As COVID-19 continues, the world is not only battling a pandemic but also contending with a sharp economic decline. How our ratings incorporate these quickly evolving business conditions varies by industry. Below, S&P Global Ratings answers questions on the possible impact on insurance services ratings as we incorporate the effects of the pandemic on this unique sector within the insurance marketplace.

Frequently Asked Questions

How is the fallout from the COVID-19 pandemic affecting ratings in the insurance services sector?

We have taken negative rating actions on 11 of the 40 insurance services companies we rate globally stemming from the economic fallout related to COVID-19 (see "Various Rating Actions On Insurance Brokers Reflect COVID-19 Fallout," published April 20, 2020, "Various Rating Actions Taken On The Insurance Services Sector," published April 6, 2020, and table 1). The negative rating actions were predominantly limited to outlook changes. We revised the outlooks on nine companies to negative while affirming our ratings, we placed our ratings on one company on CreditWatchwith negative implications, and we downgraded one company and placed the ratings on CreditWatch negative.

Table 1

While we continue to believe the majority of the companies we rate remain on relatively stable footing, we now have a negative bias to our stable outlook for the broader sector (see "U.S. Insurance Services 2020 Outlook: Stability Amid Increased Deals and Maturing Credit Cycle," published Feb. 12, 2020) considering the bleak economic backdrop and slew of companies placed on negative outlook. Of course, given the wide-ranging diversity within the sector, we view certain companies and subsectors as substantially higher risk than others. Unlike insurance carrier counterparts, the insurance servicers we rate generally do not take underwriting or investment risk, so the bulk of the negative impact from the COVID-19-related recession will be in the top line as a reduction in insured exposures, which are generally correlated to GDP, will impair revenue.

One of the reasons we currently have a prevalence of negative outlooks across the insurance services sector is because we have thus far taken so few COVID-19-related downgrades. This, in some respects, speaks to the sector's relative stability compared with many other sectors within business services (see "COVID-19, Risks Of Global Recession Spike Business Services' Downgrade Tilt," published March 19, 2020) and many other corporate sectors more broadly. Underpinning all the rating affirmations, we continue to view liquidity as generally sound across the sector, stemming from generally limited working capital and capital expenditure requirements, a favorable debt maturity schedule, and limited restrictive financial covenants, notable for companies predominantly rated in the 'B' category with high debt loads. Another key factor that's supporting ratings is the high level of cost variability, which has the potential to substantially buffer top-line declines but is predicated largely on management-led expense initiatives on discretionary costs.

A negative outlook generally indicates at least a one-in-three chance of a downgrade over the next 12 to 24 months (generally up to 12 months for speculative-grade companies and 24 months for investment-grade). We believe, for many of these companies, a downgrade is more of a heightened possibility than a probability at this point. Rating actions will depend not only on the depth and duration of the economic slowdown and impact on insurance servicers' top lines, but perhaps more so the extent to which the ultimate top-line pressures translate to EBITDA and leverage, based on each company's expense management, capital management, and strategic execution.

What companies or subsectors within insurance services are more or less exposed to revenue and earnings declines as a result of the COVID-19-related slowdown?

We believe the greatest negative impact will be in the health insurance services subsector, where seven of the 10 companies we rate have a negative outlook. For many of these companies, we are expecting double-digit revenue declines for at least the next couple of quarters. Within the health insurance services companies we rate, all three workers' compensation health insurance administrators--One Call Corp., Medrisk Midco LLC, and Paradigm--have a negative outlook based on our view that uptake in various core service offerings such as physical therapy, diagnostics, and dental will likely be materially lower in light of social distancing and shelter-in-place initiatives. Even as sheltering restrictions are eased and an economic recovery begins, we think any bounce back may be more gradual for some of these companies given the physical touch aspect of a sizable portion of the product offerings that may leave members wary. Similarly, both of the health insurance network claims repricers we rate, Zelis and Multiplan, have a negative outlook based on our view of materially lower claims volumes arising from a delay in elective procedures, though for these companies, we think pent-up demand for certain elective procedures may enable a quicker bounce back later in the year.

