market segment report: surplus lines push through various ... · the leading provider in the us...

The surplus lines market continues to grow, generating both pretax and net profits and maintaining strong balance sheets in 2017

September 14, 2018

Analytical Contacts:David Blades, Oldwick+1 (908) 439-2200 Ext. [email protected]

Robert Raber, Oldwick+1 (908) 439-2200 Ext. [email protected]

Contributors:Greg Williams, OldwickSharon Marks, Oldwick

2018-115

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BEST’S MARKET SEGMENT REPORT

Surplus Lines Push Through Various Headwinds for Higher GrowthIn a year of higher losses driven primarily by an increase in catastrophes and persistent competitive market conditions that impacted most lines of business, surplus lines and specialty market insurers continued to demonstrate the resilience that has long been one of their defining characteristics. The surplus lines market grew 5.8% in 2017, up notably from just under 3% in each of the two preceding years. Growth was constrained somewhat by competitive pressures, including pressure stemming from traditional surplus lines business being written by admitted companies. Although weather-related losses led surplus lines writers to post an underwriting loss for the third year running, the domestic professional surplus lines composite (as defined in this report) was still able to generate both pretax and net profits and maintain strong balance sheets.

The ability to operate profitably despite tough market conditions and other challenges leads A.M. Best to maintain its view that the surplus lines market is financially sound and should remain so for the foreseeable future. For most types of business—other than property catastrophe and automobile/transportation—competitive market pressures spurred by a wealth of available capacity appear to be escalating, not diminishing. The task of competing at the highest level in the surplus lines and specialty market will likely become more difficult for companies that lack the necessary scale, diversification, value proposition, or brand recognition to excel, as well as for those that do not leverage available innovations such as predictive analytics as effectively as other competitors do. With interest rates still relatively low and other economic factors presenting operational challenges, the ability to compete effectively is especially crucial. Developing ways to enhance operational or analytical strong points, exercising the proper discipline despite pressure from competitors, and creating products to address new or emerging risks will help separate the best from the rest among the surplus lines and specialty companies. Such success will result in the ability to maintain solid balance sheet strength, which is integral to any chance at future success.

Consolidation among surplus lines insurers continued to impact market competition in 2017. With a number of mergers involving prominent surplus lines and specialty market organizations expected to close in 2018, consolidation will continue to re-shape the market, including wholesale intermediaries. Acquiring insurers continue to use M&A as part of their strategies to carve out a bigger piece of the market. On the distribution side, the larger wholesalers have been growing in scale and expanding their profiles by acquiring smaller brokers and intermediaries. The push to consolidate has led to retailers often doing business with fewer wholesalers, and wholesalers in some cases doing business with fewer insurance companies. A.M. Best does not believe that M&A momentum will slow down over the near term.

ContentsI. State of the Market. . . . . . . . . . . . . . . . . . . . . . . . . . . 3II. Financial Performance and Rating Distribution . . . . 17III. Regulation and Legislation . . . . . . . . . . . . . . . . . . . . 28IV. Current Distribution Trends. . . . . . . . . . . . . . . . . . . . 35

V. Impairment Trends . . . . . . . . . . . . . . . . . . . . . . . . . . 42VI. Surplus Lines Fundamentals . . . . . . . . . . . . . . . . . . 47Appendices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

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Market Segment Report US Surplus Lines

A.M. Best Surplus Lines Market Report—A Retrospective

In the early 1990s, we published Best’s Insolvency Study: Property/Casualty Insurers 1969-1990, in an effort to bring clarity to active debates about insurers’ solvency. Sparked by interest in this topic, in 1994 the Derek Hughes/NAPSLO Educational Foundation—now the WSIA Education Foundation—commissioned a similar study, on the solvency record of the domestic surplus lines industry. Although the segment was poorly understood at the time, the data showed that the surplus lines market’s financial stability and solvency were at least on par with the overall P/C industry’s.

Since then, A.M. Best has published an annual report on the surplus lines market (commissioned by the foundation), documenting the following:

• The market’s role in developing products to cover new or emerging risks, distressed risks, high-capacity risks, and other unique risks that cannot be insured in the standard P/C market

• The importance of surplus lines insurers’ freedom of rate and form, which has allowed for creative insurance solutions to meet highly complex or unique coverage needs

• The critical and still growing role of wholesalers in developing products and forging relationships with insureds that facilitate the placement of business in this market

Throughout its history, the surplus lines market has faced significant obstacles and intense competition—including periods of aggressive pricing during which standard market carriers seeking organic growth offered broader coverage—as well as the growing appeal of the alternative risk transfer market as another means of covering surplus lines risks. Throughout, surplus lines industry representatives have maintained a consistent, active presence in the states and in Washington, DC, tracking and addressing critical regulatory issues affecting the industry and helping advance key pieces of legislation, such as the National Association of Registered Agents and Brokers (NARAB) provision of the 1999 Gramm-Leach-Bliley Act, which led to the licensing of nonresident surplus lines agents and brokers and created a new landscape in wholesale distribution. More recent initiatives entailed advocating passage of (1) the Nonadmitted and Reinsurance Reform Act in 2010; (2) NARAB II as part of the Terrorism Risk Insurance Program Reauthorization Act of 2015; and (3) the Flood Insurance Market Parity and Modernization Act of 2017 (discussed in Section III of this report).

Despite numerous challenges, the surplus lines market has more than doubled in size over the last 20 years or so, from 3.3% of total P/C direct premiums written (DPW) in 1998, to 7% at the end of 2017. As a percentage of commercial lines DPW, the surplus lines insurers’ share has more than doubled, growing from 6.7% at the end of 1998 to 14.6% at the end of 2017, further demonstrating the segment’s importance as part of the P/C industry.

As of mid-year 2018, 96% of surplus lines insurers had A.M. Best long-term Issuer Credit Ratings (ICRs) of “a-” or higher, compared with 81% for the total P/C industry, further corroborating the ongoing financial strength of the surplus lines segment.

The surplus lines market functions as a healthy and viable safety valve for the insurance industry, as emerging issues and developing exposures continue to drive the demand for new, creative, and comprehensive insurance solutions. A.M. Believes that, given the surplus lines market’s proven ability to effectively assess new exposures and the flexibility to tailor terms and limits to meet coverage demands, the market’s critical role and value to the P/C insurance marketplace will continue to grow.

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Through the end of 2017, no surplus lines insurers had become impaired in 14 years. A.M. Best has become aware of the impairment of one small surplus lines insurer (in July 2018), although details are still emerging. The surplus lines and specialty market companies have otherwise been remarkably resilient. To maintain strong operating performance amid current market dynamics, these companies must resist the competitive lure of growing top line premium revenue by relaxing risk selection standards or through more liberal pricing.

As surplus lines insurers and intermediaries ponder the short- to medium-term horizon, they remain focused on taking advantage of their proven and expanding capabilities, providing a broad array of products across different states and territories, while also enhancing their data analytics capability and investing in new technology to better serve both broker/agency partners and insured clients. Partnering with insurtech companies that are helping revolutionize the insurance industry and changing how insurance products are developed, marketed, and distributed will likely help differentiate the more successful insurers and intermediaries from lesser competitors in the future. The hiring, development, and retention of younger talent to counter the expected loss of intellectual capital stemming from an aging workforce will also be critical. Companies that effectively develop plans to address these issues will likely prosper over the coming market cycles.

Section I: State of the MarketCatastrophes and their aftermath were at the forefront of most discussions of the P/C industry’s 2017 results, with record losses from hurricane and wildfire damage being the lead story. Three Category 4 hurricanes—Harvey, Irma, and Maria—came in close succession last fall (followed by Category 1 Hurricane Nate), marking the first time that a Category 3 or worse hurricane had made landfall since 2005. The widespread damage put a great deal of pressure on the operating results of surplus lines insurers and P/C insurers overall. Couple the impact of those storms with the costliest wildfires in California’s history, and the central theme of 2017 comes into clear view.

Despite persisting additional challenges from competition owing to the wealth of capacity focused on the surplus lines and specialty market and the resulting tight profit margins, the segment’s premium rose for a sixth year in a row, and 2017 growth in DPW outpaced the growth in both 2015 and 2016. Additionally, despite a considerable underwriting loss for a second consecutive year, the overall surplus lines segment again generated pre- and after-tax net profits—as it has every year since 2001. However, profits in both cases declined by more than 30% in 2017, driven by the deterioration in underwriting results. In fact, 2017 marked the third consecutive year that profits were down from 2013 and 2014, when the segment had its best profitability since 2006 and 2007.

In 2017, DPW grew almost 6% (Exhibit 1), driven again by growth from both Lloyd’s and non-Lloyd’s alien insurers, along with US surplus lines specialists. Lloyd’s maintains its foothold as the leading provider in the US surplus lines business. Growth was again experienced among the domestic professional surplus lines insurers, which write more than 50% of their total direct business on a surplus lines basis, after a basically static year of premium writings in 2016. Direct premium production has been affected by competitive pressures domestically and abroad, buoyed by carriers with strong balance sheets putting available capital to work.

The relatively low top line growth has kept underwriting leverage for the surplus lines market modest, and most carriers are well capitalized. Surplus for the entire segment has grown

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modestly year over year, which, coupled with premium growth, has led to net and gross leverage remaining steady.

Consolidation in the excess and surplus lines and specialty market segment continues, particularly on the distribution side, affecting wholesaler brokers and managing general agencies to a large degree. M&A focused on insurance intermediaries has been driven by product distribution and the transformation in retail agents’ buying trends. Insurance company consolidations in 2016 and 2017 had a marked effect on the market; what remains consistent is that the top 25 groups (based on premium) still constitute the majority of the market. These companies are some of the most consistent surplus lines performers in terms of operating results. Product and geographic diversification, underwriting and pricing discipline, and dynamic strategic analysis have underpinned the ability of these market leaders to gain and defend solid market positions. Over the near term, we may see fewer consolidations of large global, multiline insurers and reinsurers, and more deals in which buyers focus on niche, specialty insurers, especially those with a well-established market presence or advanced technological capabilities. The environment will remain conducive to

Exhibit 1US Surplus Lines – Direct Premiums Written by Segment, 1988-2017($ Millions)

DPWAnnual % Chg DPW

Annual % Chg DPW

Annual % Chg

Sur-plus

Lines Mkt

Share# of Cos *DPW

Annual % Chg

Sur-plus

Lines Mkt

Share DPWAnnual % Chg

Sur-plus

Lines Mkt

Share# of Cos DPW

Annual % Chg

Sur-plus

Lines Mkt

Share# of Cos

1988 211,270 4.2 6,281 -4.3 3,704 -10.4 59.0 86 1,237 -7.5 19.7 1,012 31.3 16.1 104 328 2.2 5.2 1281989 220,620 4.4 6,123 -2.5 3,530 -4.7 57.7 88 1,182 -4.4 19.3 1,050 3.8 17.1 101 361 10.1 5.9 1231990 230,757 4.6 6,532 6.7 3,882 10.0 59.4 117 1,241 5.0 19.0 1,013 -3.5 15.5 85 396 9.7 6.1 1491991 235,627 2.1 6,924 6.0 4,081 5.1 58.9 117 1,322 6.5 19.1 1,111 9.7 16.0 85 410 3.5 5.9 1511992 240,410 2.0 7,549 9.0 4,491 10.0 59.5 120 1,388 5.0 18.4 1,220 9.8 16.2 74 450 9.8 6.0 1511993 253,847 5.6 8,540 13.1 5,270 17.3 61.7 123 1,631 17.5 19.1 1,183 -3.0 13.9 70 456 1.3 5.3 1381994 263,653 3.9 8,786 2.9 6,089 15.5 69.3 115 1,196 -26.7 13.6 992 -16.1 11.3 64 509 11.6 5.8 1411995 273,929 3.9 9,245 5.2 6,511 6.9 70.4 112 1,300 8.7 14.1 1,022 3.0 11.1 57 412 -19.1 4.5 1441996 279,990 2.2 9,205 -0.4 6,668 2.4 72.4 108 1,354 4.2 14.7 818 -20.0 8.9 57 365 -11.4 4.0 1251997 287,196 2.6 9,419 2.3 6,569 -1.5 69.7 106 1,609 18.8 17.1 802 -2.0 8.5 59 439 20.2 4.7 1141998 300,309 4.6 9,861 4.7 6,763 3.0 68.6 107 1,574 -2.2 16.0 1,196 49.1 12.1 58 328 -25.3 3.3 1131999 308,671 2.8 10,615 7.6 7,265 7.4 68.4 105 1,912 21.5 18.0 1,140 -4.7 10.7 55 298 -9.1 2.8 1162000 327,286 6.0 11,656 9.8 7,884 8.5 67.6 98 2,499 30.7 21.4 941 -17.5 8.1 46 332 11.4 2.8 1062001 367,798 12.4 15,813 35.7 10,773 36.6 68.1 104 3,368 34.8 21.3 1,362 44.7 8.6 44 310 -6.6 2.0 912002 422,703 14.9 25,565 61.7 19,572 81.7 76.6 108 4,082 21.2 16.0 1,600 17.5 6.3 46 311 0.3 1.2 762003 463,033 9.5 32,799 28.3 25,662 31.1 78.2 115 4,492 10.0 13.7 2,400 50.0 7.3 45 245 -21.2 0.7 632004 481,588 4.0 33,012 0.6 25,744 0.3 78.0 115 4,596 2.3 13.9 2,400 0.0 7.3 53 272 11.0 0.8 592005 491,429 2.0 33,301 0.8 25,968 0.9 78.0 111 4,675 1.7 14.0 2,400 0.0 7.2 50 238 -12.5 0.7 572006 503,894 2.5 38,698 16.3 29,410 13.3 76.0 117 5,989 28.1 15.5 3,100 29.2 8.0 55 199 -16.4 0.5 542007 506,180 0.5 36,637 -3.5 27,675 -5.9 74.1 120 6,360 6.2 17.0 3,100 0.0 8.3 55 202 1.5 0.5 562008 492,881 -2.6 34,365 -6.2 24,612 -11.1 71.6 130 6,062 -4.7 17.6 3,403 9.8 9.9 53 288 42.6 0.8 702009 481,410 -2.3 32,952 -4.1 22,830 -7.2 69.3 139 6,090 0.5 18.5 3,735 9.8 11.3 55 297 3.1 0.9 692010 481,120 -0.1 31,716 -3.8 21,882 -4.2 69.0 143 5,789 -4.9 18.3 3,758 0.6 11.8 56 287 -3.4 0.9 662011 501,555 4.2 31,140 -1.8 22,582 3.2 72.5 146 5,790 0.0 18.6 2,537 -32.5 8.1 53 231 -19.5 0.7 602012 523,360 4.3 34,808 11.8 25,490 12.9 73.2 142 6,270 8.3 18.0 2,747 8.3 7.9 61 301 30.3 0.9 532013 545,760 4.3 37,719 8.4 26,818 5.2 71.1 140 7,099 13.2 18.8 3,362 22.4 8.9 59 440 46.2 1.2 492014 570,187 4.5 40,243 6.7 28,274 5.4 70.3 135 8,157 14.9 20.3 3,311 -1.5 8.2 60 501 13.9 1.2 582015 591,186 3.7 41,259 2.5 29,333 3.7 71.1 139 8,645 6.0 21.0 2,974 -10.2 7.2 58 307 -38.7 0.7 532016 612,906 3.7 42,425 2.8 29,112 -0.8 68.6 139 9,607 11.1 22.6 3,057 2.8 7.2 61 649 111.4 1.5 592017 642,127 4.8 44,879 5.8 30,594 5.1 68.2 138 10,325 7.5 23.0 3,289 7.6 7.3 59 671 3.4 1.5 58

Source: – Best's Statement File – P/C, US, A.M. Best data and research

Total P/C Industry

Total Surplus Lines Domestic Professionals Lloyd's

Regulated Aliens (excluding Lloyd’s) Domestic Specialty

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opportunistic consolidations, such as the pending AXA S.A.-XL Group and Hartford Financial Services-Navigators Group mergers, along with alternative investment manager Apollo Global Management, which announced its intention to acquire Aspen Insurance Holdings, Ltd., and take the insurer private. These deals could alter the surplus lines and specialty market’s competitive landscape.

Surplus lines insurers have consistently shown their ability to fight through a multitude of headwinds such as transformational changes in technology, rising loss costs, and emerging risks. The segment’s counter-cyclical business profile enables it to maintain steady operating profits while meeting the challenge of a dynamic market environment. However, as market dynamics shift, market pressure may change, making favorable underwriting results more difficult to achieve and maintain, especially if the build-up in prior year loss reserve cushions starts to dissipate.

A.M. Best’s Market Outlook for the US Surplus Lines MarketA.M. Best has a stable outlook for the surplus lines market, based on the expectation that, under current market conditions, companies in the segment will continue to post overall operating profits, grow policyholders’ surplus, and retain market value. The outlook takes into account the surplus lines and specialty market participants’ retaining rational pricing, which has been a hallmark of successful surplus lines organizations. Market participants with extended favorable operating performance have shown that prudent underwriting provides consistent profitability. These companies have leveraged their abilities to customize coverages and rates, as well as technological investments to advance their underwriting philosophies. Many of these insurers have strong product and geographic diversification, minimizing the correlation across exposures. These traits have led to demonstrated pricing discipline across market cycles, helping to avoid the pitfalls of excessive rate movement in any direction.

In addition, the risk-adjusted capitalization of the strongest segment companies with the largest market share is quite strong, providing the necessary support for underwriting capacity. Segment balance sheets also support diversified investment portfolios, providing net investment returns that, in the aggregate, are better than the P/C industry’s as a whole. The strength of their balance sheets also allows these companies to weather competitive market conditions.

One key challenge that remains for surplus lines carriers is the ongoing creep into the segment by standard market companies. Until standard market companies meet their underwriting expectations in their core lines, they will maintain an interest in competing for some surplus lines business, to complement their other operations. The most prevalent challenges for the surplus lines insurers are the same challenges that the commercial lines market faces: competitive pressure from highly capitalized market participants, reinvestment rates that are lower than current returns, and declining levels of favorable prior year reserve redundancy.

The surplus lines and specialty market has recorded underwriting profits in six of the last ten years, including a relatively small profit in 2015. Through most of 2017, the industry seemingly had a good chance for a bit of a comeback after posting a combined ratio above 100 in 2016. However, record insured losses from wildfires and hurricanes at the end of the third quarter overwhelmed profitable first-half results. With standard market insurers likely to continue writing borderline surplus lines risks, a high level of market competitiveness will remain, making the task of achieving an underwriting profit tougher.

Top Line Growth Despite High Market Competition and Operating Margin Compression The surplus lines and specialty market’s 2017 top line growth of 5.8% exceeded that of 2015 and 2016, with Lloyd’s once again leading the way, with annual growth of 7.5% in DPW,

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increasing its share of the overall surplus lines market to 23.0%, from 22.6% in 2017. DPW for four categories of insurers—domestic professional surplus lines companies, Lloyd’s syndicates, regulated aliens, and domestic specialty companies—are detailed in Exhibit 1. Each of the four grew their premium base during the year, with the non-Lloyd’s regulated alien insurers matching Lloyd’s annual premium growth percentage. From a written premium standpoint,

0

5

10

15

20

25

30

($ B

illion

s)

Domestic Professional Lloyd’s Regulated Aliens (excl. Lloyd’s) Domestic Specialty

Exhibit 2US Surplus Lines – DPW by Segment, 1989-2017

Source: A.M. Best data and research

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Mar

ket S

hare

Exhibit 3US Surplus Lines – Market Share by Segment, 1992-2017

Domestic Specialty Regulated Aliens (excl. Lloyd’s) Lloyd’s Domestic Professional


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however, that segment of the market is minuscule compared to the other three. The majority of the market’s premium is generated by domestic professional companies—those writing more than 50% of their business on a nonadmitted basis—while regulated non-Lloyd’s alien insurers also accounted for a prominent percentage of annual surplus lines premiums (Exhibits 2 and 3). The domestic professionals came back from a year when premium declined slightly, to modest growth in 2017.

