S&P Global Ratings' outlook on the North American insurance services sector is stable, reflecting our expectation for limited rating changes and modest upside over the next 12 months.

Insurance services companies are a subset within the U.S.-based corporate business and consumer services sector. These companies mainly provide business services to the insurance sector, providing exposure to a large and well-established marketplace with limited exposure to underlying insurance risk. Insurance brokers make up the largest group among the insurance services companies we rate, which also include health insurance and cost-containment servicers, claims managers, and warranty administrators.

Chart 1

Rating And Outlook Overview: Most Companies Have 'B' Category Ratings And Stable Outlooks

We publicly rate 34 insurance services companies in North America (with an additional six insurance brokers rated in Europe, the Middle East, and Africa to round out our global insurance services portfolio). The portfolio count has declined by five credits since last year mainly due to consolidation and refinancing activity, partly offset by new rating activity.

The portfolio consists of public and private companies (investors led by management, private equity, and pension funds, among others). The public companies' capital structures are largely supported by a combination of common equity and senior notes. The private companies' capital structures are supported by a combination of common equity, preferred equity (generally viewed as debt per our criteria), senior notes, and syndicated bank loans.

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Unlike the insurance carrier sector, which is primarily investment grade (rated 'BBB-' or higher), insurance services companies are mostly speculative grade (rated 'BB+' or lower), predominantly in the 'B' rating category. Insurance services companies generally operate with high leverage and relatively weak credit-protection measures, mainly due to financial-sponsor ownership, acquisition-oriented growth, and aggressive financial policies related to their capital structure. As of Dec. 31, 2021, about 80% of the insurance services portfolio maintained stable outlooks, with the remainder reflecting a modest upside bias (four credits with positive outlooks and two credits with negative outlooks). On Jan. 5, 2022, we raised our issuer credit rating on Magellan to 'BBB-' from 'BB+' (following the closing of its acquisition by Centene Corp.) and removed the rating from CreditWatch, where we placed it with positive implications one year earlier. We plan to discontinue our ratings on Magellan once its senior notes have been redeemed in the next 30 days.

Rating change activity was very modest in 2021. There was one upgrade (Ryan Specialty Group in connection with its IPO, resulting in reduced financial leverage) and one downgrade (Integro Group Holdings Inc. in connection with weakened operating performance attributed to prolonged COVID-19-related strain on certain core lines of business; rating later withdrawn).

More meaningfully, we revised outlooks for several companies to stable from negative in the first-quarter 2021 period due mostly to diminished concern about the downside impact of COVID-19 on their credit profiles. This moderately favorable trend persisted over the year, and we revised the outlooks on several companies to positive from stable following our updated assessments of their business and financial risk factors.

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Inaugural ESG indicators report card highlights private equity control as a moderately negative governance driver

We published our environmental, social, and governance (ESG) criteria in October 2021 to enhance transparency about how we capture ESG factors in credit ratings (see "Environmental, Social, And Governance Principles In Credit Ratings"). Through the application of sector-specific criteria, we describe how we view the influence of ESG factors on the analytical components in our rating analysis using an alphanumerical 1-5 scale (for example, for environmental factors, an E-1 indicator is positive and E-5 is very negative). We apply ESG credit indicators after the ratings have been determined.

We disclosed our newly assigned ESG credit indicators for the global business, environmental, and consumer services sector in mid-December 2021, which includes the credits in our insurance services portfolio. Because an ESG credit indicator is an alphanumeric representation of the qualitive assessment of ESG factors' impact on creditworthiness produced as part of the ratings process, accordingly the application of--or change of--an ESG credit indicator cannot by itself trigger a credit rating or outlook change. However, the impact of ESG factors on creditworthiness could contribute to a rating action, which in turn could lead to a change in the ESG credit indicator.

For the insurance services portfolio, we have assessed environmental and social indicators as neutral (E-2 and S-2, respectively) while governance indicators reflect a negative bias, with many moderately negative assessments (G-3) in connection with private-equity ownership. This is because we believe that highly leveraged financial risk profiles reflect corporate decision-making that prioritizes the controlling owners' interests while also reflecting generally finite holding periods with a focus on maximizing shareholder returns.

For more detail, see our "ESG Credit Indicator Report Card: Business, Environmental, And Consumer Services," published Dec. 16, 2021, and commentary "ESG Credit Indicator Definitions And Application," published Oct. 13, 2021.

Economic Outlook: Favorable Business Conditions Underpin 2022 Forecast

In the U.S., where our rated insurance services companies are most concentrated in terms of domicile and business presence, S&P Global economists forecast full-year GDP growth of 5.5% and 3.9% for 2021 and 2022 (above trend), respectively. Our assessment of U.S. recession risk over the next 12 months is 10%-15%, our lowest assessment in seven years.

