(Associate Editor Jeffery Beckner contributed to this article.) MONEY GOES where money grows, so it should be no surprise that a lot of capital lately has been attracted to the E&S marketplace. Much of it has been drawn to the property catastrophe market, which was in crisis after Hurricane Katrina produced huge losses in 2005 and reinsurers sharply increased rates in 2006. Then last year's hurricane season turned out to be a non-event, and insurer profitability soared.

But while capacity is up in the E&S marketplace–and not just for property CAT risks–written premiums have grown slowly, if at all. That has set the stage for stiff competition and squeezed profits. To gauge how this dynamic is playing out in the summer of 2007, we recently contacted executives of five longtime E&S insurers. We also got in touch with the president of a company that is new to the market. Their comments follow. Kevin Kelley
Lexington Insurance Co.
At Lexington Insurance Co., the nation's largest E&S insurer, Chairman and CEO Kevin Kelley sees a competitive but manageable market, albeit one that could be subject to volatility from future windstorm activity and geopolitical risk, among other factors.

At the moment, Kelley said the market is much more competitive than it was a year ago. "We're seeing casualty rates off 10% to 15%. That's a little bit more than we would have thought," he said. "Property rates–particularly where there is catastrophe exposure–have actually held pretty good except, really, through this month (June). And now we're seeing drops even in that area."
Still, the market allows insurers to earn a reasonable profit, Kelley said. "What you're seeing is a market that is softer, but it's not a bad market."
Kelley said that going into hurricane season last year, the market was in such imbalance that he was confident that property rates would continue to increase, regardless of how mild or severe the season turned out to be. "But what we're seeing now is that supply is approaching demand–and in some cases maybe even exceeding demand," he said, "and as a consequence–absent a significant event–we'll see competition."
In this competitive market, Kelley said a key factor for Lexington is increased submission activity from a broad range of markets, which he said limits the company's exposure to adverse selection. He said he was pleased that Lexington's submission activity has been up 5% to 10% this year.
"We're involved in more markets throughout the United States than any of our peer competitors," Kelley said, adding that such diversification helps maintain the quality of Lexington's book. "In addition to that, we have a branch in London and we've just opened a branch in Bermuda."
Kelley said while Lexington might stress submission activity a little more in a soft market than it normally would, its emphasis on two other key factors remains about the same, regardless of market conditions. One is adequate rate levels, and the other is retention. "Our goal really is to increase our renewal-retention ratio for our better accounts."
Kelley said the property catastrophe reinsurance market is a little softer than it was last year, "but not much." As one would expect, he said, more capacity entered the market because of reinsurers' recent profitability, but he said that is not driving down rates as much as one might expect because of continued growth in demand.
"While the industry has, in my view, recovered from Katrina, the exposure still exists to a major catastrophe because the values have significantly increased along the U.S. coastline," he said. "So you're going to need to have more surplus to handle the volatility that we expect to see."
Increased reinsurer support for U.S.-based carriers is not the only form new capacity has taken. In recent years, some Bermuda-based reinsurers have themselves created E&S companies in the U.S. One of the latest to do so is Max Capital Group, whose E&S subsidiary started doing business in April. (See sidebar on page 42.) Kelley said it would not be surprising to see additional Bermuda reinsurers launch U.S.-based E&S carriers, "but I wouldn't underestimate the challenge" for them.
"It's very, very difficult to move closer to the client, in my view, if your business is essentially in Bermuda or in London," Kelley said. "Those strategies, historically, have proven to be very challenging for markets" that have attempted to implement them. One reason, he said, is that such companies essentially are saying to their traditional Bermuda- or London-based brokers that "'I'm going around you. I'm dealing directly with your sources of production.' And those brokers don't care for that kind of a strategy."
Asked whether Lexington's recent move into the Bermuda market wasn't in some way analogous to the move of Bermuda markets to the U.S., Kelley replied in the negative, "because I think it's easier to go what I'd call 'downstream' than 'up.' It's much easier for us to go into Bermuda and to be a market to Bermuda brokers because they welcome the capacity."
