Surplus Lines: A Market in Transition

The Soft Market and Financial Crisis Could Lead Firms into ‘Uncharted Waters’

For surplus lines insurance providers the economic turmoil and soft insurance market means a double-hit on profitability. Some industry experts predict the unstable conditions brought on by the economy and the global insurance market could mean an approaching end to the challenging soft market. And while profitability suffers, merger-mania has taken hold, especially in the surplus lines sector.

The soft market has resulted in hard times for surplus lines firms and many companies are having a difficult time growing, says F. Laughton Sherman, managing director of Charlotte, N.C.-based LMC Capital LLC, an investment banking firm that focuses on the insurance industry.

To achieve growth, surplus lines carriers and wholesale brokers are seeking growth through mergers and acquisitions strategies, he says. “What we are seeing is carriers having a lot of interest in acquiring MGAs (managing general agencies) and other larger distributions sources,” Sherman said. “Among the larger wholesalers out there, like the major publicly traded insurance brokers, they are very much looking for top line growth in this softening market,” he added. One way to fuel their growth engines is through mergers and acquisitions.

The coming year is going to be a very difficult year for surplus lines brokers in terms of profitability, predicts Terrence Dwyer, president of Los Angeles-based Sullivan Brokers Wholesale Insurance Solutions Inc., a national wholesale brokerage firm with an emphasis on professional, management and health care risks. Rest assured, Dwyer adds, firms in solid financial standing that are well capitalized, strong and have maintained their balance sheet will do well. But those firms that “didn’t tend to their balance sheet, will be looking at other more well capitalized firms, or stronger partners,” he noted.

The coming year will be marked as one of change and transition for surplus lines provides, Dwyer predicts. “It’s probably going to be the most transitional year,” Dwyer says.

‘Uncharted Waters’

While M&A activity has kicked up during for the surplus lines sector in the last few years, whether or not the recent economic turmoil and financial crisis surrounding insurance giant AIG will impact M&As remains to be seen.

“Anytime there is macroeconomic turmoil, the landscape for M&A activity changes,” says John J. Kraska, managing partner for the New York-based Hales & Co. Inc., an investment banking firm also focusing on the insurance industry. Kraska says the unprecedented scale of what’s happened on Wall Street and with AIG in the past month has led the industry into “uncharted waters.” Kraska adds, “For some surplus lines carriers, the devastation to their investment portfolios alone may cause them to seek private equity or strategic partners to shore up their balance sheets. Wholesalers, particularly those with high carrier concentration, will also face pressure to seek out strategic or financial partners.”

Managing general agencies and wholesalers overall are seeing a lot of pressure for top line growth, says LMC Capital’s Sherman. “A lot of them just simply aren’t growing right now.” But whether or not those firms seek out private equity or acquisition partners to beef up their balance sheets depends on the psychology of the firm’s owner, he added.

“The status of being flat on premium sometimes doesn’t interest a lot of people, but other people are perfectly content with that,” Sherman says. “They say, ‘we are in a soft market; we’ve seen soft markets many times before; we’ve seen hard markets before; and the hard markets will come again, and when it comes we’ll grow nicely.'” Some owners possess the patience to wait out the soft market rather than seeking growth through partnerships but that decision depends heavily on the psychology of the owner, Sherman says.

Private Equity

When it comes to finding alternatives to grow, there are many different options out there, including seeking out private equity investor support.

“If E&S brokers or brokers in general are interested in tapping private equity support it’s important for them to understand what all the nuisances are,” advised Hales & Co.’s Kraska. Brokers need to have a clear understanding of the private equity landscape if they are thinking about growing their business and accessing capital. “They need to know how to navigate that wide field of different types of private equity firms,” he said.

Just like insurance brokers, private equity firms vary in scope and style.

Many brokers shy away from private equity capital because they don’t want a bunch of New Yorkers in pinstriped suits, coming up and telling them how to run their business, Kraska joked. “Obviously the cultures of private equity firms are all different. You have firms that understand the insurance industry, and some that don’t. Some have long term capital, others will invest hoping to sell their business in a quick one to three year period.”

Sherman added, “there is no question private equity wants to make money.” How fast they make that money through their investments in brokers depends on how patient they are with their money. “Whatever they can do to best realize their investment returns they are going to do it.”

Industry Outlook

From Sherman’s perspective, the economy and soft market haven’t slowed down brokerage acquisitions.

“We think it’s (M&A activity) going to continue in a very fast pace in the next 12 to 18 months so long as the soft market is going to be here,” Sherman says. “I think carriers in particular will step up and say that they’d like to acquire more MGAs; that is happening now and we expect that to happen in the next 12 to 24 months.”

Kraska believes private equity interest in surplus lines sector will remain strong despite the soft market and down economy.

“As for private equity activity in this sector, I believe it will be active and opportunistic,” Kraska says. But due to the financial crunch, borrowing ability has been diminished, which will lead to lower valuations.

“We are seeing buyers being a little more shrewd on what they want to acquire and what they want to pay for what they acquire,” Kraska says. “Capital isn’t as cheap and readily available so you have a lot less of it to use.” In the current market, while buyers are still out there, Kraska says they are certainly more cautious and diligent about what they want to buy. “Whereas just a year ago, because capital was so cheap, people were more inclined to overpay for things.”

Whether or not the financial crisis accelerates premium rate increases — which would benefit the entire property/casualty industry — remains to be seen, Kraska adds. “However, I believe certain lines — directors and officers and errors and omissions in particular — could see a significant increase in customer demand in the near term.”

Sherman also added that in preparation of the market turning, he sees more E&S carriers looking for admitted companies to buy. Vice-versa, “a lot of admitted carriers would like to have an E&S platform so that when the market does change they will be able to capture that business from the standard market into the surplus lines market,” he added.

Even as the future of the market remains uncertain, Sullivan Brokers’ Dwyer continues to be optimistic about the future of the E&S industry.

“I think the prospect of the market changing looks good, and that the future for wholesale brokering looks excellent,” Dwyer says.

Topics Carriers Agencies Excess Surplus Insurance Wholesale Market