As expected, the surplus lines market experienced increasingcompetitive pressure in 2007, which has continued in 2008, leadingto a decline in the overall direct premium volume written by excessand surplus lines insurers.

Despite the premium erosion, adherence to disciplinedunderwriting principles helped surplus lines companies generatestrong underwriting and operating results.

Indeed, current soft market conditions portend deterioration inprofitability for surplus lines insurers, with additional decreasesin premium levels anticipated over the near term, according to A.M.Best's annual report, "U.S. Surplus Lines--2007 Market Review,"distributed this month at the annual conference of the NationalAssociation of Professional Surplus Lines Offices.

The premium decline is considered likely, absent a majorcatastrophe that curtails the incursion of standard market insurerscompeting on accounts currently written in the nonadmitted orsurplus lines market.

These current market dynamics are not uncommon and do not comeas a surprise, since surplus lines distributors and insurerstypically lose market share during the soft portion of the marketcycle.

Despite the market contraction, the relatively flat directwritten premium level of the past couple of years has not preventedsurplus lines writers from generating excellent results.

As noted in the year's report--the 15th annual study of themarket by A.M. Best--the total surplus lines direct written premiumin 2007 was $37.3 billion, down 3.5 percent from the year before.The premium decrease was greater than the 0.5 percent drop for thetotal property-casualty industry.

In 2006, despite overall softening conditions, the dearth ofcapacity for catastrophe-exposed property business led to anincreased amount of that business being written on a surplus linesbasis.

The virtually static surplus lines premium level in 2004 and2005 notwithstanding, calendar year 2007 was the first year since1996 that direct premium for the surplus lines marketdecreased.

Looking at the growth of the surplus lines market over the lastdecade--from 1997 through 2007--the surplus lines market has almostquadrupled, increasing from $9.4 billion to $37.3 billion duringthat time span.

The excellent operating performance of the E&S market notonly demonstrates the benefit of strong underwriting discipline,but it is also indicative of the magnitude of the underwritingmargins built up during the hard market period earlier in thisdecade.

Despite softer market conditions since 2004, the underwritingmargins have been sufficient enough to help E&S companies--especially the leading groups--generate stellar annual operatingreturns on revenue (net premium earned) and equity (policyholderssurplus).

Underwriting performance for the total p-c industry has alsobeen aided by favorable prior-year loss reserve development, whichhelped offset the effects of growing competition and the resultingcontinued pressure on top-line growth.

Historically, the surplus lines market has reported betterunderwriting results and rates of return than the total p-c market,and the trend continued in 2007. Consider the following:

o The loss and loss adjustment expense ratio for 72 domesticprofessional surplus lines companies making up a peer composite oftrue domestic surplus lines insurers was 52.4--more than 10percentage points lower than the same measure for the total p-cindustry.

o The combined ratio, on average, for the surplus lines insurerswas 76.0 versus 95.4 for the total p-c industry.

o The five-year average return on surplus for the surplus linescomposite was 19.2, compared to 13.8 for the total p-cindustry.

The performance of both the surplus lines composite and thetotal p-c industry over the last five years, especially in 2006 and2007, benefited from a benign Atlantic hurricane season.

During the first quarter of 2008, however, abnormal tornadoactivity throughout the country pushed the U.S. p-c industry'scatastrophe losses to the highest level in over a decade. Theselosses were attributable to high winds, hail, tornadoes, floodingand winter storms.

With forecasts of an active Atlantic hurricane season alreadybeing realized with the significant damage caused by HurricanesGustav and Ike, it appears likely that catastrophe losses will havea considerable impact on overall industry results in 2008.

This will, in turn, have a definite effect on the results of thesurplus lines insurers that provide a fair amount of capacity forcatastrophe-exposed property business.

As has been the case historically, a key challenge facingsurplus lines companies will be to manage operations through thepeaks and valleys of the market cycle.

With the supply of insurance capacity exceeding market demand,the momentum of declining rates has continued in 2008. There isstill a wealth of capacity being deployed in pursuit of specialtyand surplus lines business, with much of this capital coming fromBermuda.

Interest continues to grow in surplus lines business,particularly for the slightly tougher risks that have traditionallybeen borderline surplus lines accounts. This competitiveness isbeing felt across all lines of business, geographical territoriesand varying account sizes.

Effective management of underwriting, pricing and claimfunctions through use of new predictive modeling and otheranalytical tools should enhance the ability of insurers to succeedunder challenging present day market conditions. Databases haveimproved markedly, making these analytical tools more useful andimportant to the success of companies utilizing them.

These tools can help the industry avoid a recurrence of thedrastic soft market of the 1990s by supplying managers with betterinformation--provided that information is used with prudence andadherence to sound, proven underwriting and pricing strategies.

No matter how sophisticated the modeling tools, the E&Sinsurers that navigate this market successfully will be those thatwork through it with well-thought-out and well-executedstrategies.

The difficulty in growing organically has fueled a resurgence ofmerger and acquisition activity in the p-c market. Calendar year2008 has been very active with consolidations and mergers involvingsurplus lines market participants, both on the distribution andinsurance company sides.

In some cases, large multinational companies have targetedsurplus lines organizations to satisfy their desire for greaterdiversification into attractive market segments, while privateequity firms continue to express interest in specialtyorganizations as well.

Insurance companies with solid core operating fundamentals butsomewhat limited growth opportunities have proven to be popularacquisition targets, especially when a limited capital structure isviewed as the shortcoming of the group or company.

There is still a wealth of capacity in the p-c industry, and inmany instances, funding acquisitions is viewed as a means fordeploying excess capital in a manner that fosters growth for theacquirer.

Organizations with efficient expense management capabilities mayalso look to acquire companies with solid books of business thatinterest the acquiring organizations but whose main operationalshortcoming is an above-average expense platform.