S&P Global Ratings' sector view for global insurance services is largely stable, reflecting resilient industry fundamentals for most subsectors. We expect limited rating changes, primarily idiosyncratic, over the next 12 months.

Insurance services are a subset of the corporate business and consumer services sector. These companies mainly provide business services to the insurance sector, enabling exposure to a large and well-established market with little to no exposure to underlying insurance risk. Insurance brokers are the largest group among the insurance services companies we rate (see chart 1), 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 37 insurance services companies globally, 31 in North America and the remaining six in Europe. The number of rated companies has risen in the last decade with the trend of private-equity buyouts supported by syndicated financing. These buyers, along with the more recent addition of pension fund participants, continue to be enticed by growth and retention, predictable cash flows, and limited capital expenditure requirements in the sector, among other factors. However, the count of rated companies declined by four over the last year, mainly owing to consolidation and refinancing in the non-syndicated loan market, partly offset by new rating activity.

Unlike the insurance carrier sector, which is primarily investment grade (rated 'BBB-' or higher), insurance services companies are mostly rated speculative grade (rated 'BB+' or lower), predominantly in the 'B' rating category (see chart 2). Insurance services companies generally operate with high leverage and relatively weak credit quality measures, mainly because of:

• Financial-sponsor ownership (with over 60% of the portfolio defined as sponsor-owned),
• Acquisition-oriented growth, and
• Aggressive financial policies related to their capital structure.

Chart 2

Chart 3

Rating and outlook changes were very modest in 2022 and year-to-date 2023. There was one upgrade related to an acquisition (health servicer Magellan, which was acquired by higher-rated Centene; the rating was subsequently withdrawn) and no downgrades (see table 1). We revised a handful of outlooks, balanced between four downward revisions (both positive to stable, and stable to negative) and three upward revisions (both stable to positive, and negative to stable). Downward outlook revisions were predominantly related to debt-funded acquisition activity, while upward outlook revisions were largely a result of strengthened credit metrics due to performance improvement.

Table 1

In general, rating activity in the sector is somewhat more limited than many other corporate sectors, partly because insurance purchase tends to be more stable (and often compulsory) versus other more discretionary products, which somewhat lessens large performance swings. Rated companies demonstrated resiliency during the COVID-19 period. Negative rating action activity was more modest than many other corporate sectors, with limited downgrades. During that period, we mainly revised outlooks to negative on several higher-risk entities--primarily those with greater discretionary books of business and/or limited cushion relative to downside triggers. We subsequently revised most of the negative outlooks to stable in 2021 when performance stabilized. As of Jan. 20, 2023, over 80% of rated insurance services companies maintained stable outlooks, with the remainder equally balanced between positive and negative (see chart 4).

Chart 4

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Economic Outlook: Tipping Toward Recession

Our economists predict global economic growth to slow or modestly contract across most of the major economies this year in the context of the steepest rise in policy rates in four decades, geopolitical tensions, and energy supply constraints stemming from the Russia-Ukraine conflict. Globally, our base-case forecast sees real GDP having grown 3.5% in 2022, then dipping to 2.5% in 2023, and improving to more normal levels of slightly above 3% in 2024.

In the U.S., where our rated insurance services companies are most concentrated in terms of domicile and business presence, economic momentum protected the economy from recession in 2022. However, increasing prices and borrowing costs, coupled with persistent supply chain disruptions, have elevated recession risk for 2023. Our economists expect a shallow recession in the first half of the year. As rising prices and interest rates continue to eat away at household purchasing power and consumer confidence, S&P Global economists forecast contraction of 0.1% in 2023, from 1.8% growth expected for full-year 2022. Peak to trough, U.S. GDP is expected to decline by 0.8%, and then return to growth in 2024, at 1.4% (see table 2).

