These are unparalleled times in the insurance marketplace andthe economy. The Great Recession, Chinese drywall, the DeepwaterHorizon oil spill, the failure or near-failure of numerous “too bigto fail” companies like AIG, high unemployment, and the housing andmortgage industry meltdowns have made even the most robustbusinesses wary.

The E&S segment of the insurance industry has historicallybeen able to move independently from other financial servicesectors. In the past, a downturn in the economy has led tostrengthened pricing as insurers tightened their underwritingguidelines. Today, however, E&S carriers face pricing pressuredue to the highly competitive environment within the E&Scommunity itself and from the voluntary market. While the case fora market firming can be made, certain basic underlying principlesare preventing that from happening.

First and most notably, the principle of supply and demand,which dictates that the price for a good or service will rest atthe point that the supply of that good or service meets its demand.Given a steady supply with increased demand for a good or service,the agreeable price point also increases. Conversely, when supplyincreases at a rate faster than the demand, the price point drops —a simple yet powerful premise when considering risk transferproducts.

Florida and neighboring states know well the supply and demandprinciple and its impact on the insurance marketplace. After 2005'sHurricane Katrina, insurers established a premium charge to ensurethat their capital would be present to pay claims in the event of acovered loss. The roughly $40 billion reduction in surplus andresulting reduction in capacity (supply), forced the price pointhigher due to an unchanged level of demand. The past five yearshave been relatively benign from sudden capacity-draining eventssuch as hurricanes, giving insurers the opportunity to replenishtheir capital funds through earnings. With their increased capitalpositions, many have grown impatient to write more business.

On the demand side, thepopulation of Florida's coastal counties has nearly doubled overthe past two decades, and insurers have eagerly taken advantage ofthat tremendous growth. The Insurance Information Institute reportsthat Florida is the most exposed state for hurricane loss, with atotal insured value of some $2.5 trillion. According to the federalGovernment Accountability Office, the Florida Hurricane CatastropheFund and Florida Citizens Property Insurance Corp. alone accountfor more than $2 trillion.

The aggregation of values along the coastline has prevented thecollective insurance community from gaining an actuarially soundspread of risk, which is imperative for the insurance mechanism tofunction independently. Despite most insurers' focus on reducingconcentrations of exposures, there are still substantial pocketsthat if hit would be crippling to the industry. Given today'spricing environment, many stakeholders question the long-termability of insurers to take on more risk

In 2004, Florida sustained four hurricanes that produced $22billion in insured losses. Though the combined effect of thosehurricanes surpassed the damage from Hurricane Andrew in 1992, therobust economic environment helped to offset these sustainedlosses. Imagine for a moment if those losses were to occur intoday's environment.

Despite some signs that the economy is beginning to recover,there is still much concern that a full economic recovery will beslow in developing, which would hamper an insurer's ability toreplenish the outflow of capital. While an insurer's success oftencan be attained regardless of the economic environment, thechallenge increases significantly if capital is either unavailableor very expensive.

Voluntary Markets Encroach Into E&S

Proper management of exposure to catastrophic events isimperative for the longevity and survival of carriers that writecatastrophe-exposed risks. Because of the need to limit the amountof property aggregation, carriers have become increasingly willingto aggressively target other lines of business as a means ofdiversification, writing business at questionable rate levels tobook premium. The relatively unscathed surplus supply that isavailable is driving down rate levels in many lines of business ascarriers look to grow or maintain their top line revenue number.The price and rate decreases are the initial tools to lure thebusiness in, followed by broadened terms and throw-in coverageextensions.

The major roles of E&S lines companies are to provide extracapacity for accounts requiring large limits and to underwriterisks requiring a unique approach. The past two years have beenincreasingly difficult for E&S companies from a liabilityperspective when providing terms for hard-to-place liability risks.Two factors are driving the difficulty: Increased competition fromstandard lines carriers and the erosion of the underlying ratingbasis resulting from the economic downturn.

As admitted carriers have broadened their appetite they haveincreased the amount of risk they are willing to accept. They areaccepting — even pursuing — accounts that they normally would notwrite in a harder market when surplus is less and the guidelines topreserve the supply of capital are tighter.

