2020 proved to be an extraordinary year as the U.S. property/casualty (P/C) insurance industry effectively navigated a pandemic affecting every aspect of its business. We expect it will face some of the same challenges in 2021, including further litigation surrounding the interpretation of policy language for business interruption, the cancellation or postponement of travel plans and large in-person events, and the widespread closure of small and midsize businesses. Positively, we expect insurers to maintain favorable underwriting margins, investment returns, and strong balance sheets. The industry likely will benefit from robust pricing, expected improvement in the economy and employment, and continued support of capital markets provided by low interest rates.

2020 Was A Year Like No Other

U.S. P/C insurers' underwriting results were hurt in 2020 by a drop in insured exposures, claims uncertainty, an active catastrophe year, civil unrest, and having to mobilize and operate remotely essentially overnight. Market volatility not seen since 2009 weighed on investment portfolios.

While we believe the industry navigated these disruptions well, there were challenges. The most immediate impact of the pandemic was the steep decline in equity markets and segments of the credit markets. Fortunately, the Federal Reserve and Congress reacted quickly with measures to provide market liquidity and mitigate the sudden closure of large portions of the economy, allowing capital markets to quickly recover.

Another early challenge was whether insurers would be forced to pay business interruption claims for losses arising from government ordered shutdowns, despite the virus exclusions included in most commercial property policies. An adverse court interpretation or legislation mandating coverage could have quickly wiped out the capital of those insurers writing this coverage given the magnitude of the potential claims. However, with few exceptions, the courts ruled in favor of insurers in coverage disputes with policyholders.

Pandemic-related losses have been concentrated in other lines, notably travel insurance, event cancellation coverage, and trade credit. These lines were severely hurt as business and leisure travel and large in-person events came to a near standstill, sharply reducing premiums and increasing claims paid. These factors will continue to adversely affect these lines in 2021.

Surprisingly, the favorable pricing momentum in 2019 and early 2020 continued after the COVID-19 outbreak. Price increases across most commercial lines have exceeded loss cost trends, leading to improved underlying combined ratios.

The biggest beneficiary from the coronavirus lockdown measures was the auto line of business. Claims frequency generally fell more than 20% owing to less congested roads and fewer miles driven, leading to sizable improvements in the loss ratios throughout the year. This improvement was somewhat offset by relief measures insurers took, including personal auto premium rebates and rate reductions of more than $10 billion, according to the Insurance Services Office (ISO), and reduced commercial auto premiums for vehicles not being used. While miles driven have rebounded from the low in April, driving levels and claims activity remain below pre-pandemic levels as many of the measures taken to slow the coronavirus spread remain. Consequently, we believe the rates for auto will be more competitive in 2021.

Other lines that have better results owing to the pandemic have been workers' compensation (for non-essential businesses), as many employees worked remotely from home, and medical professional liability, as doctor visits and elective procedures were delayed or cancelled.

Property lines were challenged in 2020. An active Atlantic hurricane season, record acreage burned by wildfires, and convective storms in the Midwest led to above average weather-related losses. Civil unrest and targeted business interruption coverage--where permitted or purchased--also contributed to incurred losses.

Additionally, the issue of so-called social inflation has not gone away. Professional liability, general liability, and excess casualty writers continue to deal with challenges associated with higher levels of litigation, including securities class action lawsuits.

U.S. Economic Outlook

The U.S. economy took a sharp and unexpected turn for the worse in 2020 as the coronavirus pandemic emerged in China early in the first quarter and rapidly spread to the U.S. and other countries. Thanks to the forceful actions the Federal Reserve took and fiscal stimulus provided by the federal government, the economic downturn was less severe than it might have been. Our latest base-case forecast is for real GDP to contract 3.9% this year and increase 4.2% in 2021 (the forecast assumed passage of a $1 trillion stimulus package before year-end).

