A slice of the pie

As market conditions remain tough within core lines of business for many reinsurers, gaining routes into new markets through strategic hires and new operations is a growing trend.

One such market that continues to gain traction is the excess and surplus (E&S) market, which is worth around $37 billion of annual written premium—predominantly in property and casualty.

“As in the rest of the world, reinsurers are seeking to replace lost reinsurance revenues with primary income. In the E&S market specifically, while corporate/national and large commercial risks have lost rate over the past 18 months, smaller commercial and personal risks have been flat to 10 percent up in rate at a time when catastrophe incidence has been very low, making the sector attractive,” says Chris Hardcastle, managing director, binding authority and facility division at Arthur J Gallagher.

However, with increased interest comes increased competition, which is both positive and negative for the line’s existing players, as Bernie Heinze, executive director of the American Association of Managing General Agents (AAMGA), explains.

“When a market attracts investor interest and capital that is always something that has good credibility and sustainability to it. But for the market practitioners, more capital forces competition to keep rates low.

“That’s good for the policyholder and people who have that type of interest, but not as good for those markets that want to develop profits. However, a result of this is the encouragement of underwriting and innovation,” he says.

Heinze says that he is receiving telephone calls every week from new market, alternative capital and various other new capital providers that are looking for ways to provide additional surplus capital into the E&S market place.

Hardcastle agrees. “Reinsurers, hedge funds, pension funds and other capital sources have seen excellent returns in the retro and reinsurance markets in the past nine years, prompting them to take greater interest in the primary market where writing this business through delegated authorities represents an efficient, low cost model. This trend will continue,” he explains.

He also says that many reinsurers already have an existing primary insurance vehicle, or are in the process of creating one as a result of commercial necessity.

“At the same time as reinsurers are seeking to write greater volumes of primary business at low cost, so are MGAs seeking to access less expensive capital to support their business, so the two situations are converging with willing partners on either side,” he explains.

"When a market attracts investor interest and capital that is always something that has good credibility and sustainability to it. But for the market practitioners, more capital forces competition to keep rates low." Bernie Heinze, AAMGA."

“MGAs are seeking to move their business from capital providers whose expense ratio is seen to be high as a result of competing distribution—management, office networks, branding and advertising costs, etc.

“Reinsurers tend to have a better operational expense ratio and  by dealing with MGAs they can achieve a far lower cost of distribution.”

In March, XL Group expanded its E&S insurance team adding an underwriting manager to its newest product line, primary auto.

John Goodloe, president of XL Group’s E&S business, says that the company has seen considerable success and profitable growth in its excess auto business.

Meanwhile, Ariel Re launched Ariel Specialty Insurance Managers, an E&S property underwriting unit as part of a strategic initiative to grow its presence in the US E&S marketplace.

Heinze says that the market’s unique way of operating presents an attractive prospect to insurers.

Established around 50 years ago, the E&S market’s origination stems from a time when the admitted markets couldn’t support new business which didn’t have an adequate loss history.

Operating under a freedom of rate and form structure that doesn’t require state regulatory approval, the market offers a suitable home for hard-to-place, higher risk and unique classes of business that do not fit standard commercial lines underwriting guidelines.

“In the admitted market, regulators can take time to approve the forms and rates, which doesn’t work when there’s been a catastrophe or terrorism event,” says Heinze.

“The E&S market is unique in that it offers flexibility. Rate and form are both subject to negotiations between the retail broker and MGA or insurer who has the binding authority.

“The E&S market receives all the things that the admitted market hasn’t had time to rate and put through analytic models. It’s the incubator where those ideas can be tested and put in place for those specific risks to be secured.”

Challenges

In a report by AM Best, ‘US surplus lines—20 year retrospective’, the rating agency states that the surplus lines market in the US more than doubled from 3.3 percent of total P/C direct premiums written (DPW) in 1993, to approximately 6.9 percent by the end of 2013. As a percentage of commercial lines DPW, surplus lines insurers went from a 6.1 percent share to 13.7 percent, demonstrating the interest in the sector.

While interest in the sector is undeniably high, it has faced significant obstacles and intense competition. This includes aggressive pricing and liberal coverage from standard market carriers seeking organic growth, and the alternative risk transfer market’s appeal as another means of covering potential surplus lines risk, according to AM Best.

“Nonetheless, commercial lines pricing is flattening, and the overall markets remain competitive, which carries over to surplus lines,” says the report.

“Additionally, some of the new formations that have emerged in past years, and continue to grow in prominence relative to top-line growth, have been those with well-capitalised, Bermuda-based parents such as Ironshore, AXIS and Arch. Some believe that many of these newer surplus lines insurers have driven competition in the surplus lines market.”

Heinze says that while he welcomes new entrants to the market, they should be wary of factors such as entry costs, regulatory pressure and mergers and acquisitions activity.

“Barriers to entry are substantial—primarily monetary investment. You would need an initial $500,000 to start up as an MGA because of the requirement for data and technology,” he explains.

“Then there’s regulatory pressure. Regulators are continuing to take increasing interest in challenging freedom of rate and form in both the US and UK. If regulation began threatening the flexibility and quick actions of the E&S market, this could detrimentally impact the sector’s ability to respond quickly to new events, and ultimately force other solutions to be sought to provide that cover.”

With regard to the wave of M&A activity that is being seen throughout the industry, Heinze says that the consolidation is somewhat of a double-edged sword, as it indicates continuing interest and competitive strength in the market, but also lessens the number of existing market participants while at the same time, making room for new ones.

AM Best says that differentiation through innovative products and strong relationships will be the deciding factor for surviving surplus lines insurers.

“With the bountiful capacity currently flooding the market, leading directly to heightened competition, the most successful surplus lines insurers likely will be those that can preserve strong relationships with their distribution partners and maintain high policy retention,” the company said in its report.

“Many are investing heavily in developing, implementing and using technological platforms to support those distribution relationships and improve their competitive positions.

“Adherence to strict risk selection and pricing fundamentals to strengthen the quality of business portfolios will, of course, also be a cornerstone of future success for surplus lines companies, especially given the higher hazard risks that surplus lines carriers entertain.”

Successful insurers in the sector will also be able to meet the challenge of covering emerging risks such as cyber liability, environmental liability and those exposures brought about by new scientific, economic or technological advancements.

To conclude its report, AM Best says that it views the surplus lines insurance market as stable but does have concerns that profit margins may shrink in the near future, as the magnitude of average rate increases on different lines of coverage dissipates.