DPW remains a key metric for identifying companies actively competing in the market, as it captures the impact of both rate increases and writing new business. For fourth quarter 2017 and first half 2018, rates for most commercial lines of business trended toward modest 1% to 2% quarterly increases compared to the prior year periods, the exception being the automobile and transportation lines of business, whose rates were reportedly up 4% to 5%. The vast majority of commercial insurers that have written commercial auto or trucking risks during the last five or more years have encountered poor loss experience and have thus been raising rates on these risks more aggressively than on other commercial lines.

The better managed surplus lines companies have long shown discipline by walking away from business they strongly believe is inadequately priced—walking away from even their own renewal business, if necessary, to maintain the best quality portfolio possible, from both underwriting and pricing perspectives. Such decisions by surplus lines insurers have created a long-term ebb and flow in direct premium volume for the segment across market cycles, reflecting the impact of market-changing catastrophes or weather events, competitive market conditions and the resulting extreme price sensitivity, loss experience, and economic factors. Pricing sensitivity is especially felt during periods when standard market companies have the available capacity and desire to take on borderline risks generally handled in the surplus lines market.

0

2

4

6

8

10

12

14

16

0

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

($ M

illion

s)

Total Surplus Lines DPW Total P/C Commercial Lines DPW Surplus Lines DPW as a % of Commercial DPW

Exhibit 4Surplus Lines Direct Premiums Written (DPW) as a Percentage of Commercial Lines DPW, 1998-2017

Source: A.M. data and research

(%)

8


Total surplus lines premiums (including premium generated by Lloyd’s) as a percentage of the commercial lines insurance industry premiums more than doubled from 1998 to 2006 (Exhibit 4), before leveling off the last ten years. Over that same period, surplus lines DPW increased almost four-fold, while the industry’s commercial lines premium did not quite double. A.M. Best believes that the surplus lines segment will maintain its proportion of the overall commercial lines market.

Net consolidated financial results for the surplus lines segment have deteriorated over the last three years, driven by net underwriting losses the last two years, which the surplus line segment was nevertheless able to offset with enough net investment income to generate pretax operating earnings, even though these earnings declined by more than 30% year over year in both 2016 and 2017. The net results, however, reflect the impact of both premiums assumed by companies (in many cases from affiliated entities) and premiums allocated to companies as a function of reinsurance pooling agreements with affiliates. In many cases, the allocated premium business is not a surplus lines business. The profitability of the market on a direct basis is definitely more favorable, and over the past few years, the pure direct loss ratio for the surplus lines market has been, on average, about five percentage points lower than the pure net loss ratio. This is quite possibly an indication of the negative impact of business assumed and/or accepted on a net basis by virtue of pooling agreements. (We discuss these issues in more detail in Section II.)

Surplus lines carriers have a fair amount of exposure to weather-related and other catastrophe exposures, as 2017 results show, with a reported pure net loss ratio exceeding 125 for allied lines coverage, which includes coverage for wind and water damage losses—due predominantly to the impact of Hurricanes Harvey, Irma, and Maria. In contrast, in 2016, the surplus lines segment’s pure net loss ratio for allied lines increased by only a few percentage points, despite the impact of Hurricane Matthew in October of that year, and remained in the upper 60s, basically in line with every year since 2012. In 2016, the driver of the segment’s high combined ratio was adverse loss reserve development for the leading insurer in the composite, which we discuss further in Section II.

Performance of Core Surplus Lines Specialists Remains StrongSurplus lines specialists focus particularly on surplus lines or specialty business, as opposed to organizations such as AIG, Nationwide, and Zurich, which are global insurers with affiliates that specialize in surplus lines business, but whose business model is more focused on admitted business.

To gauge the performance of insurers whose bottom line results are based predominantly on how well they manage risk selection, risk classification, and risk pricing, A.M. Best looked at companies that write a minimum of $250 million in nonadmitted or surplus lines DPW, and for which the proportion of surplus lines to non-surplus lines DPW for each company is 90% or more. Although 29 total companies fit these criteria, we include only 16 companies in Exhibits 5a, 5b, and 6, because the others cede most of their gross premium to affiliated or unaffiliated reinsurers, many as part of intragroup pooling agreements. In some cases, these companies have no net loss and loss adjustment expense reserves on their balance sheets, so their net results are not indicative of their actual performance on written business—hence, their exclusion from our analysis.

The specialists’ wide-ranging product diversification covers moderate and higher risk exposures that require critical insurance solutions. As Exhibit 5a shows, in 2017, ten of the 16 specialists had calendar year combined ratios of greater than 100, with a median

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Exhibit 5aSurplus Lines Specialists – Operating Performance, 2017Minimum 2017 Surplus Lines DPW of $250 millionSurplus Lines DPW to total DPW threshold of 90%

Company NameDPW % Change

Loss/LAE Ratio

Combined Ratio

PretaxROR

(%)Pretax

ROE (%)

Aspen Specialty Insurance Company 14.0 125.4 129.8 -18.9 -6.9

AXIS Surplus Insurance Company 8.9 80.1 118.5 -6.5 -1.6

Colony Insurance Company 7.5 56.8 93.7 7.7 4.9

Endurance American Specialty Ins Co 29.2 94.1 106.0 -4.1 -6.2

Evanston Insurance Company 2.7 56.4 93.4 15.2 12.0

Houston Casualty Company 2.1 64.6 86.4 19.8 9.0

Indian Harbor Insurance Company 10.9 76.8 101.8 -8.4 -4.6

James River Insurance Company 42.5 95.7 77.9 39.6 34.6

Landmark American Insurance Company 1.8 82.6 111.2 13.8 2.6

Lexington Insurance Company -18.2 90.8 123.1 -11.0 -8.4

National Fire & Marine Insurance Co 30.6 85.7 110.2 8.1 1.3

QBE Specialty Insurance Company 4.7 75.6 106.8 -3.9 -4.8

Scottsdale Insurance Company 4.3 81.1 113.0 -6.2 -6.3

Starr Surplus Lines Insurance Company -3.4 77.9 36.7 81.1 25.6

United Specialty Insurance Company 41.6 49.4 99.7 12.6 3.3

Western World Insurance Company 30.9 98.1 119.1 32.4 11.1

Median – Surplus Lines Specialists 8.2 80.6 106.4 7.9 2.0

Total P/C Industry 4.7 76.0 103.9 3.8 17.7


59.1 60.1 62.8 70.988.6

24.9 25.6 26.727.3

26.7

0

20

40

60

80

100

120

140

2013 2014 2015 2016 2017

Rat

io

Expense Ratio Loss & LAE Ratio

Exhibit 5bSurplus Lines Specialists Aggregate Underwriting Performance Ratios, 2013-2017Minimum 2017 surplus lines direct premiums written (DPW) of $250 millionSurplus lines DPW to Total DPW threshold of 90%


84.0 85.7 89.598.2

115.3

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combined ratio of 106.4. Over the last five years, however, the group generated a much more favorable median combined ratio of 92.5, almost seven percentage points better than the industry’s; only five had a combined ratio exceeding 100.0. Aggregating the results for the specialists over five years (Exhibit 5b) shows that 2017 is again the outlier. Ten of the 16 companies also experienced favorable loss reserve development (Exhibit 6). In the aggregate, the group’s one-year median level was slightly better than that of the P/C industry as a whole.

Notable Shifts Among the Top 25 Surplus Lines Groups Owing to M&ABecause of long-term consolidation activity, the names in the segment’s top 25 groups have changed considerably (Exhibit 7), but no matter the changes, this group of leading surplus lines writers still wrote the majority, 78.5%, of the market’s direct premium in 2017. One constant in recent years has been Lloyd’s, with the largest share (23%) of US surplus lines DPW in 2017. The Lloyd’s platform provides a unique opportunity to write surplus lines not just directly, but also in conjunction with other participants in the market. Lloyd’s maintains a strong appetite for US surplus lines and the specialty commercial business that shows no signs of waning. As such, A.M. Best expects Lloyd’s to continue to hold the top spot in DPW, particularly given AIG’s strategic reshaping in recent years, which is partially responsible for its drop in top line nonadmitted premium—including a 14% drop in 2017. The decline may reverse in 2018, however, once AIG has completed its acquisition of reinsurer and specialty insurer Validus Holdings, for more than $5 billion in mid-July. The acquisition will give AIG a Lloyd’s arm, Talbot, in addition to a specialty/surplus lines insurer, Western World, which writes about $380 million in US surplus lines premium.

Lloyd’s and AIG together accounted for approximately 30% of direct premium for the entire surplus lines market. Of the domestic insurers, AIG, through its main surplus lines insurer Lexington Insurance Company, remains far and away the largest US surplus lines writer, a position it has held since our first surplus lines review in 1994. The company still writes a sizable portion of the market, especially for a single company (Exhibit 8), and the AIG/Lexington brand maintains considerable market strength, particularly when it comes to developing

Exhibit 6

Minimum 2017 Surplus Lines DPW of $250 million

Surplus Lines DPW to Total DPW Threshold of 90%

Company Name

One-Year Loss Reserve

Development Through 2017 ($

Millions)

One-Year Development to

Original 2016 Reserves (%)

Aspen Specialty Insurance Company 62.7 75.7

AXIS Surplus Insurance Company -1.9 -2.8

Colony Insurance Company -17.7 -4.2

Endurance American Specialty Ins Co 6.8 5.7

Evanston Insurance Company -142.9 -7.0

Houston Casualty Company -68.1 -8.6

Indian Harbor Insurance Company -1.6 -2.4

James River Insurance Company 12.8 13.7

Landmark American Insurance Company -2.6 -4.2

Lexington Insurance Company -570.9 -4.1

National Fire & Marine Insurance Co -78.9 -6.4

QBE Specialty Insurance Company -5.1 -4.5

Scottsdale Insurance Company 3.4 0.6

Starr Surplus Lines Insurance Company 1.3 1.5

United Specialty Insurance Company 0.2 3.4

Western World Insurance Company -1.8 -0.6

Average – Surplus Lines Specialists -50.3 3.5Total P/C Industry -8,862.0 -1.4


Surplus Lines Specialists – Loss Reserve Development, 2017 Calendar Year

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creative coverage solutions for surplus lines risks.

The rest of the groups in the top ten (ranked by DPW) writing US surplus lines business are familiar names, such as Berkshire Hathaway, Markel, Nationwide, W.R. Berkley, and Zurich. From a US-only perspective, the top 25 domestic groups (eliminating Lloyd’s and including the Western World Insurance Group as the 25th largest domestic group) accounted for about 57% of the industry’s surplus lines DPW.

Some key shifts in the top ten occurred in 2017. The acquisition of Allied World Assurance by Canada’s Fairfax Financial Holdings led to Fairfax moving up from 12th at the end of 2016 to 8th at the end of 2017. Through this transaction, Fairfax continues to build up its surplus lines and specialty commercial portfolios, expanding an already major industry presence.

In first quarter 2017, Japan’s Sompo Holdings, Inc., completed the acquisition of Endurance Specialty Holdings Ltd., which had the 21st highest surplus lines DPW of all US insurers at the end of 2016. The acquisition led to Sompo entering the ranks of the top 25 surplus lines groups at number 16 at the end of 2017. Endurance has used strong analytics to help refine its portfolio of specialty property and casualty insurance offerings, as well as geographic diversification to improve its performance in recent years. Endurance has been integrated into Sompo through Sompo International, a Bermuda-based integrated commercial insurance and reinsurance platform and is likely to remain a strong option for insureds looking for coverage solutions in the nonadmitted market.

How the tenth largest surplus lines insurer, XL Catlin Group, will be affected by its pending acquisition by French insurer AXA S.A. for $15.3 billion—making it the biggest insurance M&A

Exhibit 7US Surplus Lines – Top 25 Groups, 2017Ranked by Direct Premiums Written

Rank AMB# Group Name

Surplus Lines DPW

($ Thousands)

Total Surplus Lines Market

Share (%)1 85202 Lloyd's 10,325,000 23.0 2 18540 American International Group* 3,239,996 7.2 3 18468 Markel Corporation Group 2,167,568 4.8 4 05987 Nationwide Group 1,737,150 3.9 5 18252 W. R. Berkley Insurance Group 1,698,541 3.8 6 00811 Berkshire Hathaway Ins Group 1,503,234 3.3 7 18498 Chubb INA Group 1,445,248 3.2 8 03116 Fairfax Financial (USA) Group 1,305,476 2.9 9 00060 Liberty Mutual Insurance Companies 1,288,834 2.9 10 18874 XL Catlin America Group 1,142,292 2.5 11 18549 Zurich Financial Services Group NA 1,135,953 2.5 12 18640 Alleghany Insurance Holdings Group 790,305 1.8 13 04019 Argo Group 723,869 1.6 14 18733 Tokio Marine US PC Group 688,481 1.5 15 18777 AXIS US Operations 681,015 1.5 16 18878 Sompo Holdings US Group 671,194 1.5 17 18713 QBE Americas Group 642,289 1.4 18 04835 Great American P&C Group 600,356 1.3 19 18313 CNA Insurance Companies 568,441 1.3 20 18783 Aspen US Insurance Group 539,155 1.2 21 18626 James River Group 530,077 1.2 22 03262 Swiss Reinsurance Group 485,098 1.1 23 18484 Arch Insurance Group 469,965 1.0 24 18756 Starr International Group 425,901 0.9 25 18081 Navigators Insurance Group 411,553 0.9

Subtotal of Top 25 $35,216,991 78.5 Total US Surplus Lines Market $44,878,931 100.0


* The group's DPW total does not include direct surplus lines premium moved to offshore affiliate AIG Europe, Ltd.

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deal in recent years, according to data compiled by Bloomberg—remains to be seen. Some analysts are interpreting the acquisition as an indication that AXA believes the timing is right to expand its presence in the US.

Fosun US Group temporarily joined the top ten US surplus lines groups at the end of 2016 following the acquisition by its Shanghai-based parent, Fosun International Ltd., of Meadowbrook Insurance Group, in July 2015. In November 2015, Fosun International also bought the 80% it did not already own of Ironshore, Inc., but then sold the entire holding to Liberty Mutual in a deal that closed in May 2017, which led to Liberty Mutual making a big leap into the ranks of the top ten surplus lines insurers. Regulatory issues related to the Ironshore operations providing professional liability coverage for government employees was a significant factor in the decision to sell.

Market Consolidation Continues to Re-shape the Competitive LandscapeIn the specialty and surplus lines markets, M&A opportunities for both company and insurance intermediaries remain abundant. The M&A of recent years show that an enormous amount of capital is available for investing in the insurance business, much of it private equity and

Exhibit 8US Surplus Lines – Top 25 Companies, 2017Ranked by direct premiums written

Rank AMB# Company Name Group Name

Surplus Lines DPW

($ Thousands)

Total Surplus Lines Share

(%)1 02350 Lexington Insurance Company American International Group $2,500,972 5.62 03292 Scottsdale Insurance Company Nationwide Group 1,691,506 3.83 03759 Evanston Insurance Company Markel Corporation Group 1,266,710 2.84 02428 National Fire & Marine Ins Co Berkshire Hathaway Ins Group 1,177,791 2.65 03557 Steadfast Insurance Company Zurich Financial Services Group NA 1,043,251 2.36 11340 Indian Harbor Insurance Co XL Catlin America Group 1,006,126 2.27 13105 United Specialty Insurance Co Markel Corporation Group 900,078 2.08 13866 Ironshore Specialty Ins Co Liberty Mutual Insurance Cos 845,906 1.99 12515 AXIS Surplus Insurance Company AXIS US Operations 681,015 1.510 12562 QBE Specialty Insurance Co QBE Americas Group 642,289 1.411 13033 Endurance American Spec Ins Co Sompo Holdings US Group 631,144 1.412 03283 Colony Insurance Company Argo Group 628,542 1.413 03535 AIG Specialty Insurance Co American International Group 620,354 1.414 03510 Illinois Union Insurance Co Chubb INA Group 620,161 1.415 01990 Nautilus Insurance Company W. R. Berkley Insurance Group 583,232 1.316 04433 Westchester Surplus Lines Ins Chubb INA Group 573,114 1.317 03538 Columbia Casualty Company CNA Insurance Companies 568,441 1.318 12630 Aspen Specialty Insurance Co Aspen US Insurance Group 539,155 1.219 03026 Admiral Insurance Company W. R. Berkley Insurance Group 525,795 1.220 12604 James River Insurance Co James River Group 521,794 1.221 12523 Arch Specialty Insurance Co Arch Insurance Group 469,965 1.022 03837 Great American E&S Ins Co Great American P&C Group 446,796 1.023 12078 Liberty Surplus Ins Corp Liberty Mutual Insurance Cos 442,928 1.024 12619 Landmark American Ins Co Alleghany Insurance Holdings Group 442,898 1.025 12118 Gemini Insurance Company W. R. Berkley Insurance Group 433,452 1.0

Subtotal $19,803,415 44.1Total US Surplus Lines Market $44,878,931 100.0


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venture capital. Demand for acquisitions outweighs supply, so buyers are paying rich multiples for acquisitions. For organizations looking to make acquisitions, motivation remains focused on a number of drivers: diversification plays; the acquisition of talent and, especially, technology; and the classic bolt-on operations of sharply focused insurers that can continue thriving as largely independent arms of new parent organizations post-acquisition. Surplus lines and specialty insurers remain primary targets, because they can provide the desirable market expertise, diversification, and favorable loss experience. The recently announced acquisition of Navigators Group by Hartford Financial Services Group will help Hartford expand both its product offerings and geographic reach, if consummated.

In addition, a number of specialty and surplus lines companies have made sizable technology investments, making them even more attractive candidates for acquirers. Given how competitive the market is, tech-driven service providers have proven their value to companies seeking strategic acquisitions, as evidenced in the AIG-Validus and AXA-XL Group deals. Changes in the way products are being created, marketed, and sold by wholesalers are helping accelerate M&A in the distribution segment. These deals follow Liberty Mutual’s acquisition of Ironshore last year. Ironshore’s Lloyd’s syndicate operation and Bermuda platform have provided strategic enhancements and synergistic benefits for Liberty Mutual, along with increasing top line premium growth.

Shifts in the top 25 rankings over the last five to ten years due to M&A have changed the surplus lines industry landscape considerably. Major forces such as HCC Insurance Group, First Mercury, and Allied World Assurance, which were among the top 25 as of the end of 2008 (Exhibit 9), have been acquired and merged into larger organizations such as Tokio Marine and Fairfax Financial. XL Group, which was the 15th leading insurer, will soon become part of AXA S.A. Moves in the current top 25 also reflect the impact of teams of experienced surplus lines professionals that have moved from one insurer

Exhibit 9US Surplus Lines – Top 25 Groups, 2008Ranked by direct premiums written

Rank Group Name

Surplus Lines DPW

($ Thousands)

Total Surplus Lines Market

Share1 American International Group $7,216,095 21.0%2 Lloyd's 6,062,000 17.6%3 Zurich Financial Svcs. Group 1,545,572 4.5%4 Nationwide Group 1,264,051 3.7%5 ACE INA Group 1,026,177 3.0%6 Markel Corporation Group 1,006,139 2.9%7 W. R. Berkley Group 961,611 2.8%8 CNA Insurance Companies 712,603 2.1%9 Berkshire Hathaway Insurance Group 708,065 2.1%10 Alleghany Insurance Holdings 658,183 1.9%11 Argo Group 614,325 1.8%12 AXIS Insurance Group 581,270 1.7%13 Arch Insurance Group 470,663 1.4%14 Travelers Group 445,395 1.3%15 XL America Group 406,144 1.2%16 Allianz of America 398,577 1.2%17 Chubb Group of Insurance Companies 377,885 1.1%18 HCC Insurance Group 364,024 1.1%19 Allied World Assurance Group 342,618 1.0%20 Munich Re America Corp. Group 340,405 1.0%21 RLI Group 313,799 0.9%22 Assurant Solutions 301,807 0.9%23 First Mercury Group 291,153 0.8%24 Fairfax Financial (USA) Group 281,818 0.8%25 United America Indemnity Group 259,246 0.8%

Subtotal $26,949,625 78.4%Total US Surplus Lines Market $34,365,000 100.0%


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to another, bringing not only their expertise but also controlled books of business to their new parent companies.

