportion of their net earnings in their operating companies with a payout ratio (dividends/net income) of 51% through nine months in 2019, slightly up from 48% in 2018 but well below the 10-year average of 130%.

We suspect P/C insurers are holding onto dry powder as a matter of prudence, including growing industry sentiment that litigation is on the rise. Secondary considerations are selective organic growth opportunities in a hardening rate environment where risk-adjusted returns can be met and strategic M&A activity.

California Is Losing Its Cool Appeal

California is losing its appeal for homeowners insurers as wildfires are becoming more commonplace and regulatory risk is on the rise. Record 2017 and 2018 insured wildfire losses are imprinted deep within insurers' memory bank. We are continuing to see heightened focus on exposure and aggregation management; however, culling and pricing efforts to better fit with risk tolerances is becoming increasingly challenging to implement.

Proposition 103 is a regulatory restriction within the state that caps rate increases by 7%--well below repricing efforts needed to move California back to the black as 2017-2018 collectively erased twice the combined underwriting profits for the homeowners line for the past 26 years, according to Milliman. More aptly, double-digit rate increases are needed within reassessed fire lines. This rate cap also makes it more difficult for primary writers to pass down higher reinsurance costs to homeowners. Adding fuel to the fire, California instituted a mandatory moratorium (senate bill 824) in December 2019 to restrict insurers' ability to not renew 1 million policies to homeowners living near a wildfire disaster zone until Dec. 5, 2020; further handcuffing their capabilities to manage existing risk exposures. For new business in fire zones, however, we expect little appetite propelling the state to expand the Fair Access to Insurance Requirements (FAIR) plan (residual market) to double limits to $3 million. While the FAIR plan welcomed the increased limits, plan participants are pushing back on the further requirement to offer a homeowners policy instead of an endorsement that just covers the wildfire peril only by filing a petition to have the court vacate or withdraw the order. Ultimately the risk gets redirected back to private carriers that are mandated to participate in this residual pool if they offer homeowners insurance in the state.

We foresee heightened regulatory restrictions and higher perception of risk for wildfires could drive large players to reduce their California homeowners exposure in the years to come (once the moratorium is lifted). Nonetheless, we do not necessarily see large insurers embarking on a mass exodus of California as we saw in Florida a number of years ago. It is more difficult to completely exit California given the size of the market because it constitutes one-seventh of the U.S. economy.

M&A Activity Is Decelerating, With Expensive Valuations

We will not rule out the possibility of blockbuster deals occurring in 2020; however, current valuations make acquisitions expensive. Bolt-on deals are the more likely M&A darling than transformational acquisitions.

M&A activity slowed in 2019, with $4.9 billion of U.S. P/C primary insurers' announced deals compared to $30.5 billion in 2018. Deal flow in 2019 did not benefit from mega deals as was the case with the AXA-XL and AIG-Validus transactions, with Tokio Marine's acquisition of PURE being the largest transaction during the year for a purchase price of $3.1 billion. By acquiring PURE, Tokio Marine enhanced its U.S. presence, added a component of fee income given the attorney-in-fact relationship, and has the capabilities to grow in the high-net-worth homeowners market, which is fragmented and more specialized than the standard homeowners' policy. Other M&A transactions throughout the year were generally bolt-ons providing greater capabilities or scale within the markets they compete, as evidenced by Liberty Mutual's acquisition of AmTrust's surety operations.

We believe the deal flow for M&A in the P/C insurance industry in 2020 will look more like 2019 with bolt-on opportunities enhancing market positions or underwriting strengths. Excess industry capital and better opportunities for organic growth given a hardening market could persuade domestic insurers to remain patient, as they were in 2019. Nevertheless, we expect large personal line writers could look to enhance capabilities, allowing them to build a commercial presence potentially through M&A. We are also seeing carriers continuing to make technology-targeted bets, partly to defend their competitive positions and enhance capabilities to improve connectivity with the insured through distribution, claims management, or pricing capabilities. These capital-lite deals have a different risk/return profile. Some insurers have also expanded their appetites to buy noninsurance companies, which could become more appealing if investment returns remain unappealing.

