The State of Surplus Lines

• TBA - Writer
• December 2009
• 

Experts in the specialty insurance market discuss the findings of a newly published report from A.M. Best and the National Association of Professional Surplus Lines Offices on the issues shaping the excess and surplus market and how companies are faring within it. This is an edited version of the transcript.

The entire transcript can be accessed at www.ambest.com/surplus09/webcast-transcript.pdf. A video replay is available at www.ambest.com/surplus09.

A.M. Best Overview of the Surplus Lines Market

MCDONALD: Give us an overview of the lineup of companies in the NAPSLO report.

ROETHEL: Seven of the top 10 are still there. You've seen some of the new Bermuda markets entrants--Axis, Ace. You've seen Argo, Alleghany, but the top companies have not really changed that much.

MCDONALD: How about the condition of the industry and the financial strength of the overall industry and the E & S segment of that?

ROETHEL: The surplus lines industry continues to outperform the total P/C industry. Over the past five years the combined ratio has been more than 10 points better than the overall industry. We've seen a drop in the premium volume due to the competitive market conditions, seeing some competition from the admitted marketplace. On the investment side, the investments on the surplus lines industry actually are fairly conservative in comparison to the normal P/C overall operations. We've seen some favorable results. The surplus lines industry is very healthy and continues to outperform the industry.

MCDONALD: On combined ratio we saw the overall ratio go up in 2008, sharply. E & S sort of followed it but still stayed well under 100.

ROETHEL:The difference between the two actually came together a bit, given some of the catastrophes that occurred in '08, given the surplus lines market having a mix, being a property catastrophe business.

MCDONALD: Over the years there have been impairments and insolvencies. It looks like in recent years the E & S market's been a little better. I know we published our impairment study for the overall P/C industry this year and I think there were seven and 2009 hasn't actually been very good. I think there might be eight that we've already recorded, or perhaps nine. Life is about the same, too. But what has been seen among E & S writers?

ROETHEL: There haven't been any failures over the past five years.

MCDONALD: That's pretty good. That comes out of a period in the early '90s when it was a little more noticeable and there's been a lot of strengthening in that market. Is that what we've seen?

ROETHEL: Yes. Some of the reasons why we had some failures in the past also was due to some failures of parent or affiliated companies that impacted the surplus lines, so it wasn't actually driven by a surplus lines decline.

MCDONALD: We put a rating outlook on the P/C industry and as for E & S, I don't think we break it out separately, but what are we saying there?

ROETHEL: I think both overall commercial and the surplus lines industry are stable. There are still some pressures on the underwriting side as well as the investment side. I think the overall health of the surplus lines industry continues to be strong. I think there's still some cushion in the reserves, but as this prolonged soft market continues you may see some shrinking of the actual reserve redundancies.

A Look at Surplus Lines Results

MCDONALD: That's a pretty good look at the results that we're seeing for all the filings that are in. Obviously, '09 is developing. We've got some filings for the first six months, but Neal, what are we seeing?

ABERNATHY: It may be getting ready to turn but it certainly has not turned. Catastrophe property in the first half of the year firmed, the pricing increased. But with everything that's going on in the economy and all the issues that we're facing, we're just not seeing anything turn on the general P/C side. And the property actually has flattened out. We're not seeing increases on the property premiums anymore.

POWER: I think 2008 was a test for the industry and it was certainly a test for Lexington's business model. In a period of time we had Ike and you had Gustav, California wildfires, we had tornadoes moving through downtown Atlanta. It was a very, very difficult property environment--record property losses, record fire losses as well. The business model and the balance of the portfolio truly proved itself in '08. As we got into '09 we were in a very, very different market. We were in a market where, as you look at the cat property market going into wind season, it was robust. It was a very, very good market for Lexington and continues to be a good market for Lexington, but a lot of industry participants really got sort of relegated to the sidelines in terms of their skill and ability to ride that uptick. So the focus becomes casualty for a lot of those participants. And to Neal's point, the underlying economic conditions which served to sort of eviscerate exposure basis, make casualty a very, very challenging area. There are no two market cycles in the last 30 years that have been the same in terms of their causation, duration or ultimate resolution. This market is a very challenging market in that you've got a good market on the cat property side through much of the year, challenging economic conditions on your casualty book and for some established carriers, you end up with a result of a mismatch between earned premium and the current year and prior year losses: what Neal referred to earlier as a whip-saw effect. Portfolio management becomes very, very critical in this market. And the fragility of the property/casualty market is a very real concern. We started in '01. We started in Katrina, Wilma, Ike, Gustav and what we are headed toward in this industry is a

$100-billion event. I'm working right now with the Colorado State University researchers who are taking the tracks of historic wind events and applying them to today's aggregate coastal property values. For instance, you have a storm in 1926 that hit coastal Miami at a time when you had 50,000 to 60,000 people living in that area. That models out to a $100 billion event today. The 1900 Galveston storm is also north of $100 billion. So I think there is a real fragility to the market. We can't forget that a major cat event, whether it's wind, a quake or an act of terrorism, can turn this market in a nanosecond.

