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By MATTHEW BRODSKY, senior editor/Web editor of Risk & Insurance®

In hill country, you can look up the steepest slope and witness to your amazement cows and sheep grazing. You might think to yourself, "That's gotta be uncomfortable, even downright dangerous!" But you could say those cows and sheep found their niche. They've got that slope all to themselves with no competition from the animals from the plains. That is, until the cows and sheep on flat land run out of room down there and come looking for fresh grazing grounds on the slope. Things could get testy. Then watch what happens when a heavy rain comes on the nibbled-down grass and we have a mudslide.

What will be the exact date and cause of the pendulum swinging back to hard? Especially with the unusual hits the overall property/casualty industry has taken lately (the Deepwater Horizon being one), something's got to give soon, right?

"That has to have some reverberations," Heaton said.

"Everyone is looking for the catalytic event that sparks a change in the market," said David Blades, senior financial analyst at ratings agency A.M. Best & Co. "I stopped thinking that market change is imminent," he said, adding that his guess last year was that the hardening would have happened about this time this year.

"It's going to require some fear and some companies getting hurt," said Mike Stone, president and chief operating officer of the Peoria, Ill.-based insurer RLI Corp.

In the meantime, the surplus lines market has to deal with what it always deals with in soft markets: the encroachment on its turf by the admitted markets. Typically, surplus-lines carriers write business that admitted carriers pass up--sometimes riskier, newer or unique risks. Yet in soft markets, standard-lines carriers seek to show growth and less decline in written premiums so they branch out toward risks they might not be as comfortable with or competent to write in a less competitive market. Niche risks with the steep learning curve that surplus-lines writers have specialized in for years. Often, the standard players even come in with lower rates.

Right now, admitted players are "deep into that gray area," as Stone put it.

"That's not new. That's happened before," said Gerry Albanese, chief underwriting officer at Glen Allen, Va.-based specialty carrier Markel.

What is new, however, is the combination of a soft market and a beat-down economy. Sure, the economy is painful for nearly everybody except repo men. All commercial property/casualty carriers are feeling the effects of their policyholders having smaller payrolls, sales, production and anything else that would drive insurance premiums.

The economy bites in particular for the excess-and-surplus lines market. Their business often comes from startup companies, firms with new products and exposures, and construction outfits--none of which are blooming at the moment.

Whole sections of the surplus lines environment are affected. Primary property/casualty lines are a wasteland. "Even the brokers are complaining the pricing is too soft," said Heaton, who also serves as secretary of the National Association of Professional Surplus Lines Offices (NAPSLO).

Certain areas of the market are even more competitive. John Wood, president and CEO of brokerage firm Specialty Risks Associates Inc. of Louisiana, pointed to transportation.

James Drinkwater, president of the brokerage division at wholesale giant AmWINS, mentioned residential construction, healthcare and environmental as rougher patches.

For some experts and observers in the space, it is a challenge to see greener pastures in even just one line or class of business. "In general, there is not one shining line of business that can be identified as presenting an appreciable profit margin, nor is there any one line you can look at from a truly optimistic standpoint," Blades said.

Others might disagree. Professional liability is an area for opportunity, according to Heaton. Stone agreed, adding certain products in surety to the list.

According to the half-full Drinkwater, there's always business for folks out there hustling for the client. "There is always opportunity in every single place if you provide value," he said, with value (for a broker such as Drinkwater) being anything from expertise, market access and knowledge, to client and claims advocacy.

For the carrier, providing value means effective customer service and quick quote capabilities, two examples offered by Albanese.

The current climate also provides other opportunities for growth: mergers and acquisitions.

"The key thing honestly is ... there would have been more deals," Blades said. "Acquisition targets are reportedly pricing themselves too high for the buyers, not realizing the effects of the recession on their value, based on what we've heard from insurance executives."

Yet that's not to say that deals haven't been done, Blades said. Markel announced in July that it is buying Aspen Holdings Inc. First Mercury is after Valiant Insurance Group to tap into the specialty admitted market for growth. QBE the Americas has been very acquisitive.

On the brokerage side, mergers and acquisitions has been a tactic as well, the biggies being the Cooper Gay-Swett & Crawford and AmWINS-Colemont deals.

Some would say that such consolidations are not a positive result of the cycle downturn. Stone of RLI for one argued that mergers in the wholesale brokerage community has created difficulty for underwriters.

"The bigger they are, the bigger the ability to try to push on rate, to try to push on terms and conditions, with a bit of clout," Stone said. In the process, he added, the brokers might also lose nimbleness and personality, which in his view is a bad tradeoff.

AmWINS' Drinkwater perhaps best summed up the brokers' view. About the AmWINS-Colemont deal, he explained, the merger allows the brokers to provide more value.

"All of our markets are very happy with it. They're very excited about it," Drinkwater said, estimating that he's heard nay a negative comment about the deal from all of the underwriters he's spoken with.

And it could be argued, too, that in such a competitive climate, where many talk in public like they're part of the flock but go for the throat in private, brokers need to protect themselves with size. After all, some say (including Drinkwater) that, in today's market, disintermediation is up, meaning that some surplus-lines carriers are working directly with retail brokers. They're doing this to write as much business as they possibly can.

Albanese at Markel knows at least one major carrier that's created "turmoil" by changing its distribution pattern. Yet he did not seem perturbed that the economy and market conditions might be driving more of this.

"I don't know if it's more or less," he said.

Getting back to mergers, the consensus appears to be more. Public valuations of companies are attractive, as Stone explained, so the market could see an increase in activity through the next 18 months.

Some might argue that mergers are the only path for growth right now among the doom and gloom.

But not so. Even with the economy somewhere between a double dip and a jobless recovery, and the market as soft as quicksand, some surplus-lines companies are doing well, gasp, selling insurance.

"Don't feel too sorry for us. We're still reporting pretty good results," said Stone of RLI.

Heaton pointed to the record registration for the upcoming NAPSLO annual meeting, to be held Oct. 11-14 in Atlanta, as a sign of high satisfaction with the long-term prospects of the business.

Wood, who is the immediate part president of NAPSLO, said he expects to see the usual amount of "intoxicating" deal-making at the event, which is "like a shark-feeding tank," his smile coming through the phone as he said it.

Sharks in a tank. Cows and sheep on a hillside. Mixed metaphors or not, at least the animals are still out there hustling in the excess-and-surplus space.

October 1, 2010

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