As Competition Heats Up For E&S Risks, Expect Flat Growth, At Best

"I think when the premium numbers come through for 2007, you'll see something similar to what happened in 2004 and 2005," predicted Mr. Blades, recalling that relatively flat premium levels persisted for those years, with E&S premiums hovering around $33 billion each year.

But it's also possible that when surplus lines premiums are tallied for 2007 and 2008, the figures may actually move in a downward direction, Mr. Blades warned.

The idea that premiums will be flat for 2007, he said, is really based on assessments of market conditions that existed earlier this year–but conditions changed as the year went on. "More of what we've heard since June [indicates] we may actually see the overall surplus lines market premiums go down," according to Mr. Blades.

That hasn't happened since 1996, when surplus lines premiums registered a barely imperceptible decline of 0.4 percent to $9.2 billion, according to prior A.M. Best reports.

Surplus lines premiums grew for every other year in the past decade, and eclipsed the growth rate in total p-c industry premiums for all years in the decade except three–in 1997, and again in 2004 and 2005.

Indeed, even though the 2004 surplus lines premium growth rate was a meager 0.65 percent, and the 2005 rate was just 0.81 percent, these levels followed three extraordinary jumps–35.7 percent in 2001, 61.7 percent in 2002 and 28.3 percent in 2003–pushing E&S premium levels up more than fourfold for the decade.

That translates to an annual average rate of 15 percent (according to NU calculations, using the A.M. Best data). During the same 10-year period, premiums of the p-c industry overall grew 78 percent–or less than 6 percent annually, on average.

Looking ahead, Mr. Blades said "the more we talk to surplus lines insurers on a quarter-to-quarter basis–and this includes the surplus lines stalwarts…as well as some of the smaller companies that have specific niches–both those groups are feeling the competitive crunch." (He used the term "stalwarts" to refer to those companies that have consistently ranked among the top-25 E&S writers.)

Stefan Holzberger, an assistant vice president at A.M. Best, was quick to point out that in spite of the premium declines this year, overall profit margins for surplus lines business are still very good.

"Although there's competition heating up across all lines, the underlying rate levels as they earn out in 2007 are still very favorable," Mr. Holzberger said. "We expect that market segment to post very good results again in 2007, albeit with some loss ratio deterioration because of where the rates are going."

Historically, the surplus lines industry has reported better underwriting results and overall rates of return than the overall p-c business, according to graphical information provided in the A.M. Best report. Supplying some specific comparative figures for NU, Mr. Blades reported that:

o In 2006, the combined ratio for 70 domestic professional lines companies studied by A.M. Best was 79.6, versus 92.4 for the industry.

o On average, these surplus lines writers reported a loss ratio and loss adjustment expense ratio that was six points lower (better) than the industry's overall.

o The five-year average return on revenue is 21.3 percent for these E&S companies, compared with 10.9 percent for p-c insurers industrywide.

While both standard and surplus lines companies benefited from a benign hurricane season in 2006 (giving the industry an overall return-on-surplus of 18.9 percent and the E&S market a 20.6 percent return), both Mr. Blades and Mr. Holzberger noted that the much higher premium growth for the E&S sector–16.3 percent versus 2.1 percent for the industry–was the result of property capacity drying up in the standard market in coastal areas.

The premiums written for surplus lines companies for Florida and Mississippi jumped up significantly, Mr. Blades said, noting that the rating agency was able obtain some individual state data to review. "I think that's an obvious reflection of the capacity that was withheld in the standard lines market for cat-exposed business, and therefore, that capacity was supplied by the surplus lines market."

"If you look at the study, you can really see how those increases work their way through Lloyd's," Mr. Holzberger said, noting that Lloyd's is a major property-catastrophe writer and posted E&S premium growth of 28.1 percent.

The increased exposure of E&S writers to catastrophe risk is not worrisome to the analysts, who say E&S insurers practiced good enterprise risk management well before ERM became an industry hot topic.

"The nature of the business they write is high-risk, whether it's cat-exposed or just tougher classes," compelling them "to be more circumspect and to have more of the tools in place to make sure they have a good handle on their risk–that they're mitigating it where possible," Mr. Blades said.

"A.M. Best feels the stalwarts within the surplus lines market–those companies that write 75 percent of the surplus lines business–have excellent ERM programs in place," he added. "I stand to say, in some cases, those programs are more solid than we have seen from the standard markets."

Mr. Holzberger said another key risk management component relevant for surplus lines insurers relates to controls they put in place to monitor distribution partners with delegated underwriting authority. "The monitoring, I think, is a key element of the success of surplus lines organizations, and [reviewing that] is very much part of our ratings process," he said.

In terms of ratings, the report shows that 64.2 percent of domestic professional surplus lines companies (defined by Best as those that write 50 percent or more of their business on a nonadmitted basis) had ratings of "A-minus" or better, with a median rating of "A." For the industry overall, only 54 percent are "A-minus" or better, and the median rating is "A-minus."

While 90 percent of the ratings for the industry overall fall in the secure range–"B-plus" or better–100 percent of domestic professional E&S companies had secure ratings. According to the report, this was the first time since 1994 that all domestic surplus lines units earned secure ratings from A.M. Best.

Looking beyond the impact of a softening market, the analysts discussed the potential impact of other factors–Florida insurance reforms, Bermuda participation in the U.S. E&S market and merger activity–on E&S insurer growth rates going forward.

With Citizens Property Insurance Corp. taking over a bigger share of commercial risks and wind business, there will be premium declines in the broader market as well as the E&S sector, according to Mr. Holzenberger.

"That said, I think there are still a number of insureds that don't have a real comfort level with Citizens as a market that's going to handle their claims in a timely fashion. There are questions in terms of the ability to raise the huge amount of funds that they will have to raise post-event," he said.

"So, even though Citizens and the Florida Hurricane Catastrophe Fund are available, it doesn't mean that everybody's taking full advantage," he added, speculating that some business will continue to flow into the E&S market.

With respect to Bermuda, Mr. Holzberger predicted that interest in the U.S. E&S market will not subside in 2008.

"There are new entities out there that have Bermuda holding companies or lead operating companies that have acquired specialty domestic [U.S.] carriers–in some cases nonadmitted," he said. "That's seen as a great way to get a hold of small- and midmarket surplus lines business that has traditionally not found its way out to Bermuda or to the Lloyd's platform."

Turning to M&A activity, he said the most likely acquisitions will be insurers buying distributors. "Trying to get control of the pipeline of business is a good way to insulate oneself in a soft market," he said.

As for deals between insurers, he said, "nobody's distressed to the point of a fire sale," adding that he doesn't see any scenarios of a "white knight riding in and helping distressed companies" playing out anytime soon. "There are still some pretty good margins," he noted.

The Best report was commissioned by the Derek Hughes/NAPSLO Educational Foundation–set up in 1991 to improve education about the surplus lines industry.