What lies ahead for the E&S marketplace?

But as I see it, the market is clearly healthier than it was a year ago. I think the results are better. There are some lingering issues, however, that I don't think have been dealt with sufficiently. Probably the most notable is reinsurance collectibles. That still is a major concern for many insurers, not only in the E&S world but also in the admitted world.

Still, the results are better. While I haven't examined the collective industry results, I've looked at ours and those of some of our competitors, and we're seeing some pretty good combined ratios. They look great by historical standards, but we've had a relatively low interest rate environment, so in reality combined ratios are probably where they need to be. They're around 100 for the overall market and 7 or 8 points lower for those companies leading their market segments. But even a combined ratio of 93 or so represents only a 12.5- to 14-point return, depending on your capital base.

Julian James: Most sensible E&S carriers have recognized that they can provide a true and stable partnership for their clients only if they have a relentless focus on underwriting for profit. If E&S carriers are willing to learn from the hard lessons of the past, then agents and their clients can expect a degree of stability concerning pricing and coverage. Overall, Lloyd's underwriters remain optimistic about the conditions for the next 12 months.

The E&S market is in better shape today than a year ago because two years have passed without any major catastrophes or losses in the market. With a benevolent loss environment, the market has been able to make some money to start covering its cost of capital. Financially, companies are in better shape than they were a year ago. At the same time, it must be remembered that these conditions are largely attributed to a better underwriting environment, but more importantly to a benevolent loss environment.

Michael Rozenberg: We are cautiously optimistic. The E&S market should continue to play a significant role, as industry capacity is shrinking and earnings are impacted by low interest rates. From our own point of view, we were well positioned at the start of this last hard market cycle. We had no capacity issues, no reinsurance issues and were fortunate to be in the right markets at the right time.

The property & casualty industry hasn't delivered a combined ratio under 100 in over 25 years, although the July issue of Best's Review says our industry may have a "fighting chance" of doing just that in 2004. That is great news and certainly demonstrates movement in the right direction.

Having said that, the measure of our industry includes our overall return on equity, and most would agree that the property & casualty industry hasn't kept pace with other industries in the last 15 years. Furthermore, there is evidence that in total we are under-reserved as an industry, and underwriting discipline may be starting to soften as competition heats up.

Q: What is likely to happen to E&S rates, capacity and coverage in the year ahead?

Kevin Kelley: Consolidation will be the No. 1 issue affecting capacity. I think, however, that consolidation will also create opportunities for participants in the surplus-lines industry. Julian James: It's too soon to say. It will depend heavily on the loss environment. It must be remembered that the recent profits in the E&S market have not made up for the losses of the last few years. Things look positive, but there are still challenges ahead.

Michael Rozenberg: There continues to be downward pressure on pricing and rates, but many areas in which we underwrite have hard-to-place risks. We see no significant signs that the experience in medical malpractice, employment practice liability, lawyers professional liability and architects professional liability justifies price decreases.

Q: Where do you see the greatest need for E&S markets in the year ahead?

Kevin Kelley: It's kind of a mixed bag. We continue to see very strong opportunity in the casualty arena. Products liability, however, seems a little more competitive now than we think it should be. We think the experience in that line probably is not being adequately reflected in rates. We think the umbrella market is also under a little more pressure than it probably should be. General liability, however, is still a market that is showing positive signs. We also see some opportunity in errors and omissions insurance.

Julian James: The specialty and casualty area has the greatest need at the moment, as property already has a fair bit of capacity. Specifically, capacity is lacking in areas such as professional liability, directors and officers liability, and medical malpractice. If there continues to be little progress on tort reform, and if the admitted market continues to have large losses in lines of businesses where they didn't expect to have large exposures, that business could come into the non-admitted market. This is something to watch.

Michael Rozenberg: We are the safety net when traditional admitted companies can no longer bear the risks being produced with their filed rates and forms. We face political, social and economic changes that continue to create the need for coverage that won't be easily found in the standard market. Such risks depend on problem-solvers, and the E&S markets exist to respond to that need. For example, our litigious society continues to promote uncertainties that affect health-care risks. We see no near-term change in that.

Q: The Terrorism Risk Insurance Act is scheduled to expire on Dec. 31, 2005, although legislation has been introduced in Congress to extend it through 2007. How important is the extension of TRIA to the E&S marketplace?

