The Locomotive That Drive the Insurance Train

The insurance industry’s excess and surplus lines (E&S) sector has experienced a pronounced reversal of position in the last 20 years. Once considered a mere adjunct, a safety valve for risks that were too hard to cover in the standard market, E&S has gone from being the industry’s caboose, to its locomotive — a driving and influential force behind innovation and growth.

“The surplus lines market has never been stronger,” said Bernie Heinze, executive director of the American Association of Managing General Agents (AAMGA). “It’s now an integral part of the [insurance] industry and a vital part of the nation’s infrastructure.”

Facts and figures back him up. In its 13th annual review of the surplus lines market, published in September through an annual grant from the Derek Hughes/National Association of Surplus Lines Offices (NAPSLO) Education Foundation, A.M. Best noted that “without the surplus lines market, businesses would have to forego traditional insurance, self insure their exposures or seek coverage outside the U.S. market.”

The E&S market is made up of property/casualty insurers that provide insurance unavailable to consumers in the standard, or admitted, market due to the unique characteristics and needs of the consumers, according to Best. “As a result, the surplus lines market is known for aiding insurance agents and brokers by providing coverage solutions for these policyholders in addition to developing new and creative types of coverage.”

Through hard markets and soft, E&S has continued to grow and evolve. In 2005 surplus lines accounted for $33.281 billion of direct written premium from a total industry market of $488.723 billion, according to Best’s survey.

The E&S industry now faces a number of important issues. Its growth is slowing in the current soft market — with the exception of coastal property in hurricane prone regions. Retail agents and brokers are becoming more sophisticated and are demanding more and better services from wholesalers. New legislation, including a regulation reform bill, H.R. 5637, and a proposed optional federal charter, may restructure how the industry operates. These challenges require more expertise and better education. The E&S market is on the cutting edge to provide them.

Current state of the market

The trend towards a softer market began two years ago. Best’s 2006 E&S report noted that in 2005, similar to 2004, “after growing significantly for three consecutive calendar years, direct premium volume for the surplus lines industry remained relatively flat.” NAPSLO Past-President Richard Polizzi, president of Western Security Surplus Insurance in Pasadena, Calif., said: “The market clearly has changed; it’s soft and it’s getting softer. I think we’re in for a normal cycle change that will last for a few more years.”

On average, surplus lines insurers retained a greater percentage of financial strength ratings in the ‘Secure’ category compared with the total property/casualty industry, according to Best’s report. Two strong performers, AIG and Lloyd’s, with a combined market share of 35 percent anchor the E&S market (See chart below).

“Surplus lines business generates an underlining profit,” said Richard Bouhan, executive director of NAPSLO. “It’s able to, with its freedom of rate and form, to actually function properly as an insurance operation, and we are doing pretty well at that.”

That performance bodes well for future success. Despite rising loss costs, modest investment yields and decreasing rates on most businesses, Best said it “expects surplus lines industry results to remain strong. Solid profit opportunities remain for the well-established and start-up companies that have implemented an effective strategy to target small and middle-market risks that are less price sensitive than the large, high-premium policies.”

That freedom is the market’s strength. “The surplus lines market continues to provide an open flexible market for insureds of all sizes,” Best said. Freed from the constraints imposed on standard carriers, the market can “use policy forms and rates that are appropriate for the risks they accept. This flexibility allows surplus lines carriers to be more responsive to the consumers’ needs and to react quickly to changes and opportunities in the marketplace.”

That flexibility has driven the sector’s growth. Best notes that the surplus lines market as a percentage of total commercial premiums over the last 20 years increased from 4.36 percent in 1985 to 12.65 percent in 2005. During this same period, the surplus lines market as a percentage of the total P/C industry more than tripled from around 2 percent to 6.8 percent.

The E&S market has been consistently stronger than the overall P/C market. There hasn’t been a financial failure of any surplus lines carrier since 2004. Best accords an “A” rating to “domestic professional surplus lines companies, while the overall P/C industry is rated “A-.”

Best cites five distinct factors to explain why:

• The market demands that surplus lines insurers maintain a higher level of capitalization due to their lack of guaranty fund protection in virtually all states;

• Surplus lines insurers generally operate with more conservative operating leverage with sidelined capital waiting to take advantage of market opportunities;

• Disciplined underwriting standards and strong risk-management techniques produce favorable loss experience;

• The majority of the leading surplus lines insurers are strategic members of large, well diversified insurance organizations [AIG and Lloyd’s write 35 percent of all E&S business];

• The recent hard-market period has produced residual results.

Although hard/soft market periods can’t really be predicted or controlled, Best’s factors paint a good picture of why surplus lines carriers consistently outperform the general market. Best also noted that the “disciplined underwriting” factor means “surplus lines insurers have shown that they are willing to walk away from under-priced business or from insurance policies that contain undesirable terms and conditions.”

