< PreviousAsset Management 38BEST’S REVIEW • DECEMBER 2022 Prudential Financial Inc., which posted a $284 million net loss in the third quarter of 2022, reported a gross total of $25.6 million in unrealized losses on its public fixed income holdings. “This is not unique to us. We believe it’s an issue for the broader industry and it’s economic in nature,” said Ken Tanji, Prudential’s chief financial officer. “We’ll manage the change in the rate environment and we’ll maintain regulatory capitals consistent with our AA financial strength objectives. But there is a short-term impact on our statutory capital.” He said the full extent of the issue is unknown because rates aren’t done moving and industry leaders will need to speak with regulators if changes become needed. Staunching Losses Carwinski of AAM said the good news is that if a company is able to manage their portfolios appropriately—where they’ve invested, the duration of their assets and if they’re matched with their liability profile with duration—the losses should remain on paper unless they need to go to the portfolio to cover liquidity needs. For companies that report earnings using the Generally Accepted Accounting Principles stand, they will be required to report the changes as investment losses. For companies reporting on a statutory basis, the bonds are amortized over the maturity, meaning as long as money keeps coming in they won’t see the same level of losses. The impact of the unrealized losses varies by carrier and segment and those carriers with greater allocations to long-duration bonds are the most vulnerable, according to the October Best’s Special Report. Currently, maturing bonds can be reinvested at higher coupon rates, thus leading to greater investment income. Additionally, property/casualty and health insurers have nearly doubled the percentage of bonds maturing within the next year than the life/annuity insurers do on average—15% compared to 7%. Bonds maturing in the near term will be a favorable development, as the proceeds from these bonds can be invested at a higher rate in the higher interest. Jason Hopper, AM Best associate director, said coming out of the financial crisis companies sought lower durations for new bond investments, shrinking the bucket of maturities over 20 years instead opting for maturities around 10 or 15 years. “Their barbell got a little bit tighter,” Hopper said. “My guess would be that something similar might happen now if companies anticipate continued rate increases so they don’t lock themselves in.” The AM Best report said unrealized losses were expected to grow throughout the remainder of 2022 and into 2023 as fallout from the rate increases works its way through the system. In approving the November increase, the Fed’s Federal Open Market Committee also released guidance that more increases could be on tap depending on economic conditions. “In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments,” the FOMC said at the time. Luke Schlafly, global head of insurance investment solutions at PineBridge Investments, said he anticipated an “interesting” year ahead in the world of asset management for insurers, as the broader fixed-income class offers more compelling yields than in years past. As an example, the high- yield asset class finally fits its name again. And insurers are grappling with how to take advantage of those opportunities while their existing bond portfolio is in a significant unrealized loss position. Schlafly’s firm had $133.4 billion in total assets under management as of the end of September. Both he and Carwinski said they don’t see rising rates ending the growing practice of investing in alternative asset classes, though, including private debt. While the spreads between those assets and public bonds have narrowed, those securities offer insurers the ability to control risk through bespoke credit agreements and structuring, Schlafly said. “When you have a lot of unrealized losses, it does constrain your ability to change your asset allocations quickly,” he said. “Many insurers probably don’t want to crystallize those losses. I think insurers are definitely going to have more flexibility on new premiums or new assets versus trying to reallocate existing ones, especially if they are sitting on some unrealized losses.” BR22.TRI04D1 Our Insight, Your Advantage ™ Learn More: www.ambest.com/trilogy www.ambest.com • (908) 439-2200 HISTORY LIGHTS THE WAY FORWARD Get perspective on how to navigate future challenges by learning about the past. The AM Best Business Trilogy tells the story of key players in the insurance and credit rating industries, illuminating the strong business practices that blazed a trail forward in the global marketplace. A portion of the proceeds from The AM Best Business Trilogy will be donated to the AM Best Foundation, a nonprofit which supports charitable organizations that encourage education and thought leadership in insurance and risk management.40BEST’S REVIEW • DECEMBER 2022 What’s Ahead in 2023 Mix of Forces Set to Shape Insurance Markets in Coming Year Inflation, recession, interest rates and more present new concerns for insurers. by Tom Davis T he insurance industry heads into 2023 facing a very different environment from just a year ago, with inflation hitting 40-year highs, interest rates on