The picture isn't only bleak for all the health servicers. On the flip side, we believe a couple of the health services companies we rate, specifically the few that take some insurance risk, may actually benefit from the pandemic fallout. For example, Vision administrator Versant, a company that already had a negative outlook going into the year on elevated leverage, will likely lower leverage faster than anticipated given lower utilization on elective vision claims, which should increase the company's margins and offset any enrollment declines. Similarly, we expect Magellan (with ratings recently placed on CreditWatch positive on the announced divestiture of its managed care operation) to benefit from lower utilization in its capitated business, which should offset any spike in claims related to COVID-19.

Regarding non-health TPAs, consisting primarily of warranty administrators and claims adjusters, three of the eight companies we rate have a negative outlook or ratings on CreditWatch negative, including both auto warranty administrators we rate, Amynta and APCO. (APCO is the only company in the sector we downgraded on COVID-19-related fallout, and our ratings remain on CreditWatch negative). Auto warranty administrators are under particular pressure given revenue ties to light-vehicle sales, which are declining precipitously due to social-distancing measures and will likely not fully rebound to 2019 levels given the general economic slowdown. The other warranty administrators we rate, NEWAsurion (focused on handset protection) and FrontDoor (focused on home-service plans), are somewhat shielded from recessionary forces based on their book of business, though FrontDoor will likely experience pressure in its origination segment. We have maintained a stable outlook on the claims adjusters we rate, Sedgwick and KWOR Holdings L.P. (d/b/a Alacrity) because we expect pockets of pressure in certain lines of business (such as traditional WC claims, auto, and managed care) to be largely mitigated by volume increases in other areas, such as workforce absence and other COVID-19-related claim upticks.

Six of the 22 brokers we rate have a negative outlook (or ratings on CreditWatch negative), which is the lightest negative trend in the broader insurance services sector. Although brokers are certainly not immune to the economic fallout from COVID-19, they benefit to a large degree by the generally nondiscretionary and naturally recurring nature of commercial insurance purchases. Based on our most recent economic estimates and including a good first quarter for most of these companies, we think organic growth will generally be flat to negative mid-single digits (with some positive and negative outliers) for 2020, considering weaker GDP, economic activity, and payroll, which reduces insured exposures (ultimately lowering the premium base from which insurance commission and fees are derived). Our negative outlooks on Alera, NFP, and One Digital reflect our view that in addition to already operating at very limited cushion relative to our leverage downside triggers, these employee-benefit weighted brokers are somewhat more exposed to the economic downturn than property/casualty (P/C) weighted brokers given the greater revenue ties to the labor market. In addition, similar to the auto warranty administrators, performance at Confie Seguros (B-/Watch Neg/--) will be negatively affected given its concentration in nonstandard auto and the expected decline in light-vehicle sales.

How does this economic downturn compare with the last financial crisis for insurance services companies?

Our base-case U.S. economic forecast predicts that the current recession has likely reduced economic activity by 11.8% peak to trough, which is roughly three times the decline during the Great Recession in one-third of the time. All else being equal, the much steeper contraction would indicate a greater negative impact from this recession on insurance services companies. However, all else is certainly not equal.

One of the more concerning elements of this recession is unemployment, which is estimated to peak in the high teens in the second quarter of 2020, compared with a peak of 10% in the last recession. While this is a daunting figure no matter how you look at it, the devil is in the details in terms of the ultimate impact for insurance servicers. The Bureau of Labor Statistics has reported that the "bulk" of the increase in unemployment in the last couple of months occurred among people who said they were "temporarily" unemployed. Moreover, Google Trends indicates an unprecedented number of searches for "furlough" since February--hopeful signs that the two sides will be reunited sooner rather than later. A potentially shorter unemployment duration (and generally shorter base-case time frame of peak to trough) will certainly be beneficial across most sectors. However, an added nuance mitigating the headline unemployment figures for the insurance services sector is that employees who are furloughed, while contributing to the unemployment statistics, are generally able to keep their employer-sponsored benefit plans. This is meaningful for many insurance services companies, such as employee benefits brokers and health servicers, because these employees are still in insurance-related payroll calculations or are contributing to the claims count, which ultimately translates to revenue. Additionally, for many of those in the unemployed camp who were not furloughed, a key consideration will be whether they opt in for COBRA, as those that do should continue to generate revenue for many insurance services firms. Given the health-driven nature of this crisis, combined with the significant fiscal stimulus (including current proposals for COBRA subsidies), potential greater COBRA uptake could serve as a nice buffer for insurance services companies.

