Although U.S. property and casualty insurers have not all officially filed their financial results with state regulators on their statutory yellow blanks yet, preliminary information taken from several sources confirms the likelihood of the three-year slide.

In late January, the Surplus Lines Stamping Office of Texas reported a 7.9 percent decline in the premiums collected by 15 U.S. stamping offices. SLSOT said total premiums for these offices were $19.5 billion in 2009, compared to $21.2 billion in 2008.

Although SLSOT said this was the second consecutive year of decline that it tallied--following an 8.2 percent drop in 2008--in October last year, rating agency A.M. Best had already reported two straight years of decline for 2007 and 2008 for the entire U.S. surplus lines industry, with 2009 yet to play out.

While SLSOT only records information obtained from U.S. stamping offices, the Oldwick, N.J.-based rating agency compiled overall direct surplus premiums totaling $34.3 billion for 2008 in its annual report on the surplus lines industry for NAPSLO--a 6.2 percent decline from $36.6 billion in 2007. The $36.6 billion for 2007, Best's report said, represented a 5.3 percent drop from $38.7 billion in 2006.

According to the A.M. Best report, U.S. E&S insurers hadn't previously reported two consecutive years of down premium since the late 1980s. The last time premiums fell for two years straight was back in 1988 and 1989, when the drops were 4.3 percent and 2.5 percent, respectively.

Attempting to update some of the A.M. Best figures for 2009, the NAPSLO Daily captured total direct written premiums for the first nine months of 2009 from the 25 individual insurance companies that A.M. Best identified as the top 25 E&S writers in its October report.

These insurers, which together wrote 53 percent of the E&S market in 2008 according to A.M. Best, reported $12.6 billion in direct premiums written for the first nine months of 2009--a 12.1 percent drop from a total of $14.3 billion written during the first nine months of 2008.

If the nine-month results hold up for the full-year 2009, these figures suggest a three-year decline.

According to the NAPSLO Daily analysis:

o The 12.1 percent nine-month drop in direct premiums for the 25 E&S companies, followed another 12.1 percent drop for the full-year 2008 compared to full-year 2007.

o In 2008, direct premiums for the group totaled 18.4 billion, compared to $21.0 billion in 2007.

o The premium drop from 2006 to 2007 was 5.3 percent for these 25 companies.

o In 2006, the 25-member group wrote $22.2 billion, representing a 9.7 percent increase over 2005 when the same companies wrote $20.2 billion.

(Editor's Note: While the NAPSLO Daily's analysis, based on information compiled from Highline Data, a National Underwriter data affiliate, includes both E&S (nonadmitted) and admitted premiums for each of these 25 companies, and since the companies focus their attention almost entirely on the E&S segment, the distortion introduced by including admitted premiums is minimal.)

MORE RESULTS

An accompanying table displays a list of the 25 companies, along with their individual written premium totals for the first nine months of 2009 and 2008.

Additional financial information that the NAPSLO Daily retrieved for this 25-company cohort indicates healthier balance sheets and better underwriting results for 2009.

o Policyholders surplus as of Sept. 30, 2009 was $17.3 billion for this group, up 10.8 percent from year-end 2008.

o In 2008, surplus had fallen 5.7 percent to $15.6 billion--down from $16.6 billion in 2007.

o Part of the surplus recovery was attributable to better underwriting. For the group, direct loss ratios improved nearly 14 points.

On a state-by-state basis, SLSOT provides E&S premium and policy count information for 15 large E&S states, available at http://bit.ly/ct4Miu. According to the SLSOT January report, surplus lines premiums in top-ranked California plummeted 19 percent in 2009, while Florida--with the second largest E&S premium volume--saw premiums fall only 5.5 percent.

Third-ranked Texas actually reported a 4.2 percent jump in premiums for 2009, SLSOT reported.

WHAT'S AHEAD?

Are better times ahead for E&S insurers? Will the downward pricing cycle of the p&c market turn around, fueling premium jumps for E&S insurers in 2010?

The answer may depend on whether you focus on capital or on loss reserve trends to make the prediction?

Mark Watson, president and chief executive officer of Bermuda-based Argo Group International Holdings, said recently that the "primary catalyst" of every market turn in the past has been "a significant and immediate withdrawal of capital."

"That can happen from really big events, or it also can happen from a number of companies failing at the same time, and it's usually the latter that pulls capital--and therefore capacity--out quickly," he said during a presentation at the New York Society of Securities Analysts annual conference in New York last month.