the rise after years of “lower for longer” and the expectation of escalating unemployment rates. The industry also is under pressure from severe weather, social inflation and the threat of more insolvencies in the Florida market. “Both insurers and reinsurers alike find themselves facing a sharp rise in inflation, which together with sustained high expenditures for major claims is adversely impacting the profitability of the entire industry,” Michael Pickel, chief executive officer, E+S Rückversicherung AG, said in a statement. Industry leaders say they’re prepared to deal with these issues as they continue to provide coverage for policyholders and take on new opportunities. Personal lines insurers say one of their biggest worries is that they will face regulatory roadblocks that will prevent them from keeping Drew Angerer/Getty Images Key Points Economic Troubles: A recession, continued inflation and more rounds of severe weather are considered inevitable, and industry leaders and analysts say they’re prepared to deal with the effects. Financial Losses: Industry leaders say insurers should brace for losses in both commercial and personal lines, especially because of a potential slowdown in home construction and other recessionary factors. Regulatory Factors: Pricing typically lags inflation in the insurance market because of regulatory roadblocks, so industry leaders say a broader conversation about pricing in certain catastrophe-prone states is due. Tom Davis is managing editor. He can be reached at tom.davis@ ambest.com. STORMY STROLL: People walk past the New York Stock Exchange in New York City’s financial district.41BEST’S REVIEW • DECEMBER 2022 up with inflationary pressures. The personal lines market typically lags behind other industries in terms of pricing, largely because of legislative resistance thrown up by states such as California, said Neil Alldredge, president and chief executive officer, National Association of Mutual Insurance Companies. Eventually, rates catch up; otherwise, the losses continue to pile up, companies become insolvent or they pull out of states where they can’t do business and make a profit, industry leaders say. “In the regulatory approval process, you have states like California simply that are not going to approve rate filings—period,” Alldredge said. “So, you know, the longer that continues, the worse that [inflation pressure] gets in terms of California for instance.” Allstate Corp, in its third-quarter earnings statement in early November, said auto and home insurance prices continue to be increased, reflecting cost inflation. Plans to reduce personal lines insurance in states with unacceptable auto and home insurance margins were being expanded the company said. The California Department of Insurance in mid- November approved a 6.9% personal auto rate increase for an Allstate subsidiary. The insurance department had been witholding action on automobile rate requests since the early weeks of the COVID-19 pandemic. The increase was the first California auto rate increase for Allstate in almost five years, the company said. Dealing With Recession The consensus in the insurance industry is that there will be recession in the United States and throughout much of the world in 2023, said Robert Hartwig, director, Risk and Uncertainty Management Center, Darla Moore School of Business, University of South Carolina. In the United States, Hartwig doesn’t expect a deep one: In fact, he said he believes it will be a “relatively shallow recession in comparison to what we experienced during the financial crisis in 2007 and 2008.” But Hartwig and other industry leaders say the downturn will be enough to have a widespread impact on the insurance industry. “All that places pressure on insurers to find new ways to cover their claims exposure, which means rates are likely going to be increasing,” Alldredge said. Hartwig estimates the consumer price index will rise 4.4% in 2023 after increasing 8.2% in 2022, but some insurers say their industry could see even worse numbers. Property and casualty insurance claims inflation, in fact, has been rising faster than the underlying index in recent years, far outpacing increases in premiums, according to a 2022 report from the American Property Casualty Insurance Association entitled Property Insurers Challenged by Skyrocketing Inflation and Natural Disasters . Inflation rose to a 40-year high just as U.S. private P/C insurers faced an $11.3 billion net underwriting loss in third quarter 2021. Insurance- incurred losses and loss-adjustment expenses increased by 17.8% in the third quarter last year compared to the third quarter 2020, according to the APCIA report. Auto repair costs have been trending higher than the underlying rate of inflation, with the latest numbers showing they were up 11.1% year-over- year in September, including an increase of 1.9% since August, said Robert Gordon, APCIA senior vice president, policy, research and international. Inflation will pressure insurers to increase rates, but Hartwig indicated he doesn’t believe the industry’s market will be hard in 2023; he prefers to call it a “firm market.” “What I’m expecting is that pricing will remain rational and that pricing will continue to reflect the underlying loss cost trends,” he said. “So does that mean the