E&S Lines Basking in the Warm Glow of a Hard Market
Early in 2000, insurance prices started doing something they had not done in almost 15 years. They began to increase, and they kept growing at a modest pace into the third quarter of 2001, when the events of September 11 caused rates to accelerate sharply.
Although quantitative data on rate increases is not yet available, considerable anecdotal evidence suggests that among admitted insurers rate increases on the order of 30 to 40 percent are not uncommon. As prices have gone up, underwriters have also become less willing to entertain accounts that may present problems down the road or develop unfavorable loss experience.
The hard market is upon us, and many agents and brokers are finding themselves without a ready outlet for some of their accounts. Fortunately, an over-the-counter remedy for what ails agents and brokers is readily available in the excess and surplus lines (E&S) market. The wholesale brokers and non-admitted insurers who make up the E&S market stand ready, as they have during every market constriction, to absorb many of the accounts that admitted insurers are turning away. The premium may be higher, but coverage is still available to all but a handful of problem accounts. Surplus lines professionals, furthermore, do not expect emerging trends in regulation of insurance to interfere with that role.
Answering the call
“This is a time when the surplus lines market is called upon to perform,” commented Andrew S. Frazier, president of Western World Insurance Group. “There is a surge of business going to the wholesaler and the surplus lines business, and a lot of reunderwriting has taken place in the standard market. This is what we are in business for—to deal with the reunderwriting of things and do it creatively and at higher prices than it was written for previously.”
Although prices are going up in the E&S market, anecdotal evidence suggests that the pace of change is no more rapid than in the admitted market. “Rates are up significantly,” reported Gilbert Hine, president of McLelland & Hine Inc. in San Antonio, Texas. He estimated that rates in the E&S market are increasing by 15 percent, with larger increases for selected classes.
Reports that prices charged by E&S carriers are increasing at a moderate rate, however, do not reflect the full impact the hard market is having on many policyholders. As underwriters in the standard market tighten up on their underwriting and enforce their rules more aggressively, they drive many accounts into the E&S market. Shifting to carriers who traditionally charge higher rates because they thrive on accounts that present a higher risk of loss compounds the effect of the hardening market on the price the insured has to pay for coverage. That tends to make rate increases appear larger than they actually are.
“Where the more dramatic stories are, and they’re very hard to measure, are where accounts are coming out of the standard market and going into the surplus lines market,” Frazier said. “For that particular account the rate increase could be quite large although our surplus lines rate increases are not that large.”
Spectacular growth
Bill Newton, president & CEO of Lemac Associates Inc., an E&S wholesaler in Los Angeles, expects to see premium increase dramatically during 2002. He remains confident, on the other hand, that the E&S insurers can manage the growth without impairing their financial security. “This is what the surplus lines market’s been waiting for for the last 15 years, another hard market, and most of them now have more submissions than they know what to do with,” he exulted. “Most, if not all, will experience tremendous growth rates in 2002. My guess is that the typical surplus lines carrier is going to grow 50, 60, 70 percent.”
That ought to be a cause for concern because it is the kind of explosive growth that has been historically associated with strain on surplus, declining financial strength ratings and solvency problems. Surplus lines professionals, however, do not believe that will happen this time around, and Newton offered some persuasive arguments to support their optimism. He pointed to statistics that indicate excess capacity immediately before the hard market as one mitigating factor. The entry of new capital, both through the formation of new insurers and the infusion of additional capital into established players, will also cushion the shock premium growth tends to deliver to surplus.
“The earned premium to surplus ratio was somewhere around 1:1,” Newton explained. “So there’s a tremendous amount of capacity in the marketplace, particularly in view of the fact that all this new money has come into the marketplace over the last couple of months, with not only new $1 billion plus facilities out of Bermuda but so many of the other companies with new issues and offerings to raise money. The hard market in 1986 was really driven by surplus problems. Companies literally ran out of capacity. I don’t see that happening in this hard market.”
The fact that the E&S market has the capacity to absorb all that premium does not necessarily mean that ample or even adequate coverage will be available to every account. Problem lines and classes, however, are being driven more by external conditions unrelated to the state of the market.
Coverage for nursing homes continues to be a problem, according to Richard M. Bouhan, executive director of the National Association of Professional Surplus Lines Offices (NAPSLO). That is a condition that has been developing over the course of several years. Lemac’s Newton reports a crisis in general liability coverage for residential construction contractors in California. The situation is so serious that he predicts that some contractors will be unable to obtain insurance at any price. Once again, however, the real culprit is less the hard market than an external factor, in this instance a 1995 California Supreme Court decision (Montrose Chemical Corp. v. Admiral Ins. Co., 10 Cal. 4th 645) that led to an explosion of construction defect claims against builders.
