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2010 Is Test Year For E&S Carrier Execs

Posted on: March 4, 2010

It will take guts for executives of excess and surplus lines carriers to get through 2010, especially those who head up publicly traded operations, experts said at an investment analysts? conference recently.

?If you tell it like it is, it?s not very good and your stock will go down?even lower than it is now,? said Stephen Way, the managing director of Houston-based Southwest Insurance Partners, speaking at a panel discussion at the New York Society of Securities Analysts annual conference in New York earlier this month.

Mr. Way was referring to the dismal state of the property and casualty insurance industry, what he sees as the unlikely prospect of a pricing turn in 2010, and the fact that stocks of some publicly traded E&S/specialty insurers?including some conference presenters?are trading at fractions of their book values, hovering around 50 percent in some cases.

Looking back on a presentation he made last year at the same conference, Mr. Way made the following observations:

? ?I did think this year was going to be bad, and it is. It will be. There?s no good news in sight.?

? ?Investment income has all but disappeared. Underwriting profits are disappearing?Rates have been coming down now for several years.?

? ?The market may be flattening out, but it is not getting better?except in certain [select] areas. Financial [institution] D&O [directors and officers] rates are probably going up, but how many companies write financial D&O??

?The business isn?t good, but it?s a great opportunity to do things,? Mr. Way advised, going on to list possible strategies and consequences. ?You can acquire companies and dilute your earnings. You can overpay for things that don?t look very good on the surface.?

However, ?if you want to build long-term value, that?s what you have to do, and now is the time to do it,? added Mr. Way, who heads up a private holding company in Houston that invests in insurance companies and agencies. ?This is the year to make bets on the future that will not be popular with your shareholders.?

Mr. Way said analysts should be wary of an insurer showing top-line growth, and noted few public company executives will be honest about the state of the business or their individual prospects for earnings growth.

?They don?t want to tell their shareholders because they?re frightened of the results,? he said, later going on to recall the result of a similar situation he faced in 1999, when he was chair and CEO of HCC Holdings, a publicly traded organization with insurance company and underwriting agency subsidiaries.

Back then, he recalled, ?I announced that we couldn?t grow our earnings any more at 15 percent because the [insurance] market was just not good enough. Our stock went down 50 percent in three days.?

He noted that ?the three fastest-growing companies in 1999 were Reliance, Mutual Risk [Management] and Frontier. By the end of the following year, they were all gone and our stock was at $20, up from a third-quarter 1999 low of $8.?

He added that ?when we announced we were not going to grow at 15 percent, we didn?t announce we were going bankrupt. We didn?t announce we didn?t know what we were doing. We didn?t even announce the future didn?t look great. We just said we couldn?t make 15 percent in that market, and a lot of shareholders sold their positions.?

(Editor?s Note: Mr. Way resigned from HCC in 2006 when an investigation revealed improper stock options backdating practices at the company.)


?Are we going to need a Reliance, Frontier or Mutual Risk Management-type blow-up before the market changes?? one analyst asked the panel.

Mark Watson, president and chief executive officer of Bermuda-based Argo Group International Holdings, said the ?primary catalyst? of every market turn in the past has been ?a significant and immediate withdrawal of capital.?

?That can happen from really big events, or it also can happen from a number of companies failing at the same time, and it?s usually the latter that pulls capital?and therefore capacity?out quickly,? he said.

Mr. Way added, ?There?s one other way to help the market?that?s for large companies to make really bad acquisitions?They remove capacity by acquiring another company, and then they become one really big bad company. That helps the smaller companies.?

Indeed, he noted, ?one can think of quite a few companies that have done that [in the past], so maybe one or more of them will step up again. But I think getting rid of capacity clearly is the goal, and that comes from either a big loss, bad results, [incurred-but-not-reported loss reserve adequacy] that becomes negative instead of positive, and bad acquisitions Take your pick?or the market will just stay soft.?

Separately, William R. Berkley, chair and CEO of W.R. Berkley Group, attempted to ?put a hole? in the theory that capital-drains drive cycle turns when he addressed the investment community during an earnings conference call a day later.

He said the last time the cycle changed, right about the year 2000, the industry was writing at around a 1-to-1 premium-to-surplus ratio, and that historically, in earlier periods when the cycle changed, capital adequacy was always the same.

