As the property-casualty industry returns to soft-market conditions, financial analysts who follow the excess and surplus lines segment give strong recommendations to E&S insurers willing to ride out the market with a bottom-line focus.

“I'm not so much looking for companies that are having top-line growth. In fact, top-line growth that's excessive really scares me,” said Kenneth Billingsley, senior research analyst for Signal Hill, an investment bank in Baltimore.

“That's why the smaller-cap, mid-cap E&S specialty market appeals to me, and what I try to pitch to investors–'These guys are focused on underwriting profitability,' ” Mr. Billingsley said, highlighting smaller E&S companies such as Bermuda-based American Safety Insurance Holdings, which has U.S. operations in Atlanta, and ProCentury in Columbus, Ohio.

John D. Gwynn, an analyst with Morgan Keegan & Company in Memphis, observed the E&S segment, in a soft market, tends to contract more quickly than the primary sector simply because the marginal risks migrate back to the admitted market.

“It's always been that way; it certainly always will be that way,” he said.

Mr. Gwynn added that “when we get to a hard market, the E&S market expands far more rapidly than what you see in the primary market simply because they're not only getting good rates, but they're also getting a lot of marginal business that falls out of the admitted market.”

This reality for E&S carriers presents challenges in soft markets, as standard carriers race to quote risks typically viewed as E&S business in the markets.

Mark Dwelle, an analyst with Ferris, Baker Watts in Baltimore, explained that “you often see, and we are seeing, some invasion of their [E&S carriers'] turf by pretty large, pretty well-capitalized insurers that have aggressive and large marketing forces with which to attack the segments they find interesting.”

Mr. Gwynn added that “I think the companies, over a cycle, which put up the best numbers are the companies that learn to live with the fact of life the admitted companies get more aggressive in a soft market, and they learn to step away from risks and not compete with admitted companies in that type of environment.”

“Just wait out the storm,” he recommended. “Their margins and their volumes will expand the next time we get into a hard market.”

Mr. Billingsley agreed. Some investors, he said, become concerned as the standard market goes after market share, because this means specialty E&S players will effectively have some of their upper-layer, larger-account business drift away.

“The concern is that because the growth itself in the E&S market is flat or even shrinking for a number of companies, that that's a bad sign,” he said. “My take on it is, essentially, that the specialty market is doing what it has done throughout all of the cycles–and that is, when the pricing is bad, you don't write bad business. You protect the bottom line; you protect your underwriting. And in doing so, that is actually going to provide investors, in the long term, with better returns.”

Blake Phillips, an analyst with Fox-Pitt Kelton Cochran Caronia Waller in New York, believes E&S carriers can help themselves by focusing more on specialized niches that standard carriers typically avoid.

“When you lock up a certain niche–when you become the go-to for that kind of business, it puts you in a much better position going forward,” he said.

Clint Harris, vice president of Conning Research & Consulting in Hartford, also said that while the standard logic is to wait out a soft market, there is room for growth in surplus lines if companies focus on niches. “Having a certain expertise in a niche can allow for profitable growth regardless of market conditions,” he said.

So far in this current market cycle, the analysts say operating performance has been good for E&S insurers, but they don't expect profits to remain as such levels for long.

E&S carriers “have all done very well, but it's also fair to say that all their results have been well-supported by previous-year reserve redundancies,” Mr. Dwelle noted. “Current-year loss ratios are running higher than recent preceding years, and that's indicative of the erosion in price that's been occurring.”

Mr. Phillips added that “you haven't really seen the hard deterioration that you're probably going to see a couple of years down the road.”

A recent report by Conning showed that the surplus lines market has been outperforming general commercial lines over the last 10 years. Mr. Harris said the study spanned 10 years so that the results would reflect an entire underwriting cycle.

The report found insurers that are more committed to the E&S market tended to fare even better than “dabblers”–companies where surplus lines account for less than 10 percent of written premium.

“Indeed, we did find that the E&S groups, in particular outperformed…in terms of underwriting margin throughout the period–and that's in both soft and hard market conditions,” Mr. Harris said.

Looking ahead, however, analysts expect the effects of soft-market conditions to show up in short-term financial results as 2008 approaches. According to Mr. Gwynn, “this year, I think top lines will be down. I think profitability will be equivalent to what we saw in 2006.”

In 2008, he added, “barring any serious or major catastrophes, I think we'll see the top line down again at an accelerated pace, and profitability below–probably materially below–what we had this year.”

Mr. Dwelle predicted that “from a growth perspective, I don't think many of the companies will grow by much. Plus-or-minus 5 percent would probably be the expected range.”

There was some disagreement among the analysts regarding whether this current market cycle is different from previous ones, and whether insurers have learned any lessons from the past.

“Probably some of them have learned very well, but what do you do about that?” Mr. Harris asked. “No one says, 'I'm looking forward to underpricing my business,'” he noted. “But being able to have a better handle on what is the technical price for the business is something that is evolving overall in p-c insurance with the use of analytics.”

Mr. Dwelle said he believes that better use of new technologies might distinguish this soft market from those of years past.

Insurers, over the last 10 years, have become a lot more sophisticated in using modeling to understand where their exposures are and how to balance their risks, he said. “I think that's a positive, because when people are acting on the basis of information, they have a better shot of making a good decision than just blindly saying, 'Oh, this is a good deal. We should have more exposure here.'”

Mr. Gwynn remained skeptical, however. “A lot of people keep talking about how this cycle is different. I hope they're right, but I'm not buying into it at this juncture.”

He added that “some underwriters will tell you it's a better business today than it was 10 years ago. I think that's baloney. The fact is [insurers] are just trying to meet production goals, and one way to meet them is to loosen up the underwriting standards.”

Regarding the wider use of technology to better understand risks, Mr. Gwynn commented: “I hope there's something to that argument. It's certainly intuitively appealing that you'd have competent managers who would be making rational decisions in how you deploy capital.”

However, he added, “this is not an industry that has distinguished itself by being very rational throughout a cycle.”

Special Reports /

Analysts Expect E&S Insurers To Wait Out Soft Market, Protect Bottom Lines

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