Imagine for a moment that it is 2006, and a manufacturer ofwidgets is enjoying a successful year with sales topping $5million. The carrier is providing coverage at a rate of $10 per$1,000 sales, equating to a $50,000 premium. Fast forward to2009-2010. The same manufacturer's sales have now dropped to $2.5million. Assuming the carrier has been able to fight offcompetition and can still charge the same $10 rate, that $50,000premium has now been cut in half to $25,000. The reality is thatthe $10 rate is probably somewhere in the neighborhood of $6 to$7.50, further reducing the revenue to the insurer. However, theexposure from prior years' operations likely remains the same orhas increased slightly with age.

Although the exposure for the carrier has been cut in half forthis policy, the fixed costs that are associated with the policymaintenance have increased on a percentage of premium basis,ultimately making less premium available to pay future claims. Thecarrier is forced to look for more accounts to replace the premiumthat has essentially vanished, and turns to the E&S markets.(This example neglects the presence of investment income, which hasproven to be scarce during this time period.)

E&S Market Remains Challenging

This scenario is not unique to E&S companies. It does,however, impact the E&S community more adversely as it iscommonly seen as the “safety valve” of the insurance industry. Thisimplies that risks unable to find necessary coverage from anadmitted carrier will turn secondarily to the E&S marketsegment for a solution. According to A.M. Best's 2009 U.S. SurplusLines – Market Review, the top twelve U.S. domiciled insurers thatprimarily write surplus or specialty admitted business had a 12.7percent reduction in direct premiums written in 2008. This iscompared to a 2.6 percent reduction of direct written premiums forthe total property and casualty insurance industry. The 2010 reportwill be out later this year, with the downward trend expected tocontinue.

So, in the near term, the E&S marketplace remainschallenging. It all goes back to supply and demand. The supply ofcapacity is relatively abundant compared to the demand. Until thereis an increase in demand (which will stem from an economicrecovery), carriers will continue to compete aggressively onbusiness, shaving it down to the thinnest margins. Although thereare some signs of rejuvenation, many experts believe that the pathto economic recovery will take us into 2011.

Assuming a surge in demand is off the table, the focus turns tothe supply portion of the equation. In the past five years, therehave been few events that have had an immediate impact on capacity.Relatively benign storm seasons have allowed insurers to replenishcapital through earnings. These results, coupled with reserveredundancies from more favorable underwriting years, have giveninsurers a bit of a cushion on which to rely.

As those reserve banks dry up, carriers will be unable to offsetdiminished underwriting results generated from a competitiveenvironment. They will instead need to examine their underwritingguidelines and the composition of their books to protect theirsurplus. Products determined to be non-core will be spun off in aneffort to return to profitability; a hard market may appear.

Encouraging Signs in Florida

The Florida marketplace is beginning to see small signs of thispurging effect. While the exit of a few players from some classesdoes not make a trend, it does demonstrate that carriers cannotafford to grossly under price the market in a particular segmentand enjoy long-term success. We are just beginning to see thisexiting of classes that signals a change in the market. However, aslong as overall surplus remains abundant, the carriers who areleaving will be replaced by ones looking to add to their top lineresults. Hopefully they will approach these newly identifiedopportunities with discipline. There is an industry adage thatsummarizes these opportunities, “Never allow the sweet aroma ofpremium to overpower the stench of losses.” This is a creed allcarriers should live by.

As we move through this market cycle, the responsibilities ofall parties involved in the insurance transaction increase andbecome even more important. To protect the insured, we all haveareas of focus:

Insurance carriers – Remain disciplined despite the pressurethat top line reduction places on bottom line results. Achallenging market is the time for entrepreneurial spirit toblossom. Focus on methods to increase the efficiency of theinsurance mechanism, reducing the impact of the expense ratio.

Insurance agents – Fully understand the climate in which we areoperating and the serious challenges that lie ahead. Examine thefinancial stability of the markets where you are placing business.Educate insureds on the importance of carrier longevity.

Rating agencies – Ensure consistent and objective analysis ofcarriers.

State agencies – Do not allow political pressure and publicopinion to override the primary objective of protecting thepolicyholder. State insurance agencies have a responsibility toensure that coverage is fair and reasonable and to guard againstdestructive competition.

With the future so uncertain, we must collectively continue toexamine opportunities carefully and thoroughly to take advantage ofgrowth opportunities. It all comes back to supply and demand andthe protection of our supply while demand is stagnant. The carefulmanagement of supply now will reap tremendous rewards when thebusiness environment changes — as it always does.

Nick Abraham, CPCU, ASLI, ARe, is the managerfor P&C binding for Markel Corp.,southeast region. He may be reached at [email protected].