"There's one other way to help the market--that's for large companies to make really bad acquisitions," added Stephen Way, the managing director of Houston-based Southwest Insurance Partners. "They remove capacity by acquiring another company, and then they become one really big bad company. That helps the smaller companies," he said.

Indeed, he noted, "one can think of quite a few companies that have done that [in the past], so maybe one or more of them will step up again. But I think getting rid of capacity clearly is the goal, and that comes from either a big loss, bad results, [incurred-but-not-reported loss reserve adequacy] that becomes negative instead of positive, and bad acquisitions--take your pick--or the market will just stay soft."

Separately, William R. Berkley, chair and CEO of W.R. Berkley Group, attempted to put a hole in the theory that capital drains drive cycle turns when he addressed the investment community during an earnings conference call a day after Mr. Watson's presentation.

Mr. Berkley said the last time the cycle changed, right about the year 2000, the industry was writing at around a 1-to-1 premium-to-surplus ratio, and that historically, in earlier periods when the cycle changed, capital adequacy was always the same.

"It didn't change dramatically--just as it was roughly the same in 2000 as it is now. There's no tremendous redundancy of capital," which correlates with cycle changes, he said.

Using a different barometer--dwindling releases of prior-year loss reserve redundancies--to forecast the proximity of a market turn, he said the cycle has in fact started turning, and predicted price hikes in the 8-to-10 percent range by the end of year.

It is Mr. Berkley's view that corporate blow-ups--like the demise of Frontier and Reliance, along with catastrophic events--move price increases up past double-digits, but they don't drive the initial turn. "Pricing cycles turn slowly. They go up 1 percent, 2 percent, 5 percent, 7 percent," he said.

"What will make the change more dramatic--and the reason you'll have an 8-to-10 percent price increase at the end of the year--is that there will be modest difficulties" as companies comply with their Sarbanes-Oxley certification requirements tied to year-end financials and recognize loss reserve issues.

Tossing aside the capital adequacy theory, Mr. Berkley said "the highest single correlation of any factor turning the cycle is the release of prior-year reserves."

He then pointed out that recent figures reveal a slowdown in this activity.

Releases started in 2005 and increased through 2008, but in 2009 there was a slight reduction in the rate of redundancies being released. "And we think 2010 is going to basically bring that to a halt, or close to a halt in the aggregate."

Explaining the reason, he said that while favorable loss development for accident years 2003, 2004, 2005 and 2006 may have all generated redundancies, "when looked at from 2010, past years include 2007, 2008 and 2009 where we feel in many companies deficiencies are being developed."

This is "exactly what happened in the late '90s, and it's why in 2000 the pricing cycle started to turn," he said.

Recalling the late-2000 failures of Frontier and Reliance, Mr. Berkley said that those insolvencies created a crisis that tightened the market in a number of lines more dramatically, and as prices started to move up well into double-digits, losses related to the 9/11 attacks fueled even further pricing improvements.

In 2010, "I'm not anticipating some crisis hitting," he said. "We'll have modest price increases" until the next crisis.

Mr. Way also referenced the Frontier and Reliance failures--as a way of warning analysts to be wary of insurers who report top-line growth during a soft market.

Back in 1999, when Mr. Way was chair and CEO of HCC Holdings, a publicly traded organization with insurance company and underwriting agency subsidiaries, he said that "the three fastest-growing companies in 1999 were Reliance, Mutual Risk [Management] and Frontier."

"By the end of the following year, they were all gone and our stock was at $20, up from a third-quarter 1999 low of $8."

Mr. Way also explained that HCC stock had plummeted to the third-quarter 1999 low when he announced that his company couldn't grow its earnings any more at the historical rate of 15 percent because market conditions were "just not good enough."

"Our stock went down 50 percent in three days," he said.

"We didn't announce we were going bankrupt. We didn't announce we didn't know what we were doing. We didn't even announce the future didn't look great. We just said we couldn't make 15 percent in that market, and a lot of shareholders sold their positions."

The moral of the story, he said, is that few executives of publicly traded E&S insurance companies will be honest with shareholders about the state of the business or their individual prospects for earnings growth. They won't do it "because they're frightened of the results."

Mr. Way, who now heads up a private holding company in Houston that makes investments and acquisitions in specialty insurance companies and agencies, went on to give his candid assessment of the state of the business.

"There's no good news in sight," he said.

"Investment income has all but disappeared. Underwriting profits are disappearing... Rates have been coming down now for several years."

"The market may be flattening out, but it is not getting better--except in certain [select] areas. Financial [institution] D&O [directors and officers] rates are probably going up, but how many companies write financial D&O?"

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