Softening Market Challenges Growth Of E&S Segment, Best Analyst Warns

Maintaining profit margins while rates keep falling in most lines not impacted by hurricane losses will be one of the biggest challenges facing excess and surplus lines writers this year and next, one leading rating agency warns.

"We're in a changing part of the market," said David Blades, senior financial analyst for Oldwick, N.J.-based A.M. Best, briefing National Underwriter last week on some key conclusions of the agency's 13th annual report on the surplus lines market, released here during the National Association of Professional Surplus Lines Offices annual meeting. The report was commissioned by the Derek Hughes/NAPSLO Educational Foundation.

"Our opinions about the underlying strength of the surplus lines industry--specifically for the leading groups that write the majority of business--are pretty much solid," he noted.

"What's changing now, and what we'll be looking at over the next year or two--especially after we get through the hurricane season--is what's going to happen now that we've definitely turned toward a soft market. How is that truly going to manifest itself in the overall market, and what's the effect going to be on surplus lines?" he said.

"If nobody gets those third- and fourth-quarters hits" from storms that have plagued the industry over the last few years, "it will be interesting to see how that may change the aggressiveness of business plans going into 2007," Mr. Blades said.

"I definitely still expect to see the [E&S] industry continue to be profitable, although I do think, because of increased competition, we will see a slight erosion of the overall combined ratio," he added.

"As rates do come down--and there's no question that on an overall basis they are coming down--there will be some profit margin compression. But we don't expect it to be material to the point that it threatens the overall profitability of surplus lines companies," he said, noting that standard carrier margins will slip as well.

According to the Best report, premium growth in the surplus lines industry was essentially flat in 2005, marking the second year in a row of minimal gains. Direct written surplus lines premiums of $33.3 billion were just 0.81 percent higher than comparable 2004 premiums. In contrast, direct premiums for the entire p-c industry rose 2.4 percent.

Similarly, in 2004, surplus lines grew only 0.65 percent to $33.0 billion, while overall p-c premiums rose 4.5 percent.

According to the report, 2004 was the first year since 1997 that growth in total p-c industry premiums eclipsed surplus lines. The meager 2004 surplus lines growth rate followed three years of extraordinary jumps--35.7 percent in 2001, 61.7 percent in 2002 and 28.3 percent in 2003.

"Generally, surplus lines companies make a lot of headway during the harder market, when the standard market companies focus on core business and step back from...borderline surplus lines business," Mr. Blades said.

"I think that now that you're seeing more competition, it's especially going to creep into a lot of the middle-market stuff," he predicted. "We'll see if it actually starts to extend down" to smaller accounts as well, he said, referring to those with under $25,000 in premium.

"So far, we haven't seen any kind of wholesale competition" on the smallest business from standard market carriers, he noted. "But what will happen over the next two years as the soft portion of the cycle [drags on] will have a lot to say about whether the surplus lines carriers can maintain the strength that they have" over the last few years, he added.

"I think the less harm we get from the hurricane season, the more aggressive you may see standard lines carriers being--possibly coming after that middle-market surplus lines business, specifically the short-tail liability business and the non-catastrophe-exposed business," he said.

With respect to catastrophe-exposed regions, Mr. Blades noted that since the latest year summarized in the A.M. Best report is 2005, the heavy participation of the E&S market on property business in coastal regions has yet to play out through the premium figures.

State-by-state figures collected by the Texas Stamping Office through midyear give a preview of things to come, he said, noting that E&S premiums for 15 states rose 9.1 percent through the first half of 2006, with Florida's 47.9 percent jump contributing heavily to the overall result.

But even those figures don't give a totally accurate view of how the full year will develop, he said, noting that July 1 reinsurance renewals--and the trickle-down effects they'll have on primary insurers in the standard and E&S markets--are yet to be recorded.

While overall growth was negligible in 2005, some E&S insurers reported double-digit growth for the year.

"I think what we've said in our reports before still holds--that carriers that really have the strongest long-term relationships with their distribution partners, and were very clear about what they were looking to write, fare best," Mr. Blades said. "They took the most advantage of the hard market, and they are withstanding the initial onslaught of the standard market companies coming back and dipping their toes in the water, and competing on some of the borderline surplus lines business."

Beyond growth opportunities on coastal property and energy business, Mr. Blades reports that his conversations with market participants indicate there's a lot of business "in play" in the program business market--some as a result of companies such as Clarendon stepping back from the program segment in recent years. "We talked to some people, even up to a week or two ago, who still feel there's a lot of program business out there that's going to need to find a home over the next year," he said.

Turning to a trend that he described as being more certain, and definitely favorable for the E&S segment, Mr. Blades said, "I think it's major what's happening on the regulatory side," referring to legislation being considered in Washington--in particular, the Nonadmitted and Reinsurance Reform Act in the House.

The bill is "a very good step forward in terms of preserving" the ability of the E&S market "to operate independently and fluidly," while addressing the need for some uniformity of regulations, he said.

"A few years ago--and even up to last year--whether it was the SMART Act or optional federal charter, there was more trepidation about what might come out of those," he said. (The Nonadmitted and Reinsurance Reform Act is essentially a carve-out from the State Modernization and Regulatory Transparency Act--a larger bill setting forth federal standards for state regulation beyond surplus lines.)

Mr. Blades said he believed that lobbying efforts by NAPSLO and the American Association of Managing General Agents, as well as the groups' participation at Congressional hearings, helped drive these positive developments.

"There's more optimism this year that what changes will come down the pike will actually be favorable for the policyholder, and will also preserve what's been good for the surplus lines market and allowed it to truly serve as the safety valve for the insurance industry," Mr. Blades said.

Turning to prospects for merger activity and start-up operations, Mr. Blades predicted that neither would be an "overriding story" for the E&S market in 2007. "Usually by this time, we have wind of some M&A activity here or there. I would say it's not been as much as in previous years," he said, although he did believe that some deals would happen on both the carrier and distribution sides of the market.

The future for start-up activity is even less certain. "Every time I think the window [of opportunity] for start-ups is pretty much closed," Best continues to see them, he said, reporting that he recalled rating at least one new program writer recently. Still, referring to "the window where you looked at being able to lay out three-to-five-year plans with fairly aggressive growth," he said, "that one is pretty much closed."

New to the A.M. Best report this year is some commentary on the rating agency's increased focus on enterprise risk management activities for the companies it rates. "Not that we haven't looked at it before, but we're focused a lot more on it now," he said, noting that analysts are interested in how insurers are managing and modeling terrorism and catastrophe risks, as well as the correlations of risks.

"Honestly, I don't know that we've developed an opinion at this point as to whether E&S insurers fare any better or any worse" with respect to risk management practices. "But I will say that we've been comfortable" with ERM activities of the biggest E&S companies, he said.