Surplus Lines Insurers Withstand More Intense Competition, Market Report Finds

As expected, the surplus lines market experienced increasing competitive pressure in 2007, which has continued in 2008, leading to a decline in the overall direct premium volume written by excess and surplus lines insurers.

Despite the premium erosion, adherence to disciplined underwriting principles helped surplus lines companies generate strong underwriting and operating results.

Indeed, current soft market conditions portend deterioration in profitability for surplus lines insurers, with additional decreases in premium levels anticipated over the near term, according to A.M. Best's annual report, "U.S. Surplus Lines--2007 Market Review," distributed this month at the annual conference of the National Association of Professional Surplus Lines Offices.

The premium decline is considered likely, absent a major catastrophe that curtails the incursion of standard market insurers competing on accounts currently written in the nonadmitted or surplus lines market.

These current market dynamics are not uncommon and do not come as a surprise, since surplus lines distributors and insurers typically lose market share during the soft portion of the market cycle.

Despite the market contraction, the relatively flat direct written premium level of the past couple of years has not prevented surplus lines writers from generating excellent results.

As noted in the year's report--the 15th annual study of the market by A.M. Best--the total surplus lines direct written premium in 2007 was $37.3 billion, down 3.5 percent from the year before. The premium decrease was greater than the 0.5 percent drop for the total property-casualty industry.

In 2006, despite overall softening conditions, the dearth of capacity for catastrophe-exposed property business led to an increased amount of that business being written on a surplus lines basis.

The virtually static surplus lines premium level in 2004 and 2005 notwithstanding, calendar year 2007 was the first year since 1996 that direct premium for the surplus lines market decreased.

Looking at the growth of the surplus lines market over the last decade--from 1997 through 2007--the surplus lines market has almost quadrupled, increasing from $9.4 billion to $37.3 billion during that time span.

The excellent operating performance of the E&S market not only demonstrates the benefit of strong underwriting discipline, but it is also indicative of the magnitude of the underwriting margins built up during the hard market period earlier in this decade.

Despite softer market conditions since 2004, the underwriting margins have been sufficient enough to help E&S companies-- especially the leading groups--generate stellar annual operating returns on revenue (net premium earned) and equity (policyholders surplus).

Underwriting performance for the total p-c industry has also been aided by favorable prior-year loss reserve development, which helped offset the effects of growing competition and the resulting continued pressure on top-line growth.

Historically, the surplus lines market has reported better underwriting results and rates of return than the total p-c market, and the trend continued in 2007. Consider the following:

o The loss and loss adjustment expense ratio for 72 domestic professional surplus lines companies making up a peer composite of true domestic surplus lines insurers was 52.4--more than 10 percentage points lower than the same measure for the total p-c industry.

o The combined ratio, on average, for the surplus lines insurers was 76.0 versus 95.4 for the total p-c industry.

o The five-year average return on surplus for the surplus lines composite was 19.2, compared to 13.8 for the total p-c industry.

The performance of both the surplus lines composite and the total p-c industry over the last five years, especially in 2006 and 2007, benefited from a benign Atlantic hurricane season.

During the first quarter of 2008, however, abnormal tornado activity throughout the country pushed the U.S. p-c industry's catastrophe losses to the highest level in over a decade. These losses were attributable to high winds, hail, tornadoes, flooding and winter storms.

With forecasts of an active Atlantic hurricane season already being realized with the significant damage caused by Hurricanes Gustav and Ike, it appears likely that catastrophe losses will have a considerable impact on overall industry results in 2008.

This will, in turn, have a definite effect on the results of the surplus lines insurers that provide a fair amount of capacity for catastrophe-exposed property business.

As has been the case historically, a key challenge facing surplus lines companies will be to manage operations through the peaks and valleys of the market cycle.

With the supply of insurance capacity exceeding market demand, the momentum of declining rates has continued in 2008. There is still a wealth of capacity being deployed in pursuit of specialty and surplus lines business, with much of this capital coming from Bermuda.

Interest continues to grow in surplus lines business, particularly for the slightly tougher risks that have traditionally been borderline surplus lines accounts. This competitiveness is being felt across all lines of business, geographical territories and varying account sizes.

Effective management of underwriting, pricing and claim functions through use of new predictive modeling and other analytical tools should enhance the ability of insurers to succeed under challenging present day market conditions. Databases have improved markedly, making these analytical tools more useful and important to the success of companies utilizing them.

These tools can help the industry avoid a recurrence of the drastic soft market of the 1990s by supplying managers with better information--provided that information is used with prudence and adherence to sound, proven underwriting and pricing strategies.

No matter how sophisticated the modeling tools, the E&S insurers that navigate this market successfully will be those that work through it with well-thought-out and well-executed strategies.

The difficulty in growing organically has fueled a resurgence of merger and acquisition activity in the p-c market. Calendar year 2008 has been very active with consolidations and mergers involving surplus lines market participants, both on the distribution and insurance company sides.

In some cases, large multinational companies have targeted surplus lines organizations to satisfy their desire for greater diversification into attractive market segments, while private equity firms continue to express interest in specialty organizations as well.

Insurance companies with solid core operating fundamentals but somewhat limited growth opportunities have proven to be popular acquisition targets, especially when a limited capital structure is viewed as the shortcoming of the group or company.

There is still a wealth of capacity in the p-c industry, and in many instances, funding acquisitions is viewed as a means for deploying excess capital in a manner that fosters growth for the acquirer.

Organizations with efficient expense management capabilities may also look to acquire companies with solid books of business that interest the acquiring organizations but whose main operational shortcoming is an above-average expense platform.