Asked whether Lexington's move into Bermuda could be seen as more competition for Bermuda insurers' traditional business, Kelley replied, "One could look at it that way." He said, however, that the decision was not influenced by Max Capital Group's move into the U.S. E&S market.
In the year ahead, Kelley said, "I think the big story will continue to be volatility and whether the industry can absorb it." He pointed out that most meteorologists believe we're in for a long period of increased hurricane activity. "So the real question is, Is the future (going to be) more like 2004 and 2005, or is it more like 2006? The odds seem to favor more like 2004 and 2005."
Adding to potential volatility, Kelley said, is continued development in earthquake-prone California and the uncertainty surrounding geopolitical risks. "I just think you have to have a stronger balance sheet, a stronger surplus position to continue to be a market, to absorb this increased volatility."
John Latham
Markel Corp.
In the E&S marketplace, Markel Corp. sees more competition ahead and is responding to it by trying to increase its marketing activities in an intelligent manner, said John Latham, senior vice president. Markel Corp. derives about 80% of its business from excess and surplus lines. Its nine companies include Evanston Insurance Co. and Essex Insurance Co., the nation's seventh-largest and 10th-largest E&S insurers, respectively.
"The softening that seemed to be a little gradual toward the end of last year has now accelerated," Latham said. "Every product line tends to vary, but I would say it's fairly broad across the board."
Property catastrophe insurance "always has been a big focus for us," Latham said. While that is not expected to change, Latham said Markel has re-examined its approach to catastrophe modeling and managing its aggregate exposures. While reducing its presence in some areas in which it felt it was overly exposed, the company also has been able to offer capacity in areas in which it didn't write as much business before, Latham said.
But if competition for such business becomes too intense, "we're certainly prepared, as always, to walk away," Latham said. "Barring any storms, we'll see the pricing continue to soften, so we'll be very judicious in how we deal with that."
Latham said he foresees continued competition in the U.S. E&S market, particularly in regard to property insurance, from insurers with Bermuda-based parents. "Obviously they've got a good bit of capital behind them," he said. "They have to try to establish a business against that capital, so they're going to move pretty aggressively to write business, and that always makes things more competitive.
"We see that as a growing trend that challenges us a little bit," Latham continued, because differences in how U.S.-based and Bermuda-based insurers are treated for tax purposes creates an "unlevel playing field." (Both sides have argued over the various facets of this complicated issue. While legislation was introduced a few years ago in the U.S. House of Representatives to require all such companies to pay U.S. taxes on investment income, it was not enacted.)
In the year ahead, Markel plans to place additional emphasis on marketing, Latham said, while maintaining its commitment to underwriting. "We have to recognize that in this marketplace, we've got to work a lot smarter and a lot harder and be a lot more aggressive at everything we do to promote business," he said.
Markel recently established the Office of Business Development, which reports to Latham. He said Markel has been providing more resources to the marketing operations of Markel's nine insurance units, while also examining each one's business-development practices. "It's easy to go nine different ways solving the same problems," Latham said, "so part of what we're trying to do … is to find efficiencies and encourage activity designed to achieve better practices."
Latham said the marketing effort will focus more on things like product enhancement and differentiation, retention of business, added value, and improved communications with wholesaler brokers and MGAs rather than on price per se. Also, the focus is more on improved business practices than a specific growth goal, he said. While the company wants to give its underwriters more at-bats, it doesn't want them to swing at anything too far out of the strike zone. "The bottom line is still far more important to us than the top line," he said.
Latham said Markel also will continue to look for opportunities in acquisitions of insurers or books of business that will fit with the company's specialty philosophy. For example, he said, Markel recently bought a book of social-service-agency insurance from the California office of Black/White & Associates. "That not only increased our footprint in that marketplace, but broadened our targeted underwriting parameters," he said.
Mark D. Lyons
Arch Insurance Group
The E&S marketplace is softening and likely to get softer, said Mark Lyons, president and COO of Arch Insurance Group, the nation's sixth-largest E&S insurer. However, the company's chief management mandate–to achieve an acceptable return on capital–doesn't really vary with market conditions or phases of the underwriting cycle, he said.
