While the excess and surplus lines sector is maintaining goodprofitability and strong balance sheets, challenges fromhigh-catastrophe exposures and low interest rates remain, says aMoody's Investors Service report.

But the report says that, even with current challenges, E&Sinsurers are expected to continue to generate top-line growththrough product innovation and development. New products launchedover the past few years include cyber-liability coverage,environmental liability and renewable-energy liability.

At the same time, low stock valuations will limitmergers-and-acquisition activity, the report says.

The report, by analyst Enrico Leo, attributes the sector'sstrength to product innovation, underwriting discipline andrisk-management practices, which served the sector well through thesoft market.

“Collectively E&S companies reported an underwriting loss in2011 due to the high level of catastrophes,” Leo says, citing lastyear's earthquakes, tsunami, floods and severe storms.

He says E&S insurers have responded by raising rates,tightening underwriting standards, purchasing additionalreinsurance, and, in some cases, reducing line sizes.

At the same time, E&S pricing is stabilizing and beginningto improve in some business lines, Leo says, particularly forcatastrophe-exposed property risks.

Companies' strong underwriting discipline and limited appetitefor retaining risks at inadequate rates have served them well overtime, he says.

“As pricing gains traction and standard carriers shed poorlyperforming accounts, E&S insurers' revenue and profitabilitymetrics will improve, notwithstanding significant competition, lowinterest rates and still-difficult economic conditions,” Leo saysin the report.

Expense ratios are generally higher for E&S carriers thanthey are for standard property and casualty insurers in partbecause E&S carriers use wholesale distribution channels,though their loss ratios have tended to be lower over time, Leosays.

New regulations in some states are negatively affecting E&Sinsurers, however, Leo cautions. He notes that in the past twoyears, four states have passed laws that define constructiondefects as commercial general liabilities.

“Such laws affect the freedom of policy form traditionallyenjoyed by E&S companies,” Leo says, “and the recent change inlaw could open up existing policies to potentially largerclaims.”