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In the world of insurance underwriting, excess and surplus lines companies are a kind of rarified player. They must have the stomach to take on risks that other companies might be too large to handle with any agility. But as players in the margins where the general market seeks not to tread, they also pick their spots at the whim of the market.

"The objective is to be able to fill a gap and play a contrarian underwriting role where the standard market doesn't want to compete," says John Clarke, a vice president with the Richmond, Va.-based E&S specialist James River Insurance Co.

Executives and analysts say not too many E&S companies will be closing their doors anytime soon. But this is also a time when they will be watching their costs and picking their spots. This is no time for greed or ambition in growing the top line that might draw an otherwise savvy player into a ruinous piece of business.

"In a hard market, you get this nice sprinkling of business that doesn't belong in the surplus lines. In a soft market, almost everything that comes to a surplus lines carrier belongs in the surplus market. It all belongs here, and it's all tough," says Clarke.

To expand on that concept, the high prices in a hard market will sometimes drive insurance buyers into the arms of the nonadmitted insurance companies. But in a soft market, the general insurance companies are chasing premiums and a larger percentage of tough risks, leaving only the truly daredevil risks to the excess players.

Stan Galanski, the president and CEO of the New York-based Navigator's Group, which in addition to its marine specialty practice houses an excess casualty division under its Navigator's Specialty heading, says that the leaders of E&S companies and their charges have to be able to walk away from business in 2008, even as they see profits and premium rates decline.

"If Navigator thinks that they can't get their rate and their terms, we're content to let the business go away," Galanski says.

OK, that's nice, sound thinking.

But one insurance industry analyst in a January interview with Risk & Insurance® said more E&S carriers than not may fail to find it in themselves to grasp Galanski's grains of wisdom and could wind up succumbing to more primitive urges in their search for profits.

Maybe he had too many holiday cookies, or was edgy from the Himalayan-like peaks and valleys that the stock market dished out in the most recent quarter, but John Gwynn, an analyst with the Memphis-based Morgan Keegan Co., said he had little faith that E&S players weren't going to go chasing premiums all the way to the bottom of the sea as the pressure on pricing continues.

"You hear all these managers talk about market discipline. Unfortunately, I have been around a long time, and I have heard all of this before," said Gwynn, sounding like his intellect was offended at the very notion of self-disciplined insurance companies.

"I believe the greed factor in terms of market share will prevail over common sense. Companies will price their products downward in order to keep their top line going," Gwynn added.

Kevin Kelley, the chairman and CEO of Boston, Mass.-based Lexington Insurance Company, said that discipline issue is going to depend on the size of the insurance company and how healthy it is.

"Appetite doesn't necessarily correlate with the pricing of risk and so what you are seeing today is a bigger appetite for more risk at a reduced premium. The more narrow your view of the market the more narrow the distribution you have, the more of a problem that can become," Kelley said.

Having said that Kelley said he believes most E & S underwriters will behave rationally, especially given today's credit market.

"I do think there is a healthy respect for risk and the pricing of risk and there couldn't be a better example of that then what we are seeing on credit side today in the financial services business," Kelley said.

Brad Dickler, the Richmond, Va.-based president and CEO of Essex Insurance Co., says he doesn't think prices will moderate in the first quarter of 2008 as much as they did in late 2007. But he's getting the impression that some of his cohorts in the excess and surplus lines are taking on much larger pieces of business than they normally would.

"Some people are taking rather huge lines, much larger than they would three or four years ago," Dickler says. "It would take another storm or even earthquake to change that pattern."

And why are companies not able to do as Galanski advises and control themselves?If you're an insurance executive, you might wince at Gwynn's answer.

"It's sort of a sad-sack business. It is an industry that has lagged the returns in American business in general by a pretty wide margin. I think it speaks to the commodity basis of the business and a pretty fair complement of inept managers," Gwynn said.

Ouch!

But are E&S carriers, or their managers, really as "sad sack" as all of that?

RUNNING IN NUMBERS

Not according to many of their earnings statements, which for the third quarter of 2007 were looking pretty good. By way of example, Cincinnati-based American Financial Group Inc. saw its third-quarter net income in 2007 increase 9.8 percent over the same quarter in 2006.

Richmond, Va.-based Markel Corp., the parent of Essex, was looking healthy with a combined ratio of 88 percent through the first three quarters of 2007. That's the same combined ratio it maintained through the first nine months of 2006.

And RLI Corp., based in Peoria, Ill., was hitting it out of the park the last time we checked. Net income for the specialty insurer for the quarter ending Sept. 30, 2007, was $61 million. For the period ending Sept. 30, 2006, it was at $30 million. You can do the math on that one and draw your own conclusion.

Clint Harris, a vice president with Hartford, Conn.-based Conning Research & Consulting, says that, although excess and surplus carriers can expect to lose market share to general insurers as prices fall, the E&S lines are still good places to be, regardless of the market cycle.

In a nutshell, the gains they make in hard markets are consistently larger than the losses they endure in soft markets.

"You could probably take some pretty good erosion of the profits that you are used to, but at the same time it has shown itself to be a good marketplace through the cycle," Harris said.

That being said, there is nothing about the E&S business that is steady as you go.

"I think the thing you have to keep in mind is that we both grow and shrink at the whim of the market," James River's Clarke says. "We have to take what the market gives."

There is the market to contend with for sure. But there are also considerations.

Even if the E&S carriers are able to control themselves, and don't chase market share and invest capital heedlessly, there is another key player in this tightrope drama. That creature is a company's pool of investors.

And if E&S companies wait too long to invest their capital, the investors will start to clamor. And that clamor will sound like something along the lines of either "feed me," return that capital in the form of higher dividends, or go do something fun and American like buy another company.

Kenneth Billingsley, an analyst with Signal Hill Capital Group, based in Baltimore, says, to date, E&S companies have done a good job of controlling themselves and not chasing premiums in this soft market.

"Can they live off of this fat they have built up? They can to a degree," says Billingsley. But Billingsley says sooner or later investors will start looking for some sort of action, the above-mentioned returns or something along the lines of an acquisition.

Billingsley thinks the fat times will last through 2008 and well into 2009. But if nothing happens to impact premium prices, even the E&S carriers will feel the pain eventually.

"The end of 2009 and the beginning of 2010 you'll start to see a big strain on these companies," Billingsley says.

In the meantime, cost control will be one of the keys. And that means managing perhaps the trickiest and arguably one of the more important E & S relationships.

Navigators' Galanski says brokerages, which aren't exactly in the business to take on less work, will start pressuring underwriters for more money as prices continue to weaken.

"It's very tough for them to maintain their revenue. From my experience, none of them is budgeted to shrink next year, but some of them will," Galanski says.

DAN REYNOLDS is senior editor of Risk & Insurance®.

February 14, 2008

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