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There's been a lot of talk on the acquisition front by excessand surplus lines insurance companies, but little action todate–even in a year that followed back-to-back declines in organicgrowth for the segment overall, according to a rating agencyanalyst.

U.S. E&S insurers haven't reported two consecutive years offalling premiums since the late 1980s, according to the latestupdate on the state of the surplus lines market prepared byOldwick, N.J.-based A.M. Best Company on behalf of the NationalAssociation of Professional Surplus Lines Offices, Ltd. The reportwas delivered here during NAPSLO's annual conference last week.

The rating agency tallied direct U.S. premium written fordomestic professional surplus lines insurers (U.S. insurers writingmore than half their direct premiums on an E&S or nonadmittedbasis) at $24.8 billion for 2008–a full 11 percent lower than the$27.7 billion figure for 2007.

According to the report, the last double-digit drop occurred in1988, when the decline was 10.4 percent.

Report author David Blades, a Best senior financial analyst,said he's been a little surprised by the fact the soft market hasdragged on so long, and by the lack of deals getting done.

In an interview before the official release of the report at theNAPSLO annual conference, Mr. Blades said a lot of due diligence isstill being done by company management teams intent on makingacquisitions. That's to be expected, given the continuation of asoft market that's impeding the possibility of organic growth.

“There's a lot of activity behind the scenes, but the actual[merger] deals getting done still seem to be a little bit slowerthan in previous years,” Mr. Blades said.

A lot of insurance organizations still have solid balancesheets, “so there is capital there to make smaller acquisitions onthe company side–to buy an MGA, to buy an underwriting manager,” ifthe insurer has its sights on expanding into a certain type ofbusiness in which it's not currently involved. “I think that'swhere the focus is right now, but even those deals don't seem to beas frequent as in the past,” he added.

He said he believes most potential deal activity hasn't movedpast the interested-shopper stage because of concerns about theinvestment markets overall.

“There was trepidation at the start of the year as to how badinvestment losses would still be–whether the markets would comeback. What capital you had you wanted to hold a little bit closerto the vest,” he said.

Company managers who weren't sure investments were “going tocome back didn't want to go using the capital” they had–capitalthat “could actually be used to fill in some holes if they had morerealized investment losses.”

That conservatism meant that only small deals–those that couldbe executed using disposable capital–could get done. While Mr.Blades believes the conservatism was well placed given thevolatility of the investment markets, he also believes that ifinsurance companies are going to make deals, now is the time to getthem closed–before year-end.

“If conditions do start to turn around, and the market looks alittle more favorable from an underwriting standpoint, then theremight be some opportunities for which the price will only go up,”or deals might be taken off the table entirely, Mr. Bladesreasoned.

“So for those companies that do have the capital, the balancesheet strength to go out and purchase somebody–a smaller competitoror an MGA, maybe even one of some size–it may be easier to do thatnow,” he said.

SLUGGISH MARKET

How quickly soft insurance market conditions will start to turnaround, of course, remains an open question.

“We said a year ago that we really anticipated the market havinga definitive change–some sort of a hardening by this point. Themore people we talk to in doing research, however, the more werealize how far that's getting pushed out now,” he said, notingthat many market participants don't see a turn happening until latein 2010.

In addition to a recessionary economy, Best analysts highlightedthree factors at work sustaining a competitive market and pushingE&S insurance premiums downward in 2008 and 2009:

o Standard carriers competing for E&S business.

o Efforts by the E&S companies of American InternationalGroup (now known as Chartis) to protect renewals.

o The pursuit of top-line growth by Bermuda-based carriers.

Mr. Blades confirmed that Best believes the most significantfactor is the behavior of standard markets companies.

“It's amazing how the industry came through the second half oflast year and even the first half of this year,” he said.

Although investment and catastrophe losses definitely pushedpolicyholders' surplus down–for both standard and E&Scarriers–individual company balance sheets remained strong in bothsectors despite the hits, he noted. “That being the case, from thestandard market perspective, it allows them to still have interestin these borderline surplus lines businesses.”

Bermuda capital is also considerable, he said, noting that boththe companies created early in the decade–the Class of 2001 createdin the wake of the 9/11 attacks, and the Class of 2005 start-upslaunched after Hurricane Katrina–are participating in the U.S.surplus lines market. Class of '01 insurers Arch and AXIS, in fact,are among the top-25 E&S insurers ranked by direct U.S. E&Swritten premiums.

Mr. Blades explained that in the early weeks after news of thenear-bankruptcy of their AIG parent, some Chartis companybusiness–in particular, portions of layered insurance programs onlarge accounts–began moving away from Lexington Insurance and otherChartis E&S insurers.