The U.S. economy picked up in the fourth quarter as COVID-19 infection rates subsided and vaccination rollouts progressed, allowing more people to get out and spend.

The unemployment rate, at 4.6%, is closer to pre-pandemic levels. When adjusted for the labor force exit, it is 6.4%. We expect the adjusted unemployment rate to reach its pre-pandemic lows in first-quarter 2023. Inflation picked up dramatically in the U.S. in fourth-quarter 2021, with various price indicators reaching multidecade highs. The Consumer Price Index is likely to reach 5.9%, moderating from its 30-year high of 7.9% in the second quarter.

Table 1

General economic conditions can materially affect insurance broker revenue because the premium exposure base (from which commissions and fees derive) fluctuates depending on the level of payroll, inventories, sales receipts, and other insured risk. Given our expectation of near mid-single-digit GDP growth in 2021 and 2022, we believe macroeconomic conditions will continue to benefit the sector.

Credit conditions remain largely favorable for North American borrowers (especially for the middle-market insurance brokers) due to the resilience demonstrated through the 2020-2021 COVID-19 stressed period, but significant risks are rising--not the least of which are the heightened input-cost pressures and ongoing supply disruptions many corporate borrowers face. At the same time, with inflation running hotter and for longer than most economists expected, the potential for central bank monetary-policy missteps has increased. This could result in investors' rapid repricing of risk, raising financing costs for borrowers we rate, particularly those at the lower end of the ratings scale.

S&P Global Ratings believes the new omicron variant is a stark reminder that the COVID-19 pandemic is far from over. Early evidence points toward faster transmissibility, which has led many countries to close their borders with Southern Africa or reimpose international travel restrictions. Over coming weeks, we expect additional evidence and testing will show the extent of the danger it poses to enable us to make a more informed assessment of the risks to credit. Meanwhile, we expect the markets to take a precautionary stance and governments to put into place short-term containment measures. Nevertheless, we believe this shows that, once again, more coordinated, and decisive efforts are needed to vaccinate the world's population to prevent the emergence of new, more dangerous variants.

Insurance Brokers: Strong Macro Fundamentals, With Generally Stable Margins

Overall, we believe insurance brokers will demonstrate continued steady performance in 2022, supporting their current ratings. We believe sustained economic growth will support an increasing insured exposure (i.e., risk assumption) trends. This combined with rates that are increasing, though at a slower pace, is likely to result in sustained favorable market conditions for brokers. We expect organic growth to moderate from its very robust 2021 level--which rose following the 2020 COVID-19 impacted period--to a still-favorable mid-to-high single-digit pace in 2022. Beyond 2022, it will likely drift back to a 3%-5% underlying trend.

We expect insurance brokers to generate strong cash flows given our expectation for above-trend revenue growth with generally stable EBITDA margins. The residual benefit of COVID-19-induced expense management will wane as companies move to a more normalized level and allocate more funding to staffing growth and development. We expect acquisitions to remain robust and help strengthen brokers' scale, scope, and diversification as the marketplace continues to consolidate, particularly at the middle-market level. We also expect this trend to limit any significant deleveraging, given still-escalating purchase price multiples.

Company-specific trends, however, may vary based on product diversification and geographic presence, as well as new business and retention strategy success rates. In an increasingly complex business environment, the standouts will be those brokers that can differentiate themselves through value-added services and products, including data and analytical capabilities, the use of artificial intelligence, and risk management expertise in existing and emerging risks--such as cyber risks, extreme weather, and self-insured retention levels, among others.

Insurance rates provide a tailwind for brokers

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We believe market impact is best captured by insurance premium growth--the base from which broker commissions and fees are largely derived--and encompasses both the insurance rate environment and insured exposures. In our view, 2019 was an inflection point, as pricing momentum significantly accelerated, which helped mitigate the impact of COVID-19 in 2020 when exposure units declined. The insured exposure part of the premium equation remains strongly aligned with economic variables, since exposures will fluctuate depending on the level of payroll, inventories, sales receipts, and other insured risk. Overall, the trend has been favorable in 2021 and is likely to be sustained through 2022 as brokers benefit from continued rate increases across most business lines and rising exposures.

Margins expected to stay steady, with perhaps some enhancement linked to use of technology, virtual work efficiencies, and growing scale

We view margins, which mostly fall within a 25%-35% range across the sector, as strong on an absolute basis, but we assess them as average for the industry. In 2022, we expect margins to remain relatively steady compared with the prior year. This will allow companies to bolster their cash flow generation to balance incremental leverage and support escalating debt-servicing requirements. While highly variable cost structures in terms of producer compensation protect against volatility when revenue is down, they also mitigate margin improvement as revenue rises.