While the labor market remains tight, the rising economic pressure is expected to constrain the job market through 2024, as businesses scale back their hiring and trim headcount in response to slowing demand. Our economists expect the unemployment rate to peak at 5.6% in the fourth quarter of 2023, and then slowly descend to 4.7% by the fourth quarter of 2025. Over this same timeframe, we expect negligible movement in the level of payroll employment, which is partly a reflection of the degree of strain anticipated (compared with the job losses associated with the 2008/2009 Great Recession).

Inflation is well above policy targets, though there is some evidence of slowing, and our economists believe it likely peaked in the third quarter of 2022. Core CPI (Consumer Price Index) is expected to fall to 4.7% in 2023 from 6.3% in 2022 and continue inching toward the Fed's 2% target thereafter. Getting inflation under control while minimizing the damage to output remains the main macro policy challenge. After the dramatic rise in 2022, the fed funds rate is expected to peak at 5%-5.25% by the second quarter of 2023, before the Fed begins to cut rates in late 2023 as inflation somewhat moderates.

Table 2

Insurance Brokers: What Recession?

Overall, we expect insurance brokers will demonstrate continued favorable performance in 2023, though somewhat decelerated from 2022 highs, with organic growth generally in the mid-single digits or better and steady to modestly improving margins. Excluding cost of capital considerations, external conditions should remain an overall net tailwind despite the weakening economic backdrop, since brokers are net beneficiaries from continued elevated, albeit moderating, inflation and insurance pricing.

Continued premium rises set the stage for growth

In our view, market impact for brokers is best captured by insurance premium growth (the base from which broker commissions and fees are largely derived), which encompasses both insurance rates and insured exposure. For the first nine months of 2022, U.S. statutory P/C direct premiums written rose 8.1%, fueled both by increasing insurance pricing and rising exposure unit growth. The positive market impact from premium growth, coupled with generally solid new business and retention trends, enabled most brokers to post very favorable organic growth trends over the last couple of years. The median organic growth was 9% across the companies we rate for the first nine months of 2022 and far exceeded pre-COVID-19 run-rate levels in the low to mid-single digits. Brokers with material wholesale, managing general agent, or other specialty operations displayed the greatest outperformance as premium growth in the excess and surplus markets far exceeded standard lines largely because of the increasing flow of business into the non-admitted markets. (Wholesalers AmWINS and Ryan Specialty, for example, posted organic growth in the mid to high teens for the year.)

Chart 6

On the rate side of the premium equation, P/C premium price increases, which have been rising steeply for the last several years, started to show signs of moderation in 2022 but remained robust in the high single digits, on average, throughout the year (see chart 7). Carriers continued to push for rate in response to rising loss costs on account of social and economic inflation, and more severe and frequent weather trends, among other factors. Commercial insurers often priced in excess of trend to achieve target profitability. With commercial lines writers improving performance largely through year-over-year rate increases, we expect commercial lines rate increases in aggregate will likely continue to decelerate into 2023. (The companies we rate have very modest concentration in personal lines, since this segment tends to be far less brokered by the independent channel.) Nevertheless, inflationary pressure on loss costs, rising reinsurance pricing and shrinking capacity following Hurricane Ian, and continued underwriting discipline by management teams more focused on margin protection should keep the overall market firm.

Chart 7

The 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. In 2022, slower, but still positive, real GDP growth and continued strong employment aided premium momentum. But the much bigger boost to insured exposures came from the above-trend nominal GDP growth caused by inflation, which has driven up insured values and cost factors, thereby raising premiums. With recessionary pressures ahead in 2023, we believe continued high inflation will be the saving grace for brokers to continue to benefit from market impact. In addition to supporting pricing momentum, continued above-trend inflation will keep insured exposures positive, albeit slowed, despite somewhat reduced economic activity. And while inflation likely peaked in the third quarter of 2022, its impact on premiums lags owing to the insurance renewal cadence, so it should continue to provide a top-line boost throughout the year.