Those insurers have historically “been stalwarts in the surpluslines [segment]. They built up very good, very solid businesses,”he said–noting, however, that insureds became less comfortable withhaving 60-to-70 percent of a program with AIG insurers.

“I think in reaction to that,” the Chartis E&S companies,“because they like the business, began to compete very hard toretain as much of it as possible,” Mr. Blades said. “You hear thisanecdotally and you can see it in the numbers.”

“If these clients had been AIG clients for a long time, I thinkthey began to be very protective of their renewals,” he said.“That's not to say there was any kind of wholesale price slashing,but I think they competed hard for it–whether it was rate orpromising more services or doing whatever needed to be done from avalue-added perspective.”

“It only makes sense because from a reputational perspectivethey were getting beaten about the head and face, obviously, afterall that had happened at the parent-company level,” he said–whileemphasizing, however, that Lexington and other Chartis companiesare “still very strong. We still have an 'A' rating out on thosecompanies.”

From a numbers perspective, E&S premiums for the Chartiscompanies fell 12.8 percent in 2008, but Chartis retained itsposition as the lead writer with $7.2 billion in E&S premiums.Lloyd's and Zurich–ranked second and third, respectively–hadsmaller premium drops (4.7 percent and 6.2 percent), but most othergroups on A.M. Best's top-25 list, like Chartis, saw double-digitpremium declines.

Lloyd's, which hasn't ranked first since 2001, recorded $6.0billion on U.S. E&S premiums recorded in 2008, according to theA.M. Best report.

How likely is it that Lloyd's will emerge as the leader when therating agency publishes its next report for NAPSLO 2010?

“Where we stand right now, they might [be number one]. There isabsolutely a possibility that might be the case,” he said,admitting that he hadn't actually contemplated the question before.“That will be a big story, even though those two are so separatedfrom everybody else. It's not like AIG is going to drop down tothird.”

Another unit of the rating agency recently published anotherreport suggesting that Lloyd's has been the primary beneficiary ofany insured movements away from Chartis, and Mr. Blades agrees.

While Lloyd's capital structure is difficult to understand,there's no question that the overall capital position is strong, henoted. “Insureds may have a comfort level with Lloyd's [from] anunderwriting acumen standpoint and because they have the capacityto write this business,” he said.

PROFITS DESPITE CATS

For the E&S segment overall, premiums continue to dropthrough the first half of 2009, but the rating agency is expectingthe segment will post an underwriting profit for 2009, Mr. Bladessaid.

“A key theme for the surplus lines companies is to wait out thispart of the market–to continue being disciplined,” he said, givingone reason for the conclusion.

“The management teams of those groups in the top-25 are writingthe lion's share of the business because they've been around for awhile–they understand how the cycle goes. And I think a lot ofpeople truly believe that at some point–maybe it will take anotheryear–that there will be some sort of turn in the market.”

“I do believe that overall, there will be enough underwritingdiscipline to allow that business that is truly believed to beunderpriced to leave [E&S company] books for another year withthe knowledge that they'd be able to get it back once the marketturns,” he said.

As has been the case for two decades, E&S insurers reporteda lower combined ratio than the property and casualty industryoverall, according to Mr. Blades, who reported that 74 domesticprofessional surplus lines companies tracked by A.M. Best posted acombined ratio of 93.6 in 2008–more than 11 points better than theindustrywide result of 105.

Still, severe property-catastrophe losses drove the 2008 resultfor the E&S segment well above the 76.1 E&S combined ratiofor 2007. In fact, information in the report suggests that in theabsence of prior-year loss reserve takedowns–which shaved 10.7points off the 2008 E&S combined ratio–the segment would havesuffered an underwriting loss.

After the 2005 storms of Hurricanes Katrina, Rita and Wilma,more catastrophe-exposed business found its way to the E&Smarket, Mr. Blades said, explaining why E&S insurerunderwriting results took such a blow from last year's naturalcatastrophes–events that included Midwestern storms and tornadoesearly in 2008, and then Hurricanes Gustav and Ike later on.

All the events together added 16 points to the loss ratiocomponent of the E&S combined ratio in 2008, he said.

As for loss reserves, the 10.7-point takedown is significantlyhigher than the comparable figure calculated for the overallindustry by National Underwriter earlier this year–3.3points (excluding some distortion related to financial guarantylines).

The relationship is not surprising to Mr. Blades, who said theE&S insurers traditionally are more conservative when they putup reserves initially–because they deal in more hazardouslines–prompting larger takedowns as claims settle.

Overall, A.M. Best currently has a stable outlook on the E&Ssegment.

A.M. Best's 16th annual report on the surplus lines market wascommissioned by the Derek Hughes/NAPSLO Educational Foundation, afoundation set up in 1991 to improve education about surpluslines.