Kevin Kelley: There are two issues with TRIA. One is that the deductible levels are very high. So even if TRIA were to be reinstated, it probably would be with even higher deductibles, which means that if a company were to suffer a loss, it would still be very material despite TRIA. (Under the proposed TRIA extension, the industry's collective annual retention would rise from $15 billion currently to $17.5 billion in 2005 and $20 billion in 2007. Individual insurer deductibles would stay at the current 15% in 2006 and increase to 20% in 2007.) Higher deductibles would force underwriters to be conservative in how they view the terrorism exposure and to have underwriting safeguards in place to make sure they are not overexposed.

The second issue is that, absent a backstop from the federal government, clients are going to really have to look at insurance company balance sheets in an even more acute way than they currently are. For weaker insurance companies, insolvencies would become a major risk.

Julian James: The extension of TRIA is very important to the E&S marketplace, but the more critical issue is that the American economy needs it to maintain the recent recovery.

Michael Rozenberg: I don't see TRIA as primarily an E&S issue. In general, TRIA speaks to our economic viability in the event of extreme losses by communicating to our citizens a confidence in our society's ability to withstand and rebuild after experiencing unexpected shocks.

Q: In your opinion, what is the overall condition of the reinsurance market, compared with last year? What is your outlook for the reinsurance market in the year ahead, and how will it affect your business?

Julian James: The reinsurance market, similar to the surplus-lines market, has greatly improved its results in the last few years due to substantial rate increases across the board as well as the absence of large catastrophes. Not only that, but companies are financially stronger, having cleaned up their balance sheets and added reserves for liability business. However, there's still a long way to go, as unknown historical liabilities could affect businesses at any time. Still, many insurance companies are in a better financial position, and new companies in the market don't have historical issues surrounding old liability claims (e.g. asbestos, environmental), so there is room for optimism.

Michael Rozenberg: Many reinsurance companies that were operating in the 1980s are no longer in operation today. The evidence speaks to the need for consistent underwriting profit on all levels. Without strong partners, reinsurers can't be profitable. Our company is not heavily dependent on reinsurance but the few we work with have enjoyed consistently profitable results.

Q: What other factors do you expect to have a major effect on your business and the E&S market in the year ahead?

Julian James: Old books of business with historical liability claims could affect the profitability of the E&S market. Another factor that could affect business (but not that of the Lloyd's market) is the possibility of interest rates going up substantially. In this event, some carriers may start writing businesses at higher combined ratios to get a return on investments, instead of focusing on underwriting for profit. A reliance on cash-flow underwriting instead of underwriting for profit is something Lloyd's has long warned against. Its impact on the industry in the past has been damaging. Finally, other factors such as a large catastrophe or a large company withdrawal from the market could also have a huge effect.

Michael Rozenberg: Recruiting the right people into our organization, then training them and creating the bench strength we will need for the future is critical. This is a constant work in progress, but for an underwriting company it is a core mission. We need to grow and develop the next generation of underwriters and claims professionals.

Q: How are MGAs, surplus-lines brokers and retail agents likely to be affected in the year ahead by developments in the E&S marketplace, and what advice would you have for them?

Kevin Kelley: As I mentioned previously, the industry is still facing a lot of challenges. As a consequence, clients and their brokers need to focus on the balance sheets of their carriers and on their likely continuity. We don't think that point is stressed enough.

I think consolidation is going to be even more significant in the next two or three years than it has been lately, and that's going to cause disruption. That disruption will create opportunities for surplus-lines brokers, because retail agents and brokers will need help with the problems such disruption creates.

Julian James: MGAs and surplus-lines brokers should focus on achieving an underwriting profit and delivering stable and consistent partnerships. Be selective in your business and keep the lines of communication going with your insurers. Never forget that clients value stability and coverage above instability and no coverage! As for retail agents, if rates change, they will have to explain those fluctuations to clients. The ability of retail agents to interpret, explain and value policy coverage is going to be the differentiator between the best and the worst.

Michael Rozenberg: Managing general agents and surplus-lines insurance brokers need to be problem-solvers for their clients. Even if you can't solve a particular need for a particular risk, be the person who helps the retail agent find the solution. Speed, knowledge and ultimately access to an insurance company are what retail agents expect us all to provide. Because we are a wholesale-dedicated market we are only as effective as the producers we choose to work with, and they are our key to effectively marketing products.

With insurance companies' increased specialization, retail agents and brokers are most effective when they have a broad reach across many insurance options and can access solutions quickly. We believe that means retail agents increasingly will use MGAs and surplus-lines brokers to access the broad base of new and changing programs within the surplus-lines industry.