Ten years ago, AIG wrote more surplus lines DPW than Lloyd’s, and ACE, XL Group, Chubb, Fairfax, and HCC were already major players before the consolidations that have resulted in organizations with even greater scale advantages and influence. Ironshore, QBE Americas, Sompo Holdings, and Aspen US Insurance Group had not yet grown into the surplus lines writers they are now. A portion of the market will always be dominated by organizations focused solely on the surplus lines business, including multi-faceted organizations with multiple internal affiliates or reinsurance participants. However, because of M&A, a significant part of the surplus lines market segment now consists of subsidiaries and affiliates of national or global organizations that can be better viewed as insurance conglomerates. These organizations have a number of characteristics in common: considerable balance sheet strength, solid historical operating performance built on underwriting integrity, and well-developed enterprise risk management.

Surplus lines carriers in organizations that pool risks among their member companies or whose member companies cede 100% of their business to an affiliated reinsurer have become much more common. Such a strategy can help provide balance sheet support for affiliated direct surplus lines writers, smooth out the parent company’s underwriting results, and expand the parent’s invested asset base. As systems improve operational efficiency and data analytics provide more usable, granular information, standard market insurers will be armed with better tools to identify, underwrite, and price small business that might otherwise be outside its desired scope. For some products and classes of business, these improvements can have a meaningful impact on strategic reinsurance initiatives that companies use.

A Dynamic Market Develops More ChallengesThe sustained competitive pricing environment has been a reality for most lines of business in the P/C market. Commercial lines insurers, including surplus lines companies, have faced shrinking profit margins and the need to both develop greater efficiency and use improved data analysis to sharpen risk selection and pricing fundamentals to generate underwriting profits. This has been especially important with options to enhance investment income that has been limited by the prolonged low interest rate environment. Volatility in equity market valuations also challenges insurers, similarly to private placements that often fall short of expectations and hedge funds that are generating lower returns. Nevertheless, the allocation of P/C company investments to equity and alternative investments in search of higher returns and a better investment yield remains relatively conservative and limits downside risk. From a global perspective, the investment portfolios of US-based surplus lines insurers have a mostly domestic focus and are therefore somewhat insulated from the ultimate impact of Brexit.

The distribution landscape has become tougher to navigate, as many retailers likewise limit the number of wholesalers with which they work. Advantages in the distribution marketplace reside more with the larger wholesalers with greater scale and greater influence in the market. Many surplus lines company executives have told A.M. Best that the flow of qualified submissions from their intermediaries has never been more plentiful, providing opportunities for growth despite the challenges of heavy competition and profit margin compression.

Although their freedom from rate and form-filing regulations gives surplus lines insurers flexibility in setting rates, price sensitivity challenges their ability to charge adequate rates. The growing number of companies willing and able to write non-standard business is pressuring established carriers on price, terms, distribution, and service. Nonetheless, given the segment’s

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track record of generating underwriting profits, the surplus lines market will remain an attractive investment for parties both inside and outside the industry.

Furthermore, insurance companies have learned to take advantage of a world driven increasingly by data, leveraging big data to help improve different aspects of operations, from sales to underwriting—connected devices and wearables can also help insurers better manage risk, optimize sales opportunities, and boost intermediary and policyholder loyalty. Surplus lines insurers are using cleaner available data in analyses to develop more sophisticated and accurate predictive patterns and trends of loss for different classes of risk and lines of business—which can lead to better pricing and optimized business strategies. Surplus lines insurers are among the market leaders in this regard, allowing the segment’s insurers, especially the more proven specialists, to be first to market with new products and coverages for exposures such as cyber liability, new technology companies in the context of an evolving gig economy, as well as the burgeoning risks associated with the expanding cannabis industry.

Thirty states and the District of Columbia have passed laws broadly legalizing marijuana in some form; eight states and DC have adopted the most expansive laws legalizing marijuana for recreational use. As a result, a growing number of people in the country are being employed in the marijuana industry. The upshot from a surplus lines perspective is that this more legitimized industry is now in need of creative coverage solutions from both personal and commercial lines perspectives. Insuring cannabis-related risks will require the type of creativity that has long been the strong suit of surplus lines companies. However, most insurers (including Lloyd’s) that withdrew from the cannabis market in 2015 are not providing related coverage because it is still illegal under federal law in the US.

Along the same lines of exploiting creativity, the companies making the best use of insurtech advances should find themselves in a good competitive position. New technologies will not change the fact that when solutions for new exposures are needed, the surplus lines segment’s core competencies foster a more creative environment in which to innovate advanced solutions.

Underwriting and pricing acumen have been the bedrock of the surplus lines market, and the toughest times in competitive market cycles have always intensely challenged insurer underwriting discipline—times that highlight the expertise of the surplus lines insurers, particularly the leading groups writing the majority of the segment’s premium. Pre-loss safety and control measures and post-loss claim handling strategies that are clearly integrated into the insurers’ risk decision-making, differentiated as needed for appropriateness by line of business or risk class, are also qualities that help surplus lines companies expertly assess and price unique or large scale risks.

The major question now is whether the surplus lines market has the wherewithal to design and implement coverage for the next wave of new products, as it has so often in the past. As market dynamics continue to change at an unprecedented and accelerating pace, maintaining strict adherence to proven principles and fostering the creativity—the surplus lines companies’ hallmark—that leads to solutions for new insurance exposures will be critical. Success in this endeavor will be paramount, if the surplus lines market is to maintain its importance in the P/C industry.

In light of the growing interest in the surplus lines market, the wealth of capital available to insurers, and the number of players outside the market looking for an opportunity to get in, surplus lines insurers will find retaining market share while preserving profitability

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Service Offices Report Record Breaking Surplus Lines Growth in 2017

According to the Surplus Lines Stamping Office of Texas, which captures insurance data from service offices across the US, surplus lines service offices in 15 states experienced a 6.4% increase in surplus lines insurance premium, ending 2017 at $28.2 billion, up from $26.5 billion in 2016. The reported number of recorded filings for surplus lines business also grew significantly, 9.9%. A change in the number of filings provides a rough estimate of the flow of business into and out of the surplus lines market.

Premium growth was driven primarily by the addition of a new North Carolina service office as well as the increase in demand for surplus lines policies represented by the increase in filings. The annual data includes premium and filing totals from stamping offices in 15 states depicting the landscape of the excess and surplus lines marketplace in the four primary US regions—the Northeast, Midwest, South, and West. The South, which according to A.M. Best data includes the number two (Florida) and three (Texas) states by surplus lines DPW, and the new North Carolina service office, accounted for the highest amount of surplus lines insurance premiums—approximately $11.8 billion—and solid growth at 6.8%. Texas reported its best surplus lines premium year, ending at $5.6 billion.

Every service/stamping office reported increases in both premium and policy filings, with the largest growth in Minnesota (26.6%) and Utah (19.2%). Other states that saw double-digit premium growth included North Carolina (17.1%), Oregon (16.8%), Arizona (16.4%), and Nevada (12.4%). In Nevada, the growth was attributable to staffing for mega factories that created a surge for housing, resulting in a residential construction boom, and the legalization of recreational marijuana and its related operations. In Utah, the growth was specifically attributed to the dissolution of the Non-Admitted Insurance Multi-State Association (NIMA), a multi-state tax sharing compact that ceased to exist.

California, Florida and New York remained major producers of surplus lines business, generating a total of $15.7 billion in premium: California ($6.5 billion), Florida ($5.2 billion) and New York ($4.0 billion). In a year dominated by numerous natural and weather-related catastrophes, the growth in the surplus lines market reflected the ability of intermediaries in the wholesale insurance industry to remain on task, working with companies to innovate coverages to meet both customer needs and the challenges of new/emerging markets.

Through June 2018, according to the Surplus Lines Stamping Office of Texas, premium growth by the 15 service offices rose a reported 9.4%, with total premium reaching $15.7 billion, up $1.4 billion from first half 2017; the number of transactions increased as well, by 5%. Filings grew 10% in seven states: Illinois, Minnesota, North Carolina, Nevada, Oregon, and Pennsylvania. The four largest states also saw significant increases in premium volume: California, 8%; Florida, 10%; Texas, 11%; and New York, 13%, accounting for $12.1 billion of the total $15.7 billion in premium—the lion’s share of US surplus lines premium volume—in the first half.

As was the case with the annual results for 2017, the southern region of the US service offices (consisting of Florida, Texas, North Carolina, and Mississippi) accounted for $6.95 billion in premium, the most premium for any region, with Florida and Texas accounting for 92% of the total in first half 2018. However, Washington (18%) and Utah (16%) realized the greatest spikes in premium year over year. Surplus lines premium also rose in Oregon (9%), Arizona (8%), and Idaho (7%).

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quite a challenge. The surplus lines market has traditionally been a wholesale broker-driven business and will always be subject to price-sensitivity. The disruption in the market due to M&A increases the possibility that clients will shop for the lowest rate or price for their insurance program. Whether policyholder concerns are related to catastrophe-exposed property business or complex liability issues, the appropriate use of numerous resources, technological innovations, and improved analytics to address policyholder needs will separate top competitors from the rest of the market.

In 2018, tax reform, lower catastrophe losses year to date and a growing economy have been the key factors affecting P/C insurers so far. Insurers have reportedly chosen to significantly decrease the portion of premiums ceded to their non-US affiliates, owing to concerns about possible tax implications under the new tax law. Results have been helped by larger reserve releases owing to the lower cost of prior years’ claims, although expectations for across-the-board rate increases have largely not been met, as only targeted lines such as commercial auto (including trucking, directors and officers liability, and excess liability) have reportedly benefited from sizable increases.

Section II: Financial Performance and Ratings DistributionIn this section, we examine the financial performance of A.M. Best’s Domestic Professional Surplus Lines (DPSL) composite, which is composed of some of the leading companies in the surplus lines segment. We believe that the composite provides an accurate picture of the overall segment’s financial performance. This section also discusses A.M. Best’s ratings on the DPSL composite companies, in comparison to the overall P/C industry.

The companies in the DPSL composite generated approximately $18.4 billion in DPW in calendar year 2017, accounting for approximately 41.3% of the total surplus lines market and 61.0% of the entire DPSL market. These are companies that write more than 50% of their business on a nonadmitted basis.

Overall, the DPSL composite’s bottom line results were again largely affected by the net results of the segment’s largest single insurer, Lexington Insurance Company. In 2017, Lexington alone accounted for 36.2% ($4.2 billion) of the composite’s NPW, 38.0% of net premiums earned (NPE), and 45.0% of incurred loss and loss adjustment expenses (LAE). Considering its size, the company’s 2017 underwriting and operating results, although in some ways improved in 2017, still skewed the results of the DPSL composite, as we will highlight in the next section.

A.M. Best’s DPSL Composite

The analysis in Section II is based on the statutory financial data of the 70 US-based DPSL companies, although not all of the companies identified in Appendix B as Domestic Professional Surplus Lines companies are included in this special composite. When creating the composite for this section, A.M. Best excluded any surplus lines companies that (1) are members of intercompany pools that write predominately admitted business, as opposed to surplus lines business; (2) reinsure all of their business with an affiliate; or (3) write a relatively small amount of premium. The composite does include companies that may be part of an intercompany pool but still write surplus lines business on a predominantly direct basis and retain a meaningful portion of it.

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DPW Volume IncreasesThe composite’s aggregate DPW increased 5.6% in 2017, following a decline of 2.5% in 2016, the first decline in five years. The five-year compound annual growth rate (CAGR), however, declined to 2.8% from 3.6% at the end of 2017, largely because the largest recent year-over-year increase in DPW (9.8% in 2012) now falls outside the five-year calculation. In calendar year 2012, the composite generated the largest amount of top line growth since the 12.7% growth in 2006, a year affected by property rate increases following two years that were heavily impacted by active North Atlantic hurricane seasons.

The DPSL composite’s DPW in 2017 was augmented by the 10% increase in documents filed with surplus lines service offices we noted earlier. A significant number of new small accounts arising as the economy continued to improve, along with significant price competitiveness, likely factored into top line premium growth in the nonadmitted market falling short of the magnitude of growth in the number of items filed.

Net premium written (NPW) volume for the composite declined 3.8% in 2017, compared to the 5.8% drop in 2016. An increase in the amount of ceded premium and the resulting five percentage point drop in the composite’s aggregate net retention of gross premium (comprised of direct and assumed premium) helped drive the decline in net premium.

Three Major Lines of Business Account for Nearly 70% of Direct Premium WrittenGeneral liability business (coded as Other Liability for NAIC statutory reporting) easily accounts for the largest share of both direct and net premiums written by the DPSL composite (Exhibit 10). This includes business written on both an occurrence basis and on a claims-made basis, with the latter classification largely entailing professional liability coverage. Outside of the general liability line, the only other line of business with a double-digit percentage of the composite’s total business written is allied lines. This business (property coverage that is almost always bought in conjunction with a fire policy and that covers perils such as water damage, wind damage, sprinkler leakage, or vandalism) increased to 11.5% of the composite’s DPW in 2017, up from 9.7% the year prior. Of the other lines of business, the fire (commercial property) business was the only one that came close to a double-digit share of DPW, at 9.7%, after accounting for 10.2% in 2016. Once again, more than 80% of the DPSL composite’s direct premium was attributable to the segment’s five leading lines of business.

Exhibit 10DPSL Peer Composite – Top 5 Product Lines, 2017 vs. 2016Ranked by Direct Premiums Written

Rank Product Line

2017 Surplus Lines DPW

($ Thousands)

2017DPSL Peer Composite

Market Share (%)

2016 Surplus Lines DPW

($ Thousands)

2016DPSL Peer Composite

Market Share (%)

YoY DPW Change (%)

1 Other Liability 8,742,348 47.6 8,394,340 48.4 4.12 Allied Lines 2,108,479 11.5 1,676,227 10.2 25.83 Fire 1,603,584 8.7 1,767,165 9.7 -9.34 Inland Marine 1,285,587 7.0 1,177,283 6.8 9.25 Commercial Multi-Peril 962,518 5.2 1,002,482 5.8 -4.0

Subtotal of Top 5 14,702,516 80.1 14,017,497 80.8 4.9Total DPSL Peer Composite 18,357,457 100.0 17,349,959 100.0 5.8

Note: "Other Liability" consists primarily of commercial occurrence and claims made general liability policies.Source: A.M. Best data and research

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Devastating Catastrophe Year Significantly Impacted 2017 ResultsOverall underwriting and operating results for the DPSL composite were essentially on par with 2016 results, although the primary drivers of those results differed. In 2017, the impact of catastrophe and weather-related losses was offset largely by improved performance on other leading lines of business, and was thus the main reason that net underwriting loss was only slightly worse for the year. Nonetheless, bottom line results for 2017 were acutely impaired by the devastating impact of catastrophe and other weather-related losses. The impact was particularly evident in the results for the allied lines, for which the composite posted a 146.1 pure net loss ratio following the comparatively benign catastrophe years from 2013 to 2016, during which the allied lines loss ratio ranged from a low of 58.5 to a high of 69.5. The 2017 result was the worst since the Superstorm Sandy-impaired results of 2012, which resulted in a 180.1 pure net loss ratio for the composite.

The entire P/C industry felt the impact of the weather-related losses on its bottom line in 2017, but the level of deterioration was worse for the surplus lines composite. On a strict accident year basis, if we look solely at the impact of 2017 loss events on the year’s underwriting performance, the composite suffered a 15 percentage point deterioration in its accident year loss and LAE ratio, year over year. This compared unfavorably to the less than five percentage point deterioration in the accident year loss and LAE ratio for the P/C industry overall, underscoring the volatility associated with weather- or catastrophe-exposed business and the impact it can have on an industry-wide portfolio of surplus lines risks, which include catastrophe-exposed risks that cannot find coverage in the standard market.

Net Underwriting Results Again Negatively Impacted by Results of Largest Composite Member In 2017, the net underwriting results for the DPSL composite deteriorated for a third year in a row, with Lexington impacting those results substantially. Lexington generated an underwriting loss that was markedly less than in 2016 but still sizable. Excluding Lexington from the results, the DPSL composite would have generated a small underwriting profit and a net combined ratio of 97.9, a full six percentage points better than the P/C industry’s 103.9 calendar year combined ratio. Lexington’s elevated net loss and LAE ratio of 90.8 and combined ratio of 123.1 had an outsized impact on the composite’s figures, similar to the effect the company’s results had on the composite’s performance in 2016. Nonetheless, the impact was not as adverse in 2017 as in 2016, because, although the company’s overall performance was unfavorable, it did report across-the-board improvements in several key underwriting metrics, including its pure loss, loss and LAE, combined, and operating ratios.

Additionally, although the deterioration in Lexington’s 2016 underwriting results was due mainly to unfavorable prior year loss reserve development attributable to both Other Liability – Occurrence and Claims-Made business (comprising the General Liability line of business) and to its workers’ compensation business, in 2017, both of these lines reported favorable prior year loss reserve development. This enhancement augmented the decidedly more improved company pure net loss ratio results for both lines of business. The DPSL composite likewise posted substantially improved pure net loss ratios on these two lines of business.

As Exhibit 11 shows, in 2017, the DPSL composite’s combined ratio remained relatively steady at 107.4 (107.8 in 2016), while the combined ratio for the entire P/C industry deteriorated by more than three percentage points, continuing its worsening trend since the beginning of 2014. The composite’s net loss and LAE ratio edged upward, as NPE declined by a larger amount, 6.8%, than the 5.6% decline in net losses and LAE expenses incurred. However, the composite’s underwriting expense ratio dropped by more than a percentage point in 2017 and contributed to the combined ratio remaining relatively static.

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Despite generating unfavorable results in the last two years, the DPSL composite’s underwriting performance remains in line with that of the broader P/C industry over the last five years, and compares a little more favorably over the longer, ten-year term. The composite’s five-year average combined ratio of 99.4 is slightly higher than the P/C industry’s 99.3, but it has outperformed the industry over the last ten years, with an average combined ratio of 99.2 compared to the industry’s 101.4. The combined ratio results for the DPSL composite and the total P/C industry have been converging of late, as evidenced by a two-point difference in the comparative ten-year average combined ratios through the end of 2017, compared to the five-year average combined ratios, which were virtually the same. Since 2000, the DPSL composite has generated a calendar year combined ratio higher than that of the broad P/C industry in only four years—in 2012, 2015, 2016 and 2017, all within the past six years—spurring the recent convergence in underwriting results.

Taking into account both underwriting and investment results, the DPSL composite posted a slightly better operating ratio than the broad P/C industry in 2017 (93.9 to 94.6). Over the longer term, the composite’s average operating ratios of 82.7 (five years) and 82.8 (ten years) have clearly been superior to the total P/C industry’s respective 89.4 and 90.8. However, the more than six-point jump in the composite’s loss and LAE ratio the last two years drove it higher than the P/C industry’s loss ratio in both years (Exhibit 12).