ABERNATHY: But you just had the worst event in the history of the economy that had virtually no impact.

POWER: You mean the financial meltdown?

ABERNATHY: If you deplete resources, surplus, capital, it doesn't matter what causes it. And that happened in the financial meltdown and the market just continues to keep doing whatever it's doing. So I'm not sure an event's going to do it, that's what I'm saying.

POWER: I think a major event has the ability of that scale to take capacity out of the market, change the focus of the reinsurance community in terms of where they want to apply their capacity. And certainly in terms of the economic crisis that you reference, we are seeing it affect these casualty exposure bases that I talked about. I think that a sense that you're not feeling it, you'll feel it second quarter 2010 to the extent that that business is not being right priced in the market today. I believe that.

DECARLO: Look, I think what Matt's saying is absolutely accurate. Lots of changes. When Lex and AIG were going through turmoil last year, a lot of folks felt like that would change the market and it really didn't. We saw an uptick in prices in the first quarter. The U.S. economy is struggling and it comes to roost in our pricing. And people can't afford the coverage, governmental entities can't afford the coverage, limits are being reduced, pricing on a unit basis is being reduced, people are out of business, no construction in America. So from just a gut feel, it's tough times. Tough times on the average consumer, the average business and from our perspective. Look, I think the insurance industry weathered a pretty tough storm compared to the banking industry. There are a lot of people counting on the demise of my good friends over here and that didn't occur. For that we're grateful. But the change that's afoot, the change that we feel is if pricing doesn't begin to turn around a little bit, the results in 2010 are going to come home. Because there's not going to be the reserve releases that have occurred over the last 24 to 36 months. We've got to see a change in the market or we're going to start seeing some of these insolvencies that we're so proud haven't occurred.

AIG's Impact

MCDONALD: Matt, take us through what it was like when the headlines started hitting, when there was the emergence of the crisis. We heard a lot about increased activity, everything was going to be shopped around, people were running left and right. What really happened and how did we get to this point today, where it looks a little more stable now than then?

POWER: I think that when an organization is faced with a crisis as we were in the fourth quarter of last year, it really is how you respond. In my view, our clients, our customers, our brokers had a considerable number of questions relative to the solvency of the organization, the structure of the organization. There were a lot of conversations that needed to be had. We found that our management team during the course of the day might individually be having five to six or seven conference calls daily with CFOs, with risk managers, with brokers, talking about the issues--talking about the fact that we were state-regulated entities, to understand that our asset base and our policyholder surplus was walled off from the issues apparent.

Those conversations brought us back to that hand-to-hand combat on a deal-by-deal basis that proved to be very effective in achieving a solid comfort level on the part of our customers.

MCDONALD: The other side of that question is, going back a year or two, there were some people who formerly were with the organization and they're now still in high profile roles but happen to be with other organizations. That has to come back to you a lot. How do you address that?

POWER: Well, it's an interesting question because when you have an organization as large as Lexington, an organization that's had consistent leadership over an extended period of time, when you have a change at the top, that change can be a very positive effect, it can be disruptive, it can be neutral. There are all kinds of scenarios that can play themselves out. In the case of Peter Eastwood taking over as our president and CEO toward the end of last year, Peter's action-steps in the early days were to secure the senior staff, to make sure that our brokers and our customers were being engaged in a very positive fashion, to make sure that our employees were assured and there was a lot of client engagement that took place in those early days. I think over the next two-and-a-half months he's got about 51 travel days; so he's done yeoman's work in terms of getting out and engaging. Peter's management style that he's brought to the organization is very refreshing. It's been very collaborative and it's changed the tenor of the organization and I can tell you that the energy level at Lexington Insurance Co. is higher than it's ever been before. There's a lot of activity and it's a really good story when you look at it. Today our policyholder surplus is a result of these efforts. It's at its highest level. The first two quarters of 2009 have set records by Lexington standards. If we can get through '09 without a major cat event, the models hold and trends continue in the direction that they're going, I believe that we're on track for perhaps the third-best bottom line in the history of the company since it was founded in 1969.

DECARLO: And how do you answer your critics? The critics say, "It's the federal government, you've got change coming, you've got to do an IPO." How do you address that? Because we hear that all the time, obviously. How do you address the change that's coming? Can you IPO it? Can you get out in this market? What's the impact the government's had on your firm?

POWER: The greater Chartis organization: When you talk IPO, that's really what we're talking. That organization is an absolutely incredible company. We had 33,000 employees across the platform last year. It had net income of, I believe, $3.3 billion on over $50 billion of gross written premium and they generated cash flow from operations of $5.7 billion. This is an enormous undertaking and it's been very well-executed at the executive level. And what we focus on at Lexington is not that. What we focus on at Lexington is the things we can control. We focus on business. We focus on managing our constituents. The portfolio that we currently manage is very significant. We're on track. This year, I believe, we'll finish the year north of $8 billion. And, again, one of the most profitable years in the history of the company.

