The Evolving Excess & Surplus Lines Market

The excess and surplus lines, or non-admitted, market is comprised of property & casualty companies that provide insurance that is unavailable to businesses in the standard, or admitted, market due to the unique characteristics and needs of the consumers. As a result, the surplus lines market is known for developing new and creative types of coverage, such as emerging e-commerce products that provide coverage for damage caused by computer viruses or hackers. Without the surplus lines market, businesses would have to forgo traditional insurance, self-insure their exposures or search for coverage outside the U.S. market. Beginning in the late 1980s, the surplus lines segment became a more established market, despite soft market conditions and the excess availability of capital. Leading factors that contributed to the greater importance of the E&S market included: underwriting actions by large standard carriers to shed non-core books of business; increased frequency and severity of weather related claims, which resulted in a reduction in capacity for property coverage in cat-prone areas; continuing legal and regulatory issues that have resulted in a difficult underwriting environment for standard carriers operating in certain locations; and expanding expertise and market position of many surplus lines companies in difficult niche markets.

Meanwhile, the surplus lines market has had to adapt to intense competitive market pressures such as:

aggressive pricing and coverage expansion offered by standard carriers to preserve market share.
market encroachment by standard carriers that write more surplus lines risks on an admitted basis.
greater appeal of the alternative market as self-insured entities attract and retain potential surplus lines business.
widening commercial lines deregulation as more states exempt ‘sophisticated’ commercial insurance buyers from burdensome rate and/or form filing requirements.
At year-end 1999, direct premium volume for the surplus lines industry increased by nearly 8 percent. This increase reflects primarily the migration of business rises from the standard market into the surplus lines market. This compares favorably to the anemic 3.2 percent growth experienced by the property & casualty industry during 1999.

While several niche-surplus lines companies have been successful, this market is increasingly dominated by larger carriers. Size and flight to quality trends have benefited the large surplus lines carriers, with the top 25 groups commanding an 80 percent share of the market. Going forward, A.M. Best believes that many mid-sized surplus lines carriers will align with larger diversified organizations that provide greater operating and financial flexibility. 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 successful companies will focus on customized products and services in today’s competitive environment. Offering valuable risk and claim management services can combat the tendencies of policyholders to gravitate to the cheaper admitted market. Further, companies that have strong underwriting expertise and broader product offerings can leverage their distribution channels more effectively to find new growth opportunities. Best of breed insurers will leverage technology and employ data mining techniques to target and retain their customers. Although the insurance buyers purchase through intermediaries, even the E&S segment is being forced to expand customers’ channel options to the Internet to remain competitive, reduce costs and allow agents to focus more on value-added services and less on administrative tasks.

Strong Financial Condition

The surplus lines market has historically been viewed in a somewhat negative light by the public and the insurance industry, which have questioned the financial security of this less regulated segment of the market. However, A.M. Best’s analysis of this market segment refutes this misperception. Our review of the financial condition of the surplus lines market is based on a composite of domestic professional surplus lines companies.

We have developed a composite of 67 companies that had direct premium volume of $4.6 billion at year-end 1999, which represents 43.4 percent of the total surplus lines market.

Over the past five years, the underwriting performance of the surplus lines market has continued to outperform the property & casualty industry by 9 points. Its favorable underwriting results are due to its disciplined underwriting approach, solid underwriting expertise and strong risk management techniques. Underwriting results have also benefited from the release of prior year loss reserves.

Prolonged soft market conditions have eroded loss reserve margins. While A.M. Best believes that the loss reserve position of the surplus lines composite remains strong, future underwriting results are not expected to benefit significantly from the release of prior year loss reserves.The overall performance of the composite has remained outstanding, evidenced by a five-year pre-tax and total return on revenue of 27.7 percent and 25.5 percent, respectively.

The composite has also generated steady investment earnings growth over the past five years, despite prevailing low interest rates. Since 1995, the composite’s investment income has increased 23 percent, versus 15 percent for the property & casualty industry. The stronger growth rate is principally due to the fact that the composite maintains a greater percentage of assets that are invested in fixed income securities than that of the property & casualty industry.

An indicator of the intense market conditions is the weakening cash flow position of the composite. While operating and total net cash flows remain slightly favorable, underwriting performance has weakened, producing negative cash flows in 1998 and 1999. Despite the deterioration, overall liquidity measures remain strong and the quality of the investment portfolio remains very conservative.

The surplus lines composite has historically maintained a lower level of premium and reserve leverage than that of the property & casualty industry. This is largely attributable to: insured’s demand for greater financial security, due to the lack of guaranty fund protection in virtually all states; modest premium growth from soft market conditions; and the need for excess capacity to quickly respond to opportunities in the market.

The surplus lines composite maintained net premium leverage and net underwriting leverage of 0.5 and 1.8, versus 0.9 and 2.5 for the property & casualty industry, at year-end 1999.

However, on a gross basis, the surplus line composite maintains underwriting leverage that is slightly higher than that of the industry. This is not unexpected given the higher liability limits provided by the surplus lines carriers and the greater catastrophe exposures associated with their property book of business, which would require greater reinsurance to protect the balance sheet.

During 1999 and 2000, specialty risks that had previously been insured by the standard market began to migrate back into the surplus lines market, as many standard market insurers refocused on their core operations. This migration is also attributed to tightening in the reinsurance market.

Over the near-term, A.M. Best expects that the surplus lines market will benefit from the re-underwriting initiatives being taken by the standard market. This should have a favorable impact on the E&S market’s operating performance as well as its balance sheet strength.