Favorable Operating Results ContinueWith regard to the key financial indicators for both the DPSL and the total P/C industry, Exhibit 13 shows that the percentage decrease in losses incurred for the composite was slightly larger than the decrease in NPE. However, LAE actually rose 8.2%, leading to the slightly higher loss and LAE ratio for the composite. Overall, the composite’s underwriting performance was basically on par with results in 2016, although still unfavorable considering the more than $900 million underwriting loss. The total P/C industry’s underwriting loss increased three-fold, driven by poor property results,

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100

110

120

Com

bine

d R

atio

DPSL P/C Industry

Exhibit 11US DPSL Composite – Combined Ratios vs. US P/C Industry, 2000-2017


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affecting the homeowners and commercial property lines in particular, including allied lines. The higher loss and LAE totals outweighed the P/C industry’s modest increase in earned premium. Despite the underwriting loss, however, the DPSL’s overall operating results benefitted from solid net investment income of $1.5 billion—a figure that

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85

90

Net

Los

s an

d LA

E R

atio

DPSL P/C Industry

Exhibit 12US DPSL Composite – Net Loss & Loss Adjustment Expense Ratios vs. US P/C Industry, 2000-2017


Exhibit 13

($ Billions)

12 Months 2016

12 Months 2017

YoY % Change

12 Months 2016

12 Months 2017

YoY % Change

Net Premiums Written 12.1 11.7 -3.8 538.1 562.3 4.5

Net Premiums Earned 12.2 11.4 -6.8 533.3 550.2 3.2

Pure Losses Incurred 8.0 7.4 -7.6 323.1 352.9 9.2

Loss Adjustment Expenses (LAE) 1.2 1.3 8.2 62.0 65.2 5.2

Losses & LAE 9.3 8.7 -5.6 385.1 418.1 8.6

Underwriting Expenses 3.9 3.6 -7.7 149.9 153.4 2.4

Policyholder Dividends 0.0 0.0 19.8 3.3 3.6 11.6

Underwriting Income (Loss) -0.9 -0.9 0.0 -4.9 -24.9 411.3

Net Investment Income 1.9 1.5 -18.7 48.0 51.1 6.4

Other Income/Loss 0.2 -0.3 N/M 1.0 -5.4 N/M

Pretax Operating Income 1.2 0.4 -70.2 44.2 20.9 -52.8

Realized Capital Gains/Losses 1.0 0.5 -51.2 8.1 15.7 94.5

Federal Income Taxes 0.0 -0.1 N/M -7.4 0.6 N/M

Net Income 2.2 0.7 -66.5 44.9 37.2 -17.1Note: Figures may not add due to roundingN/M = Not MeaningfulSource: A.M. Best data and research

DPSL Composite Total US P/C Industry

US DPSL Composite – 12-Month Financial Indicators, 2016-2017

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still represented an 18.7% year-over-year decline, with long-term bonds and affiliated investments in particular generating less investment income.

The composite’s lower investment income was unable to offset the net underwriting loss, which led to a 70% year-over-year drop in pretax operating profit from $1.2 billion to $306 million. Net income likewise declined significantly, from $2.2 billion to $728 million, due also in part to a sizable drop in realized capital gains from the sale of owned securities, from $987 million to $482 million. The broader P/C industry also saw significant declines in pretax operating income (53%) and net income (17%), reflecting the impact of the same weather-related events (wildfires, etc.) that plagued the composite’s performance. The drop in the overall P/C industry’s net income, however, would have been much greater if not for a 95% increase in realized gains.

A 6.4% increase in investment income helped the P/C industry offset the higher underwriting loss and led to almost $21.0 million in pretax earnings—although that total was still less than half the pretax earnings in 2016. As noted, investment income for the composite was down, by a little under 20%, and along with the slightly higher underwriting loss, resulted in the considerable drop in the composite’s pretax earnings. Both the composite and the broader industry benefitted from realized gains, although the benefit was muted by a decline in gains, especially in the case of the DPSL composite, whose realized gains were cut by half year over year. Ultimately, the result for both the composite and the total industry was a decline in net income in 2017—again, with the decline (66.5%) in the composite’s net income being much larger than the decline in the total industry’s (17.1%).

Notwithstanding the decline in underwriting results in 2016 and 2017, the composite’s balance sheets, on an aggregate basis, remain strong. The impact of the weather-related losses on the surplus lines market is tempered by the line of business distribution, which remains decidedly weighted toward liability exposures. This has, in turn, allowed the composite to maintain solid risk-adjusted capitalization despite the impact of major weather-related catastrophe loss years in 2005 (Hurricanes Katrina, Rita, and Wilma); 2012 (Superstorm Sandy); 2016 (Hurricane Matthew); and 2017 (Hurricanes Harvey, Irma and Maria, and the California wildfires).

This type of loss activity reveals the inherent volatility associated with the role that the surplus lines market plays for catastrophe-exposed business and the impact that underwriting those exposures can have in active catastrophe years. A close look at the composite’s direct loss ratios shows that, in recent years, with the expanding impact of pooling and reinsurance agreements on the surplus lines carriers, net calendar-year results have not necessarily reflected the performance driven primarily by the traditional surplus lines business. In years prior to the historic catastrophe loss totals of 2017, removing the impact of assumed business on net loss ratios and focusing only on the business that the DPSL companies compete for and write directly in the market yielded lower direct pure loss ratios than net pure loss ratios. In 2017, however, the loss activity consisted largely of catastrophe-exposed risks, the type that the admitted market typically leaves to surplus lines insurers to underwrite because of the higher inherent loss potential of the risks. This led to the composite’s direct pure loss ratio of 69.4 exceeding its net pure loss ratio of 65.9. In 2016, a year in which the insurance industry’s losses were less driven by catastrophe losses, the direct pure loss ratio of 56.6 for the composite was much lower than its 66.0 net pure loss ratio.

Considerations When Analyzing Operating Profitability and Balance Sheet StrengthSome of the organizations competing in the surplus lines segment have implemented strategies to enhance operational flexibility and balance sheet capacity. For example, firms

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have implemented risk-sharing measures such as internal reinsurance programs and pools, distributing risks across US-based and foreign-domiciled affiliates, for both the admitted and nonadmitted carriers in their organizations. The establishment of multiple carriers in an organization and the consolidation of statutory reporting across the entire organization reflects its operational success. However, the resulting blurring of statutory reporting lines among carriers makes discerning the results specific to individual carriers more difficult.

An examination of the differences in DPW and NPW by line of business shows that surplus lines carriers in some of the organizations that pool or share risks via reinsurance cessions are carrying a larger risk load. For example, the composite’s group accident and health and workers’ compensation DPW totals are well below 1% of its total DPW but make up 4.6% and 3.3% of NPW after the assumption of some business, largely from affiliates. Additionally, depending on the line of business, whether short or long tail, the distribution of net loss and LAE reserves can be somewhat incongruous with the actual business a surplus lines insurer is competing for on a direct basis. Lexington Insurance Company, for example, writes virtually no workers’ compensation premium on a direct basis, yet, through pooling, that line of coverage accounted for 17.8% of the net loss and LAE reserves on the company’s books at the end of 2017.

Net Investment Income DropsThe DPSL composite’s net investment income in 2017 dropped noticeably, by 18%, to a little over $1.5 billion (Exhibit 14), leading to a decline in net overall investment gains. The total investment return for the P/C industry grew 77%, primarily because of the positive impact of both realized and unrealized gains. For the DPSL composite, unrealized losses diminished total investment returns somewhat in 2016, but total investment return made a huge turnaround in 2017, benefitting substantially from unrealized capital gains.

Because of the decline in net investment income, the composite’s net investment ratio (net investment income as a percentage of net premiums earned) of 13.5 was down from 15.5 a year earlier. The 2017 result was even more noticeable in comparison to the composite’s five-year average of 16.7. Nonetheless, the composite’s net investment ratio for both 2017 and the most recent five-year period exceeded the total P/C industry’s respective 9.3 and 9.8.

The composition of invested assets has been relatively stable for both the composite and the P/C industry, given that insurance companies are maintaining their conservative investment

Exhibit 14

($ Millions)YoY

ChangeYoY

Change2016 2017 (%) 2016 2017 (%)

Net Investment Income 1,889 1,545 -18.2 47,988 51,096 6.5

Realized Capital Gains/Losses 987 482 -51.2 8,086 15,729 94.5

Net Investment Gain/Loss 2,876 2,027 -29.5 56,074 66,825 19.2

Unrealized Capital Gains/Losses -644 2,047 N/M 15,618 59,957 283.9

Total Investment Return 2,232 4,074 82.5 71,692 126,782 76.8N/M = Not MeaningfulSource: A.M. Best data and research

DPSL Total P/C Industry

US DPSL Composite – Investment Performance vs. P/C Industry

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strategies while carefully considering alternatives to increase yield in the low interest rate environment. Common stock leverage (total common stocks/policyholder’s surplus) for the composite remained slightly above that of the total P/C industry, with some of the composite’s insurers increasing their stock positions in 2017. However, the insurers that have done so have maintained to A.M. Best that their current allocations remain within stated risk tolerance levels.

Interest rates are likely to continue rising at a very deliberate pace in 2018, with equity allocations likely at or close to their risk tolerance levels, while the appetite for alternative investments remains modest. The bottom line for our DPSL composite is that, by total return measures, 2017 results—return on revenue (ROR) of 24.3 (compared to 12.5 in 2016) and return on equity (ROE) of 11.2 (compared to 6.3)—were much improved year over year and once again more in line with long-term averages. Due to the drop in net investment income, however, pretax return measures were far below those averages.

Loss Reserve Development TrendsFor the P/C industry as a whole, the favorable loss reserve development that has bolstered the financial results of many insurance companies has been diminishing slowly but steadily. Historically, the impact of favorable prior year development on current calendar year underwriting results has varied by segment. A.M. Best has in the past noted before that current calendar year operating results for companies may not much longer be able to count on the benefits of considerable prior accident year loss reserve redundancies in certain lines of business, particularly longer-tail lines such as auto liability, general liability, and workers’ compensation. Companies must continually re-assess reserve levels to ensure that they remain adequate. With no repeat of the anomalies for the composite caused by Lexington’s need to substantially bolster reserves in 2016 for multiple lines of business, the DPSL composite experienced very favorable prior year development in 2017, of just over $1.1 billion, which represented 9.8 points of benefit to the reported calendar year loss and LAE ratio. The 2017 prior year reserve development represented a stark turnaround for the workers’ compensation and other liability (occurrence) lines of coverage, in particular reflecting the positive turnaround in Lexington’s reserve actions in 2017.

Reserving trends for the DPSL composite indicate that the cushion with respect to the development of reserves from where they were initially set had been diminishing the past couple of years coming into 2017. For both calendar year and accident year loss reserve measures, the amount of favorable development had declined and already appears adverse for older, pre-2010 accident years. Driven largely by the turnaround in reserve development reported by Lexington, adverse prior year reserve development for calendar year 2017 benefitted the composite’s 107.4 calendar year combined ratio by 9.8 points, following the aberrant 2016 year when reserve development added 8.8 points to the composite’s 107.8 combined ratio. The P/C industry’s favorable development also improved, with its calendar year combined ratio of 103.9 representing a turnaround of sorts for the year, as the shrinking impact of favorable development on results was reversed.

Direct Premium Versus Net Premium Growth TrendsThe DPSL’s net premium growth over the last several years has been clouded by new pooling agreements between affiliates writing surplus lines business—in 2017, the composite’s 3.8% NPW decline was easily outpaced by the P/C industry’s modest 4.5% NPW growth (Exhibit 15). However, direct premium volume, which is not affected by pooling arrangements, serves as a more accurate measure of surplus lines segment growth. Although the DPSL composite’s direct premium volume declined 5.6% in 2017, it has grown 14.6% over the last five years, modestly trailing the 22.7% growth for the P/C industry. However, focusing

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solely on 2017, the P/C industry’s 4.7% DPW growth lagged that of the DPSL composite’s. The CAGRs over those five years are also relatively close: 2.8% for the DPSL composite and 4.2% for the P/C industry.

-30

-20

-10

0

10

20

30

40

50

60

70

80

90

Cha

nge

in N

PW (%

)

DPSL P/C Industry

Exhibit 15US DPSL Composite vs. P/C Industry – NPW Growth, 1974-2017


0

10

20

30

40

50

RO

R (%

)

DPSL P/C Industry

Exhibit 16US DPSL Composite – Pretax Returns on Net Premiums Earned vs. US P/C Industry, 2005-2017


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Policyholders’ Surplus and Operating Returns Fortify Balance SheetsDespite the net underwriting loss and decline in investment income, the composite’s policyholders’ surplus grew almost 8.0% from year-end 2016, driven primarily by the more than $2.0 billion in unrealized gains, and ended 2017 at $25.8 billion. Although pretax and net earnings were down year over year, the composite generated a pretax ROR of 3.2%, despite falling well short of the 9.8% return in 2016. This pretax return, however,

-20

-10

0

10

20

30

RO

E (%

)

DPSL P/C Industry

Exhibit 17US DPSL Composite – Total Returns on Surplus vs. P/C Industry, 2005-2017


Exhibit 18

($ Billions)

12 Months

2016

12 Months

2017YoY %

Change

12 Months

2016

12 Months

2017YoY %

Change

Beginning Policyholders' Surplus (PHS) at Prior Year End 24.5 23.9 -2.2 705.8 735.1 4.2

Net Income 2.2 0.7 -66.9 44.9 37.2 -17.1

Unrealized Capital Gains/Losses -0.6 2.0 418.8 15.6 60.0 -284.6

Contributed Capital 0.1 0.1 49.2 -2.1 7.4 -456.5

Stockholder Dividends -1.9 -0.8 -54.6 -28.4 -29.6 4.3

Other Changes -0.3 -0.2 40.3 -0.7 -22.8 N/M

Ending Policyholders' Surplus 23.9 25.8 7.8 735.1 787.2 7.1

Change in PHS from Prior Year End ($) -2.2 7.8 N/M 4.2 7.1 68.8

After Tax Return on Surplus (ROE) (%) 6.3 11.2 77.8 8.4 12.8 52.4Note: Figures may not add due to rounding.Source: A.M. Best data and research

DPSL Composite Total US P/C Industry

US DPSL Composite – 12-Month Change in Policyholders' Surplus, 2016-2017

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was commensurate with the overall P/C industry’s 3.8% return. As Exhibit 16 shows, the composite had consistently generated higher pretax returns on revenue than the P/C industry for a decade—until last year, owing to the impact of the heavy catastrophe loss year on results. The DPSL composite’s total ROE (surplus) has alternately been modestly higher or modestly lower than the total P/C industry’s ROE, often reflecting striking year-over-year differences in unrealized gains, and to some extent, in stockholder dividends (Exhibit 17).

Although the composite appears to maintain sufficient policyholders’ surplus to support its business risks, stockholder dividends have been significant, amounting to approximately $12.4 billion over the past five years. However, management teams of companies appear to have been managing dividend declarations responsibly, given that dividends declared have declined in each of the last three years, as the composite’s pretax income has declined. The composite’s dividends are generally based on overall profitability (Exhibit 18).

Underwriting leverage ratios have historically been lower for the DPSL composite than for the P/C industry. Ceded leverage remains the exception, running higher for the composite, at 1.0 times policyholders’ surplus, compared to 0.5 for the P/C industry. The difference remains minimal for the surplus lines industry, as its 2.9 gross leverage ratio remained in line with the P/C industry’s 2.8. Judicious use of reinsurance to mitigate exposures is a sign of prudent capital management. Disciplined expansion of reinsurance coverage is likely, given that reinsurance market conditions remain competitive and still favor the buyer for most

Exhibit 19

Category Rating LevelRating

Units %Rating

Units %aaa 1 1.0 3 0.4

Sub-Total 1 1.0 3 0.4aa+ 8 8.3 19 2.4aa 6 6.3 21 2.7aa- 19 19.8 50 6.3

Sub-Total 33 34.4 90 11.4a+ 15 15.6 92 11.6a 26 27.1 185 23.4a- 17 17.7 267 33.8

Sub-Total 58 60.4 544 68.8bbb+ 3 3.1 35 4.4bbb 1 1.0 48 6.1bbb- 0 0.0 42 5.3

Sub-Total 4 4.2 125 15.896 100.0 762 96.4

Fair bb+, bb, bb- 0 0.0 19 2.4Marginal b+, b, b- 0 0.0 5 0.6Weak/Very Weak ccc+, ccc ,ccc-, cc 0 0.0 2 0.3Poor c 0 0.0 0 0.0Reg. Supervision/Liquidation e / f 0 0.0 2 0.3

0 0.0 28 3.596 100.0 790 100.0

Domestic professional surplus lines ratings are as of July 25, 2018.Total industry ratings data is as of June 14, 2018.Source: A.M. Best data and research

US DPSL Composite – Best's Ratings by Rating Unit vs. P/C Industry

Superior

Excellent

Total Issuer Credit Ratings

Total P/C Industry

Good

Exceptional

DPSL

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lines of business, with broader terms and conditions and lower rates available, especially for companies whose results have experienced relatively low volatility over the long term.

The health of the composite members’ balance sheets can also be assessed by the quality of the invested asset base. Bonds at the highest rating levels—US government and NAIC Classes 1 and 2—constituted over 94% of bond holdings, in line with the quality of the P/C industry’s holdings.

Ratings DistributionAs Exhibit 19 shows, DPSL insurers have a higher proportion of issuer credit ratings in the “Exceptional,” “Superior,” “Excellent,” and “Good” categories than the overall P/C industry. As of July 25, 2018, 100% of the ratings on the A.M. Best-rated DPSL rating units were in these categories, compared to 96.5% for the total P/C industry.

The percentage of DPSL insurers in the top-tier rating categories of Excellent to Exceptional remained extremely high, at 96%, with 92 out of 96 rating units in the top tier. Over the last several years, the number of DPSL rating units has declined slightly, owing primarily to intragroup consolidations and M&A in the surplus lines market. In some cases, the use of new quota-share reinsurance or reinsurance pooling agreements resulted in multiple rating units merging into single rating units.

For the P/C industry overall, the number of rating units in the Excellent to Exceptional categories improved slightly during the past year, with 80.6% of the ratings in the top tier, compared with 78.6% through mid-2017. The DPSL composite’s rating median remains higher, at “a,” than the P/C industry’s “a-.”

Section III: Regulation and LegislationCongress and the current administration continue to face numerous issues related to the economy, health care, federal regulation, and domestic and foreign terrorist threats, as well as issues spanning numerous other areas. As the economy evolves and innovation progresses, surplus lines insurers continue to play a key role in developing solutions for new risks and emerging exposures along with improving coverage for known risks.

Dodd-Frank Repeal Actions and the Impact on Surplus Lines Regulation On May 24, 2018, President Donald J. Trump signed the Economic Growth, Regulatory Relief and Consumer Protection Act, a major financial regulatory package. This legislation dealt largely with non-insurance issues but does roll back a number of regulations applicable to financial institutions originating in the Dodd-Frank Wall Street Reform and Consumer Protection Act adopted in 2010 after the financial crisis. During the 2016 presidential election, Trump had pledged to dismantle Dodd-Frank, criticizing the regulatory burdens it imposed and contending that it was impairing US economic growth and discouraging lending by banks; he touted this bill as the first step in that process. Dozens of banks have been relieved from more stringent Federal Reserve oversight as a result, although the bill falls short of a full repeal or replacement of Dodd-Frank.

The legislation also included a requirement that federal officials engaging in international insurance negotiations consult with state insurance regulators. The provision, the International Insurance Capital Standards Accountability Act, requires greater transparency in international discussions and mandates that US negotiators achieve consensus positions through the National Association of Insurance Commissioners (NAIC). Although much of the bill aims to

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rescind provisions of Dodd-Frank, neither the president nor his advisers have directed much specific criticism at Dodd-Frank’s impact on the insurance industry, other than rules proposed to help stabilize the health insurance markets.

