While the U.S. property/casualty insurance sector passed the capital test in 2017, a year with record catastrophe losses, insurers will face the real test in 2018 if catastrophe losses come close to last year’s activity and if reserve development becomes unfavorable, according to analysts at S&P Global Ratings.
The sector had enjoyed a good build-up of excess capital through multiple years of benign hurricane activity and, to a lesser extent, earnings generation. But there is a catch 22: Lack of category 3 or higher hurricanes over a 12-year span and cheap reinsurance have led to pricing complacency, particularly in commercial property, S&P said in a report, “U.S. P/C Insurance Sector Outlook Remains Stable, But Something Has Got To Give.”
According to S&P, the industry is “stable but somewhat in a state of flux” and it may take time to fully grasp the extent of 2017 catastrophe losses, given the $20 billion-$40 billion gap between the amounts reported by companies so far and consensus estimates of total losses among industry participants.
“During 2018, we will scrutinize the effectiveness of insurers’ enterprise risk management programs and react to developing insurer losses that materially exceed risk tolerances. Another avalanche masking true underwriting results is 10+ years of favorable reserve development, which we acknowledge is not sustainable, but we have not seen the turning point,” said S&P Global Ratings credit analyst Tracy Dolin. “After a prolonged period of pricing complacency leading to rate inadequacy in many product lines, something has got to give in 2018. Even though we expect pricing to improve, our combined ratio forecast near 100 percent implies a bleak pricing correction.”
The report claims that even though insurers have data analytic tools to improve underwriting performance, risk tolerances are their Achilles heel. Data analytics can only go so far for insurers with subpar internal performance targets and/or inability to meet their cost of capital.
“We are skeptical of insurers that believe they can achieve double-digit returns on equity ‘through the underwriting cycle,’ but tolerate consecutive years of underperformance and/or reliance on the continuation of healthy reserve releases to reach underwriting profitability,” S&P said.
S&P affirmed its stable outlook for the P/C insurance sector, citing very strong capitalization. However, S&P analysts said they foresee potential downward rating actions on insurers coming more from underwriting challenges and/or adverse reserve development than from capital declines.
“The sector benefits from excess capital levels, but it needs to improve its operating fundamentals to maintain this edge. In fact, our stable sector outlook depends on it,” S&P said.
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