overall market will be harder? Potentially not, but pricing will likely be at level pace that would allow insurers to generate reasonable underwriting results.” Others are not so convinced. Kristof Terryn, chief executive officer, Zurich North America, said supply chain issues are expected to remain a problem and the war in Ukraine could affect energy prices. That fact could cause the cost of supply and materials to rise again, impacting the manufacturing industries and, ultimately, the companies that insure them. “They’re [energy prices] much more severe in Europe but you see it here in the U.S. So it definitely has an impact on the economy on prices,” he said. “The inflationary pressures of just putting two $85,000 cars back together again when they crash—that’s not a catastrophe necessarily, but it’s just more expensive to fix those because their cars are more expensive,” said NAMIC’s Alldredge. Alldredge and Terryn agreed that another driver for a continuing hard market will be social inflation What’s Ahead in 2023 42BEST’S REVIEW • DECEMBER 2022 as the industry deals with rising claims costs and record-high payouts in litigation. “The hard market is driven by a couple of underlying factors now and a lot of them actually are not directly related to real GDP growth or the lack thereof,” Terryn said. Severe Weather Even if inflation “cooled” nationally, Hartwig said, issues with property and casualty and homeowners insurance will continue to be “a never-ending problem,” particularly in the coastal states. Hurricane Ian is expected to have losses exceeding $50 billion, and severe weather and other related issues have led to industry losses on the casualty side that have gone up by almost 60%, Terryn said. “It’s still in the early days and there’s a lot of different estimates out there in terms of what is the size of the industry loss, but it is a massive event and it will reduce the capacity that is available in the property market,” he said. “So property for sure is going to be a rock-hard market next year.” Terryn said he believes the weather events of the past five years are continuing to pressure the market to keep prices high to prevent even bigger losses. “You’re just seeing growing risk exposures and if you then think about the inflation components in there as well, property premiums will continue to have to rise,” he said. Storm damage repair materials, in particular, are rising largely because of global inflationary pressures, Alldredge said. The cost of lumber and other materials will rise as supply chain issues remain. “And there are density issues. There was a lot more development today when Hurricane Ian hit in Southwest Florida than there was even 15 years ago. And so there’s just more buildings able to be destroyed,” he said. Even before Ian, the additional effects of higher rebuilding costs in the wake of major disasters—a phenomenon known as “demand surge”—combined with supply chain disruptions pushed up the price of construction materials by 44.1% between December 2019 and December 2021, according to the APCIA report. California also will continue to experience problems because of the wildfires, Hartwig said. But Florida will continue to deal with high catastrophe losses and “a market that was completely dysfunctional” before Hurricane Ian, potentially driving more insurers to leave the state, shrink their presence or—in a few instances—go into insolvency. “I think something that will draw attention— and is already drawing a bit of media attention—is that we are experiencing a rash of insolvencies in the property/casualty insurance industry. These insolvencies will generate interest not only in those states affected, but potentially at the federal level,” Hartwig said. Hartwig believes there will continue to be a broader conversation about the adequacy of regulation in certain catastrophe-prone states. He suggested that steps could be taken at the federal level that regulate the solvency issues in Florida and Louisiana “in the face of what’s certain to be a continued escalation of catastrophe losses due to climate change as well as population and economic growth in vulnerable areas.” “This is already an issue that’s on the radar scope of Congress and various financial regulatory agencies, with banks already required to make disclosures on these issues. It would not surprise me to see an expansion of this type of regulation,” he said. “There will be noise coming “With a general slowdown on the commercial side and then on the personal line sides, the expectation is that new home construction will also slow and as a result of higher mortgage interest rates.” Robert Hartwig University of South Carolina43BEST’S REVIEW • DECEMBER 2022 out of certain markets such as Florida in 2023, but Florida has problems of its own making, particularly with respect to rampant abuse of its legal system,” he added. Playing Catch-Up Personal lines insurers are very challenged in times of volatile or rapidly escalating inflation because there is a long lag time in catching up with rising costs, insurance leaders say. The time to identify increasing cost trends, model and determine necessary rate increases, file and obtain regulatory approval, sell the product, and provide the full period of coverage may take anywhere from nearly 12 months to 36 months, the APCIA’s