All in all, while we don't expect the positive market impact to be as strong as it was in 2022, brokers should still get a nice boost this year. With that support, we expect organic growth of mid-single digits or better for most brokers in 2023.

Company-specific growth trends, however, will continue to vary in 2023 based on product diversification and geographic presence, as well as new business and retention strategies and success rates. In an increasingly complex business environment, the standouts will continue to be the brokers that can differentiate themselves through value-added services and products. These include:

• Enhanced data and analytical capabilities,
• Investments in specializations and industry verticals,
• Successful producer/talent engagement and recruitment, and
• Risk mitigation and management expertise in existing and emerging risks (such as cyber risks, extreme weather, and self-insured retention levels, among others).

Margins hold up on operating leverage and efficiency gains as inflation rears its head

We view margins, which mostly fall within 25%-35% for our rated brokers, as strong on an absolute basis, but we generally assess them as average for the industry (see chart 8). Despite scale-driven operating leverage from robust top-line growth in 2022, the margin picture was more mixed, with many brokers posting relatively steady to slightly down margins for the year (though some posted gains). Brokers faced tough prior-year comparisons, as travel and entertainment (T&E) expenses started to normalize somewhere between pre-COVID-19 levels and the depressed 2021 levels. After margin gains in 2020 and 2021 from lower expenses during COVID-19, many brokers have also been willing to give a bit on margins to bolster organic traction, and have invested more heavily on sales tools, back-office technology, and producer recruiting.

While the inflation benefit to the top line more than offsets any negative impact on the bottom line, inflation and the tight labor market have also added cost burdens. The large variable component of brokers' compensation structures to production staff (who are often paid a percentage of new and renewal premium) softens the hit, but wages, particularly non-production related, and other expense items are on the rise. Insurance brokering is an intangible asset-oriented sector 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). While we have not generally observed outsize attrition at the production level (which tends to be sticky, aided in part by non-compete and non-solicitation requirements), the fight for talent in the industry continues, particularly with current employment conditions.

For 2023, we continue to expect a mixed margin trend, but most issuers to show relatively steady to slightly improved margins (and generally higher than pre-COVID-19 levels). Comparisons to last year should be better, with T&E and investment spending leveling out, and issuers realizing some permanent efficiency gains from reduced real estate footprint (with more hybrid/remote work arrangements) and increased use of video conferencing. Further, while a small component of broker earnings, investment income on fiduciary funds, which goes right to bottom line, will improve from higher market interest rates. These benefits, combined with continued operating leverage from top-line growth, should offset the inflation-driven cost increases we expect will continue in 2023.

We expect restructuring and integration costs to continue to somewhat temper earnings and cash flows, 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. Although issuer and covenant calculated EBITDA often gives credit for such expenses, we generally do not because we view them as a cost of doing business in the sector. Accordingly, our adjusted EBITDA figures are often lower than those reported by management or for covenant purposes. In general, we see a wide variance in EBITDA add-backs, with some issuers far more aggressive than others.

Chart 8

Crowded buyers' club keeps deal activity, and valuations, high

Acquisitions remain at the heart of the broker industry, with a frenzied pace of activity in the markets for well over the last decade. While 2022 was still the third-highest M&A (mergers and acquisitions) year on record, broker deal activity slowed about 20% relative to 2021 and closed out the year at just over 700 reported deals in the U.S. (per MarshBerry). Volume was down on account of rising interest rates, economic uncertainty, and continued higher valuations. While activity may continue to moderate somewhat into 2023 as players make more focused bets in light of higher cost of capital considerations, we believe deal volume will remain robust owing to enduring supply and demand characteristics.

On the supply side, the industry consolidation of the last decade has put a dent in the increasing market share of the most active acquirers. But the industry remains highly fragmented, with still plentiful acquisition opportunities (there are more than 30,000 insurance brokers remaining in the U.S. alone). With barriers to entry low, acquired targets are replenished quickly by scaling entrants that become future acquisition targets. Meanwhile, on the demand side, there remains a plethora of interested buyers, most notably a large pool of private-equity-backed buyers that have made up more than 70% of deal volume in the last year. Adding to the crowded buyer pool, public and independent brokers also continue to vie for deals.

