Amid heightened inflation, we expect U.S. property/casualty insurers to maintain reserving discipline and favorable reserve development in aggregate, even as some lines remain under pressure.

S&P Global Ratings thinks the U.S. property/casualty (P/C) industry's loss and loss adjustment reserves are adequate. Since 2006, the industry has averaged about $8.6 billion in net reserve releases per year. While some lines of business, such as commercial auto liability and other liability--occurrence, have required repeated strengthening, reserve releases have been steady overall, particularly in short-tail lines (those with a condensed two years of historical loss reporting in Schedule P of an insurer's statutory annual statement) and workers' compensation.

Last year was the 18th consecutive year of net reserve releases for the U.S. P/C industry, though the $0.4 billion net release was the lowest since 2006.

Chart 1

Positive Reserve Development Supports Earnings

Personal lines writers' earnings have historically benefited from consistently positive reserve development. Over the past 20 years (2004-2023), reserve development on average improved personal lines' combined ratio by 1.3 percentage points.

Over 2006-2023, favorable reserve development on average improved commercial lines' combined ratio by 2.3 percentage points, principally through reserve releases in workers' compensation of $53.5 billion, which represented around half of the total $102 billion of releases in this period.

Reserve development in commercial lines underwent dramatic strengthening (around $71 billion) in 2001-2005, when adverse reserve development increased the commercial lines' combined ratio by 8 percentage points per year on average. The adverse development stemmed primarily from a huge increase in asbestos and environmental claims and strengthening of reserves for underpriced workers' compensation business.

Chart 2

Favorable Development Outweighs Adverse Development

In 2023, $12 billion of favorable reserve development in workers' compensation and short-tail lines modestly offset the increase in adverse development in the other liability--occurrence, commercial auto liability, commercial multiperil, and reinsurance of casualty lines (see chart 3).

Reserve releases from short-tail lines decreased in 2022, mainly due to adverse reserve development of $5 billion in private passenger auto liability, but bounced back in 2023 with favorable reserve development of $6 billion. Meanwhile, workers' compensation has been a consistent source of reserve releases for over a decade.

Chart 3

Adverse development in other liability--occurrence and commercial auto liability has worsened over the past three years as achieving rate adequacy in both lines has remained a challenge. Despite nine consecutive years of significant rate increases and reserve strengthening for commercial auto liability, the industry can't seem to catch up with loss trends that in part reflect increased litigation costs and higher jury awards, often referred to as "social inflation."

The sources of unfavorable development in other liability--occurrence, which includes general liability and excess casualty, are less easily identified, given the diversity of coverage in this line, but they include the impact of social inflation, as well as the regular strengthening of reserves to cover ongoing defense costs associated with settling asbestos and environmental claims. We think companies with material liability exposure may be increasing reserve ranges to absorb the potential reserve volatility from social inflation, which is lengthening payout and reporting patterns.

How Do Loss Reserves Affect Credit Quality?

Loss reserves affect several aspects of a P/C insurer's credit quality, including operating performance, capital and earnings projections, and risk exposure. Loss reserve adequacy is a key consideration in S&P Global Ratings' determination of a P/C insurer's creditworthiness, given that loss and loss adjustment expense reserves represented 50% of total liabilities for the P/C industry at year-end 2023 (see chart 4). Though reserve development has been relatively quiet for the industry, material underestimation of reserves could lead to downgrades or even company insolvencies, as it has in the past.

Chart 4

As of year-end 2023, the industry held about $885 billion in loss and loss adjustment expense reserves for all lines excluding mortgage and financial guaranty, supported by $1.04 trillion of statutory capital and surplus. These liabilities are management's best estimates, incorporating numerous assumptions and actuarial methodologies, which can leave them subject to increased volatility that can materially affect capital and earnings.

To put the magnitude of this potential liability into perspective, if the industry were to strengthen its total reserves by 20% (which is the amount of strengthening the industry undertook in 2001-2005, its last period of material reserve strengthening, as a percentage of year-end 2000 loss and loss adjustment expense reserves), the equivalent loss, based on year-end 2023 reserves, would be $130 billion.

Relative to the industry's total capital and surplus, a loss event of this size would be manageable. In practice, such an adverse event would likely occur over several years and only in certain lines, so the financial impact would fall mainly on insurers writing the affected lines, typically the long-tail casualty lines.

The most likely cause of such a tail event would be the emergence of a bodily injury risk that was unknown at the time the coverage was underwritten, as occurred with asbestos. Two areas of potential risk currently are PFAS (perfluoroalkyl and polyfluoroalkyl substances) and microplastics. However, their potential health impact is not yet well understood, and to date, no direct link has been established between either and a specific illness, as occurred when asbestos exposure was identified as the cause of mesothelioma.

Asbestos And Environmental Losses Slowly But Steadily Decreasing

A spike in asbestos and environmental claims substantially contributed to the P/C industry's net adverse reserve development in the early 2000s. The lines affected were other liability--occurrence, product liability--occurrence, and commercial multiperil.