Best security blanket
Shifting coverage from the admitted market to E&S carriers raises another concern for policyholders. When an admitted insurer can no longer pay its claims, state guaranty funds offer policyholders at least a modicum of protection. Because E&S carriers operate as non-admitted insurers, however, their policyholders do not enjoy this benefit. This means that if an E&S insurer becomes insolvent, the policyholder bears the full amount of the loss, unless the agent’s or broker’s errors and omissions insurance picks up the tab.
Surplus lines professionals stand ready with reassurance from a highly respected source, one that agents and brokers are accustomed to relying on. Hard data indicates that surplus lines insurers are at least as secure as admitted carriers, and that has been true for a long time. “A.M. Best continues their annual reviews and continues the analysis that says that the solvency of the surplus lines companies is equal to if not better than the admitted companies,” Bouhan pointed out. “For the last 25 years that’s been the case, and there’s no reason that would change.”
A.M. Best’s Annual Review of the Excess & Surplus Lines Industry, the latest in a series of annual evaluations of security in the excess and surplus lines market the rating agency has been doing since 1994, gives non-admitted insurers high marks and points the way to identifying carriers that are most at risk. For the last 30 years the annual failure rate among non-admitted insurers has been less than one percent, about the same as in the admitted market. Best gives pricing discipline in the surplus lines market credit for maintaining the similarity in failure rates.
The report found a common thread among surplus lines insurers that have become insolvent. The warning sign to look for is modest surplus. More than half the surplus lines insurers that have failed since 1971 had surplus of less than $5 million, and 85 percent had less than $25 million in surplus.
Regulatory pincer movement
Despite current prosperity and a rosy outlook, the future of the E&S market continues to worry some in the insurance community. The source of their concern is a growing trend among insurance regulators to rely on competition to regulate the marketplace. The National Association of Insurance Commissioners (NAIC) is now recommending elimination of requirements for filing policy forms, rules and rates with insurance departments. Several states have made significant moves toward implementing the NAIC recommendation, and trade associations representing admitted insurers had been holding out high hope that other states would jump on the bandwagon.
Many admitted insurers also perceive a federal charter as a vehicle for obtaining relief from a state regulatory regime that they regard as oppressive. Segments of the insurance industry that favor federal regulation have thrown their support behind an optional federal chartering bill that Sen. Charles Schumer (R-NY) introduced in the Senate just before Christmas. One advantage frequently cited for either deregulation proposal is that it would give admitted insurers the freedom of rate and freedom of form that has been a hallmark of the E&S market.
Regardless of the source, surplus lines professionals are not worried about potential competition from admitted carriers for three principal reasons. They believe that the hard market has taken deregulation off state regulators’ front burner, postponing any significant change in the regulatory environment. They are confident that no matter what comes out of Congress, state regulation of insurance will survive.
They also have a lot of confidence in their ability to deal with the prospect of competition from the admitted market. Even if admitted insurers suddenly found themselves with complete freedom of rate and form, surplus lines professionals foresee a continued need for non-admitted insurers and the professional wholesalers who represent them.
Western World’s Frazier asserts that there will “absolutely” be a need for the E&S market if admitted insurers obtain freedom of rate and form. He does not believe that the mind set required to succeed in the lines of business and classes that populate the E&S market can survive in standard lines carriers. “There’s an attitude as to how do you underwrite these things,” he explained. “Clearly in the surplus lines market they’re looked at less on an actuarial basis and more on an underwriting judgment basis. Can that kind of underwriting mentality and expertise and compensation coexist in a large standard underwriting environment?” Cultural issues, he added, make the surplus lines modeling compelling.
NAPSLO’s Bouhan sees history standing firmly on the side of the E&S carriers and wholesalers. “The state of Illinois has had a pretty free flowing rate and form operation for a long time,” he pointed out. “In fact that’s the deregulation model, and the surplus lines business has existed and flourished quite well in that state during that period of time. California before 1988, when they passed Proposition 103, was an open market state. The surplus lines business there operated concurrently—and was a flourishing market, and did quite well in conjunction with that rate and form freedom that existed in California. So there is certainly some history to suggest that freedom of rate and form for admitted carriers does not necessarily eliminate the operations of the surplus lines marketplace.”
No matter what the regulatory regime, Bouhan maintained there will always be business the giants of the industry will turn away. “Standard companies write standard types of business, even if they have freedom of rate and form, and there is going to be a substantial portion of the business at any point in time that standard companies will decide they don’t want to write, even with the freedom,” he said. “It doesn’t fit their marketing mold, it doesn’t fit their rate tolerance, they don’t have an appetite for that particular line, and that business will find its way to the surplus lines marketplace.”
The secret in Newton’s eyes is a level playing field that allows E&S carriers equal access when admitted insurers obtain equal freedom of rate and form. He pointed out that states that have adopted regulations giving admitted insurers freedom of rate and form have also added automatic export provisions to their statutes or regulations. This allows agents and brokers to take business to the E&S market without first going through a diligent search process, and that, Newton said, is what levels the playing field.