Capital markets have returned to or surpassed precrisis levels, but the general economic recovery will take more time. By early December the U.S. economy recouped two-thirds of the economic losses from the COVID-19 recession. In the current forecast, real GDP will not return to its precrisis level until the third quarter of 2021, and the U.S. unemployment rate won't reach its precrisis low until 2024. The recent approval of two coronavirus vaccines is a big step forward, but it will take several months for most individuals to be vaccinated and the economy to fully reopen.

Not surprisingly, interest rates declined sharply in 2020 from already low levels. The 10-year Treasury note yield fell from 2.1% in 2019 to 0.9% at year-end 2020. We expect it to gradually recover but remain below 2.0% until 2023, reinforcing the lower-for-longer market expectation for rates and declining net investment income for P/C insurers.

Under our baseline forecast, we expect core inflation to remain subdued in 2021 at 1.9% and remain below the Fed's 2% target through 2023. While the consumer price index (CPI) is the standard inflationary indicator, we also pay close attention to medical inflation and litigation trends to assess whether claims costs are outpacing rate increases.

As vaccine rollouts in several countries continue, S&P Global Ratings believes there remains a high degree of uncertainty about the evolution of the coronavirus pandemic and its economic effects. Widespread immunization, which certain countries might achieve by midyear, will help pave the way for a return to more normal levels of social and economic activity. We use this assumption about vaccine timing in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

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Growth in P/C direct premiums written (DPW) has generally paralleled that of nominal GDP, except during hard P/C pricing cycles. This relationship was again evident in 2019 with DPW growth of 5.3% and nominal GDP growth of 4.1%. For 2020 we expect these metrics to diverge as DPW continued to grow despite a decline in GDP because of the pandemic.

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Underwriting Performance Shows Resilience

For 2021, we expect reported underwriting results to remain resilient, supported by continued rate increases in most commercial lines, partly offset by more competitive rates in personal auto. The social distancing measures should remain in place well into 2021 which can be expected to keep claims frequency trends muted. Assuming a normalized level of catastrophe losses (about 6 points) we anticipate an industry combined ratio of 98%-100%.

Considering the massive economic dislocation the pandemic caused, industry underwriting results in 2020 held up remarkably well. Based on S&P Global Market Intelligence data, the industry's statutory combined ratio (including policyholders' dividends) was 99.0% for the first nine months of 2020, up only slightly from 98.1% during the same period in 2019, and better than the five-year average of 100.2% (2015-2019). An increase in policyholder dividends added 0.7 points to the 2020 ratio and accounted for most of the year-over-year change, and a 0.3 increase in the expense ratio accounted for the rest. The loss ratio was unchanged at 70.7%. Catastrophe loss data and prior-year reserve development are not yet available for the nine-month period. However, the six-month industry results for the first six months of 2020 published by ISO suggest improvement in the underlying loss ratio of 3-4 points. We expect much of this improvement was in the auto lines.

Top-line growth slowed somewhat as DPW rose 2.2% in the first nine months of 2020 period versus 4.8% in the prior year period, though net premiums written (NPW) grew 3.0% versus 2.6% as insurers reduced premiums ceded to reinsurers by about 5%. The most noticeable changes were in workers' compensation, with DPW down about 8%, and in other liability, with DPW up about 10%. The change in workers' compensation premiums reflects a multiyear decrease in rates in response to lower claims frequency. A decline in payrolls in the second and third quarters of 2020 likely also contributed to the drop. Other liability includes several products, but companies have been aggressively raising rates in D&O and excess casualty, so rate increases likely contributed most of the growth in this line. Estimated personal auto DPW fell about 1% as premium rebates apparently offset the rate increases taken in 2019 and early 2020.

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2020 Ratings Recap

In the U.S. P/C insurance sector, we expect the number of upgrades and downgrades to be about equal over the next 12 months. Despite the profound impact on the U.S. economy from the pandemic, many U.S. P/C insurers have strong underwriting earnings and maintained strong balance sheets, and we expect this to continue. Throughout the pandemic we've focused on key risks to insurers, to ensure ratings and outlooks appropriately reflect our expectations. To date, we've taken six actions (three downgrades, one upgrade, and two on CreditWatch negative), representing about 8% of our North America P/C insurance ratings. This compares favorably to North American corporates and government, where 43% of the ratings were lowered, outlooks revised to negative, or placed on CreditWatch negative.