In March 2018, the Senate confirmed Trump nominee Thomas E. Workman as the next independent member with insurance expertise to serve on the Financial Stability Oversight Council (FSOC), replacing S. Roy Woodall. The president had nominated Mr. Workman to the position on January 8, 2018. The language in the new law allows the independent member to serve up to 18 months after the end of his or her five-year term, or until a successor is appointed. The president’s actions came after he signed the FSOC Insurance Member Continuity Act on September 5, 2017.

The surplus lines industry is also closely following attempts to repeal more provisions of Dodd-Frank via the Financial CHOICE Act, given that the Nonadmitted and Reinsurance Reform Act of 2010 (NRRA) was passed as part of Dodd-Frank. The NRRA significantly improved the regulation and taxation of surplus lines transactions and remains a foundation for surplus lines insurance operations. The NRRA’s surplus lines reform provisions, which took effect in July 2011, simplified the regulation and taxation of the industry, whereby an insured’s home state is the only jurisdiction with authority to regulate and tax surplus lines transactions.

Congressional Action on Private Flood Insurance In recent years, Congress has pushed legislation promoting and developing private market solutions for flood insurance that could greatly aid American citizens. Although the surplus lines market has long written flood insurance policies for commercial properties or homes, flood reform legislation is still critical to the industry, to clarify that lenders may accept private flood insurance policies, including those written by surplus lines insurers, to fulfill a mortgagee’s mandatory purchase requirement.

The National Flood Insurance Program (NFIP) was scheduled to expire on September 30, 2017, in accordance with the Biggert-Waters Act of 2012. Congress began negotiating various program reforms and the length of reauthorization early in the session. No major reform bills were passed by either house; as a result, on September 26, Congress passed the first short-term extension of the program to December 8. The program would receive another six short-term extensions, with the current extension set to expire on November 30, 2018. Congress continues to struggle with how the highly indebted program should be reformed, and when or if the program will receive a long term extension or reforms is unknown, but, with so many states being impacted by flooding, it remains a top priority and hot issue in Congress.

Below, we provide details on other flood insurance-related bills:

• The Flood Insurance Market Parity and Modernization Act, H.R. 1422, would be helpful not just to surplus lines insurers, but also to lenders, consumers, and private insurers, because it would clarify that flood insurance policies written by private carriers can satisfy the mandatory purchase requirements for both personal and commercial mortgages while providing consumers with more insurance choices. The House has passed versions of this legislation four times since it was first introduced in 2015, but the Senate has not yet taken action. The private insurance industry, especially surplus lines insurers, as well as the banking, real estate, building, and other related industries have asked for the clarifications in this legislation since the initial implementation of the Biggert-Waters Act of 2012, when language defining private flood insurance inadvertently created confusion as to how the lending community can accept private policies in lieu of an NFIP policy, for the purpose of

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fulling a mandatory purchase requirement on federally backed mortgages. • In November 2017, the House passed H.R. 2874, the 21st Century Flood Reform Act of 2017,

a package of seven bills that would renew the NFIP for five years, with provisions seeking to encourage the growth of the private flood insurance market, lower costs from repetitive loss properties, cap annual premium increases, and improve flood mapping, among others. H.R. 2874 includes the Flood Insurance Market Parity and Modernization Act, for which both the WSIA and the NAIC have consistently advocated their strong support. The bill was received in the Senate on November 15, 2017, and has since been referred to the Committee on Banking, Housing and Urban Affairs, but the Senate has not yet acted on the bill. H.R. 2874 also modified the 31.9% reimbursement that insurers participating in the Write Your Own (WYO) program can receive, to a maximum of 27.9% over three years.

• The NFIP Policyholder Protection Act of 2017, H.R. 2868, aims to improve coverage in urban areas, by limiting premium rates and requiring that FEMA (Federal Emergency Management Agency) conduct a study to analyze the unique characteristics of flood insurance coverage for urban properties.

• The NFIP Administration Reform Act of 2017 would strengthen FEMA’s oversight of the WYO program, by enhancing disclosure requirements and transparency so that policyholders have a better understanding of what NFIP policies cover. The bill would also authorize WYO insurers to inspect pre-existing structural conditions of insured and pre-insured properties, which could result in the denial of a flood claim.

• The Repeatedly Flooded Communities Preparation Act, H.R. 1558, would limit the funds NFIP spends on claims for properties that have flooded multiple times.

• The Taxpayer Exposure Mitigation Act of 2017, H.R. 2246, would repeal the mandatory flood insurance coverage requirement for commercial and multi-family properties located in flood hazard areas. It is also designed to help provide for greater transfer of risk under the NFIP to the private capital and reinsurance markets.

• Use of Replacement Cost in Determining Premium Rates, H.R. 2565, would require the use of replacement cost valuations to determine premium rates for flood coverage. The bill also calls for FEMA, which manages the NFIP, to (1) conduct a study of insurance industry best practices for risk rating and classification, including practices related to replacement cost value in premium rate estimations, and (2) develop a “feasible implementation plan and projected timeline” for making these changes.

Reporting Requirements under TRIPRAIn the terrorism risk insurance data call for 2018, both the Federal Insurance Office (FIO) and the NAIC made revisions to reporting of federal and state terrorism insurance-related activities. For the first time, state insurance regulators and the Treasury agreed to consolidate the collection of related data, which allows companies subject to both the federal and state data calls to submit the same information to Treasury and the states. (The International Insurers Department will continue to issue a separate terrorism risk data call for alien surplus lines insurers.)

Section 111 of the Terrorism Risk Insurance Program Reauthorization Act of 2015 (TRIPRA), which reauthorized the Terrorism Risk Insurance Act (TRIA) through 2020, requires that the US Treasury Department collect data and provide Congress an annual report on the state of the terrorism insurance market and the effectiveness of the TRIA Program. Calls by Treasury (in 2016 and 2017) and the NAIC (July 2016) were initially voluntary, but became mandatory in 2017. The 900 or so participating insurers were required to submit some of their data by May 15, 2017, with the remainder due October 1, 2017. The dual requests resulted in complaints about the inefficiency of separate and largely overlapping data calls, resulting in efforts to facilitate a single, consolidated data collection method.

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For 2018, data is being collected in two parts, through a Joint Reporting Template and a State Property Supplement. Once completed, the Joint Reporting Template and the State Property Supplement must be submitted electronically through a portal maintained by the New York Department of Financial Services. The deadline for completing the Joint Reporting Template was May 15, 2018 (although insurers needed to register in advance to obtain the appropriate Joint Reporting Template); the deadline for the State Property Supplement is September 30, 2018.

Participating insurers have been required to submit the following information:• Lines of insurance with exposure to terrorism-related losses • Premiums earned on such coverage• Locations of exposures• Pricing of coverage• The take-up rate of coverage• The amount of private reinsurance purchased for acts of terrorism• Any other information the Treasury secretary considers appropriate

Data is provided through one of four templates depending on whether participating insurers (1) fall under the Treasury’s “small insurer” definition; (2) are larger insurers that do not fall under the small insurer definition; (3) are alien surplus lines insurers; or (4) are captive insurers as defined in the Code of Federal Regulations.

In June, the FIO issued its “Report on the Effectiveness of the Terrorism Risk Insurance Program” based on the past two years of reporting data they have received. In general, the report indicates that the program is working well. Although more capacity and coverage are available in the private market, capacity for NBCR (nuclear, biological, chemical, and radiological) events remains uncertain.

Domestic Surplus Lines Insurance Companies (DSLIs)Generally, a surplus lines carrier cannot write surplus lines insurance in its state of domicile. However, more states are changing laws so that surplus lines carriers will be able to issue policies in their state of domicile as Domestic Surplus Lines Insurers (DSLI), for which a carrier would to be approved or admitted in that state as a DSLI.

In 2018, Georgia, North Carolina, and Virginia all passed DSLI legislation. The Georgia and Virginia laws became effective on July 1, and North Carolina’s, on June 28. With these new states, a total of 16 states allow DSLI companies including: Arizona, Arkansas, Connecticut, Delaware, Georgia, Illinois, Louisiana, Missouri, New Hampshire, New Jersey, North Carolina, North Dakota, Oklahoma, Texas, Virginia, and Wisconsin.

Foreign Account Tax Compliance Act (FATCA) The Foreign Account Tax Compliance Act, enacted in March 2010, was intended to improve US taxpayer compliance with reporting foreign financial assets and offshore accounts. H.R. 871, if passed, will eliminate the P/C industry’s requirement to report non-cash-value insurance premiums. The P/C industry has asked for relief from FATCA reporting since the law’s enactment, because of its unnecessary and burdensome application to the industry. The act is directed at foreign financial institutions and financial intermediaries and aims to prevent tax evasion by US citizens, residents, and corporations through the use of offshore accounts, but the application cast a wide net—covering groups like the P/C industry, which is not in a position to commit the type of tax evasion the law is intended to curtail. A vote on H.R. 871 remains pending in the House.

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Surplus Lines Taxation – The NIMA Wind-DownThe run-off period for the Nonadmitted Insurance Multistate Agreement (NIMA) ended officially on October 1, 2017. In accordance with the NRRA, and as a result of NIMA’s dissolution, surplus lines taxes in 48 jurisdictions (46 states, DC, and Puerto Rico) are now based on 100% of the premium based on the home state’s tax rate and retained 100% by the home state. The only states requiring the submission of taxes with multistate allocations of risk are Florida, Hawaii, New Hampshire, and Vermont.

In Massachusetts, S.B. 2238 was incorporated into a budget-related amendment and passed by the legislature on July 31, 2018, to eliminate multistate premium tax allocation and instead tax 100% of a multistate risk at the Massachusetts rate of 4% when Massachusetts is the home state.

In Florida, H.B. 465 and S.B. 784 contained similar provisions that would have eliminated multistate premium tax allocation and instead calculated all premiums for which Florida is the home state, entirely at the Florida rate. Ultimately, however, the provisions were not heard because more pressing state issues limited legislative calendar time, and the bills were not passed.

NARAB II UpdateAlthough the focus of TRIPRA is terrorism, the law includes a modified version of the national licensing proposal, the National Association of Registered Agents and Brokers (NARAB II). The insurance industry had been lobbying for many years for the creation of NARAB, to streamline the licensing process for agents and brokers throughout the US, with the aim of eliminating burdensome multistate requirements while preserving state regulatory authority and consumer protections with respect to nonresident licensing.

NARAB is designed to act as a national clearinghouse, allowing insurance producers licensed in their resident state to sell, solicit, or negotiate as a nonresident in any other state they wish to place business. The producer will be able to apply to NARAB for “membership” and, if approved, be given nonresident status in the specific states it sought authority to do business in. As part of the application process, the producer will undergo a background check and be required to meet certain requirements (to be established by NARAB) and to pay each state’s licensing fees. In effect, NARAB will be a one-stop nonresident licensing system once its board of directors is in place, making the nonresident licensing process much more efficient for producers doing business in multiple states. The 13 members of the board are nominated by the US president and subject to confirmation by the Senate, and are to be made up of eight state regulators and five industry members, three of which will represent the P/C segment. Unfortunately, NARAB has not become operational because a board of directors has not yet been established. However, reports indicate that the FIO and the White House have begun efforts to review and nominate candidates for the inaugural board.

Additional Legislative & Regulatory Highlights, by StateAlaskaIn March and May, the Alaska Division of Insurance issued Regulatory Orders 18-01 and 18-02 allowing specific entities to provide policies of workers’ compensation maritime employer’s liability coverage in the nonadmitted insurance market. Alaska Statute 21.39.040(f) allows the director to suspend or modify statutory requirements in specific instances where workers’ compensation is not available in the admitted market.

ArizonaS.B. 112 provides an exemption from surplus lines law to federally recognized Indian tribes or members of federally recognized Indian tribes. The bill became effective August 3, 2018.

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CaliforniaThe Department of Consumer Affairs announced the re-adoption of emergency cannabis regulations for the Bureau of Cannabis Control related to the industry’s activities in the state. The regulations continue to permit nonadmitted companies to provide insurance required to operate a cannabis distributor. The regulations became effective on June 6, 2018.

FloridaH.B. 1011 provided for disclosure on all homeowners insurance policies that their policies do not cover flood insurance. Previous versions of the bill suggested purchasing insurance from an admitted insurer or from the NFIP. The amended bill encouraged homeowners to buy a separate flood policy but does not endorse any particular source. The bill takes effect on January 1, 2019.

H.B. 1073 removed certain requirements and references to managing general agents in the surplus lines broker licensing statute that were primarily technical in nature. The bill took effect on July 1, 2018.

IndianaH.B. 1301 repealed all statutes related to the Surplus Lines Insurance Multistate Compliance Compact, which never went into effect owing to an insufficient number of states enacting the legislation. It also lowered the number of tax filings and dates from two to one so that taxes are paid on February 1 of each year, eliminating the previous additional requirement of August 1. The bill was signed into law by the governor on March 25, 2018.

IllinoisS.B. 1286 alters the tax rate on independently procured nonadmitted insurance from 3.5% to 0.5%. If the governor signs the bill, the effective date will be January 1, 2019; however, the bill’s text states that the new rate shall be applied to contracts effective January 1, 2018 or later. How the state will implement the new tax rate is still to be determined.

KansasAs passed, S.B. 70 expanded the inspection requirements for amusement park rides, while S.B. 307 added home-owned amusement rides and registered agritourism activities to the statute governing insurance on amusement rides. Both bills, which became effective on July 1, 2018, specify that required insurance may be provided by a surplus lines insurer.

KentuckyThe Kentucky Department of Insurance introduced H.B. 345, an omnibus insurance bill, which, at the request of WSIA, eliminated language authorizing the state to join SLIMPACT. The bill also clarifies that a surplus lines premium tax is applicable only to portions allocable to the state of Kentucky and that disability insurance is permissible in the surplus lines market after a diligent search of the admitted market. WSIA was pleased with these revisions, which passed and become effective July 25, 2018.

In April, the Kentucky Department of Insurance issued Bulletin 2018-01 to assist surplus lines brokers in complying with changes and procedures related to Kentucky local government premium taxes. Kentucky is the only state in the nation that requires separate municipal taxes on surplus lines policies.

LouisianaH.B. 247 was passed and specifically permits surplus lines to write health and accident insurance. The bill takes effect on January 1, 2019.

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MarylandS.B. 743, which took effect July 1, 2018, established requirements for peer-to-peer car sharing programs and allows surplus lines insurers to provide required insurance. (A peer-to-peer car sharing program is one in which individuals rent their cars to others for short periods.)

MissouriS.B. 594 exempts admitted commercial insurers from filing rates with the state’s Department of Insurance and exempts the filing of policy forms for commercial insurance, for which the aggregate total annual premium for a single commercial policyholder exceeds $100,000. WSIA requested that surplus lines insurance be exempted from diligent searches for the same lines of business exempted from rate and form filing in the admitted market. However, the bill was ultimately not amended to include the request; it passed, leaving the diligent effort requirement intact.

MississippiS.B. 2467 extends the expiration date of the 3% nonadmitted policy fee for the purpose of funding the Windstorm Underwriting Association (WUA), from July 1, 2018 to July 1, 2019. The bill diverts a portion of the revenue from the fees to the Rural Fire Truck Fund and Supplementary Rural Fire Truck Fund and will take effect on October 1, 2018. The Mississippi Department of Insurance adopted several rules setting forth compliance with provisions of the bill and the rules, which became effective July 1, 2018, do not change tax/fee remittance procedures for surplus lines brokers.

NebraskaL.B. 799 changes tax payment days to conform with recently changed surplus lines reporting dates (March 1, June 1, September 1, and December 1 for preceding calendar quarters). The bill also allows the Director of Insurance to assess fines against a surplus lines licensee without first issuing a cease and desist order, such that for minor violations, the director will now be able to assess fines without interrupting the licensee’s business operations. The bill takes effect on July 19, 2018.

New MexicoH.B. 223 transfers certain duties for premium tax collection, including those related to surplus lines, from the Superintendent of Insurance to the Taxation and Revenue Department. The bill will take effect on January 1, 2020.

New YorkA.B. 4734, introduced in 2017, would permit a liability policy to provide coverage for punitive damages, civil penalties, and other non-compensatory damages, but was amended to exclude personal lines and commercial automobile liability policies. Currently, only New York and Utah maintain absolute bars on insuring punitive damages.

OklahomaS.B. 1485, an insurance omnibus bill, changes (a technical change) a reference from a “licensed” surplus lines insurer to an “approved” surplus lines insurer. The bill, which takes effect on November 1, 2018, is related to a February 1, 2018, notice from the Oklahoma Insurance Department (OID) stating that it was voiding all “certificates” indicating that surplus lines carriers are “licensed and authorized” to transact surplus lines business in the state. The notice indicates that the OID had no such authority to confer “licensure” on surplus lines carriers, and indicated that the list of “Approved Surplus Lines Companies” found on the OID website would constitute the only evidence of the acceptability of US-domiciled surplus lines insurers.

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South CarolinaS.B. 1042 added international major medical insurance to the definition of surplus lines insurance. The bill took effect on May 15, 2018.

TennesseeS.B. 1795 provides exemptions from rate and form filing for admitted commercial lines insurance, including boiler and machinery, environmental impairment/pollution liability, kidnap and ransom, political risk or expropriation, employment practices liability, media liability, and product liability. These revisions did not eliminate diligent effort requirements for placement in the nonadmitted market. In addition, the threshold for qualifying as an exempt commercial policyholder in the admitted market dropped from $250,000 to $200,000. The bill took effect on May 21, 2018

UtahH.B. 39 eliminated a statutory requirement related to allocating a multistate surplus lines premium tax and stamping fee and codifies a home state approach to taxation, meaning a broker is not required to provide an allocation report and can simply submit the surplus lines premium tax based on 100% on Utah’s surplus lines premium tax rate. The bill, which also modernizes carrier eligibility requirements consistent with the NRRA, took effect on May 8, 2018.

Stamping Fee ChangesIllinoisThe Surplus Lines Association of Illinois (SLAI) announced a reduction in its stamping fee for policies and any endorsements to those policies. As of January 1, 2018, the stamping fee was lowered from 0.2% to 0.125%, rounded to the nearest whole dollar.

UtahThe Utah insurance Department passed an amendment to its regulations in December that raises its surplus lines stamping fee from 0.15% to 0.18%. The change was effective on January 1, 2018, and endorsements will be charged the same stamping fee the original policy was charged.

Section IV: Current Distribution TrendsFeedback that A.M. Best has received from wholesalers reveals that their primary concerns in 2018 and heading into 2019 are numerous and varied, among them:

• Continued investment in insurtech • Growing pressure on wholesalers from ongoing market consolidation• Proliferation and impact of data analytics• Competition from standard market carriers• Challenges in workforce dynamics• New growth opportunities• Evolution of cyber • Flood insurance issues

Continued Investment in InsurtechInsurtech companies are helping revolutionize the insurance industry. Both enabling and disruptive technologies have upended traditional insurance products and changed the way

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insurance coverage is conceived, marketed, distributed, and sold. The impact of insurtech has been a featured topic at industry conferences and annual meetings the last few years or so, as savvy tech players enter the insurance industry and bring forth changes similar to those seen in the banking industry with the emergence of financial technology companies. Both insurers and intermediaries are using enabling technologies as competitive enhancers to make existing processes more effective or efficient, and to also improve services and product offerings. Just a few years ago, when banks were dealing with changes wrought by fintech, only a few insurance companies were blazing a trail with new technologies.

One key aspect of the trend that is particularly critical to the insurance industry involves the growing use of automation. The insurance industry has always been a marketplace based on relationships, but the ability to automate personal lines coverage and the need to digitally package insurance products in the small business market to be more cost-effective are now undeniable facets of insurance transactions. An intermediated value chain that has traditionally depended so much on human interaction may have inherent inefficiencies, but that interaction is often the key to achieving the best solutions for complex problems in the specialty and surplus lines segment.