For insurance brokers, the largest subset of insurance servicers we rate, perhaps the greatest difference between the last recession and now lies in the insurance pricing environment. In the last recession, brokers were not only contending with declining exposure units as a result of the economic downturn, but were also operating amid a backdrop of declining P/C insurance pricing trends. Brokers, in effect, were double hit. In contrast, brokers entered this recession with composite commercial P/C pricing on the rise (see chart). To the extent this trend continues, it could serve as a meaningful shock absorber against the weakening economy.

Chart 1

How will the COVID-19-related downturn affect ratings on top global brokers?

We have not thus far taken any rating actions on global brokers. Relative to middle-market brokers, we believe their well-developed market presence, wider business scope, and lower proportion of small to midsize accounts should enable greater underlying stability in their insurance and reinsurance brokerage segments. While a smaller proportion of overall revenue, their nonbrokerage services (i.e., consulting and related services) are more likely to incur greater strain given the more discretionary nature of service uptake.

Marsh & McLennan (MMC) has remained on a negative outlook since October 2018 because of elevated leverage given its largely debt-funded Jardine Lloyd Thompson Group PLC (JLT) acquisition. MMC's deleveraging trajectory has been mainly on track since the close of the acquisition due to strong earnings momentum along with modest debt paydown. MMC has indicated it will keep focusing on lowering leverage, supported by actions such as halting share buybacks for the remainder of the year and cutting nonessential expenses and capital expenditure. However, the pace of debt paydown will ultimately depend on cash flow generation in the current macroeconomic environment. We will monitor its performance and leverage throughout the year.

Aon PLC announced it would acquire Willis Towers Watson PLC in March 2020 in an all-stock transaction. The rating on Aon was unaffected by the announcement, while we placed our rating on Willis Towers Watson on CreditWatch positive. Despite worsened business conditions, we continue to expect Aon to sustain adequate cushion relative to our downside leverage threshold, both before and after the acquisition closes. In response to the pandemic, Aon has taken likely the most extensive cost-cutting measures of rated brokers thus far. In addition to pausing share buybacks and curtailing many other discretionary costs, Aon has imposed temporary base salary reductions, generally around 20%, on the majority of staff. While there is inherent risk in executing a transformational acquisition in such uncertain times, we believe the all-stock deal financing and its substantial cost measures will help preserve operational flexibility and credit metrics stability.

How will underlying managed care profitability trends affect rated health insurance services companies?

With the fallout from COVID-19, health insurers will likely experience greater-than-usual swings in underwriting performance throughout the course of the year. Specifically, we believe most health insurers' underwriting earnings to be better than expected in the earlier part of the year as the significant deferral of elective or discretionary medical services will support better medical claims trends. However, we expect a reversion as we get further into 2020, given pent-up demand for various elective procedures. For the full year, our expectation so far is that the benefits from the lower utilization arising from deferred services will at least balance, if not more than offset, the COVID-19-related claims.

For health insurers, more claims generally equate to worse profits. However, for most of the health services companies that support them (except for those that take a degree of capitation risk), the reverse is generally true. Health services companies generally make their money from helping health care payers control medical costs in areas such as out-of-network claims, mental health, radiology, and pharmacy. More claims could equate to more revenue opportunity, depending on whether the claim is in their sweet spot of core capabilities. Accordingly, the sooner and the greater claim volumes pick up again for insurers, the better for health servicers.

On the top line, the economic slowdown will strain both insurers and health servicers. As payroll employment declines, we will likely see a decrease in premiums from the fully insured group/employer business. There will be some offset as eligible individuals who may have lost their job and their job-based insurance shift to the individual or Medicaid market. Though these markets may blunt the blow, they won't eliminate the increase in the uninsured rate and a slowdown in expected revenue growth for the full year for both insurers and the servicers who support them.

How will underlying P/C insurer profitability trends affect rated brokers?