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Rating actions have declined considerably since the highs in 2008 and 2010. Surprisingly, the negative actions last year were unrelated to the pandemic. These unrelated factors include:

• Acquisitions and divestitures (Farmers Exchange and AIG, respectively),
• Changes in group status (equalizing our ratings on HCC with those on its parent, Tokio Marine, and downgrading Navigators International Insurance Co. after we changed our view of the company to non-strategic from core as it was placed into runoff), and
• Weakened capital and earnings amid continued headwinds in medical professional liability (The Doctors Exchange and ProAssurance).

We upgraded Kemper Corp to 'A' from 'A-' on Feb. 18, 2020, in recognition of the company's very strong capital and earnings, combined with improved operating performance across the business.

As of year-end 2020, 93% of P/C insurers had stable outlooks, 3% had negative outlooks, and 5% were placed on CreditWatch negative. The financial strength ratings in the North American P/C sector remain predominantly in the 'A' category, representing about 73% of our rated P/C insurers.

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Pricing Accelerates In 2020, But Does This Cycle Have Legs?

2019 served as a springboard for increasing prices, with many insurers playing catchup with loss cost trends, most notably in commercial auto and excess casualty. Insurers pushed harder in 2020 with loss inflation continuing to challenge commercial lines, downward pressure on investment income, higher expected reinsurance costs, weather-related losses in recent years, and discipline by market participants, including those with ample capital.

On a composite basis, commercial pricing (excluding workers' compensation) was in the high single- to low-double digits during 2020, according to the Council of Insurance Agents & Brokers (CIAB). While the standard commercial market rate increases were robust, excess and surplus lines accelerated faster drawing the attention of many, as evidenced by announced or completed capital raises, including White Mountains recapitalizing Ark, the creation of Vantage by industry veterans, and one capital raise during the year by Lancashire. Workers' compensation has been the outlier, with rate decreases in recent years, but is getting closer to an inflection point with rate decreases moderating on a quarter-over-quarter basis owing to the compounding effect of rate decreases, moderating frequency improvements (before COVID-19), and a lower investment yield.

We expect a divergence in rates for personal lines, with homeowners increasing in the low to mid-single digits while auto will be flat to modestly down. Higher frequency of natural catastrophes over the last few years and a hardening market for reinsurance protection will continue to support favorable rate movement in homeowners' insurance. Competition and an expected continuation of fewer miles driven should lead to modest rate decreases in personal auto. A higher proportion of policyholders choosing to use telematics should provide insurers more insight on driving behaviors, allowing them to price more accurately.

The P/C market has ample capital which has generally led to more competition and declining rates in past pricing cycles. However, the investment environment was much different, with higher rates encouraging insurers to cash flow underwrite to boost their investment portfolios. With the 10-year benchmark rate below 1% and inflationary pressures impacting the loss cost environment for most liability lines, we think rates will remain strong. But rate increases should slow in 2021 as compounding of these rate actions enables insurers to achieve adequate underlying profitability and returns on capital.

Investments Portfolios Endured The Shock Of COVID-19 With Marginal Changes Despite Yield Pressures

P/C insurers' investment posture remained largely unchanged in 2020. Their conservative and well-diversified portfolios demonstrated resilience during volatility in the capital markets, highlighting the benefits of their fixed-income allocation mix emphasizing high credit quality. With interest rates expected to remain low, P/C insurers' net investment income--primarily interest on bonds and dividends from stocks--face pressure as the 10-year government benchmark rate sat below 1% for most of 2020. In the first nine months of 2020, the net yield on invested assets dropped 30 basis points, to approximately 2.8%, which translates to a $2.6 billion reduction of investment income for the industry on a year-on-year basis, according to ISO data.