With the abundance of demand, valuations have not come down much (particularly on platform deals) in the short term even as acquisitions become more expensive to finance and the financial markets have their worst showing since 2008 (with the S&P 500 dropping 20% in 2022). While we believe the higher cost of capital may ultimately cap or modestly compress valuations, it remains to be seen whether it will be enough to stop the purchase price multiple creep (see chart 9) given market forces and other valuation factors. Although the difference has narrowed with the continued rise in valuations, most in the buyers' club are still valued at even higher multiples, keeping the deals accretive to value.

Through their acquisition strategies, many brokers we rate are expanding geographic reach, scale, and content capabilities. Most are small and "tuck-in" deals and often within the acquirer's core competency--with occasional platform or transformational activity. There were a couple of notably larger deals this year, including Brown & Brown buying U.K.-based Global Risk Partners and Howden acquiring TigerRisk. We also note a pickup in specialty oriented deals as many brokers prioritize adding capabilities or proprietary products over simply growing, and as traditional retail brokerages continue to expand into the wholesale and delegated authority space in light of very attractive market fundamentals. The retirement sector, which is in earlier innings of consolidation and offers a natural complement, has also become an area of acquisition within our broker portfolio.

We continue to monitor due-diligence practices and post-acquisition performance carefully and have noted few material operational hiccups to date. However, exacerbated by continued high purchase price valuations and earnout obligations (which we treat as debt in our leverage calculations), acquisition strategies often prevent lowering leverage, particularly as excess cash-flow sweep provisions that require debt paydown in many broker credit agreements typically have carveouts for acquisition payments.

Chart 9

Chart 10

High debt leverage and worsening interest coverage keep ratings in check

With choppier credit markets, insurance brokers' capital market activity was down in 2022, particularly in the second and third quarters, with activity picking up slightly toward the end of the year (see chart 11). Unlike some other sectors, the debt markets were open for insurance distribution, just at a more expensive price. With frothier conditions, many brokers opted to finance their 2022 M&A from internal cash generation, combined with revolver borrowings and dry powder from late 2021 and early 2022 issuances. With dry powder dwindling for those that have not recently issued, we expect several brokers will likely tap the markets again within the next few quarters to fund ongoing acquisition pipelines. For our speculative-grade issuers, we expect activity to generally be opportunistic (for M&A purposes) and incremental over the next 12 months, rather than for refinancing purposes, since none of these issuers have material debt maturities until 2025 (aided by a wave of refinancing in 2021). Upcoming refinancing needs are also modest across our investment-grade issuers. They generally benefit from well-laddered maturities (weighted average maturity is roughly 10 years).

Leverage across rated companies was steady to modestly improved in 2022 (with a couple idiosyncratic exceptions of notable deterioration), driven by solid performance and somewhat more subdued debt activity. We think some issuers may gravitate toward the more conservative end of their leverage tolerances given current cost of capital considerations and with slightly less debt needs for M&A. But we generally don't see leverage, which is high for our speculative-grade issuers (often north of 6x-7x), changing materially in 2023 or beyond.

Brokers have relatively mild working capital and capital-expenditure needs and, as a result, fairly high cash-flow conversion rates, which, combined with a relatively predictable and recurring revenue stream, allows for high leverage but also a naturally deleveraging business model. Rather than sustaining credit improvements, however, we rarely see reduced leverage for long, since brokers tend to revert to the mean through debt recapitalizations. For the privately owned brokers, which are dominated by financial-sponsor ownership, recapitalizations are driven by frequent debt-funded M&A, shareholder dividends, and ownership flips between sponsors, all norms in the space. For the public brokers, increased earnings generally translate to increased debt capacity for share repurchases, internal initiatives, and acquisitions. Notwithstanding a possibly slightly lower leverage posture in light of current financing conditions, we expect this cycle of lowering and raising leverage to continue--the former limiting rating downside and the latter limiting rating upside.