Gordon said. The problem, he said, is the industry is “very challenged when you have volatile or rapidly escalating inflation, because it’s really hard to catch up with rising costs.” “High inflation often triggers political resistance to insurance rate increases, even when the real net increase is minimal or negative. The recent escalation of personal lines loss ratios suggests it will take insurers a while to stabilize underwriting results,” he said. But Alldredge said legislators shouldn’t stand in the way of insurance companies raising rates. It’s the best way to keep them in business, he said. “You know, it’s a challenging environment. Insurers need to take steps to make sure that they protect their solvency,” he said. “We want them to be here for the next Hurricane Ian. That’s the way this system is supposed to work. And if that means they have to increase their rates to be here, then that’s what they should do.” More troubling, Gordon said, is that loss ratios in the current highly competitive market for both auto and homeowners insurance are “very, very high.” “And even if inflation were to slow down, prices will still be increasing, and they are increasing faster for several categories of insurance cost inputs than the CPI,” he said. Paul Blume, senior vice president, state government and member relations, APCIA, said political overreach on top of inflation is highly problematic in California. “On the auto insurance side, there have also been significant delays in reviewing and approving rate filings. This results in companies holding rates in place for over two years, which means they’re not covering the costs of the increases associated with inflation, supply chain disruptions, or legal system abuses.” There are regulatory overreach problems regarding the California FAIR Plan, the homeowners market of last resort, Blume said. The FAIR Plan sued the state’s insurance commissioner because he was mandating that it offer an HO-3- type policy that is available in the private market, Blume said, and this would put the FAIR Plan in competition with the private market. Get fast, efficient delivery of: • Best’s Credit Ratings • Insurer Financial Data • Insurance Industry News And easily incorporate them into your internal applications. AM BEST’S INSURANCE INFORMATION FEEDS & WEB SERVICES 22.MK132B2 Our Insight, Your Advantage ™ Learn More: sales@ambest.com www.ambest.com • (908) 439-2200What’s Ahead in 2023 44BEST’S REVIEW • DECEMBER 2022 However, Blume said, the FAIR Plan’s purpose is not to compete with the private market; rather, it is intended to be the market of last resort. In addition, he said, the commissioner also is not allowing private insurers to include reinsurance costs in rate development and has publicly stated that the FAIR Plan does not need to purchase reinsurance, despite state law specifically allowing the FAIR Plan rates to cover reinsurance costs. The commissioner would prefer to have the private market provide “free” reinsurance to the FAIR Plan, but his action goes directly against the Legislature’s desire to protect California consumers, Blume said. With reinsurance, if claims exceed the ability of the FAIR Plan to cover the claims, the reinsurer would pay the claims; under the commissioner’s proposal, such losses would be passed on to every California policyholder, many of whom do not live in high-risk areas, Blume said. “There’s a bubbling crisis just under the surface right now in California. On the regulatory side, the regulator seems not to acknowledge that inflation is impacting the cost of things insurance pays for, but inflation does not stop at the doors of insurance companies. Insurers are impacted by rising costs just like every other industry,” he said. Other Weak Economic Signs Hartwig said the slowdown in the economy will be accompanied by an increase in the unemployment rate, which he believes will eventually rise to 5% or 5.5% after being at close to 3.7% for most of 2022. Hartwig said things could be somewhat worse for other major economies, including the U.K., for instance, and some other Western European countries that are particularly impacted by high energy prices. Alldredge said job losses mean fewer workers to insure, so the insurance industry won’t capture as much premium. “Some troubling areas there, but you also have a smaller claims exposure at the same time. That seems to be what’s going on in some of the costs and the workers’ comp system,” he said. Because of the expected recession, Hartwig said the industry should brace for a deceleration in growth in both commercial and personal lines, especially because of a looming slowdown in home construction and other recessionary factors. “With a general slowdown on the commercial side and then on the personal line sides, the expectation is that new home construction will also slow and as a result of higher mortgage interest rates,” he said. On the investment side of the business, the industry has had to contend with low interest rates for years, which kept returns on invested assets low. “[In past years,] more people were having more severe weather losses, but at least we had pretty good results on our investment portfolio,” Alldredge said. “But at the moment, that’s not the case. Hopefully that’s more temporary. The good news about that is interest