We remain mindful of the growing demand for talent in the professional services realm. Insurance brokering is an intangible asset-oriented sector that is strongly reliant on people talent. As a result, compensation costs are by far the largest operating expense in the sector--often well exceeding half of a broker's total operating expenses (excluding depreciation and amortization).

We believe brokers are likely to benefit from improving operating leverage as they continue to grow, as well as from continued technological and cost-efficiency initiatives. However, we expect restructuring and integration costs to continue to temper earnings and cash flow generation (we do not give credit for these costs in our credit measure calculations, viewing them as the cost of doing business), particularly as rated brokers continue to pursue acquisition-oriented growth strategies and incur costs to build out vertical presence, add talent, and streamline the producer compensation relationship. Additionally, as business travel continues to return, we expect brokers to see higher levels of costs from travel and entertainment expenses, albeit likely not back to pre-pandemic levels.

Our ratings are greatly influenced by our forecasts and views of expected synergies and future EBITDA. Marketing leverage and the language around add-backs, as defined in debt agreements, do not determine our view of credit risk (other than when assessing compliance with financial maintenance covenants).

Strong M&A activity is expected to continue in 2022

The U.S. insurance brokerage market continues to be the most active subsector in terms of transaction volume. Mergers and acquisitions (M&A) among insurance brokers and agents continued to surge in the third quarter, pushing total deals to 553 as of Sept. 30, 2021 (854 on a third-quarter 2021 last-12-months basis; see chart 5). This was up 13% compared with the same period last year, according to the latest report from Optis Partners LLC, the Chicago-based investment banking and financial consulting firm. Optis Partners said all-time high valuations for brokerages, aging owners, and an expected rise in capital gains tax rates have contributed to the rise in deals. We believe the pace of deal activity could ease somewhat in fourth-quarter 2021 as concern about a capital gains tax change diminishes. Even so, we see no material slowdown on the horizon, and we expect another highly active year for M&A in 2022.

Part of this frenzy of activity stems from the plentiful acquisition opportunities on the supply side. While the industry is rapidly consolidating, it remains highly fragmented, with more than 30,000 insurance brokers in the U.S. alone. Demand-side dynamics remain buoyed by relatively easy access to still-inexpensive credit with an abundance of interested buyers, most notably by private equity and pension funds. Key sector attributes underpinning borrowing capacity include growth and retention, generally strong and predictable cash flows, and limited capital expenditure requirements.

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In our view, the question is not whether the robust pace of acquisitions will continue, but at what price. While valuations have been high and growing, most strategic buyers within our rated portfolio are valued at even higher multiples, keeping the deals accretive to value.

Many rated brokers are successfully expanding geographic reach, scale, and capabilities via M&A. Most are small and "tuck-in" deals--in which the target blends into the acquirer to enhance its existing market share or resource base--with occasional platform or transformational activity. We monitor post-acquisition performance carefully and have seen few material operational hiccups historically. However, marketplace zeal has resulted in escalating purchase price multiples and earn-out obligations, which we treat as debt in our leverage calculations. This core industry strategy often stalls deleveraging, especially when excess cash flow sweep provisions, which require debt paydown, in many broker credit agreements include carve-outs for acquisition funding.

Accommodative financial conditions and escalating multiples are bringing more deals to the marketplace, but they are also inviting increasing deal scrutiny and selectivity. We believe more established middle-market brokers with stronger cash-flow-generating capacity and equity to support funding have more flexibility to support and grow their deal pipelines.

Robust capital market activity for brokers likely to continue

Insurance brokers' capital market activity was robust in 2021, with 75% of our rated portfolio engaged throughout the year--and some on multiple occasions--for incremental or replacement financing to fund acquisitions, shareholder distributions, and refinancing activity (see table 3).

We evaluated $22 billion of new debt issuance--excluding revolver upsize/loan reprice activity, which are generally achieved via amendments to existing credit agreements--across the portfolio. In all cases, we assigned new ratings at the same level or we affirmed existing ratings and outlooks, or they were unaffected, as cash flow additions offset capital market activity or capacity existed at the current rating levels, keeping rating changes in check.

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Amid all the activity, a few takeaways contribute to our stable outlook for the sector. Most insurance brokers we rate engaged in capital market activity in 2021 and did so in a manner essentially within the bounds of our rating downside triggers. For many that were adding on debt to fund M&A, the add-ons came with incremental EBITDA of acquired targets, which we include on a pro forma basis and mitigated the increase in debt.

Brokers have relatively low working capital and capital expenditure needs, which support relatively high cash flow conversion rates. These characteristics, combined with relatively predictable and recurring revenue streams, allow for a business model with diminishing leverage via the strengthening of internal cash flow generation. However, we rarely see deleveraging for long because brokers tend to revert to an expected range more common for the sector through debt recapitalizations.