While leverage on the whole should be relatively steady in 2023, EBITDA coverage (a supplemental metric we track closely) paints a bleaker picture. In addition to higher credit spreads negatively affecting the pricing of new issuances, most speculative-grade-rated brokers have a substantial portion of their debt structure in variable rate debt. As a result, they're materially affected by the floating-rate benchmarks that have continuously risen alongside policy rate increases. While coverage metric deterioration in 2022 has been muted (on a GAAP accrued interest basis) by the benefits of much lower floating-rate benchmarks in the earlier part of the year, we expect deterioration in 2023 on account of a full year of higher and still rising rates.

Notwithstanding the expected deterioration, we expect the companies we rate to generally be able to absorb coverage declines at their current rating levels. (Although, we are continuing to closely monitor this trend and may need to address a negative outlier here or there.) This is supported by the continued solid core performance and acquisition earnings, steady to improving leverage, and the favorable spread pricing most issuers have on their existing debt. In addition, over 60% of the speculative-grade-rated brokers have interest rate hedges (in the form of swaps or caps) in place on a portion of their variable rate debt. Many of these hedges have just come in the money in the latter part of 2022 and should provide somewhat of a buffer against the rising rates. Lastly, the downside interest coverage thresholds we set were in a period of low interest rates, and we're generally easing them modestly in the current environment.

Chart 11

Chart 12

Non-Brokers: Managing Through The Headwinds

Outside of the broker subsector, insurance services includes a mixed group of warranty administrators, health insurance and cost-containment servicers, and claims managers. Many of these companies have:

• Lower EBITDA margins (though profitability varies widely in the group),
• Greater client concentration, and
• Narrower size and scope (often, niches within niches) relative to their broker counterparts, resulting in business risk assessments on average lower than the brokers.

Additionally, we view this diverse group of companies as somewhat more susceptible to macroeconomic factors relative to rated brokers, often with a higher proportion of transactional and/or discretionary product. Accordingly, we expect the weakening economy in 2023--including elevated inflation, tight financing conditions, and continued supply chain disruption--to take a bigger toll on this group. Nevertheless, we expect most of the non-brokers we rate to manage well through market headwinds on generally steady retention, continued product and market expansion, and effective expense management. Most maintain stable outlooks, with the remaining equally balanced between positive and negative outlooks owing to idiosyncratic factors.

Among the insurance services companies we rate, the macroeconomic and market backdrop has been toughest for the warranty administrators, which cover a mix of automobiles, home appliances and electronics, and handset protection. For these companies, growth is strongly tied to consumer purchases, the base for warranty sales. Throughout 2022, industrywide supply-chain disruption and inventory shortages weighed on sales and top-line growth for warranty administrators while inflation of equipment, parts, and wages heightened expenses. To combat near-term challenges, warranty administrators worked to leverage distribution networks and expand relationships while proactively managing expenses and positioning for long-term growth.

For 2023, we anticipate a similar dynamic as 2022, with headwinds extending and companies controlling costs to preserve EBITDA. We view rated warranty administrators as well-positioned in their markets to withstand near-term pressure though not elude it completely. We forecast organic developments to be constrained while supply shortages persist. We expect rising prices and interest rates to chip at consumer appetite, though underlying demand should remain strong and support growth for warranty administrations once inventories stabilize, which could be as early as the second half of 2023.

For claims managers, organic growth is somewhat linked to insurance carriers' decisions on levels of outsourcing versus insourcing of claims and overall trend in claims volume. With carriers contending with insurance loss cost pressure in many lines, and as claims adjusters continue to invest in client service levels and technological capabilities, we expect stable utilization and demand from carriers for outsourced claims solutions. This should support overall growth for 2023, though levels will vary by line of business.