rates are going up, and insurers should benefit from that from an investment perspective.” Hartwig said insurers will have material unrealized capital losses going into 2023. But, he said, higher interest rates “will provide the industry with a much-needed tailwind in terms of generating investment income. The return on invested assets in 2021 reached a 60-year low.” “So that’s the sort of silver lining in all of this,” he said. BR “The inflationary pressures of just putting two $85,000 cars back together again when they crash—that’s not a catastrophe necessarily, but it’s just more expensive to fix those because their cars are more expensive.” Neil Alldredge National Association of Mutual Insurance Companies22.BLINK016A Best’s Alert Service offers insurance agents and brokers a way to monitor changes to Best’s Credit Ratings and other important insurer information effortlessly. With custom notifications, you’ll always be aware of developments that impact the insurers whose policies you recommend or compete with. Our Insight, Your Advantage ™ Learn More: www.ambest.com (908) 439-2200 WHEN RATINGS CHANGE, YOU NEED TO ACT FAST46BEST’S REVIEW • DECEMBER 2022 What’s Ahead in 2023 APCIA: Inflation Will Make the P/C Industry Pay in 2023 The American Property Casualty Insurance Association is worried that inflation exacerbated by natural disasters such as Hurricane Ian and social inflation will make the industry suffer next year. by Tom Davis C ontinued inflation in 2023 will be especially problematic for a property and casualty insurance industry that’s already confronted with the painful costs of natural disasters such as Hurricane Ian and the hefty, rising price tag of litigation and social inflation, according to officials from the American Property Casualty Insurance Association. Best’s Review interviewed three APCIA leaders who warned about the potential troubles facing the P/C industry, still reeling from the rising costs of litigation that have led to record-high legal payouts, with some in the tens of billions of dollars. Participants included Robert Gordon, senior vice president, policy, research and international; Nat Wienecke, senior vice president, federal government relations; and Paul Blume, senior vice president, state government and member relations. Following is an edited transcript of the interview. Do we have an insurance industry that is facing a hard market across the board, particularly in the P/C industry? Gordon: So, the short answer is yes. Inflation has become a top challenge for the insurance industry, including a broad swath of issues such as economic inflation, social inflation— which we call legal system abuse—and supply chain constraints. … We expect that Hurricane Ian will test some of the recent legal reforms in Florida and exacerbate some of the very tight supplies for home rebuilding goods and labor, further pressuring auto and property insurance losses overall. Why do higher energy prices raise insurance rates? Wienecke: Everything in America and around the world is touched by the price of fuel. So, delivering building supplies as fuel prices go Tom Davis is managing editor. He can be reached at tom.davis@ambest.com. Robert Gordon47BEST’S REVIEW • DECEMBER 2022 up—that’s a pressure on building supplies. Even if you look at the inputs on cars, for example, how much of the car body is made out of petroleum products? The seats are made out of petroleum products. Tires may have petroleum products. So even the cars themselves, as those get higher, that’s potentially problematic. You are bracing for continued losses in commercial and personal lines? Gordon: The commercial lines have proven a little more able to get rates more quickly than the personal side. There’s just not as much political resistance there. The personal lines have a little bit extra to catch up. … However, just like the personal auto lines are suffering very severe inflation, so are the commercial lines. For example, legal system abuse really hits commercial auto insurance more than a number of the other lines. So, I think you’re seeing some very steep challenges in commercial auto. Can any steps be taken at the federal level to deal with the solvency issues as a result of Hurricane Ian and other catastrophes? Blume: The state guaranty fund system [in Florida and elsewhere] is there for a reason—to backstop any insolvencies. The companies that have gone into liquidation in Florida are not large companies. They were started up to help take business out of [Citizens Property Insurance Corp.] When they expanded into other states, perhaps they expanded too far and too fast. But these companies have not been, at least thus far, large companies. With that said, if other regulators do what they’re doing in California and arbitrarily withhold the rate that is needed, then that is contrary to their role to regulate for solvency. BR Nat Wienecke Paul Blume CONNECT WITH AM BEST The Twitter, LinkedIn, YouTube & Facebook logos are trademarks of Twitter, Inc., LinkedIn Corporation, Google & Facebook, Inc. www.ambest.com On Twitter @AMBestCo @AMBestRatings On LinkedIn ambest.com/corplinkedin ambest.com/ratingslinkedin ambest.com/infoserviceslinkedin On YouTube www.ambest.com/ AMBestYouTube/ On Facebook www.facebook.com/ ambestcompany/ Via Multimedia Channels 21.MK011JANext >