New Coverages

MCDONALD: That's where I want to go and we'll start with Matt because Lex has been known as kind of a product lab. A lot of development going on there--new forms of coverage and different things like that. What are the kind of things that you're producing now that people may not know about?

POWER: Over the past five years I think we've generated somewhere in the area of $1.5 billion in gross written premium from products that simply didn't exist in the market heretofore. So, new product creation and innovation is very important to who we are; not only culturally, but it's also a core part of our business plan. How do you develop new products? The notion that the customer comes to you with a problem, you solve the problem and slap a new label on it and call it a new product, by and large, it doesn't happen. The way you develop meaningful products is to look at trends. And whether they're legal trends, whether they're societal trends with the changes in government regulation, to understand what's on the horizon. Right now, for instance, we like the health care business. Hospitals, when you go out and talk to those risk managers and CFOs, they bring up their issues. H1N1--big issue. Why? Because to the extent that you have a major influenza event, the hospital converts overnight to a triage unit. The cost of doing just that, the cost of cancelling elective surgeries and ramping up for an influx of patients, is a real concern because it's not typically an insurable event. We'll insure that event through our pandemic Rx response. Things like Legionnaires' disease can cause a part of the hospital floor or ward to shut down. Again, lost income, no insurable event--we will provide cover for that.

DECARLO: Take things like HIPAA. Right? You have to provide information then. People putting data into these databases and they can be stolen. So, it goes all across the spectrum of health care. Such simple things as data. You know you see the commercials and they talk about sharing all this data. Really? How are you going to do that? What are the insureds? What are the rights and how do you protect yourself from their perspective, that sharing that data doesn't get you in trouble.

POWER: I think one of the realities of today's economy is manufacturing concerns across the United States. They employ just-in-time manufacturing standards. This has really become the standard for midsize manufacturers all the way up the food chain. And what we saw on 9/11 is the borders were shut down. It impacted midsize manufacturers in a very significant way. We saw it again in the West Coast port lockout. You know the famous Ericsson loss. I mean, people are quite familiar with it in the insurance industry. How a single location had a very small fire, interrupted the supply chain of that company with cataclysmic results. We've developed a global supply-chain protection for global manufacturers that covers a myriad of interruptions to their supply chain, whether it's an act of terrorism, whether it's a wind event, a geopolitical event, covering the interruption to a major manufacturing supply chain. Looking at trends and looking for concerns within specific segments is very key to the whole issue of product development.

ABERNATHY: And I think it's key for us on the wholesale broker side.

What's Ahead

MCDONALD: Let's spin it forward and look to the next year, next season. What do you see, Neal? How's it shaping up and what are you doing inside your own business based on your expectations?

ABERNATHY: We're operating the business on the basis that the market's not going to do anything to help us. We just have to take that approach because we can't assume that the market's going to turn. We're looking for efficiencies in our business, but at the same time we're looking at expanding our producer-base and looking for business.

There are a lot of opportunities. As I mentioned earlier, for us to find business we're already doing business with a retailer, but we may just be doing one line of business and so we're doing a lot of work in that area to try to steal Steve's business. But that's OK because Steve's trying to steal our business. That's a good balance for us.

MCDONALD: Matt, how is Lex preparing for the six, 12 months ahead? What are you seeing?

POWER: I agree with Neal. You're likely to see an overall stabilization of rates on multiple lines throughout the industry. As we go forward, in the absence of a major cat, as I said before, a cat event you cannot discount. The industry cannot get complacent relative to its own balance sheet and the major impact of a catastrophic event. I believe that we're continuing to focus on innovation, new products, new businesses. That's a sustainable advantage that I think we've maintained for several years now in terms of our ability to compete and build new markets. Again, I think that the economy is a big issue. New entrants that have come in aggressively have, in my view, come in underpriced. A lot of casualty insurances can't make it up on investment income, probably going to find it difficult to attract new capital. It's important to watch the new entrants as we get into next year. By the second quarter of 2010, I expect there will be some challenges.

DECARLO: Well, obviously I echo what the folks have said. Look, we're bullish. We think the economy will be tough. We do think there's opportunity for market share across the board. We're acquiring. We tend to acquire two or three firms a year, so we'll continue that. As I mentioned earlier on the benefits base, we like our opportunities in the benefits base, but prices have come down on acquisitions. They're a little more reasonable than they were during the high times of debt. And so, we're pretty bullish. We're pretty optimistic about where we can take the business. In terms of pricing, we don't run our business on the wind blowing or the earth shaking. We run our business as if this is the market forever and those are just the upticks. So, like Neal, we're making sure that we're doing all the right things every day, but there's plenty of opportunity and we're pretty bullish on looking at different niches across the board.

MCDONALD: Joe, we'll close out with you in the context of reporting we've done on this industry and P/C in general. What are we looking to at this point?

ROETHEL: The focus has to be on the underwriting and that has to be a great proportion of earnings. Again, we've seen some stabilization of pricing, but the prolonged soft cycle and the investment returns being low, you'd expect or hope to see some upward movement in some rates, but we'll see.