Over the last several quarters, commercial insurance carriers have accelerated rate momentum to combat inflationary pressures, especially in casualty (excluding WC) or loss-affected property lines. Adverse loss trends stemming from increased litigation and a more plaintiff-friendly legal environment, coupled with capacity withdrawal, have helped the market harden. Insurance brokers have benefited from the rate hardening because it increases the premium base upon which commissions and fees are derived. Partially as a result of the rate improvement, coupled with increasing insured exposures up until the end of the first quarter of 2020, organic growth across the sector has generally improved in the last year.

We believe the added uncertainty and ultimate impact from rising COVID-19 claims, and a now bleaker interest rate and investment income expectation for carriers, should continue to support positive insurance rate trends for the commercial insurance space. In terms of explicit pandemic coverage, we believe a large majority of business interruption (BI) coverage in the U.S. excludes communicable disease coverage and will not trigger valid claims (see "How COVID-19 Risks Factor Into U.S. Property/Casualty Ratings," April 27, 2020). Even with discussion around retroactive changing to policy wordings, we do not expect the constitution and sanctity of contract law to be taken lightly when trying to determine the best way to support businesses, and we anticipate current political efforts to extend BI coverage would be largely unsuccessful. Nevertheless, there remain material exposures, including "silent" pandemic coverage, affecting various commercial lines including event cancellation, travel, professional liability lines, WC, and credit. We believe the uncertainty around these loss potentials will only further fuel underwriting discipline and rate needs going forward, thereby continuing the insurance rate tailwind for brokers.

On the flip side, economic contraction will lower insured exposures, thereby hurting the other side of the premium equation and resulting in our ultimate expectation of top line reductions of 4%-6% across the commercial sector. While we expect the combination of rate and exposure to be negative for brokers, it would be a lot worse without the rate momentum softening the blow.

Compared with the commercial insurance landscape, personal lines writers are less likely to experience uncertain adverse loss as a result of the current economic downturn. On the contrary, most major personal auto writers have announced rebates to policyholders as they aim to pass back some of the benefits they experienced from lower miles driven and ultimately claims frequency. Notwithstanding, most rated brokers have little to no presence in affected personal lines, which will limit their exposure to any commission clawbacks. There have also been modest signs of pressure in terms of premium rebates in affected commercial lines (i.e., commercial auto, certain small business segments, etc.), such as the announcement by the California Commissioner of Insurance that it would pursue premium rebates in any lines of coverage where risk measures are overstated because of the pandemic. While we will continue to monitor this development and view it as a risk factor, our current viewpoint is that exposure on the commercial side is fairly limited, and at least up until this point, brokers are largely being made whole on the commission front for any premium return.

Why have a slew of brokers recently been issuing debt and how does that affect S&P Global Ratings' credit and liquidity views?

While borrowing conditions remain oppressive for the most "at-risk" corporate sectors (e.g., retail, restaurants, entertainment, etc.), financial conditions for the insurance services sector, especially insurance brokers, have been more accommodative due in part due to their more resilient business profiles (i.e., client persistence, nondiscretionary revenue, margin strength and stability, etc.) with lower likelihood of shock revenue decline. This has been evidenced by recent issuance activity and spread levels (see table 2).

Table 2

Several speculative-grade insurance services companies have opted to bolster their liquidity via debt issuance (as well as revolver drawdowns) in response to elevated uncertainty about the duration and intensity of the economic contraction and its potential impact on timing and receipt of cash flows. Meanwhile, investment-grade issuers such as Marsh and Aon are benefiting from improving financing conditions stemming from the Fed's historic liquidity facilities.

Aided by favorable liquidity dynamics across the sector like good cash conversion and low working capital and capital expenditure requirements, those that have tapped the capital markets for liquidity purposes have done so from a position of strength. We view the incremental financings as both opportunistic given credit conditions and cautious given market uncertainty, and not because of actual liquidity duress or need. While dynamics in the current market environment such as premium grace periods and higher days sales outstanding will likely hurt flows, our current view is that the likely hit will be modest and highly absorbable for those companies who have tapped the capital markets and for most insurance servicers at large.