For privately owned brokers, which are generally controlled by financial sponsors, recapitalizations are driven by shareholder dividends, ownership flips between sponsors, and debt-funded M&A. For public brokers, increased earnings generally translate into increased debt capacity for share repurchases, internal initiatives, and acquisitions. We expect this cycle of falling and rising leverage to continue in 2022, with the impact on ratings likely to be limited given our focus on underlying run-rate expectations.

Health Insurance And Cost-Containment Servicers: Sector Shows Resilience As It Evolves

Our sector outlook includes the insurance-focused health care services companies in the portfolio. This is a smaller--but still diverse--group of companies that manage medical costs on behalf of health care payers, including health insurers, property/casualty insurers, government entities, and employers. The premium growth rate for the U.S. health insurance sector has been robust over the past few years as the market has expanded, and we expect this trend to persist.

In 2022, we believe health care services companies will achieve sustained incremental improvement via positive, though varied, revenue growth given product niches and company-specific factors. Although we believe uncertainty and risk from the pandemic remains, COVID-19 developments are having less of an impact on market conditions. Widespread immunization is supporting a return to more normal levels of social and economic activity, which will help drive business activity for these companies.

Like most of the middle-market brokers, almost all health care service companies are private-equity owned with generally aggressive financial risk tolerances. While most remain highly leveraged, many are somewhat less aggressive with leverage than brokers. This is partially because their business risk profiles are generally weaker and characterized by greater client concentration, a narrower size and scope (often, niches within niches), and lower EBITDA margins. Given the weaker business risk profiles and less robust earnings, there tends to be less margin for error. As a result, we tend to be more cautious about leverage in the capital structure when assessing health care services companies than for most of the brokers we rate.

Warranty Administrators And Claims Adjusters: Consumer Activity And Weather Influence Credit

Our sector outlook also includes the rest of the insurance services companies we rate, which essentially consists of warranty administrators (covering handset protection, automobiles, and home appliances and electronics) and insurance claims adjusters. For warranty administrators, growth is strongly tied to consumer purchases (the base for warranty sales), so product focus typically depends more on discretionary spending than it does for most other insurance services firms, which can increase susceptibility to macroeconomic factors.

We expect generally robust economic conditions to continue to propel underlying consumer product sales (smartphones, autos, etc.). Supply constraints and headwinds however are expected to continue into 2022 and weigh on growth. We expect warranty administrators to work to counter supply challenges by leveraging distribution networks and expanding relationships.

For claims managers, organic growth is somewhat tied to overall trends in claims volume and insurance carriers' decisions on levels of outsourcing versus insourcing of claims. Unlike in the carrier segment, where higher claims reduce profitability, claims managers benefit from higher claim trends, given their lack of underwriting risk and a fee structure that depends on volume of claims.

Claims volume will depend on the line of business. We see workers' compensation claims volume rising from continued payroll increases, whereas property claims will depend highly on weather trends. As carriers continue to contend with subpar pricing in many lines, and as claims adjusters continue to invest in client services and technological capabilities, we expect stable utilization and demand from carriers for outsourced claims solutions from independent adjusters.

Elevated Capital Market Activity For Non-Brokers Likely To Moderate In 2022

Capital market activity for non-brokers was elevated in 2021, with about 60% of the portfolio engaged throughout the year--and some on multiple occasions--for incremental or replacement financing to fund shareholder distributions, ownership change, or refinancing (see table 4), with relatively less need for acquisition-driven financing compared with the insurance brokers.

We evaluated $19 billion of new debt issuance--excluding revolver upsize/loan reprice activity, which are generally achieved via amendments to existing credit agreements--across the non-insurance broker portfolio in 2021. In all cases, we assigned new ratings at the same level, or we affirmed existing ratings and outlooks, or they were unaffected.

Table 3

Competitive Developments, Balance Sheet Management, Operating Performance, And Execution Are Key In 2022

Considering the generally supportive economic, business, and financial conditions for the U.S. insurance services portfolio credits, we expect modest rating volatility with some upside for the sector in 2022, with movement hinging mainly on fundamentals aligned with competitive position developments, balance sheet management, operating performance, and strategic execution.

Appendix: Insurance Services Rating Distribution--Strongest to Weakest

Table 4

Related Criteria

• Environmental, Social, And Governance Principles In Credit Ratings, Oct. 10, 2021

Related Research

• ESG Credit Indicator Report Card: Business, Environmental, And Consumer Services, Dec. 16, 2021
• Economic Outlook U.S. Q1 2022: Cruising At A Lower Altitude, Nov. 29, 2021
• ESG Credit Indicator Definitions And Application, Oct. 13, 2021