Chart 5

Investments: Growing Equity Holdings Because Of Market Appreciation

P/C insurers typically invest fairly conservatively, with investment-grade bonds dominating their investment portfolios. Traditionally, P/C insurers have favored municipal bond investments, yet tax reform has reduced the attractiveness of tax-exempt municipals and has led the sector to increase its allocations to corporate bonds and structured assets, including collateralized loan obligations (CLOs). We don't foresee the sector's holdings of municipal bonds going away entirely because the book yield on many older bonds remains attractive relative to the current yield available on similarly rated taxable bonds. Cash is also becoming a viable asset, and municipals can offer a barbell investing approach because many of the maturities in this sector are long-dated. In addition, market appreciation and moderately higher allocations in common stock drove this asset class to account for 25% of total investments at Sept. 30, 2019, compared with 20% at year-end 2018 and 18% at year-end 2013, the highest level since 1999. The strong rally in equity markets in 2019 likely increased the allocation to equities further.

National Association of Insurance Commissioners (NAIC) Class 1 bond holdings allocation has declined somewhat over the past five years to 80% of bond holdings at year-end 2018 from nearly 84% at year-end 2013. This was offset by an increase of similar proportion in 'BBB' category bonds (NAIC Class 2) during the same period to 16% from 12% of total bond holdings. The aggregate allocation to speculative-grade bonds (NAIC Classes 3 to 6) has been stable at about 4% for the past five years. These modest changes in the composition of fixed-income portfolios indicates that P/C insurers have largely avoided the temptation to reach for yield at the expense of credit quality.

Chart 6

Based on Insurance Services Offices Inc. (ISO) data, the annualized investment yield for U.S. P/C insurers in 2018 was 3.4%, up from 3.1% in 2017 and the highest since 2013. P/C insurers' investment portfolios have about a four-year duration; that is, 12.5% turns every year and is reinvested in assets at current yields. Year-end 2018 market yields have trended lower, so we would expect portfolio yields to decline modestly for 2019. We believe that for every 100-basis-point (bps) drop in portfolio yield, insurers will need to improve their combined ratios by 3 percentage points just to tread water.

We have also seen initial efforts for some P/C insurers to exit their coal bond holdings to reduce their environmental, social, and governance (ESG) exposure. In our view, those early adopters already had very little concentrations within this sector, so this is perhaps low hanging fruit.

Issuer Outlooks Are Mostly Stable

Our outlook on the U.S. P/C insurance sector is stable, meaning the number of upgrades and downgrades should be about equal over the next 12 months, assuming normalized operating conditions. As of year-end 2019, 85% of P/C insurers had stable outlooks, 7% had positive outlooks, 5% had negative outlooks, and 2% were placed on CreditWatch negative (see chart 7). Also, the financial strength ratings on most of the rated universe in this sector remains in the 'A' category.

Chart 7

Chart 8

In addition to outlooks, another indicator of trends in creditworthiness is the actual changes in credit ratings. Through year-end 2019, we took one positive rating action and no negative rating actions (see chart 9).

Chart 9

Critical Momentum Is On The Horizon

The industry is becoming less reliant on excess capital to mask deficiencies. Pricing linked to achieving acceptable risk-adjusted returns is becoming cool again. We consider 2019 pricing actions are playing catch up to loss experience to some extent, but they are overall more proactive than reactive. We don't look at headline pricing movements alone--we recognize that the industry has been making adjustments to underwriting standards. We expect the industry to sustain this critical momentum into 2020.

On the other hand, continued reserve releases are a bit worrisome. We expect to see more slippage of reserve strengthening on a by-line basis, but aggregate reserve releases will remain positive into 2020. Overall, the sector is strategically holding onto more capital as a matter of prudence over growth opportunities. For these reasons, we have a positive view of business conditions heading into 2020. Nonetheless, there will be some winners and losers among the insurers we rate where company-specific underwriting practices will be fully on display.