Given the current soft market, surplus lines insurers can expect “additional competition and pricing pressure,” Best notes. Nonetheless, the report concludes, that, primarily due to the factors cited above, most E&S writers will continue to outperform the overall P/C market.

They will be challenged, however. Best said it believes that “certain commercial lines of business, such as high-hazard product liability and catastrophe-exposed property, are not yet priced at economic break-even levels.” But the rating agency also expressed optimism that “despite these pressures,” it “expects the surplus lines market to continue to generate solid operating profitability.”

The need for expertise

The disappearance of the hard market puts pressure on the entire industry.

“Surplus lines insurers that established value-added relationships with brokers and insureds during the recent hard market may successfully combat the inclination of policyholders to gravitate to the less-expensive admitted markets,” Best said. “Insurers that have ‘pre-positioned’ themselves for the softer market that still is evolving should be in a strong competitive market position.”

The brokers, who are the crucial liaison between retail agents, policyholders and the carriers, are well aware of this. “Best practices are constantly evolving,” Heinz said. “Our goal is to get better over time; to get rid of stuff that doesn’t work and to look for something better.” He pointed out that the key to any business relationship, especially in the insurance industry, is to assure that the customer/ insured/policyholder has confidence in the broker and the carrier. To maintain that confidence requires a thorough knowledge of the client’s business, an expert analysis of the risks involved and the production of policies that are underwritten to address those concerns.

The carriers, the brokers themselves, retail agents and the insureds all benefit from the establishment of close working relationships. Best noted that, “the surplus lines insurers that provide extensive underwriting expertise across multiple market segments also can leverage their distribution channels to find new growth opportunities in emerging markets.”

As a consequence retail agents, who deal with wholesale brokers are also becoming more sophisticated. “Every retailer is reevaluating their relationship with the wholesalers,” said Chris Treanor, CEO and president of Mercator Risk Services in an interview with Insurance Journal’s Andrew Simpson.

Treanor explained that many retailers are currently “looking to scale back” the number of wholesalers they do business with. That doesn’t mean they will be making less use of the wholesale market. What they are looking for, Treanor said, is “stronger relationships with fewer players.” Who those players will be depends on how well those wholesale suppliers assure the degree of “customer service and customer satisfaction” the retailers are increasingly coming to expect.

Retailers may simply be expressing a larger trend across the entire industry. Treanor pointed out that they are “seeking to grow in a crowded marketplace.” They need to differentiate themselves around expertise, and that carries through to the people they partner with. “It’s not satisfactory any more to deal with just generalists,” he stressed. The growth of the surplus lines industry reflects this trend. By specializing in taking on the risks that standard carriers were reluctant to write, the carriers and brokers who accepted those risks had to learn a great deal more about what they were getting themselves in to.

Regulatory changes

The explosive growth in surplus lines (as well as the recent controversy over contingent commissions) has caused many people both inside and outside the industry to consider changes in the way the sector functions.

So far three different proposals have been advanced. The first proposal was the State Modernization and Regulatory Transparency Act, or SMART. It proposed national standards for the entire industry, including surplus lines. Best noted that it envisioned the creation of a competitive rating system, “and was designed to create uniformity among the state in the areas of financial regulation, market-conduct examinations, product approval, and insurance company and producer licensing, including surplus lines brokers.” Although never formally introduced, it influenced further developments.

Earlier this year the House of Representatives passed H.R. 5637, the Nonadmitted and Reinsurance Reform Act, which applies specifically to the surplus lines industry and reinsurers. It’s not a “federal regulation” measure, but rather one to harmonize the various and sundry laws, rules, regulations and judicial decisions under which the surplus lines industry currently operates. NAPSLO’s Bouhan, characterized the proposed law as a “Mini-Smart Act.”

H.R. 5637’s main sponsor was Richard Baker (R-La.), who also drafted SMART.

“Unfortunately, we don’t see a lot of support for it right now in the Senate,” Bouhan said. “It may wait until next year before both Houses of Congress agree. We’re extremely grateful that we have been able to get that bill this far in the U.S. Congress.”

The third proposal, however, differs greatly in its approach. The National Insurance Act (NIA) or S. 2509 would establish an optional federal charter that would give both life and P/C insurers the option of receiving a federal charter in place of the current state licensing procedures. Its sponsors envision insurance companies operating along the lines of the banking industry, under both state and federal regulation. This plan is more controversial than H.R. 5637, and has divided the industry.

Despite the challenges and the impending regulatory reforms, the surplus lines industry seems well positioned to weather the current soft market, and to emerge stronger than ever. The expertise it has developed over the past 20 years now serves as a model for the entire industry. In that sense it has truly become the locomotive that drives the train — or at least provides the engineers.

Topics Carriers Legislation Agencies Excess Surplus Market Property Casualty