We observed P/C insurers' portfolios continue to be dominated by high-quality corporate bonds with slightly higher allocations to private debt, structured products, and cash and short term investments within the fixed income mix, while generally staying the course on the level of common and preferred stock as a percentage of their asset allocations. Despite a modest increase over the last few years, P/C insurers' exposure to structured securities is generally concentrated in the less risky senior tranches with a higher degree of cash flow certainty.

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Credit quality remains high as insurers' allocation to National Association of Insurance Commissioners (NAIC) Class 1 bond holdings stayed relatively flat year over year at around 80% at year-end 2019, but still down from 2013-2014 when it was almost 84%. With credit transitions, macroeconomic challenges, and historic debt issued by corporate borrowers, we believe 2021 could bring a modest deterioration in credit quality. The total allocation to speculative-grade bonds (NAIC Classes 3 to 6) has not changed, remaining between 4%-5%. Even with the temptation to chase yield, P/C insurers have remained disciplined by focusing on credit quality at the expense of lower investment income.

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Market yields continue to decrease, and we think that for every 100-basis-point drop in the portfolio yield, insurers will need to improve their combined ratios by about 3 percentage points to tread water. We don't foresee any wholesale shifts in the investment portfolio, especially since insurers have been successfully offsetting declining portfolio returns with improved underwriting margins to maintain appropriate returns on capital.

P/C insurers continue to reevaluate investment exposures with a growing focus on enhancing their environmental, social, and governance (ESG) driven investments, but other than reducing exposure to coal there is little tangible change on a year-over-year basis.

Capital Continues To Be A Beacon Of Strength Despite 2020 Tests

The industry's very strong capitalization is the cornerstone of our stable sector outlook. Our rated U.S. P/C insurers had a 20% risk-based capital buffer at the 'AA' level per our capital analysis as of year-end 2019, essentially flat from the buffer level one year prior.

We expect balance sheet strength will persist with a somewhat reduced focus on liquidity preservation, the posture insurers took at the onset of the pandemic, as business and cash flow has been resilient. We expect insurers to hold similar capital levels at year-end 2020 as at year-end 2019, with excess capital available to take advantage of the current pricing environment, opportunistic acquisitions, and more aggressive share repurchases if market valuations remain below historic norms. Overall industry statutory capital peaked again at $877.2 billion as of Sept. 30, 2020 (according to S&P Market Intelligence) compared with $865.7 billion as of year-end 2019. While capital generation slowed year to date, primarily because of a $3.6 billion unrealized loss versus $85.4 billion of unrealized gains in 2019, somewhat stable net income levels and a modestly lower amount of stockholder dividends helped to offset some pressure.

The U.S. P/C sector maintained similar buyback activity in 2020 compared to 2019 despite earnings pressure from natural catastrophes, civil unrest, COVID-19 losses, and investment challenges. Specifically, the sector repurchased $4.5 billion of shares during the first nine months of 2020, compared with $4.1 billion for the same period last year, and $4.8 billion in 2018. Share buybacks had been falling in recent years, with repurchases down 16% in 2019 and 42% in 2018.

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U.S. P/C insurers have taken advantage of the current market to access the capital markets to pre-fund upcoming maturities, fund acquisitions, or bolster the balance sheet for general corporate purposes. While capital market activity was not as robust as in 2019, year to date through Dec. 2 they have raised approximately $16.5 billion at a weighted average cost of 3.3% compared with $19.9 billion at 4.3% in 2019 and a five-year average run rate of $10.0 billion at 4.1%. Despite the volume of activity, financial leverage and coverage for most insurers have remained within tolerances, with operating performance and lower cost of debt supporting fixed- charge coverage levels.

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Insurance Market Challenges

California wildfires continues to threaten property insurers

2020 brought another devastating year with record acreage burned in the western states, and California suffered the most damage. With the industry still reeling from severe losses paid out in 2017 and 2018, P/C insurers pushed rates where possible and reduced exposures in some high-risk counties where there were no moratoriums on policy cancellations. According to the actuarial firm Milliman, since 2016 wildfire losses have cost the California homeowners market $37 billion, outpacing the premiums of $32 billion collected for this line. If playing rate catchup in the homeowners' line wasn't challenging enough, tightening reinsurance capacity in a firming market is only going to further exacerbate the need for rate increases to maintain adequate margins.