?It didn?t change dramatically?just as it was roughly the same in 2000 as it is now. There?s no tremendous redundancy of capital,? which correlates with cycle changes, he said.

Using a different barometer to forecast the proximity of a market turn?dwindling releases of prior-year loss reserve redundancies?he said the cycle has in fact started turning, and predicted price hikes in the 8-to-10 percent range by the end of year.

It is Mr. Berkley?s view that blow-ups? like the demise of Frontier and Reliance, along with catastrophic events?move price increases up past double-digits, but they don?t drive the initial turn. ?Pricing cycles turn slowly. They go up 1 percent, 2 percent, 5 percent, 7 percent,? he said.

?What will make the change more dramatic?and the reason you?ll have an 8-to-10 percent price increase at the end of the year?is that there will be modest difficulties? as companies comply with their Sarbanes-Oxley certification requirements tied to year-end financials and recognize loss reserve issues.

Tossing aside the capital adequacy theory, Mr. Berkley said ?the highest single correlation of any factor turning the cycle is the release of prior-year reserves.?

He then pointed out that recent figures reveal a slowdown in this activity.

Releases started in 2005 and increased through 2008, but in 2009 there was a slight reduction in the rate of redundancies being released. ?And we think 2010 is going to basically bring that to a halt, or close to a halt in the aggregate,? he said.

Explaining the reason, he said that while favorable loss development for accident years 2003, 2004, 2005 and 2006 may have all generated redundancies, ?when looked at from 2010, past years include 2007, 2008 and 2009 where we feel in many companies deficiencies are being developed.?

This is ?exactly what happened in the late ?90s, and it?s why in 2000 the pricing cycle started to turn,? he said.

Like Mr. Way at the NYSSA conference, Mr. Berkley recalled the late-2000 failures of Frontier and Reliance. Those insolvencies created a crisis that tightened the market in a number of lines more dramatically, and as prices started to move up well into double-digits, losses related to the 9/11 attacks fueled even further pricing improvements.

In 2010, ?I?m not anticipating some crisis hitting,? he said. ?We?ll have modest price increases? until the next crisis.


Despite holding different views of the timing and extent of an overall pricing turn, Mr. Berkley and executives of E&S insurers presenting at the NYSSA gathering all highlighted business strategies focused on long-term diversification goals they?ve undertaken during the soft market?ranging from hiring teams of expert underwriters to outright business acquisitions.

To a person, these E&S executives said such strategies are raising their expense ratios, but at the same time helping to keep top-line shrinkage to modest levels.

Stressing the underwriting discipline they are exercising in areas being attacked by standard markets and new entrants, they said that even small amounts of revenue in a wide array of new businesses and product areas serve to offset massive declines recorded in the most competitive areas of the E&S market, as well as those most affected by fallout of an economic recession.

?We really walk the talk,? said Stephen Crim, CEO of American Safety Insurance Holdings, giving a striking example of discipline in action.

Back in 2006, he said the company wrote about $100 million of premium in its largest line?construction. ?This year, we?ll probably write closer to $20-to-$25 million, and for a company our size to lose that kind of premium is a big hit,? he added.

?But we did it for the right reason. Our underwriters are willing to walk away when pricing doesn?t meet our standards,? he said, later going on to detail American?s Safety?s soft-market acquisitions of a long-term care managing general agency and a surety operation, and its investments in information technology. He also highlighted a recent focus on fronting opportunities that generate fee income for the organization at a time when competitive conditions produce inadequate premiums for taking risk.

Giving an example of underwriting discipline similar to Mr. Crim?s construction example, Jonathan E. Michael, CEO of Peoria, Ill.-based RLI Corp., described a general liability book that had been ?hit hard by standard lines companies??a book that fell from $200 million at its peak, down to $125 million today.

At the NYSSA meeting and in a separate interview with NU, Mr. Michael explained that discipline is ingrained in the RLI culture and secured by a unique compensation scheme in which underwriters are actually paid a portion of the underwriting profits they generate.

He also described strategies to enter into and expand specialty businesses that diversify the company, including:

? A foray into the crop insurance area through a reinsurance arrangement.

? The introduction of a cyber liability product.

? The hiring of new underwriters to broaden the company?s surety footprint.

? The launch of fidelity, facultative reinsurance, and architect and engineers liability insurance operations.

?We?ve got a history of investing when the markets are soft,? he said, noting that RLI has added roughly 50 underwriters over the last three years.

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