Workers' compensation claims are generally tied to payroll levels, and we anticipate sluggish growth in this line given rising unemployment. On the property side, claims will be highly dependent on weather trends and will face a tough comparison given the Hurricane Ian boost in 2022 (with limited revenue trickling into 2023). Although, the extreme rain in California and winter storms that swept across most of America in December is providing for a fast start to the year. Auto claim volumes continue to normalize as vehicle miles and accident frequency return toward pre-COVID-19 levels. Project and event driven business (product recall, legal, etc.) and continued expansion of addressable market provide opportunity for upside beyond base-case expectations.

Across all market segments, the tight labor market and wage rate increases continue to pose challenges, though rated adjusters have passed through some of the higher costs through price increases. Further, some pass-through pricing is embedded in contract structures, including cost plus constructs and those with automatic CPI-based price increases. We view adjustors that successfully manage a diversity of products, maintain a favorable mix of pricing constructs, and cater to a variety of clients to be less susceptible to isolated fluctuations in volume.

The rated insurance-focused health care service companies, which manage medical costs on behalf of health care payers (including health insurers, property/casualty insurers, government entities, and employers), should benefit from continued rising health insurance premiums, normalized medical utilization compared with depressed utilization trends during the COVID-19 period, and persistent medical inflation (as many companies generate revenue as a percentage of medical savings). Trends will continue to vary widely based on product niches and company-specific factors, but we believe the market backdrop will provide revenue opportunity for health services companies, so long as outsourcing continues. While insourcing remains a risk, the payor environment remains generally constructive. Demand remains strong for cost management services, as clients seek expertise and ways to optimize medical cost savings amid a continued rise in health care costs.

Further, we have a stable view on earnings for insurance-focused health care service companies. Revenue growth should improve operating leverage, creating cost efficiencies for some companies. However, ongoing industry factors--such as price competition, new client/contract implementations, and technology/systems investments--will likely keep operating margins in check, along with inflation-induced wage and expense increases.

Chart 13

Limited refinancing risk for non-brokers

Debt issuance was notably low for non-brokers in the insurance services group in 2022 amid capital markets volatility (see chart 14). The non-brokers segment generally engages with debt markets for incremental or replacement financing to fund shareholder distributions, ownership change, or refinancing. It has notably less need for acquisition-driven financing compared with insurance brokers given more sporadic and lower deal volume. With the benefit of elevated refinancing activity in 2021, none of our non-broker issuers have material debt maturities until 2025 (with the exception of one in late 2024), alleviating the need for refinancing over the next 12 months. Accordingly, we expect debt activity will depend mainly on opportunistic M&A but could remain muted this year.

With debt balances relatively unchanged and market trends somewhat constraining EBITDA expansion, leverage was comparatively stable for the non-brokers we rate in 2022. All but one are financial sponsor owned and all are rated speculative grade. Leverage tends to be slightly lower for this cohort relative to the sponsor-owned/speculative-grade-rated brokers given the generally lower margin/cash flow dynamics and less earning predictability. We expect relatively steady leverage trends in 2023 on likely subdued issuance activity and generally stable earnings.

Similar to insurance brokers, EBITDA interest coverage for non-brokers began deteriorating in 2022 because of higher debt servicing costs and growing variable rates. About 45% of rated non-brokers has some form of interest rate hedging (a somewhat lower proportion than the speculative-grade brokers), which provides some relief against the still-rising floating rate benchmarks. We expect further deterioration in 2023 but expect most companies to be able to absorb the declines at the current rating levels.

Chart 14

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Appendix

Table 3

Related Research

• Global Macro Update: Surprising Resilience Unlikely To Last Into 2023, Nov. 30, 2022
• Economic Outlook U.S. Q1 2023: Tipping Toward Recession, Nov. 28, 2022
• Rating Pressure Intensifies On Global Business And Technology Services As Recession Looms, Oct. 25, 2022