P&C’s Positive Forecast for 2023, Despite the Two-Headed Monster of Wage and Medical Inflation

The U.S. property and casualty (P&C) industry will improve its profitability over this year and the next after a weak 2022.

That’s the shared expectation of James Finucane, senior economist, and  Thomas Holzheu, chief economist Americas at Swiss Re, who co-authored the company’s latest U.S. P&C Outlook Report.

Despite this positive assessment, the pair forecast that reserves adequacy will deteriorate due to higher wage and medical inflation in 2024 after more than 15 consecutive years of favorable development.

After a year when return on equity fell on the back of high inflation and payouts from an active natural catastrophe year headlined by Hurricane Ian, the forecast for 2023 is more positive. Inflation is easing and gains from reinvesting portfolios are accruing higher yields.

The report concludes that it expects the gap between commercial and personal lines loss ratios to narrow as property rates have surged and liability gains have slowed.

“We see a process of convergence toward sustainable profitability levels. In 2022, commercial lines profitability was roughly in line with the preceding decade while personal lines struggled significantly,” Finucane said. “So commercial lines are working to maintain profitability while personal lines are taking necessary steps to improve it.”

“The shift is also playing out due to structural differences between the segments: Personal lines insurers are typically more constrained in the rate increases they can achieve through regulation, which prevented them from reacting as quickly as commercial lines when the inflation surge materialized in 2021 and 2022. By now, more rate increases have been approved and should begin to materialize in improved results later this year,” he added.

“Additionally, a larger share of personal lines claims is linked to inflation in the cost of goods, while commercial lines are more impacted by the cost of services. As inflation for goods has peaked and we face a shift toward more sticky increases in wages and health care costs, personal lines insurers should see some relief in claims growth while commercial lines insurers are more likely to face continued pressures on claims inflation.”

Inflation as a Driver

Finucane said that the main driver for property rates was inflation, which hit the construction sector especially hard during the COVID-19 pandemic. By his estimate, the replacement cost of buildings increased by 40% between 2020 and 2022, with property insurance claims climbing broadly in line with that.

At the same time, Finucane said that natural catastrophes keep recurring with high frequency and severity, adding 6.9 points to the 2022 combined ratio, above the prior 10-year average.

While Hurricane Ian made the headlines, other disasters such as tornadoes, floods and storms have also pushed up claims costs as January through March this year saw the highest number of first quarter catastrophes in the U.S. (23) since records began in 1950, he added.

Simultaneously, while the directors and officers (D&O) and employment practices liability insurance liability segments underwent strong rate increases during the pandemic, they have since faded, said Finucane. Liability lines have also been less exposed to the inflation surge and they benefited more from rising interest rates than short-term lines due to their longer tail nature, he said.

“Certain lines have seen drops in demand — such as D&O with the reduction in IPO and SPAC activity,” added Finucane. “However, insurers need to remain wary because the ongoing impact of social inflation, and the unwinding of the COVID court backlog remains a concern.”

Strong Premium Growth

Swiss Re predicts premium growth of 7.5% this year and 5.5% in 2024, with return on equity (ROE) improving to 8% and 9.5% respectively, based on the higher rates and investment yields. This represents the strongest year-on-year (YOY) ROE improvement since 2009.

While the industry net combined ratio reached 102.4% in 2022, driven by inflation raising loss severities across most lines, the report forecasts that it will improve to 100% in 2023 and 98.5% next year. Swiss Re expects loss severities to ease as headline consumer price index (CPI) inflation decelerates to 4% this year and 2.8% in 2024, despite above average claims for the first quarter of 2023.

Amid these positive trends, however, personal auto physical damage experienced its worst year in a quarter of a century, with a direct loss ratio more than 20 percentage points (ppt) above the average during that 25-year period and 12 ppt above the second highest year, in 2021. Based on earned premiums of $113 billion in 2022, there was more than $23 billion in extra claims costs compared to the historical average.

Peaking used car prices proved the main driver of claims inflation last year, while repair costs have also risen and will likely contribute to higher claims costs, the study predicted. However, the authors also projected a rapid improvement in motor profitability in 2023 as approved rate increases outpace severity indicators. As of March, auto insurance prices have jumped 15% YOY, according to the CPI and 10% YOY based on its estimate derived from statutory filing data.

In terms of investment income, Swiss Re expects the average yield to climb to 3.5% in 2023 and 3.7% in 2024 as recurring yields continue to rise. Despite a decline in reinvestment yields in Q1, they remain comfortably above maturing securities rates, with the report projecting a yield of 5.2% this year.

Looking forward, Finucane said, “Some of the biggest challenges facing the U.S. P&C industry are the potential for more persistent high inflation, which has lifted claims costs and poses a risk to reserve adequacy and the expected economic slowdown in the second half of the year, which may cause headwinds to premium revenues and investment returns for P&C insurers.

“At the same time, 2023 and 2024 have the potential of improving profitability for the industry: P&C insurers are less exposed to financial stresses than other financial services firms, easing inflation should support underwriting results, and reinvestment yields are well above the average of the past decade.” &