Customers, particularly Millennial and Generation Y customers, are demanding more simplicity and efficiency when it comes to dealing with insurance issues. The challenge to wholesalers will be to find ways to use technology to enhance their roles. Wholesalers should still be in the best position to help customers obtain insurance for their difficult loss exposures and to tailor coverage to fit their customers’ needs. Both insurance and non-insurance risk management solutions are becoming increasingly sophisticated, and the most successful surplus lines brokers will likely differentiate themselves by offering clients a multitude of services.

Emerging technological advances will also spark more creative digital advertising methods. As websites and web-based applications inundate the marketplace, questions of advertising restrictions may arise. Restrictions on surplus lines insurers vary by jurisdiction: Eligible surplus lines insurers may advertise in California, provided the company’s unlicensed status is disclosed, while New York generally prohibits any person from calling attention to a surplus lines insurer by advertisement, although there are exceptions to this rule. Offerings of web-based products can pose additional advertising risks that were not anticipated only a few years ago. For example, a surplus lines insurance company’s website can lead to the question of whether it constitutes advertising and is thus operating in violation of applicable state laws. Some states prohibit brokers from identifying the actual names of unauthorized insurers in their advertisements, although licensed brokers can advertise specific types of insurance products generally available in the nonadmitted market.

Lifestyle apps will continue to help shape how brokers and insurers engage with insureds through the impact of technology on the life, P/C, and health insurance industries. Customer expectations of simplicity and transparency have fostered innovations not only in product design, but also in service design and delivery by brokers. More and more buyers today are opting for lifestyle apps over the annual hunt for the lowest-priced insurance—which, unless they suffer a loss, they can then forget about for the next 12 months. For brokers, and insurers in particular, the appeal of these apps lies in the possibility of higher retention owing to deeper connections with insureds and real time engagement and feedback.

Ultimately, insurtech and products will have a positive impact on those on all sides of a surplus lines transaction: customers, surplus lines brokers, and insurance companies. Delivery platforms allowing consumers to bind coverage with the click of a button

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online will be transformative. However, surplus lines insurance participants will still face the challenge of satisfying the diligent search requirement, which is unique to surplus lines transactions.

In today’s competitive marketplace, diversifying both product offerings and operating regions has become even more critical for surplus lines insurers and intermediaries. Providing a broad array of products and being able to reach areas where those products are in demand will be vital—especially if surplus lines insurers and wholesalers are to capitalize on growth opportunities.

Legacy insurers and intermediaries may be making greater use of insurtech, albeit sometimes with trepidation. One of the long-term advantages of insurance companies and intermediaries has been the large amount of detailed risk data collected over many years that is used to inform underwriting and pricing decisions. However, given the amount of alternative data available via insurtech companies, they may not be able to hold on to that advantage for much longer. Many legacy insurers are already partnering with insurtech companies to help speed up digital innovation. Other legacy insurers are investing capital in technology startups (such as USAA Ventures, AXA Strategic Investors, and XL Innovate) as well as offering strategic support.

As changes come about more rapidly and pressure businesses for real-time responses, making effective use of available technology will be critical if insurers are to keep pace. Insureds will be using even more advanced technologies in the years ahead, and brokers, agents, and other intermediaries, as well as insurers, need to be able to understand clients’ increasingly sophisticated and highly differentiated needs, to develop effective risk management or coverage solutions. This could become a key factor in the ability of companies and their broker/agency partners to build long-term relationships with their clients.

Growing Pressure on Wholesalers from Ongoing Market Consolidation The intermediaries that shared their perspectives with us indicated that consolidation throughout the entire surplus lines distribution chain—wholesalers, retailers, underwriting managers, and managing general agencies—remains a key issue. Consolidation at the retail broker level is also prevalent, affecting wholesale brokers as well. Acquisitions are being driven not just by entities flush with capital, but also by the speed of technological changes and aging owners worried about the perpetuation of their businesses.

The impact of retail agencies cutting back on the number of wholesalers with which they do business is also leading to further mergers or consolidations of independent wholesalers—owing to the fear of being squeezed out of the market by larger brokers, for example. However, several other factors are playing roles in wholesale brokerage M&A:

• Succession planning challenges, given the sizable percentage of firms privately owned by Baby Boomers who are getting closer to retirement age

• Very well-capitalized buyers, often backed by private equity firms • The price that private equity firms are willing to pay for distribution chain members—often

anywhere from 25%-40% more than owners can get from an internal transaction (internal perpetuation)

• The rising cost of operating wholesale firms, combined with a shortage of talent that could lead to higher salaries to retain talent

• Changes in the roles of surplus lines intermediaries—retail agency customers are interested in buying from larger wholesale platforms because of the benefit of economies of scale

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• Greater discernment by the industry’s largest retailers—Marsh, Aon, and Willis—over the past four or five years of their most important, mutually beneficial partnerships, as retailers minimize the number of relationships they need to maintain

Acquisitions of smaller wholesalers by larger ones are resulting in a smaller wholesale broker marketplace, although competitive options for the insured remain plentiful. In many cases, the combined entities end up competing for both brokerage and binding authority business. Some larger, privately owned wholesalers say they have been focusing on organic growth and internal development, because potential acquisitions have not been to their liking due to pricing. Not finding a good fit of talent and culture in potential acquisitions has also led to the death of some deals.

Some surplus lines intermediaries have expressed concerns that broker consolidation could hurt existing relationships and response times. Given the dynamics of an increasingly price-driven market, smaller insurers may feel a competitive squeeze that significantly threatens their bottom line. Intermediaries also expressed concern about consolidation among insurance carriers, especially among the larger insurers, which limits the number of markets the intermediaries can access. Mergers between surplus lines insurers and competitors that create larger organizations could lead to changes in the relationships between the brokers/agents and the new entity—a particularly critical concern if one of an intermediary’s main companies is the subject of an acquisition, particularly in smaller, more defined market segments or geographic regions.

A.M. Best believes that consolidations will continue for some time, driven by entities already operating in the surplus lines insurer or wholesale broker market and continued interest from private equity. New amalgamations will continue to re-shape the marketplace, while still effectively focusing on the needs of insureds by providing expansive insurance solutions at the best possible prices. Small and medium-sized wholesaler brokers and managing general agencies will find surviving in the changing market more difficult owing to a decline in the number of small to medium-sized retail intermediaries and to retailers limiting the number of their wholesale partners.

Proliferation and Impact of Data AnalyticsBig data and predictive analytics have become more widespread in the insurance industry over the last several years. The P/C industry has traditionally been data-driven, depending on solid data to shape underwriting and pricing decisions. Predictive analytics and related tools (such as artificial intelligence, machine learning, big data, and predictive modeling) often focus on the same concept—using statistics and probabilities to predict outcomes.

These innovative tools facilitate the processing, analysis, and correlation of massive amounts of data in real time. Enhanced analytical capability has afforded decision-makers greater insight and thus strengthened their ability to determine target markets and products, develop more efficient underwriting processes, and analyze overall performance.

In recent years, insurers and intermediaries have made significant investments in analytical tools to better serve both broker/agency partners and insured clients. Valuable insight can be provided to insureds, in terms of loss cost reduction and comprehensive performance analysis. A.M. Best expects this trend to continue, because data analytics investments are creating value for surplus lines organizations, which they will need if they are to thrive.

Translating growing amounts of available data into actionable business intelligence entails understanding the technological needs of the surplus lines insurers’ wholesalers and other

39


intermediaries, to see where gaps can be filled. Doing so can facilitate the creation of better strategies to improve underwriting tools, claims reporting and processing, and risk management. Smaller businesses benefit from new technology that simplifies tasks, while larger companies benefit from greater efficiency. Improvements to data analytics tools and techniques will allow for deeper and more extensive data mining.

Competition from Standard Market CarriersAnother theme in the feedback from intermediaries was the ongoing migration of borderline surplus lines business to the admitted market. Some intermediaries noted that, although competition from standard market insurers did not have a particular impact on their particular markets or territories, the amount of traditional surplus lines business being written by admitted insurers was still meaningful in the context overall market conditions.

Some also expressed that, with the new analytical tools available to all insurers, the concept of traditional excess and surplus lines business might need to be redefined. Standard market insurers can use those tools to learn more about the risks traditionally insured in the surplus lines market. Improving operational systems also augment company efficiency, which has helped companies write a larger portion of traditional surplus lines business in the small business segment (less than $10,000 in annual premium) than previously. Given the low volatility associated with this business, this trend is likely to continue over the next couple of years. The abundant capacity available in the P/C market is another factor driving more standard market companies to compete on borderline surplus lines accounts, indicating that such business may not return to the surplus lines market anytime soon.

The still sluggish investment climate and efforts to maintain—and even increase—market share are also resulting in standard market insurers’ dipping into the surplus lines business. Competition from standard market insurers, along with alternative capital seeking access to the surplus lines market, could result in less informed risk selection decisions that could negatively impact surplus lines pricing.

Challenges in Workforce DynamicsAlthough labor issues were not mentioned as often as in previous years, an aging workforce and the challenge of attracting and retaining new talent remain critical concerns. As the most experienced workers retire, taking with them a significant amount of intellectual capital, that expertise has to be replaced, leading to a major demographic challenge that will span disciplines—marketing, underwriting, claim, loss control, risk management, marketing, and actuarial functions.

Where executives were once most concerned about simply transferring the knowledge and skills of more senior, retirement-age employees to new hires, they now consider the alignment of talent and skills with business strategy as vital to success. Given that relationships play such an integral part in the industry, human capital has always been viewed as an important asset. Formulating the right talent strategy has become increasingly vital, as technological development transforms the way the industry works and how business is conducted.

The data/technology skills needed by the staff of wholesalers, managing general agents, and underwriting managers to meet client needs have changed markedly—accurately interpreting, analyzing, and manipulating data requires specific skills. To attract the best, brightest, and most technologically savvy young minds, insurance intermediaries and insurers are developing effective recruiting techniques and creating internship programs with universities to give future college graduates early, practical exposure to opportunities in the industry.

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Well-developed onboarding programs and structured training for new hires, especially programs that give new employees access to mentors, could provide crucial benefits. Industry organizations such as WSIA have developed internship programs and devoted resources to professionals under age forty to not only develop their understanding of and interest in career opportunities in the surplus lines market, but to also pave the way for the next generation of leaders.

New Growth OpportunitiesAchieving organic growth in a soft market replete with capacity poses a significant challenge to surplus lines underwriters and brokers. Outside of growth fueled by M&A, the development of products covering new or emerging exposures has traditionally been one way insurers and brokers have differentiated themselves in the effort to generate revenue growth in a challenging marketplace. The commitment to fostering new ideas is critical, but without the proper technological tools and the financial wherewithal to convert ideas into actual insurance products, these endeavors could prove fruitless, regardless of the resources spent.

The emergence of insurtech start-ups may help drive the development of innovative products and services and lead to sustainable premium growth in the nonadmitted market, given that surplus lines insurers will be in the best position to address the risks in new industries. For example, the personal and commercial drone market—for small unmanned aerial vehicles (UAV) or unmanned aerial systems (UAS)—has exploded in recent years. Users include insurers and engineering or surveying firms, real estate agents, photography and motion picture companies, government entities, and law enforcement organizations. Insurance products to address the risks presented by drones are therefore also rapidly entering the market. Surplus lines producers and insurers have already partnered with insurtech companies to develop and market products for personal and commercial drone operators. Automated platforms for these types of products on the web or mobile apps are one way companies are meeting market demand for new products.

Coverages developed for Transportation Network Companies (TNCs)—commercial ride-sharing companies such as Uber and Lyft—will create greater opportunities for the surplus lines market. One challenge specific to this segment is that TNCs must satisfy minimum levels of automobile financial responsibility requirements applicable for both companies and drivers. Because meeting these requirements can be difficult in the admitted market, most states allow surplus lines insurers to issue TNC insurance policies. As TNCs expand beyond passenger transportation into product and food delivery areas, new products designed to cover these exposures will be needed. Whether states will expand their TNC laws to allow surplus lines insurers to adequately cover these services remains to be seen, however. Surplus lines brokers and insurers will have to comply with new sets of restrictions and laws as the regulatory environment evolves, but they will have opportunities to craft inventive coverages to fit these unique exposures.

Evolution of CyberThe growing frequency and severity of cyber attacks highlight the risks and potential rewards of this line of business, with the scope and scale of attacks in recent years underscoring the seriousness of cyber crime as a growing exposure to loss. The increasing dependence on mobile devices to handle personal business transactions exacerbates the vulnerability of information such as personal and medical data, store purchases, bank accounts, and other confidential material, making mobile devices enticing targets for cyber criminals. Hacks of personal data prove that, without greater safeguards—which drive up the cost of doing business—the Internet is simply not safe

41


for the free-flowing exchange of information. However, it is an essential platform for all businesses, and businesses will continue to move to the web.

As a result, companies are looking much more closely at their cyber exposures and whether their existing coverage is sufficient. Some insurers are adding cyber coverage to package policies as endorsements, but this can be problematic owing to the limitations of coverage. Surplus lines intermediaries and insurers may offer better solutions, via customized cyber policies that address a client’s specific risk exposures. Such policies also help diminish the intermediary’s E&O exposure.

With cyber security threats showing no signs of abating, governments around the globe are expanding and refining their regulatory requirements. Companies are being required to provide greater protection for online assets, in addition to facing requirements for the storage of data on local servers. These realities present significant opportunities for surplus lines insurers, to tailor the kind of customized coverages that are their hallmark. The evolving nature of cyber exposures should continue to provide opportunities for surplus lines insurers to step up and meet the needs of insureds when standard coverage is insufficient or nonexistent as the cyber insurance market matures.

Flood Insurance Issues

Production SourcesDuring the second quarter of 2018, A.M. Best sent surveys to the insurers writing the majority of surplus lines business, regarding the most common production sources to generate surplus lines premiums in 2016 and 2017. We received responses from companies accounting for approximately 54% of all US surplus lines premium. Some of the companies that did not respond are global or national insurance groups that collect premium data written by their various companies on an overall or group basis; they do not track their surplus lines premiums separately from their admitted market premiums.

Results for 2016 and 2017 were very similar (Exhibit 20). In 2017, wholesale brokers without binding authority constituted the surplus lines’ primary distribution channel, accounting for approximately 54% or more of total surplus lines premium in both years, while wholesaler brokers with binding authority accounted for 11% to 12%. Program managers, also a valuable source for niche surplus lines business, accounted for around 25% of premium each of the two years, while retail agents and brokers accounted for around 7%. The wholesale brokerage distribution channel is still the main engine directing the majority of surplus lines clients to companies.

Exhibit 20

Production Source2016

% of Total2017

% of Total

Wholesale Agent/Broker Without Binding Authority 56.9 54.1

Wholesale Agent/Broker With Binding Authority 11.5 11.6

Program Manager – Retail or Wholesale Agent/Broker 24.8 25.6

Retail Agent/Broker 6.7 7.1

Direct Procurement 0.1 0.1

Other 0.0 1.4

Total 100.0 100.0

Source: 2017 A.M. Best Surplus Lines Distribution Survey

US Surplus Lines – Leading Production Sources by DPW

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The push for Congress to simplify regulatory issues that have created barriers between private insurers and the flood market have been stymied to a large extent by Congress’s failure to make comprehensive reforms to the NFIP. Instead of taking definitive action that could generate more opportunities for surplus lines insurers, Congress has legislated seven short-term reauthorizations since the end of the last fiscal year (September 2017), with the latest reauthorization ending on November 30, 2018. Congress has yet to conduct the kind of overhaul the program requires.

Greater legislative clarity would ameliorate some of the issues banks have with accepting private flood policies for their mortgage holders. Streamlining the process to enter the market will preserve the surplus lines industry’s ability to provide flood insurance solutions, which could serve as a key component of necessary NFIP reforms. Providing flood insurance would not break new ground for these insurers, which have long covered specialized risks that do not meet the NFIP’s limits or eligibility requirements.

Seriously outdated maps, subsidized flood insurance premiums, and repeated payouts for business-as-usual post-disaster rebuilding in floodplains have thwarted efforts to make communities fully aware of their flood risks—these factors have also blunted incentives to reduce those risks and, in line with what would appear to be common sense, limit development in areas prone to flooding.

Section V: Impairment TrendsFinancial impairments in the P/C industry have been declining since 2011, and at the end of 2017 were down to their lowest levels in almost three decades. As Exhibit 21 shows, industry impairment rates over the past few years have been more in line with those in the early 1980s. The surplus lines market segment in particular has had an excellent track record, with no impairments from 2004 through 2017.

0

10

20

30

40

50

60

FIC

s (#

)

Admitted Surplus Lines

Exhibit 21US Property/Casualty – # of Annual Impairments, Admitted Companies vs. Surplus Lines, 1980-2017

Source: A.M. Best data & research

43


On June 27, 2018, a petition was filed in South Dakota Circuit Court to place ReliaMax Surety Company into liquidation because the company was in a hazardous financial condition. ReliaMax was established as an excess and surplus lines carrier in 43 states and Washington, DC, and as an admitted carrier in six states, including South Dakota. The carrier was a unique monoline surplus lines insurance company created solely to issue monoline coverage to insure private and federal student loans originated by financial institutions that had been consolidated and/or refinanced. The surety bond coverage issued by the company covered 12-month periods for loans issued by the financial institutions during that time. However, the insurance policies covered the life of loans with terms that in some cases were longer than 20 years. Based on available documentation, at least part of the company’s financial difficulties apparently concerned two uncollectible loan receivables from its parent company, with a combined balance of $22.2 million at the end of 2017. It also appears that a majority of the claims against the company will be for a return of unearned premium. A.M. Best believes it is important to note that the liquidation order for ReliaMax was filed late in the second quarter of 2018, and that many details of the insolvency are still developing. At present, however, ReliaMax appears to be the first surplus lines impairment—of which A.M. Best is aware—in more than a decade.

In analyzing industry impairment trends, A.M. Best believes that financial impairment frequency (FIF) is a more accurate indicator than a simple count. The FIF is calculated by dividing the number of companies that become impaired in a given year, by the number of companies operating in the insurance market in that year. The P/C industry’s 2017 FIF was 0.23, far below its historical average of 0.84. A review of the most recent ten-year period shows that the 2011 FIF of 1.06 seems to have marked the apex for impairment, reflecting the impact of the soft market in 2007-2010 and the recession in 2007-2009.

A.M. Best has found that a rise in the insurance industry’s FIF correlates strongly with preceding negative operating periods. These periods have usually been sparked by events such as stock

Financially Impaired Companies (FIC) DefinedA.M. Best designates an insurer as being financially impaired if it is placed under court order, into conservation, rehabilitation, and/or insolvent liquidation, as of the date of the earliest court action.

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

FIF

(%)

P/C Industry Surplus Lines Admitted Companies

Exhibit 22US Property/Casualty – Financial Impairment Frequency Admitted Companies vs. Surplus Lines, 1980-2017

Source: A.M Best data and research

44


market declines, economic recessions, or extraordinarily large catastrophe losses that typically force the end of soft markets, as evidenced by a review of FIF rates in 1988-1993 and 2000-2003.

The number of impairments could rise because of a lag in the reporting of impairments owing to the growing use of confidential actions by state insurance regulators, who are reluctant to publicly disclose impairments until all possible avenues to rehabilitate or find buyers for troubled insurers have been exhausted. On average, A.M. Best has found that there is a lag of about 18 months between a confidential regulatory action and public disclosure of the impairment, usually the time between supervision and liquidation—that is, if the confidential action ever becomes public at all.