While further bolstering liquidity, most of the issuance and drawdown activity has incrementally increased financial leverage because we generally don't net cash for companies with weak business risk profile assessments or private equity owners per our criteria. That said, the issuances generally have not altered our view of fundamental credit quality.

How does the current market environment shape S&P Global Ratings' views on its preferred equity assessments for insurance services companies?

We currently rate 10 insurance services companies that contain preferred equity in their capital structure, all of which we rate in the 'B' rating category. In the majority of cases, we apply our criteria for non-common equity financing for nonfinancial corporate entities because most companies we rate with preferred equity are sponsor-owned, and the holders of the preferred equity tend to be the company's financial sponsor or management (see "The Treatment Of Non-Common Equity Financing In Nonfinancial Corporate Entities," April 30, 2018). In a couple of instances where this is not the case or the company is not financial-sponsor owned, we apply our criteria for hybrid capital (see "General Criteria: Hybrid Capital: Methodology And Assumptions," July 1, 2019).

Based on application of the relevant criteria, 70% of the insurance services companies we rate with preferred equity in their capital structures receive full debt treatment for the instrument, and we therefore include it in our adjusted leverage and coverage measures. In our analysis, the main factors supporting debt treatment in most instances are the lack of alignment in economic incentives between the company's equity and non-common equity financing (i.e., stapling provision) as well as redemption risk (given the optional redemption feature in most of the preferred agreements).

While insufficient to obtain equity treatment in many cases, most preferred instruments in the portfolio do have some equity-like features, meeting some, but not enough, of the requirements for equity treatment. Most notably, most of the instruments have a payment-in-kind (PIK) toggle feature, such that companies have the option to service the instrument through either cash or a PIK accrual mechanism (when the latter is chosen, our adjusted debt balance will go up by the coupon). While we continue to treat most of these instruments as debt in our credit metrics calculation, the PIK servicing option provides financial flexibility, particularly in the current market environment where some of the firms may be facing some greater earnings or cash strains than anticipated. Accordingly, we look at the company's credit measures both with and without the effects of the preferred and pay particular attention to cash interest coverage measures when evaluating a company's debt servicing capabilities.

What are S&P Global Ratings' expectations for mergers and acquisitions (M&A) and how do they factor into our ratings?

A frenzy of acquisition activity has been a mainstay in the insurance services markets, along with deal prices that have continued to creep up each year. In 2019, brokerage deal activity beat its prior-year record with almost 650 deals in the U.S. insurance brokerage market alone, by far the insurance market's most active subsector in terms of transaction volume.

While 2020 started out looking to be another record-setting year, the coronavirus and related economic slowdown have put the acquisition market in a state of flux, causing many market participants to rethink their approach to M&A. Some have indicated putting a pause on deal activity altogether to focus on core operations and preserving liquidity, while others are indicating significant interest in M&A, including the potential to take advantage of distressed assets at more favorable valuations. Most participants lie somewhere in between, indicating they are still in the market for deals but likely at a slower pace than the year prior and with a generally more cautious approach.

For deals that were already in pipeline (under diligence or with letters of intent in place), the current environment has caused many buyers to re-diligence, reprice, and restructure. In evaluating existing and new deals, market participants are putting an enhanced emphasis on industry mix and remote capabilities, and are seeking to negotiate lower multiples with more downside protection including a greater proportion of earnout consideration (i.e., a greater portion of purchase price deferred), hold-backs, or material haircuts to EBITDA.

From a rating perspective, we view the somewhat tempered M&A landscape as a credit positive in this environment. Many rated insurance services firms have successfully expanded geographic reach, scale, and capabilities via M&A, and there have been few operational hiccups to date. At the same time, cash outlay for acquisitions has been by far the largest cash use across the space, and the rapid pace of acquisitions combined with elevated multiples has often prevented lowering leverage and in some cases caused leverage to increase for many insurance services firms. While most firms until now were able to absorb debt-funded M&A through a combination of organic growth and earnings momentum from acquisition targets who often benefited from being part of a larger and more capable enterprise, the same cushion is not there in an environment of potential earnings erosion. We think those brokers that exercise M&A discipline with regard to pacing, due diligence, valuation, and capital management will be best positioned from a rating perspective to weather the COVID-19 storm.

Appendix

Table 3