Natural catastrophe frequency and severity loss trend persists

We will remember 2020 as an extraordinary year for the number of named storms (30 versus average of 14) and major hurricanes (six compared with an average of three) with total U.S. natural catastrophe insured losses of $67 billion in 2020, according to Munich Re. In retrospect, the catastrophe loss ratio (catastrophe insured losses as a percentage of premium earned) has been rising, adding, on average, about 5.8 percentage points to the combined ratio between 2015 and 2019, up from 5.3 points between 2010 and 2019. With most predictive models projecting increased climate volatility translating to higher insured loss damage, we anticipate the average annual natural catastrophe loss ratio edging closer to 6%-7%.

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COVID-19 presumption rules might affect workers' compensation business

Many states have passed executive orders requiring workers' compensation insurers to cover essential workers who test positive for the virus. We believe the expansion of presumption laws might affect the workers' compensation industry, but the impact will vary by state and the duration of the pandemic. Moreover, the scientific community is still collecting data on the long-term health effects of the coronavirus, so the full impact on workers' compensation claims will not be known for some time.

Presumption rules have historically covered injuries sustained by certain occupations like firefighters and other first responders. Although each state views this issue differently, in the past a key exclusion for nearly all presumption laws was not covering infectious diseases. In total, 17 states and Puerto Rico have expanded presumption coverage to include COVID-19, according to the National Council on Compensation Insurance (NCCI).

Reinsurance placement for Jan. 1 renewal sees higher cost for primary insurers

Property and casualty reinsurance pricing has been hardening during the past 24 months in reaction to natural catastrophe and pandemic losses, as well as alternative capital and retrocession capacity constraints. Reinsurance pricing increased during the January 2021 renewals indicating a firming market, but not a hard one. Rate increases were somewhat less than what reinsurers had hoped for. According to the latest Willis Re report, U.S. property and casualty loss impacted reinsurance policies were up +5% to +30%. On the other hand, loss free reinsurance policies experienced lower rate increases (flat to low double digits). We expect the reinsurance pricing positive momentum will carry throughout 2021, with tightening terms and conditions, influenced by whether COVID-19 losses are contained within the industry's related booked reserves.

Insurers see heightened cybersecurity threats

With most businesses and workers forced to work remotely as a result of COVID-19, insurers have been facing greater exposure and ultimately cyber insurance loss experience as IT infrastructures have been tested. In 2020, insurers were already dealing with loss challenges for recent accident years as the tail associated with prior business written was turning out to be longer than expected. While the insurance industry has been relatively disciplined with its entrance into this coverage by keeping low limits and providing exclusive policy language where there could be silent cyber gaps, this has not allowed insurers to avoid loss pressures. As a result of these challenges, we expect the industry to continue to increase rates as reinsurers will be pushing for increases on the back end. Commercial and private cyber-risk insurance premiums now total about $5 billion, an amount we expect will soon increase by 20%-30% per year (see "Cyber Risk In A New Era: Insurers Can Be Part of the Solution," published. Sept. 2, 2020).

Rising tort inflation could undermine underwriting profit

Tort inflation continues to drive higher insurance claims cost on certain lines of casualty business, such as medical malpractice and other liability claims made (includes D&O). Defense costs on product liability have declined but remained elevated as one of the more expensive coverage for insurers to defend. Based on the industry's reported statutory defense costs and containment expense data, a proxy for defense and litigation costs for insurers, between 2017 and 2019, P/C insurers incurred about $4.40 on all lines, compared with $6.06 for casualty business, in legal expenses for every $100 in premium written. In both cases, the most recent three-year average is somewhat lower than the 10-year average, suggesting that the issue has so far largely been confined to the lines insurers most frequently cited when discussing their results--D&O, medical professional liability, and commercial auto liability.

