Surplus Lines: Set To Outperform Traditional Insurance Market

In the current context of rising premium rates (when traditional insurers have less appetite for market share and exercise more underwriting discipline with greater focus on their core lines), such refusals increase, enabling surplus lines carriers to absorb the business at advantageous prices.

Relative freedom from pricing constraints has also contributed to the overall performance and profitability of these nonadmitted carriers.

Among the other unusual surplus lines coverages are: aviation shows, crop dusters, fireworks displays and racehorses, as well as insurance for high-performance, racing and vintage cars.

The top-100 U.S.-domiciled surplus lines insurers wrote about $8.5 billion in nonadmitted direct premiums in 2000.

Preliminary results reveal the high level of specialization in the industry, with 51 of these companies representing almost 75 percent of surplus lines premiums and generating 95 percent or more of their direct premiums written from surplus lines business alone.

Other insurers tend to write in some states on an admitted basis and on a nonadmitted basis in others. There is also a significant foreign-carrier contingent underwriting in the U.S., notably Lloyd's.

The four largest excess and surplus lines companies operating in the U.S. include two members of American International Group: Lexington Insurance Co. and American International Specialty Lines Insurance Co. The combined market share of the AIG companies puts it just ahead of Lloyd's, and Scottsdale Insurance Co., a subsidiary of Nationwide, is the next largest in terms of direct premiums written.

Lexington and American International Specialty benefit from their diversified product offerings and distribution channels. Lexington has proven innovative in creating products to serve the unique risk characteristics of its large, predominantly corporate commercial clientele.

American International Specialty has seen rapid growth since its inception in 1989 and specializes in difficult-to-place casualty risks in health care, professional services, construction, transportation and financial institutions. More than 80 percent of its business is written on a claims-made basis, meaning claims must be reported during the policy period, as opposed to an occurrence basis, where claims can be filed at any time during or after the covered year. The former protects the company from long-tailed exposures.

Meanwhile, Scottsdale has reported combined ratios consistently in the 110-112 range in recent years, reflecting competitive pressures, along with runoff in its construction defect business.

Overall growth in surplus lines direct premium volume in the U.S. has accelerated somewhat in the past year, with about a 10 percent jump for first-quarter 2001, compared to first-quarter 2000. Premiums increased 9 percent in 2000, up from just under 8 percent in 1999, when growth in the overall property-casualty industry was only about 3 percent.

Of the top 100 surplus lines writers domiciled in the United States, companies rated by Standard & Poor's represent about $8 billion, or about 95 percent, of total direct premiums written in 2000. Those in the secure range (with ratings of "triple-B" or higher) represent about 96 percent of premiums of this rated universe, with the breakdown by rating category as follows:

36.7 percent at "triple-A."

18.5 percent at "double-A."

38.2 percent at "single-A."

2.8 percent at "triple-B."

Many smaller players, however, may be exposed to downgrades, in an industry where large carriers dominate and the top 10 groups command about two-thirds of premiums.

Claims, when incurred, are generally very severe. Also, since policy buyers do not have the safety net of a state guaranty fund for such business, an insurer's ability to pay takes on greater than usual importance. Any flight to quality by insureds further erodes the standing of the more marginal players.

Seven of the companies among the top-100 are in the vulnerable range (with ratings of "double-B" or lower) and together represent about 4 percent of premiums of the rated companies. Two companies that have come under regulatory supervision or voluntary rehabilitation in the last year or so, Reliance Insurance Company of Pennsylvania and Frontier Insurance Company in New York, are the lead companies of groups which write significant amounts of surplus lines business.

With less product, distribution and geographic diversity, smaller writers are particularly susceptible to competitive pressures. And any deregulation that opens up more surplus lines business to admitted carriers is a particular concern.

Standard writers in search of higher profitability are now offering certain lines that were once the exclusive domain of the surplus market, such as product liability. Some admitted primary and reinsurance companies have capitalized separate surplus lines companies, often as a means to develop business they can write on an admitted basis in the future.

State-sponsored insurance facilities, such as the California Earthquake Authority or the Florida Windstorm Underwriting Association, can also diminish opportunities for locally concentrated insurers by absorbing business that surplus lines companies would otherwise write.

Another potentially negative factor is the firming rate trend in the reinsurance marketa market which surplus lines writers are heavily dependent on to limit their losses.

Still, the U.S. surplus lines industry's growth trend remains underpinned by firming premium rates in p-c business overall, suggesting an improving outlook. Moreover, its own price increases are unfettered by the constraints of the admitted market, allowing for greater profitability.

Professional liability coverage, particularly medical malpractice, is likely to remain a strong area, with more business written on a claims-made, as opposed to an occurrence basis.

The large players are generally on solid ground, combining innovative product development and risk solutions with underwriting discipline. The top three companies also enjoy the financial resources of strong parents.

The financial impact of loss associated with the World Trade Center event is unknown at this time. Standard & Poors believes, however, that companies that are well diversified with excellent financial alternatives and resources will remain among the strongest in this industry.

Some of the smaller companies, however, squeezed by competitive pressures, are vulnerable to downgrades.

Some defensive consolidation is possible, as the more marginal players seek increased efficiencies, opportunities to sell to new client bases, and diversification of risk, distribution and geographic scope. Nevertheless, the potential for widespread merger or acquisition has largely been played out.

Matthew Coyle is a director of research and Frederic Sklow is an associate director for Standard & Poors in New York

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, September 21, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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