Surplus Lines Results Will Improve; Admitted Market Not out of Race

The surplus lines’ marketplace should not miss Legion Indemnity Company too much. In 2001 Legion Indemnity wrote less than $90,000,000 of direct premium written. This was about 1 percent of the total of the top 24 domestic surplus lines writers. As it is widely believed that the underwriting cycle has turned to favor insurance companies, what can we discern from a review of the statutory financial statements of the top 24 domestic surplus lines insurers?

To answer this question, we created a database of the latest six years of statutory financial statements of the top 24 surplus lines insurance companies. Unfortunately our database did not include Lloyds of London because they do not report to the National Association of Insurance Commissioners in the NAIC statement format. In reviewing the financial statements of the domestic surplus lines market leaders, two generalizations jumped out at me.

Although Demotech, Inc. has consistently stated that financial stability is independent of size, in the surplus lines marketplace, bigger may be better. Or, at least, bigger may mean more tentative in the short-run, and sometimes tentative is good. The second observation was limited growth may be the way to go. At least, the leaders seem to think so.

Is bigger better, or is bigger more tentative?
In 2001 Texas and California direct premium written accounted for 26.6% of the countrywide direct premium written of the top 24 domestic surplus lines companies. However, the same calculation of the two leaders, Lexington and American International Specialty Lines, were 21.4 percent and 19.8 percent, respectively. In other words, neither of the two domestic leaders was exposed to Texas or California to the same extent as their competitors.

Given the oxymoron of allure based upon the size of the Texas and California marketplaces contrasted with fear created by the judiciary system in each state, is it possible that the two leaders exercised self-restraint and discipline? Did they look to smaller, less litigious jurisdictions to obtain growth? Could a combination of expertise, internal re-allocation of resources and the extensive licensing necessary to execute a plan of this type have contributed to this phenomenon, or was serendipity a factor?

By way of example, in 2001, the comparable percentage for Admiral Insurance Company was 38.1 percent, with California accounting for 26.2 percent of Admiral’s business. Does Montrose Chemical Corporation of California versus Admiral Insurance Company ring a bell? If you tried to place a contractors general liability insurance renewal since 1995, it should. Admiral’s 2001 percentage is down slightly from the comparable Admiral percentages of 1996. In contrast, the two leaders had a lesser percentage concentration back in 1996 and they still mitigated the 2001 percentage as an added precaution.

As an actuary I am oriented toward operating profits, or at least toward stable and predictable jurisdictions in which to operate. I respect insurers that balance profit against marketshare and seem willing to give up the latter when there is little chance of the former. Now that many markets have turned rock hard, will the discipline remain intact?

Will slow but steady win the race to profits?
From 1996 to 2001 the direct premiums written by Legion Indemnity Company grew over 3600 percent. Evidently, their surplus and profits did not keep pace with their premium growth. In the soft market of the mid 1990s through 2001, growth should have been viewed as one views a yellow traffic light. There are two responses to a yellow light – hurry on through or stop before it turns red. Hesitation exacerbates the situation.

The issues related to premium growth are simple – do we stick with what we know, do we write what we know at a price that provides us with an opportunity to make money, do we concentrate on the jurisdictions we know, do we accept production from the producers we know, do we listen to the underwriters we trust, or do we open up for other types of business, at prices that are forced upon us, in states we are unfamiliar with, accepting business from producers we do not know well or relying upon the advice of underwriting managers that have no track record with us?

Slow but steady. That phrase implies to me that nothing unusual or extraordinary is happening. In the mid 1990s through 2001, boring was better than exciting. Few things associated with premium growth were likely to be better than the status quo. The leaders in the surplus lines arena recognized this early on and watched the admitted marketplace write surplus lines business at admitted market prices – heavily deviated admitted market rates in some cases.

Where does the domestic surplus lines market go from here?

I would expect year-end 2002 operating results to be modestly better than 2001 operating results but probably less favorable than we would expect. For the first quarter of 2002, the top 24 surplus lines writers reported a combined ratio of 103.23 percent, an improvement from 112.80 percent at year-end 2001. Since rate levels are up and ‘underwriting’ has been injected into the underwriting cycle, the surplus lines combined ratio should improve more quickly than the combined ratio of the admitted marketplace.

During 2002 surplus lines insurers should experience greater premium volume growth than their admitted brethren. Similarly on a combined ratio basis, operating results should be more favorable than the results of the admitted marketplace.

Parting Thoughts
I mentioned the Montrose case. Let me mention one other case, even though it does not involve a surplus lines carrier – Ballard versus Fire Insurance Exchange. This is the Texas case that created the turmoil related to mold claims.

Do surplus lines insurance companies improve their combined ratios faster than admitted companies because they have the underwriting expertise to address the types of exposure that create construction defect, mold claims or whatever becomes the ‘turmoil du jour’? Or, do surplus lines insurance companies show improvements sooner because of the relative rate and form freedom that shortens their rate and form revision processes?

I respectfully suggest that the latter is closer to the truth. Surplus lines insurers and admitted carriers wind up in the same court rooms the same judges and juries that admitted carriers face. The surplus lines advantage may be speed to market. The regulatory authority of insurance departments over rate and rule revisions take them weeks instead of months or years.

The morale to the story?

Watch for surplus lines operating results to improve during 2002. During the hard market, admitted carriers will trail the improvements of surplus lines carriers. How-ever, do not give up on the admitted marketplace, they are a step behind but not out of the race.

Petrelli is the president and founder of Demotech Inc. Since 1985 Demotech Inc. has been a financial analysis and actuarial services firm serving the needs of the property and casualty insurance industry. Demotech Inc. was the first company to have its rating process formally reviewed and accepted by Fannie Mae, Freddie Mac and HUD.