Asbestos and environmental incurred losses have fallen since then, but ongoing defense costs have resulted in a steady pattern of reserve additions, which we expect to continue. This is a good example of the underwriting volatility that casualty lines are subject to because of the elevated litigation risk in the U.S. P/C market relative to other developed economies--a significant factor in our view of industry and country risk in the U.S. P/C sector.

Personal Lines Have Long Shown Positive Reserve Development

For 2024, we expect personal lines' reserve development to continue improving as rate increases earn through and more personal auto writers return to profitability.

Personal lines insurers' reserve releases have been consistently favorable since 2003 except in 2016 and 2022, when spikes in claims frequency and severity in personal auto liability led to reserve strengthening in 2015-2017 and 2022 (see chart 5). In 2023, personal lines again posted favorable reserve development, due to much lower reserve strengthening in personal auto liability lines relative to 2022.

The most consistent sources of favorable reserve development have been homeowners and auto physical damage (we assume 80% of this line is related to personal auto and 20% to commercial auto, based on the proportional split of reserves and premiums). However, the releases in homeowners have been suppressed in recent periods due to higher catastrophe losses and, most recently, the spike in inflation that has boosted the cost of construction materials and labor, resulting in modest adverse development in 2022.

Chart 5

Personal auto liability companies reacted quickly to an increase in claims frequency (as measured by year-over-year growth in the number of claims closed with payment) in 2014-2016 through higher rates and underwriting actions, but they posted three years (2015-2017) of reserve strengthening totaling $3.5 billion (see chart 6). The line had almost $4 billion of releases over 2018-2021 as the industry benefited from sharp reductions in miles driven and claims frequency due to the shelter-in-place restrictions during the COVID-19 pandemic. About half of these releases were taken in 2021 for accident year 2020, the first year of the pandemic restrictions.

Chart 6

However, the spike in claims frequency and severity in 2021 and 2022, which occurred as pandemic-related restrictions were lifted, caught insurers by surprise and led to a sharp deterioration in underwriting results for personal auto carriers. In 2022, the personal auto liability line had substantial adverse reserve development of $5 billion (75% related to accident year 2021).

Fortunately, 2023 showed significant improvement due to the rate increases for personal auto during 2020-2023 (around 4.7% on average annually and 25% of cumulative rate change) and other underwriting actions, which led to lower adverse development of $1 billion.

Commercial Lines Show More Volatile Reserve Development

Commercial lines in 2023 reported $0.5 billion of adverse reserve development, marking the first time in 18 years that net development was not favorable. This was mainly due to increased adverse development in commercial auto liability ($3.0 billion), other liability--occurrence ($4.7 billion), and commercial multiperil ($1.8 billion) (see chart 7). However, continued strong reserve releases in workers' compensation ($6.1 billion) and commercial short-tail lines ($5.2 billion) largely offset the adverse development.

Chart 7

Workers' compensation has been the industry's good news story

The largest source of reserve releases over the past 10 years has been workers' compensation. This line accounted for $53 billion, or around half, of the industry's total reserve releases over 2006-2023. Workers' compensation writers have benefited from declining claims frequency amid a shift in the workforce toward less hazardous occupations and more focus on loss prevention (see chart 8).

While average severity has modestly increased, the substantial decline in claims frequency more than offset this. On average, the industry has released 4% of prior-year-end reserves each year for the past 10 years. As a result, the $141 billion of workers' compensation reserves at year-end 2023 is almost unchanged from the $143 billion at year-end 2014.

Chart 8

We see no signs that workers' compensation releases will diminish anytime soon. Reported claims have ticked up since 2020 but remain well below pre-pandemic levels. After declining steadily from 2011 to 2018, incurred loss ratios increased in 2020 and 2021, likely in anticipation of COVID-19-related claims, but fell back in 2022 and 2023 when those claims did not materialize (see chart 9). We expect favorable reserve development to continue in 2024.

Chart 9

Commercial auto liability remains a sore spot

Commercial auto liability has been a consistent source of adverse reserve development since 2012, with roughly $19.6 billion of total adverse reserve development in this period (see chart 10). The insurers writing commercial auto liability have failed to catch up to loss trends despite the compounding of significant rate increases. This failure is attributable to several factors, including a shortage of experienced drivers of commercial vehicles and social inflation. We expect further adverse development as insurers continue to struggle to regain profitability in this line.

Chart 10

Other liability shows growing adverse development

The other liability--occurrence line has shown adverse development in each of the past nine years (2015-2023), totaling $23.7 billion (see chart 11), and we expect reserve strengthening to continue.

Despite the increase in rates in the past five years, the industry has had trouble keeping up with loss trends, which in part reflects social inflation. Recent profitability has essentially been break-even, with the combined ratio for this line at 99.0% in 2021 and 99.5% in 2022 (per the National Assn. of Insurance Commissioners).

Chart 11