Solvency Study Shows Continued Good Ratings

The solvency record of the domestic surplus lines industry continues to mirror that of the total property/casualty industry, according to the ninth annual study of the excess and surplus lines industry by the A.M. Best Company.

The “Annual Review of the Excess & Surplus Lines Industry,” commissioned by the Derek Hughes/National Association of Professional Surplus Lines Offices (NAPSLO) Educational Foundation, found that since 1972 surplus lines company insolvency rates have mirrored those of traditional insurers, with an average failure frequency rate less than one percent. In addition, Best found that professional surplus lines companies have maintained higher ratings than that of the P/C industry.

To determine solvency, Best evaluated the number of insolvencies in both the overall insurance industry and surplus lines segment to determine a “failure frequency rate.” Best found similar failure frequency rates and attributed the similarity of rates between the admitted and non-admitted markets to the pricing discipline of the surplus lines market. Both markets experienced a higher failure frequency rate from 1987 to 2002 compared to 1972-1986. Insolvency rates for the P/C industry generally stabilized in the late 1990s.

Over the past five years, operating results generated by the surplus lines market have continued to outperform the overall P/C industry, as evidenced by the five-year average pre-tax return on net premium of 22.7 percent compared to 4.8 percent for the P/C industry. The underwriting results achieved by the surplus lines market weakened in recent years because of competitive pricing pressures and a reduction in the level of favorable loss reserve development on prior accident years.

In 2001, direct premium volume for the surplus lines industry increased by nearly 35 percent over the prior year. Best attributed the increase primarily to the increased rates and prices of the hardening market and the migration of business from the standard market into the surplus lines market. This compared favorably to the 11 percent growth experienced by the P/C industry during 2001.

The events of Sept. 11, 2001 accelerated the hardening of the reinsurance and primary markets and exacerbated the lessened capacity that was already affecting commercial lines such as aviation, energy, and ocean marine that are among the traditionally predominant surplus lines. Standard market insurers continued to eliminate non-core or under-performing books of business.

Going forward, opportunities for surplus lines insurers to increase premium volume at decidedly higher average rates are available, however, as business moves into the surplus lines market, loss cost inflation and higher reinsurance costs are expected to mitigate the benefit of favorable rate activity somewhat.

Best said surplus lines’ intermediaries are facing a host of operational challenges as they deal with the realities of the hard market. The sheer volume of increased submission activity has made it tougher to quickly and effectively identify those offering true opportunities. The need for training of personnel in addition to the pre-underwriting activities has made efficient processing difficult. The lack of experience across underwriting staffs, particularly for professionals that have hard market experience, also presents a major challenge. The lack of investment by the industry as a whole in the underwriting discipline has led to a diminished pool of underwriting talent.

In addition, the augmented flow of business into the surplus lines market has made it more complicated for surplus lines intermediaries to cultivate relationships with new or previously underutilized insurers. Carriers are able to generate desired production from their core producers because of the higher premiums and are primarily focusing on conducting business with those agents and brokers that stood by them during the soft market. Some surplus lines intermediaries are therefore finding it difficult to place business despite the price firming.

Reserves
Over the past several years, reserve margins have diminished significantly, evidenced by diminished availability of prior year reserve redundancies to support future underwriting results. In fact, in 2001 the surplus lines market experienced adverse loss reserve development over all, Best found.

Several companies posted sizable increases in reserves during the last year that could diminish the amount of capital available for surplus lines subsidiaries to aggressively operate in the current market. Struggling carriers are more susceptible to tougher regulatory requirements and fierce price competition because their business tends to be concentrated in a particular distribution system or product mix.

A.M. Best believes the higher prevailing rates of the current market will continue through the end of 2002 and possibly through all of 2003 as well. While this would help the market improve its loss reserve margins, further increases in reinsurance costs and rising loss costs will mitigate the benefit, placing additional pressure on carriers to adequately replenish loss reserves. As a result, underwriting results over the near term are not expected to benefit significantly from favorable prior accident year loss reserve development.

Ratings
Consistent with prior years, Best found that most professional surplus lines companies have maintained higher ratings than that of the P/C industry. The median Best’s Rating for the professional surplus lines composite remains “A” (Excellent) versus the industry’s median rating of “A-” (Excellent). The more favorable ratings are attributed to four factors:
1.) Demands of the market that surplus lines carriers maintain a higher level of capital, due to their lack of guaranty fund protection;
2.) Surplus lines writers tend to operate with more conservative operating leverage with sidelined capital waiting to take advantage of market opportunities;
3.) Disciplined underwriting coupled with strong risk management techniques that have consistently produced favorable loss experience; and
4.) A majority of the leading surplus lines writers are strategic members of large, well-diversified insurance organizations.

The hard market and strong earnings prospects will likely engender a number of strategic acquisitions where surplus lines companies or groups are acquired by or merge with standard market insurers or reinsurers. The stronger mid-sized and larger organizations will seek to acquire or merge with brethren in the specialty segments of the commercial marketplace to capitalize on the profit potential of these companies.

While several niche surplus lines companies have been successful, larger carriers continue to dominate this market. Size and flight-to-quality trends have benefited the large surplus lines carriers, with the top 25 groups commanding an 86 percent share of the market.

Going forward, A.M. Best believes that many mid-sized surplus lines carriers will continue to align with larger diversified organizations that provide greater operating and financial flexibility. However, surplus lines companies that are part of larger organizations may find their ability to take full advantage of the market conditions impaired if their parent organization is having difficulty achieving profit goals.

Mike Ardis is Director of Communications & Technology for NAPSLO.

Topics Carriers Profit Loss Excess Surplus Underwriting Reinsurance Market Property Casualty