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Insurers Might Put The Brakes On Reserve Releases

Weak economic recovery prospects combined with prolonged high unemployment could make it difficult for the P/C insurance industry to sustain operating profitability, but so far the industry is still benefiting modestly from reserve releases. Over the past 14 years (2006-2019), the industry released a total of $132 billion of reserves, which on average has reduced the combined ratio by about 2 percentage points. For the first six months of 2020 the industry released nearly $5 billion of reserves. However, we believe a trend reversal could be forthcoming.

During 2019, P/C insurers reported a net $5.6 billion of favorable reserve developments from prior accident years, compared with $10.6 billion of reserve releases in 2018 for all lines, excluding mortgage and financial guaranty. It may be premature to declare an end to reserve releases, but upon closer inspection the industry reserve releases were almost entirely from workers' compensation and short-tail lines. Excluding these lines, the industry would have booked $4 billion of unfavorable development. The main culprits were commercial auto liability and other liability, which together booked over $5.6 billion of adverse development in 2019 and $4.9 billion of adverse development the year before.

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We are cautious about the sustainability of net releases as rate decline in workers' compensation could begin to outpace improvement in loss emergence. Since 2003, the workers' compensation rate cumulatively has declined more than 40%, according to the NCCI. 2021 could be the inflection point, but the big question remains whether the P/C industry is approaching a period of significant adverse developments. The answer will depend on how long the current firm pricing cycle lasts and on P/C insurers' effectiveness in using the various risk controls and tools developed over the years under their enterprise risk management frameworks, which could mitigate potential future adverse development.

Valuations Remain Robust As M&A Activity Is Resilient During COVID-19

2020 proved to be an active deal-making year for the industry despite the many challenges COVID-19 posed to some of the traditional due diligence and culture assessments because of shelter in place restrictions. While no deal was truly transformative, there were many sizable transactions with a few key themes, including enhanced distribution access, greater scale, and capitalizing platforms to provide growth opportunities in the current pricing cycle. Regarding divestitures, a key theme has been strategic business reviews leading many entities to explore divesting their life insurance businesses, thereby reducing exposure to interest rate and mortality risk and potentially unlocking some of the valuation differential versus less diversified peers.

Merger and acquisition (M&A) activity picked up in 2020, with $10.4 billion in announced activity by U.S. P/C primary insurers, compared with just $4.9 billion in 2019, but well below the $30.6 billion of activity in 2018. These M&A volumes represent acquisitions completed by U.S.-domiciled companies where the acquiring company writes predominately primary P/C business. While the deal volume and total spend is up from 2019, there were no transformational acquisitions.

Notable announced acquisitions include Allstate's acquisition of National General, Zurich/Farmers' acquisition of MetLife's nonlife business, and State Farm's acquisition of GAINSCO. Allstate's acquisition of National General allows it to build a more meaningful presence in the non-standard auto market, gain greater access to independent agents for its core home and auto book, and the opportunity to garner fee income from the attorney-in-facts managing the reciprocal exchanges underwriting this business. Zurich/Farmers' acquisition of MetLife's nonlife business is an opportunity for Farmers to meaningfully expand in the Northeast and Midwest and bolster its market share to sixth overall in the U.S. While the valuation of $400 million for the acquisition of GAINSCO by State Farm is quite small, it is noteworthy as the company's first acquisition of another carrier in its almost 99-year history and for providing it a greater presence with independent agents and increasing its share of the non-standard auto market.

The biggest transaction announcement in 2020 was AIG's planned separation of its life and P/C businesses (not included in the 2020 activity figures since no value has yet been determined).

We believe M&A activity in 2021 could reflect similar themes to 2020. Assurant has announced a strategic review of its Preneed life business that may lead to a divestiture of this business in 2021. Technology-targeted investments could accelerate as 2020 highlighted the importance of a strong IT infrastructure and digital footprint to defend an insurer's competitive position and enhance distribution, claims management, and pricing capabilities. Additional factors supporting a robust M&A market are cheap available financing and some moderation in the trading valuations of potential targets.

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