Surplus Lines Impairments Despite the absence of surplus lines financial impairments in 2004-2017, the industry’s FIF of 0.71 from 1977 through 2017 is only modestly lower than the admitted company average of 0.84, reflecting the surplus lines companies’ significantly higher impairment frequencies during certain past periods—particularly in

Exhibit 23

Year

P/C Industry

Surplus Lines

Admitted Cos.*

P/C Industry

Surplus Lines

Admitted Cos.*

1980 8 0 8 0.27 0.00 0.281981 16 0 16 0.49 0.00 0.551982 13 1 12 0.42 0.52 0.411983 14 2 12 0.44 0.98 0.401984 34 0 34 1.13 0.00 1.141985 54 3 51 1.54 1.52 1.541986 30 2 28 0.95 1.08 0.941987 33 1 32 1.04 0.54 1.071988 49 1 48 1.49 0.53 1.551989 48 0*** 48 1.45 0.00 1.541990 55 3 52 1.66 1.54 1.671991 59 4 55 1.77 1.99 1.761992 60 6 54 1.72 3.03 1.641993 42 1 41 1.21 0.52 1.251994 28 2 26 0.80 1.08 0.791995 16 1 15 0.46 0.56 0.451996 13 2 11 0.38 1.15 0.341997 32 1 31 0.92 0.58 0.941998 20 4 16 0.62 2.29 0.531999 21 3 18 0.66 1.70 0.602000 48 2 46 1.53 1.05 1.562001 50 6 44 1.62 3.03 1.522002 47 4 43 1.54 2.07 1.502003 37 5 32 1.21 2.64 1.112004 20 0 20 0.64 0.00 0.682005 14 0 14 0.45 0.00 0.472006 18 0 18 0.56 0.00 0.602007 6 0 6 0.19 0.00 0.202008 17 0 17 0.53 0.00 0.562009 22 0 22 0.66 0.00 0.692010 23 0 23 0.68 0.00 0.712011 35 0 35 1.06 0.00 1.112012 25 0 25 0.76 0.00 0.812013 15 0 15 0.46 0.00 0.492014 12 0 12 0.39 0.00 0.402015 13 0 13 0.42 0.00 0.442016 3 0 3 0.47 0.00 0.492017 7 0 7 0.23 0.00 0.241977-2017 1,101 55 1,046 0.84 0.71 0.84* Includes alternative markets.** Failure frequencies are annualized rates.


Financially Impaired Companies (FIC)

Financial Impairment Frequency (FIF) **

US Property/Casualty – # of Financially Impaired Companies & Frequency, Industry vs. Surplus Lines, 1980-2017

*** 1989 figures have been adjusted from previous reports to exclude 7 UK-domiciled companies.

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1992, 1998, 1999, and 2001-2003 (Exhibits 22 and 23).

It is still noteworthy that, in contrast to the admitted companies, no surplus lines companies became impaired between 2004 and 2017. Improved underwriting (attributable to underwriting discipline and careful risk selection) and adequate overall pricing were the reasons for the absence of surplus lines insurer impairments during this period. Effective underwriting also resulted in strong risk-adjusted capitalization for most of the surplus lines companies, better insulating them from the occasional periods of market hyper-competitiveness—particularly over most of the last few years. Investments in advanced technologies, data analytics, and underwriting, claims, or processing systems, along with better management reporting and more vigorous oversight, also contributed to the decline in surplus lines insurers’ impairments.

From 2007 to 2012, however, underwriting profitability and operating performance deteriorated, marked by a rise in the reported combined ratios of the surplus lines market—and the P/C industry as a whole—before improving from 2013 through 2015 (Exhibits 24 and 25). The two most recent calendar years have seen the underwriting performance of the surplus lines market and the overall P/C industry notably impacted by hurricanes and other natural catastrophe activity, including wildfires.

80

85

90

95

100

105

110

115

120

125

130

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

Com

bined Ratio

FIF

(%)

P/C FIF % Combined Ratio

Exhibit 24 US Property/Casualty – Financial Impairment Frequency vs. Industry

*Combined ratios are after policyholders' dividends. A combined ratio below 100 indicates an underwriting profit; above 100, an underwriting loss.

Exhibit 25

Year FIFCombined

Ratio1997 0.58 93.81998 1.72 98.51999 1.70 99.82000 1.05 105.02001 3.54 105.32002 2.07 93.02003 2.64 92.22004 0.00 93.52005 0.00 93.22006 0.00 79.42007 0.00 76.12008 0.00 93.6

2009 0.00 93.12010 0.00 100.52011 0.00 105.12012 0.00 110.52013 0.00 92.42014 0.00 88.82015 0.00 101.12016 0.00 107.82017 0.00 107.4Source: A.M. Best data and research

US DPSL Composite – Financial Impairment Frequency & Combined Ratio, 1997-2017

Exhibit 25

46


The lack of impairments in the surplus lines from 2004 through 2017 was—at least initially—related more to the companies’ overall capital strength than to the quality of their underwriting performance. The market’s profitability dipped initially in 2015 and then further in 2016 and 2017, as incurred losses increased, while written and earned premium volume remained relatively flat. Prolonged market competitiveness has led to margin compression, which continues to adversely affect premium volume and, thus, the bottom line profitability of the surplus lines companies.

Characteristics of P/C Financial ImpairmentsBased on our December 2017 study of financial impairments from 2000 through 2016 (2016 Property/Casualty Impairments Update), A.M. Best determined that, although there are some specific causes for impairments, most fall into the category of general business failure owing to some combination of poor strategic direction, weak operations, inadequate internal controls, or underpricing or under-reserving of business written, for both the surplus lines and the admitted P/C industries. The study also provided some interesting conclusions when it came to the products offered by the impaired companies and the relative risks those products posed.

During the 16-year period of the study, 354 P/C insurers became impaired: 281 insolvent liquidations and 73 rehabilitations, of which 28 were closed during the period and 45 remained open at the time the report was published. Another 43 of the impaired companies went into conservatorship, all of which subsequently led directly to either rehabilitation or liquidation actions. A.M. Best identified the major lines of business for 345 of the 354 impairments: The leading line of business was workers’ compensation, which accounted for 26% of the 354 impairments during the period. Personal lines insurers accounted for 28%, split between private passenger automobile business (20%) and homeowners (8%). Private passenger auto can be further split as standard (12%) and non-standard insurers (8%). Commercial lines insurers, accounted for 22%, split between other liability/commercial multi-peril (15%) and commercial auto (7%). The remaining 23% of impairments was split among specialty lines such as medical professional liability, title, surety, financial/mortgage guaranty, and warranty.

Specific causal factors were identified for 91 impairments, or about 26% of the 2000-2016 impairments reviewed. Of those, fraud or alleged fraud was present in 23, while 21 impairments related primarily to affiliate problems. Catastrophe losses, largely in Florida and Texas, caused 18 impairments—before the 2017 devastation caused by Hurricanes Irma and Harvey. Sixteen companies suffered impairment after experiencing rapid growth, while investment losses were a significant factor in 11 others. One company was placed into liquidation after marketing warranty insurance products without a license.

A.M. Best remains guardedly optimistic about the favorable trend in surplus lines impairments since 2004, which drove the market’s FIF down below that of the admitted market. Stock market volatility, rising interest rates, weakening economic conditions that negatively affect gross domestic product growth, and inflation, combined with soft market conditions, could continue to pressure insurance companies’ combined ratios. Substantial inadequacy in setting appropriate prices and loss reserves can greatly imperil a company’s financial strength, as has been evident in studying the entities that became impaired between 2000 and 2016. The prolonged low interest rate environment limits the ability of surplus lines—and admitted—companies to withstand or offset any deficiencies in pricing, reserving, or inadequate risk selection with investment returns and capital market gains.

47


Section VI: Surplus Lines FundamentalsThis section is a primer for readers who are not familiar with the wholesale, specialty, and surplus lines market, to help them gain an understanding of this unique segment of the insurance industry. Below, we discuss the market and the types of risks insured; industry participants; the distribution system; licensing and compliance; and market cycles.

The Surplus Lines Market The surplus lines, or nonadmitted, market functions as a supplemental market insuring risks that are not acceptable to the standard, or admitted, insurance market. The majority of the surplus lines business consists of commercial lines insurance, but can also include personal lines such as homeowners insurance in catastrophe-prone areas. Businesses unable to obtain insurance coverage from admitted insurers also have the option of self-insuring or seeking solutions in the alternative risk transfer (ART) market.

The surplus lines market has historically been an innovator of new kinds of insurance designed to meet emerging risks. For example, surplus lines insurers were the first to provide cyber insurance, environmental impairment liability insurance, and employment practices liability insurance. These and other types of policies that originated in the surplus lines market can now be obtained in either the admitted insurance market or the surplus lines market, depending on the characteristics of the particular risk.

When the insurance market or capacity becomes restricted and market conditions harden, the appetite of the admitted market carriers for some risks or lines of insurance tends to diminish, and business flows into the surplus lines market. Even in normal or soft markets, there will still be many risks that require surplus lines treatment. By fulfilling the role of insuring risks that the admitted market cannot or will not insure, the surplus lines market operates as a safety valve for the insurance marketplace.

Risks insured in the surplus lines market can be divided into four categories:

• New or emerging risks, which require special underwriting expertise and the flexibility that the surplus lines market affords—for example, the risks associated with technological innovations such as transportation network platforms and the nonmilitary use of unmanned aircraft systems (drones)

• Distressed risks, which are characterized by unfavorable attributes, such as a history of frequent losses or the potential for catastrophic losses, making them unacceptable to admitted insurers—for example, a vacant building in an area that experiences frequent crime losses; a shopping mall with frequent liability claims; or a manufacturer of explosives

• Unique risks, which are so specialized or unusual that admitted insurers are unwilling or unprepared to insure them—for example, a medical device manufacturer that needs products liability coverage for a new product in clinical trials

• High-capacity risks, which require high insurance limits that may exceed the capacity of the admitted market—for example, a chemical plant that could become legally liable for hundreds of millions of dollars in damages if a toxic chemical were to leak in large quantities

Surplus Lines InsurersSurplus lines insurers are referred to as nonadmitted insurers because they are not licensed, or “admitted,” in the state of the insured’s principal place of business or principal residence

48


(for an individual). By federal law, the insured’s “home state” is responsible for overseeing and regulating surplus lines transactions. Every US jurisdiction has a surplus lines law that permits specially licensed intermediaries (also referred to as surplus lines brokers or licensees) to “export” risks that cannot be placed in the admitted market to eligible surplus lines insurers.

Although not a licensed insurer in the insured’s home state, a surplus lines insurer must be licensed in its state or country of domicile and be regulated for solvency by that jurisdiction—the same way that the state-based insurance regulatory system in the US ensures the financial stability of licensed or admitted insurers.

Unlike admitted carriers, surplus lines insurers are not subject to the rate or form regulations of an insured’s home state; a surplus lines insurer and its policyholder are free to use whatever policy forms and rates they agree upon. This approach ensures that the surplus lines market provides an open and flexible marketplace for insureds who are unable to fulfill their insurance requirements in the state’s admitted market.

A state’s minimum capitalization requirement for surplus lines insurers is generally higher than for admitted insurers. The enhanced capital requirement allows for greater protection for policyholders insured by surplus lines companies, given that the state guaranty fund protection provided to policyholders of admitted insurers that become insolvent is generally unavailable to surplus lines insureds.

For this report, A.M. Best has divided surplus lines insurers into three categories:

• Domestic professional companies (the largest segment) are US-domiciled insurers that write 50% or more of their total premium on a nonadmitted basis.

• Domestic specialty companies are US-domiciled insurers that operate to some extent on a nonadmitted basis but whose direct nonadmitted premium writings amount to less than 50% of their total direct premiums written.

• Regulated aliens (including Lloyd’s) are non-US domiciled insurers that must file financial statements and auditors’ reports, the names of their US attorneys or other representatives, as well as information on their US trust accounts, with the International Insurers Department (IID) of the National Association of Insurance Commissioners (NAIC). Regulated aliens must also meet IID criteria relating to capital and surplus, as well as underwriting and claims practices, and have a reputation of financial integrity. The NAIC publishes a Quarterly Listing of Alien Insurers naming the alien insurers that meet its criteria.

As a result of the Nonadmitted and Reinsurance Reform Act (NRRA) of 2010, which was enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, a state may not prohibit a surplus lines broker from placing nonadmitted (surplus lines) insurance with or procuring such insurance from a nonadmitted insurer listed on the NAIC Quarterly Listing of Alien Insurers.

The Distribution SystemFor this report, the entities in the surplus lines distribution system are defined as follows:• Retail producers, which can be either agents who represent the insurer or brokers who

represent the insured• Surplus lines intermediaries, which can operate as wholesale brokers, managing

general agents (MGAs), underwriting managers, or Lloyd’s coverholders or open market correspondents (OMCs)

• Program managers, which manage specialty or niche insurance products and market to retailers and wholesalers

49


These three types of organizations are the primary distributors for surplus lines insurers and play an important role in helping consumers obtain coverage that is unavailable in the admitted market.

Surplus lines intermediaries are licensed in the states where the insured or risk is located and act as intermediaries between retail producers and surplus lines insurers. Typically, a surplus lines intermediary provides the retail producer and the insured access to the surplus lines market when the admitted market cannot provide coverage or the risk qualifies for export.

The basic difference between wholesale brokers and MGAs is that MGAs are authorized to underwrite and bind coverage on behalf of the surplus lines insurer through binding authority agreements. Wholesale brokers are authorized only to submit business to surplus lines insurers; the insurers then underwrite, quote, and bind the risk if they deem it acceptable. Some MGAs also have claims-handling responsibilities and may be involved in placing reinsurance.

A Lloyd’s coverholder is a firm that has been authorized to bind coverage on behalf of underwriting syndicates at Lloyd’s; a Lloyd’s open market correspondent is a firm that has been approved to generate business for a Lloyd’s broker for placement at Lloyd’s.

Before a risk can be exported, surplus lines laws generally require a “diligent search” of the admitted market, to allow the admitted market the opportunity to insure the risk first. In general, three declines from admitted insurers are required before the risk can be placed in the surplus lines market.

In some states, specific types of risks can be placed in the surplus lines market without the diligent search. These states have “export lists” of risks for which the insurance commissioner has determined there is little or no coverage available in the state’s admitted market; the types of risks listed can be exported to an eligible surplus lines insurer without having to conduct a diligent search. In a few states, commercial lines deregulation laws allow for “automatic export” waivers, giving qualifying commercial buyers and their brokers or intermediaries immediate access to both the surplus lines market and a deregulated admitted market without a diligent search.

In a surplus lines transaction, the surplus lines intermediary is generally responsible for the following:

• Filing an affidavit affirming that a diligent search has been conducted, if required• Maintaining the records relating to the transaction• Collecting and remitting premium taxes to the insured’s home state

In addition, the surplus lines intermediary must have the following, among other things:

• The technical expertise about the risk to be insured• Extensive insurance product and market knowledge• The ability to respond quickly to changing market conditions• Access to eligible surplus lines insurers

Licensing and ComplianceIn a surplus lines transaction, the insured’s home state has the greatest degree of regulatory oversight, and the onus of compliance is on the surplus lines intermediary—the regulated

50


entity in the transaction. In addition to being a licensed (resident or nonresident) agent or broker, a surplus lines broker or licensee must:

• In many states, pass a written surplus lines examination to secure a resident license • Pay an annual licensing fee• Determine whether the risk meets all the requirements for placement with a surplus lines

insurer• Collect and remit the state’s surplus lines premium taxes

Furthermore, the surplus lines intermediary is responsible for determining whether the nonadmitted insurer insuring the risk meets the insured’s home state eligibility requirements. A surplus lines intermediary may be held liable for payment of claims when a risk is placed with a surplus lines insurer not authorized to receive the risk or with one that is financially unsound when the risk is bound. However, depending on state law, there may be no cause of action against a broker who exercises due diligence or care in selecting the insurer, even if the insurer were to become insolvent some time after.

Surplus lines policies must disclose that a nonadmitted insurer is providing coverage and that guaranty fund protection will not be available if the insurer becomes insolvent.

Market CyclesIn general, the same market conditions that affect admitted insurance will also affect surplus lines insurance, sometimes significantly. When conditions in the admitted market harden, or become more difficult, a sizable amount of business will flow from it to the surplus lines market. In a hard market, underwriters tend to become more conservative and restrictive, scrutinizing loss exposures more carefully, to determine how they can write a particular risk at a profit. In these circumstances, admitted carriers tend to insure only those risks they are most comfortable assuming and to avoid risks that are more complex or with which they have little or no experience.

As the market cycle progresses, competition heats up and market conditions in the admitted market soften, with producers and insurers trying to maintain market share by lowering rates, expanding coverage, and offering additional services at the expense of profit margins. During this soft market phase, consumers’ bargaining power increases significantly, causing a drop in rates and relaxation of coverage limitations or exclusions, at which point business begins to return to the admitted market.

Over time, as margins deteriorate to unprofitable levels, competitive pricing pressures erode the admitted market’s capacity, which again leads to a hardening of the market, and the cycle continues.

51


Appendix AUS Surplus Lines – Top 50 Groups, 2017Ranked by direct premiums written; ratings as of August 31, 2018($ Thousands)

Rank AMB# Group/Company Name TypeSurplus

Lines DPW

Year/ Year

Change in DPW

Total Group PHS

Best's Financial Strength Rating

Financial Strength

Rating Outlook /

Implications

Rating Effective

Date1 85202 Lloyd’s $10,325,000 7.5% A Stable 12-Jul-182 18540 American International Group $3,239,996 -14.0% $21,701,808 2 3535 AIG Specialty Insurance Co PROF $620,354 $83,011 A r Stable 20-Jun-182 22237 Blackboard Specialty Ins Co PROF $118,704 $91,067 A g Stable 10-Aug-182 2361 Illinois National Insurance Co MISC -$34 $41,340 A r Stable 20-Jun-182 2350 Lexington Insurance Company PROF $2,500,972 $5,441,854 A p Stable 20-Jun-183 18468 Markel Corporation Group $2,167,568 75.7% $3,450,573 3 22991 City National Insurance Co MISC $780 $12,028 A p Stable 22-Sep-173 3759 Evanston Insurance Company PROF $1,266,710 $1,375,644 A g Stable 20-Dec-173 13105 United Specialty Insurance Co PROF $900,078 $148,990 A p Stable 22-Sep-174 5987 Nationwide Group $1,737,150 0.6% $14,741,155 4 1931 Scottsdale Indemnity Company MISC $24,524 $39,661 A+ r Stable 2-Oct-174 3292 Scottsdale Insurance Company PROF $1,691,506 $737,790 A+ p Stable 2-Oct-174 12121 Scottsdale Surplus Lines Ins PROF $15,320 $48,660 A+ r Stable 2-Oct-174 601 Western Heritage Insurance Co PROF $5,800 $115,502 A+ r Stable 2-Oct-175 18252 W. R. Berkley Insurance Group $1,698,541 -1.5% $5,481,806 5 3026 Admiral Insurance Company PROF $525,795 $666,036 A+ r Stable 24-May-185 14158 Berkley Assurance Company PROF $125,134 $54,775 A+ r Stable 24-May-185 11296 Berkley Regional Specialty Ins PROF $26,429 $57,252 A+ r Stable 24-May-185 12118 Gemini Insurance Company PROF $433,452 $57,005 A+ r Stable 24-May-185 11231 Great Divide Insurance Co MISC $4,500 $69,230 A+ r Stable 24-May-185 1990 Nautilus Insurance Company PROF $583,232 $165,798 A+ r Stable 24-May-186 811 Berkshire Hathaway Ins Group $1,503,234 27.0% $170,264,117 6 864 Berkshire Hathaway Spec Ins Co MISC $9 $3,749,637 A++ g Stable 7-Dec-176 3806 General Star Indemnity Co PROF $186,305 $677,142 A++ g Stable 26-Jan-186 2540 Mount Vernon Fire Ins Co PROF $95,963 $579,362 A++ g Stable 22-Aug-186 18657 Mount Vernon Specialty Ins Co PROF $2,852 $61,236 A++ g Stable 22-Aug-186 2428 National Fire & Marine Ins Co PROF $1,177,791 $7,187,197 A++ g Stable 7-Dec-176 4406 National Indem Co of Mid-Amer MISC $2,834 $252,557 A++ g Stable 7-Dec-176 1824 National Indem Co of the South MISC $2,506 $265,959 A++ g Stable 7-Dec-176 22320 Radnor Specialty Insurance Co PROF $955 $52,830 A++ g Stable 22-Aug-186 3736 U S Underwriters Insurance Co PROF $26,073 $122,076 A++ g Stable 22-Aug-186 2541 United States Liability Ins Co MISC $7,946 $827,226 A++ Stable 22-Aug-187 18498 Chubb INA Group $1,445,248 -2.3% $17,690,733 7 2713 Chubb Custom Insurance Co PROF $218,945 $223,296 A++ g Stable 5-Oct-177 3761 Executive Risk Indemnity Inc MISC $612 $1,489,648 A++ g Stable 5-Oct-177 11251 Executive Risk Specialty Ins PROF $32,417 $184,660 A++ g Stable 5-Oct-177 3510 Illinois Union Insurance Co PROF $620,161 $130,649 A++ g Stable 5-Oct-177 4433 Westchester Surplus Lines Ins PROF $573,114 $105,541 A++ g Stable 5-Oct-178 3116 Fairfax Financial (USA) Group $1,305,476 77.7% $6,942,221 8 12525 Allied World Asr Co (US) Inc MISC $208,520 $140,685 A g Stable 20-Dec-178 12526 Allied World National Assur Co MISC $77,368 $153,733 A g Stable 20-Dec-178 11719 Allied World Surplus Lines Ins PROF $245,512 $96,484 A g Stable 20-Dec-178 11123 Crum & Forster Specialty Ins PROF $228,424 $50,305 A r Stable 28-Feb-188 11883 First Mercury Insurance Co PROF $233,239 $52,720 A r Stable 28-Feb-188 14995 Hudson Excess Insurance Co PROF $56,992 $59,080 A g Stable 28-Feb-188 12631 Hudson Specialty Ins Co PROF $186,944 $195,366 A g Stable 28-Feb-188 12258 Seneca Specialty Ins Co PROF $68,476 $50,821 A r Stable 28-Feb-189 60 Liberty Mutual Insurance Cos $1,288,834 274.7% $17,966,672 9 13866 Ironshore Specialty Ins Co PROF $845,906 $297,236 A r Stable 16-May-189 12078 Liberty Surplus Ins Corp PROF $442,928 $91,649 A r Stable 16-May-18