Arch Insurance Group is an arm of Arch Capital Group, a Bermuda-based insurer and reinsurer that also has operations in the U.S., Canada and Europe. "Where we think Arch is a bit different is that we are strongly driven by the margins on the business," he said. "We view ourselves as pretty flexible and nimble (enough) to move our capital around, on all phases of our operations–whether it's the insurance group or the reinsurance group."
Lyons said the company reviews its strategy and reallocates its capital on a quarterly basis in light of where it thinks the best margins are. "Our primary measure is our return on capital," he said, adding that the target return is 15% or better for all of Arch Capital's businesses.
In the U.S. market, "everything we write is specialty in one form or another," Lyons said. Among the risks Arch accepts are D&O, health care, aviation, construction and energy, as well as traditional P&C lines supporting specialty business. While much of its business is written on a nonadmitted basis, it also can provide admitted paper where needed, he said.
Asked to comment on the E&S market's change over the last year, Lyons replied, "I think it's pretty clear that in almost all lines of business it's much more competitive." While the increased competition currently is being reflected in lower rates, he said, it also is beginning to affect coverage, something insurers usually find more problematic. He said he's seeing some broadening of terms and conditions in medical malpractice, as well as other forms of professional liability and E&O insurance. But he added that such broadening so far is moderate. Terms and conditions "started to slide" much faster after the last hard market, in the late 1980s, than they are now, he said.
Arch has two divisions that cover property catastrophe risks, Lyons said. One targets cat-exposed risks, he said, while the other leverages its cat capacity in the course of writing all lines of coverage for accounts.
In the property catastrophe market, Lyons said, you have "the tip of the tail wagging the dog," which is to say that the reinsurance market has a disproportionate effect on market behavior. It takes a lot of reinsurers to create the capacity needed to cover catastrophe risks, Lyons said, so their discipline–or lack thereof–significantly affects front-end pricing.
A year ago, pricing for property catastrophe reinsurance went "through the roof," Lyons said. As a result, primary insurers took bigger net positions on their property catastrophe books, paid a lot more for whatever they did cede to reinsurers and passed on their increased costs in the form of sharply higher premiums. Now, with more reinsurance capacity available, front-end pricing is easing, Lyons said. Property catastrophe reinsurers remain fairly disciplined, however, so if rates head still lower, the primary carriers–not the reinsurers–likely will lead the way, Lyons said.
Lyons said more capacity, and hence competition, also is being created by Lloyd's syndicates setting up shop in Bermuda, as well as Bermuda-based reinsurers creating E&S operations in the U.S. Lyons was philosophical about the latter development. He noted that Arch Capital itself went down that path in 2002. "So when we see other companies doing it, we certainly understand their desire … but we like to think that we got to first base sooner," he said.
Lyons said a number of Bermuda-based reinsurance markets are probably considering the idea of starting or acquiring a U.S.-based E&S company but would face an unfamiliar managerial environment if they make the leap. "When you can write a treaty that gives you $50 million in one shot, you don't need regional offices, satellite offices, hundreds of people. Your major cost is the commissions you pay, not the overhead costs."
Lyons said such a move can be good for a Bermuda-based company's stability because it makes it more diversified. "That's Insurance Principle 101," he said. Such developments, however, tend to drive down the E&S market as a whole, he said, "whether it's pricing or terms and conditions."
Also contributing to the competitiveness of the environment is the movement of standard-line carriers into E&S product lines, Lyons said. Of course, some business always has swung like a pendulum between the admitted and nonadmitted markets, he said, adding that in 2002 standard carriers could well have complained that E&S insurers were taking their business.
To a degree, however, Lyons said, admitted carriers are doing more than taking back standard-lines business that nonadmitted insurers wrote in the hard market; they're also luring away some traditional E&S businesses, like bars and restaurants. Lyons speculated that perhaps a third of the business E&S carriers had on the books in 2005 is now subject to competition from the standard-lines marketplace. Thomas Kuzma
Nautilus Insurance Co.
Asked to describe present conditions in the E&S market, Nautilus President Thomas Kuzma doesn't need time to reflect on his answer: softer than a year ago and likely to get softer. Conditions are still tolerable, however. "This is still a market where you can make underwriting profits," he said.