10 18874 XL Catlin America Group $1,142,292 1.6% $2,290,540 10 10092 Catlin Specialty Insurance Co PROF $134,511 $243,986 A u g Developing 6-Mar-1810 11340 Indian Harbor Insurance Co PROF $1,006,126 $47,536 A u g Developing 6-Mar-1810 789 T.H.E. Insurance Company MISC $1,655 $51,754 A- u Developing 6-Mar-1811 18549 Zurich Financial Svcs NA Group $1,135,953 -2.4% $7,639,652 11 2147 Empire Fire & Marine Ins Co MISC $1,474 $39,417 A+ g Stable 8-Dec-17

52




Lines DPW

Year/ Year

Change in DPW

Total Group PHS


Financial Strength

Rating Outlook /

Implications

Rating Effective

Date11 2148 Empire Indemnity Ins Co PROF $89,579 $52,362 A+ g Stable 8-Dec-1711 3557 Steadfast Insurance Company PROF $1,043,251 $508,785 A+ g Stable 8-Dec-1711 3565 Zurich American Ins Co of IL MISC $1,649 $34,843 A+ g Stable 8-Dec-1712 18640 Alleghany Ins Holdings Group $790,305 3.8% $6,882,395 12 1960 Capitol Specialty Ins Corp PROF $177,718 $58,915 A g Stable 29-Sep-1712 13859 Covington Specialty Ins Co PROF $143,564 $47,296 A+ r Stable 29-Sep-1712 22013 Fair American Select Ins Co PROF $26,125 $102,802 A+ r Stable 29-Sep-1712 12619 Landmark American Ins Co PROF $442,898 $184,581 A+ r Stable 29-Sep-1713 4019 Argo Group $723,869 7.0% $992,787 13 3283 Colony Insurance Company PROF $628,542 $424,480 A g Stable 20-Sep-1713 2619 Colony Specialty Insurance Co MISC $5,068 $23,740 A g Stable 20-Sep-1713 11035 Peleus Insurance Company PROF $90,259 $53,588 A g Stable 20-Sep-1714 18733 Tokio Marine US PC Group $688,481 7.6% $7,855,415 14 12531 HCC Specialty Ins Co PROF $17,012 $16,938 A++ r Stable 13-Dec-1714 3286 Houston Casualty Company PROF $360,583 $1,865,135 A++ g Stable 13-Dec-1714 22607 Safety Specialty Insurance Co PROF $13,726 $73,484 A+ g Stable 15-Sep-1714 763 Tokio Marine Specialty Ins Co PROF $297,160 $190,543 A++ p Stable 1-Dec-1715 18777 AXIS US Operations $681,015 9.0% $1,511,480 15 12515 AXIS Surplus Insurance Company PROF $681,015 $173,449 A+ g Negative 16-Feb-1816 18878 Sompo Holdings US Group $671,194 N/M* $1,680,580 16 13830 Canopius US Insurance, Inc.** PROF $40,051 $122,160 A- g Stable 22-Mar-1816 13033 Endurance American Spec Ins Co PROF $631,144 $99,974 A+ g Stable 20-Jul-1817 18713 QBE Americas Group $642,289 4.7% $1,655,858 17 12562 QBE Specialty Insurance Co PROF $642,289 $116,990 A p Stable 13-Jun-1818 4835 Great American P & C Ins Group $600,356 5.1% $2,730,953 18 3735 American Empire Surplus Lines PROF $133,183 $153,651 A+ r Stable 17-Aug-1818 3837 Great American E&S Ins Co PROF $446,796 $47,835 A+ r Stable 17-Aug-1818 3293 Great American Fidelity Ins Co PROF $18,181 $47,987 A+ r Stable 17-Aug-1818 14150 Mid-Continent E&S Ins Co PROF $2,197 $18,076 A+ r Stable 17-Aug-1819 18313 CNA Insurance Companies $568,441 -7.6% $10,726,216 19 3538 Columbia Casualty Company PROF $568,441 $244,973 A g Stable 5-Jul-1820 18783 Aspen US Insurance Group $539,155 14.2% $536,276 20 12630 Aspen Specialty Insurance Co PROF $539,155 $139,207 A u g Developing 29-Aug-1821 18626 James River Group $530,077 43.0% $219,132 21 13985 James River Casualty Company PROF $8,283 $17,319 A g Stable 14-Aug-1821 12604 James River Insurance Co PROF $521,794 $161,053 A g Stable 14-Aug-1822 3262 Swiss Reinsurance Group $485,098 23.0% $4,842,877 22 10783 First Specialty Ins Corp PROF $226,286 $73,324 A+ g Stable 7-Dec-1722 11135 North American Capacity Ins Co PROF $258,812 $52,360 A+ g Stable 7-Dec-1723 18484 Arch Insurance Group $469,965 -10.7% $2,930,75223 12523 Arch Specialty Insurance Company PROF $469,965 $300,746 A+ g Negative 30-Aug-1724 18756 Starr International Group $425,901 3.7% $1,875,290 24 13977 Starr Surplus Lines Ins Co PROF $425,901 $133,603 A g Stable 15-Mar-1825 18081 Navigators Insurance Group $411,553 7.3% $1,056,560 25 1825 Navigators Insurance Company MISC $163 $1,056,560 A Positive 14-Aug-1825 10761 Navigators Specialty Ins Co PROF $411,390 $141,978 A r Positive 14-Aug-1826 5696 Everest Re U.S. Group $403,903 31.7% $3,391,852 26 12096 Everest Indemnity Insurance Co PROF $402,421 $65,947 A+ g Stable 16-Mar-1826 11197 Everest Security Insurance Co MISC $1,482 $23,622 A+ g Stable 16-Mar-1827 18674 Travelers Group $389,700 1.9% $19,903,068 27 4869 Northfield Insurance Co PROF $128,136 $120,216 A++ g Stable 5-Oct-1727 4025 Northland Casualty Company MISC $263 $37,576 A++ g Stable 5-Oct-1727 712 Northland Insurance Company MISC $127 $516,111 A++ g Stable 5-Oct-1727 3592 St. Paul Surplus Lines Ins Co PROF $14,298 $183,447 A++ g Stable 5-Oct-1727 241 Travelers Excess & Surp Lines PROF $246,876 $61,693 A++ g Stable 5-Oct-1728 2946 Western World Insurance Group $381,901 25.8% $376,178 28 2598 Tudor Insurance Company PROF $47,529 $122,263 A u g Developing 22-Jan-18

53




Lines DPW

Year/ Year

Change in DPW

Total Group PHS


Financial Strength

Rating Outlook /

Implications

Rating Effective

Date28 3132 Western World Insurance Co PROF $334,372 $376,178 A u g Developing 22-Jan-1829 3883 RLI Group $275,378 5.1% $864,554 29 2591 Mt Hawley Insurance Company PROF $275,378 $441,227 A+ g Stable 17-Sep-1730 3873 SCOR U S Group $260,008 1.9% $991,266 30 2837 General Security Indem Co AZ PROF $260,008 $49,451 A+ g Stable 1-Sep-1731 18429 Allianz of America Companies $250,587 51.7% $2,668,799 31 407 Allianz Global Risks US Ins Co MISC $83 $1,850,576 A+ g Stable 30-Aug-1831 2618 Allianz Underwriters Ins Co PROF $74,129 $73,541 A+ g Stable 30-Aug-1831 2267 Interstate Fire & Casualty Co PROF $176,375 $70,082 A+ g Stable 30-Aug-1832 18717 HIIG Group $233,675 3.9% $261,310 32 13825 Houston Specialty Insurance Co PROF $201,284 $261,310 A- Stable 10-Oct-1732 14363 Oklahoma Specialty Ins Co PROF $32,391 $19,466 A- r Stable 10-Oct-1733 4294 The Cincinnati Insurance Cos $229,850 15.7% $5,093,566 33 13843 Cincinnati Specialty Undrs Ins PROF $229,850 $435,960 A+ g Stable 31-Jan-1834 856 State Auto Insurance Companies $226,020 15.2% $1,220,987 34 13023 Rockhill Insurance Company PROF $226,020 $88,698 A- r Stable 12-Jun-1835 25045 GeoVera U.S. Insurance Group $225,529 35.9% $78,370 35 11678 GeoVera Specialty Insurance Co PROF $225,529 $19,157 A g Stable 31-Jan-1836 14027 Kinsale Insurance Company $222,419 18.5% $213,833 36 14027 Kinsale Insurance Company PROF $222,419 $213,833 A- Positive 31-May-1837 18669 Global Indemnity Group $208,524 9.7% $274,818 37 3674 Penn-America Insurance Company PROF $58,263 $63,070 A g Stable 21-Dec-1737 11460 Penn-Patriot Insurance Company PROF $5,356 $16,639 A g Stable 21-Dec-1737 12050 Penn-Star Insurance Company PROF $46,380 $45,411 A g Stable 21-Dec-1737 3128 United National Insurance Co PROF $98,524 $147,923 A g Stable 21-Dec-1738 3926 Selective Insurance Group $208,116 3.6% $1,672,865 38 13842 Mesa Underwriters Spec Ins Co PROF $208,116 $89,893 A p Stable 8-Sep-1739 18458 OneBeacon Insurance Group $207,347 -4.9% $618,053 39 14398 Homeland Insurance Company DE PROF $19,885 $52,678 A r Stable 23-Feb-1839 10604 Homeland Insurance Company NY PROF $187,461 $115,644 A r Stable 23-Feb-1840 18753 Munich-American Hldng Corp Cos $204,948 2.4% $5,238,044 40 13062 Amer Modern Surpl Lines Ins Co PROF $545 $28,405 A+ g Stable 13-Jul-1840 2666 American Modern Select Ins Co MISC $661 $59,462 A+ g Stable 13-Jul-1840 3763 American Western Home Ins Co MISC $1,589 $71,147 A+ g Stable 13-Jul-1840 14838 HSB Specialty Insurance Co PROF $10,036 $50,678 A++ r Stable 6-Feb-1840 12170 Princeton Excess & Surp Lines PROF $192,118 $65,225 A+ g Stable 13-Jul-1841 18605 Hallmark Insurance Group $203,634 38.7% $233,320 41 14154 Hallmark National Insurance Co PROF $6,749 $24,111 A- p Stable 23-Aug-1841 10838 Hallmark Specialty Ins Co PROF $196,885 $57,409 A- p Stable 23-Aug-1842 18533 AmTrust Group $187,310 15.0% $2,092,318 42 11693 Associated Industries Ins Co MISC $146,757 $48,368 A- r Stable 3-Jul-1842 4070 Republic-Vanguard Ins Co PROF $15,733 $25,200 A- r Stable 3-Jul-1842 2522 Security National Ins Co MISC $24,821 $108,998 A- p Stable 3-Jul-1843 18567 IAT Insurance Group $184,644 -6.7% $811,425 43 11774 Acceptance Casualty Ins Co PROF $21,017 $67,232 A- p Stable 28-Sep-1743 10611 Acceptance Indemnity Ins Co PROF $104,612 $181,631 A- p Stable 28-Sep-1743 12276 Commercial Alliance Ins Co MISC $19 $46,178 A- p Stable 28-Sep-1743 975 Wilshire Insurance Company MISC $58,996 $140,216 A- p Stable 28-Sep-1744 48 Hartford Insurance Group $181,334 4.4% $11,459,082 44 2611 Hartford Insurance Co of IL MISC $1,280 $1,253,533 A+ p Stable 2-Aug-1844 12563 Maxum Indemnity Company PROF $158,008 $104,304 A+ r Stable 2-Aug-1844 2706 Nutmeg Insurance Company MISC $0 $257,770 A+ p Stable 2-Aug-1844 11654 Pacific Insurance Company, Ltd PROF $22,047 $238,035 A+ p Stable 2-Aug-1845 18523 Assurant P&C Group $179,311 12.7% $1,152,142 45 2050 Standard Guaranty Ins Co MISC $11,880 $129,763 A g Stable 18-Apr-1845 2861 Voyager Indemnity Ins Co PROF $167,432 $50,229 A g Stable 18-Apr-1846 897 IFG Companies $163,480 1.7% $429,573

54




Lines DPW

Year/ Year

Change in DPW

Total Group PHS


Financial Strength

Rating Outlook /

Implications

Rating Effective

Date46 709 Burlington Insurance Company PROF $161,601 $178,656 A g Stable 8-Aug-1846 12242 Guilford Insurance Company PROF $1,879 $272,484 A g Stable 8-Aug-1847 4861 Hanover Ins Grp P&C Cos $122,364 7.2% $2,077,091 47 13763 AIX Specialty Insurance Co PROF $122,364 $46,070 A r Stable 7-Jun-1848 419 ProSight Specialty Group $115,006 39.4% $433,946 48 728 Gotham Insurance Company PROF $56,988 $78,966 A- g Stable 6-Oct-1748 13309 Southwest Marine & General PROF $58,018 $63,304 A- g Stable 6-Oct-1749 18830 ProAssurance Insurance Group $99,505 21.0% $1,165,095 49 12468 Noetic Specialty Insurance Co PROF $18,229 $81,379 A+ g Stable 23-Aug-1749 2698 ProAssurance Casualty Company MISC $12,674 $294,883 A+ g Stable 23-Aug-1749 11697 ProAssurance Specialty Ins Co PROF $68,602 $33,484 A+ r Stable 23-Aug-1750 18587 Atain Insurance Companies $95,467 -14.6% $190,842 50 12422 Atain Insurance Company PROF $4,637 $52,159 A p Stable 21-Dec-1750 2842 Atain Specialty Insurance Co. PROF $90,831 $190,842 A p Stable 21-Dec-17

* The N/M (Not Meaningful) designation for the percentage increase in the DPW for Sompo Holdings, Inc. in 2017 reflects the fact that the group wrote only $33.7 million in surplus lines DPW in 2016, but increased that total by more than 20 times because of its acquisition of Endurance Specialty Holdings, Ltd. during the first quarter of 2017.** Canopius US Insurance, Inc., was sold (along with its parent company, Sompo Canopius Group) to a private consortium led by Centerbridge Partners, LP, in a deal that was finalized on March 8, 2018. PROF = Company that wrote more than 50% of its 2017 DPW on a nonadmitted basis.MISC = Company that wrote more than 1% but less than 50% of its 2017 DPW on a nonadmitted basis.Source: A.M. Best data and research

55


Appendix BDomestic Professional Surplus Lines Companies, 2013-2017X denotes domestic professional surplus lines companies, defined as those whose direct premium from the surplus lines business constitutes more than 50% of total premium.

Company Name 2013 2014 2015 2016 2017Acceptance Casualty Insurance Co X X X X XAcceptance Indemnity Insurance Co X X X X XAdmiral Insurance Co X X X X XAdriatic Insurance Co X X X X XAgent Alliance Insurance Company XAIG Specialty Insurance Co X X X X XAIX Specialty Insurance Co X X X X XAllianz Underwriters Insurance Co X X X X XAllied World Asr Co (US) Inc X X XAllied World Surplus Lines Ins X X X X XAlterra Excess & Surplus Ins* X XAmerican Empire Surplus Lines X X X X XAmerican Modern Surpl Lines Ins Co X X X X XAmerican Mutual Share Ins Corp X X X X XAmerican Safety Indemnity Co X X XAmerican Safety Insurance Co X X X X XAmerican Western Home Ins Co X X XAppalachian Insurance Co X X X X XArch Specialty Insurance Co X X X X XAspen Specialty Insurance Co X X X X XAssociated Industries Insurance Co X XAssociated International Ins X X XAtain Insurance Co X X X X XAtain Specialty Insurance Co. X X X X XAtlantic Casualty Insurance Co X X X X XAXIS Surplus Insurance Co X X X X XBerkley Assurance Co X X X X XBerkley Regional Specialty Ins X X X X XBlackboard Specialty Insurance Co XBurlington Insurance Co X X X X XCanal Indemnity Co X X X X XCanopius US Insurance, Inc. X X X X XCapitol Specialty Insurance Corp X X X X XCatlin Specialty Insurance Co X X X X XCentury Surety Co X X X X XChubb Custom Insurance Co X X X XCIM Insurance Corporation XCincinnati Specialty Undrs Ins X X X X XCity National Insurance Company XClear Blue Specialty Ins Co X X XCM Vantage Specialty Ins Co X XColony Insurance Co X X X X XColumbia Casualty Co X X X X XCompanion Specialty Ins Co XConifer Insurance Co X X XCoverys Specialty Insurance Co X X XCovington Specialty Ins Co X X X X XCrum & Forster Specialty Ins X X X X XCUMIS Specialty Ins Co Inc X X X X XDiscover Specialty Insurance Co XDover Bay Specialty Ins Co X XEmpire Indemnity Insurance Co X X X X XEndurance American Spec Ins Co X X X X XEssex Insurance Co ** X X XEvanston Insurance Co X X X X XEverest Indemnity Insurance Co X X X X XExecutive Risk Specialty Insurance X X X X XFair American Select Ins Co X X X XFireman’s Fund Ins Co of OH X X XFirst Financial Insurance Co X

Company Name 2013 2014 2015 2016 2017First Mercury Insurance Co X X X X XFirst Specialty Insurance Corp X X X X XGemini Insurance Co X X X X XGeneral Security Indem Co AZ X X X X XGeneral Star Indemnity Co X X X X XGeoVera Specialty Insurance Co X X X X XGNY Custom Insurance Co X X X X XGotham Insurance Co X X X X XGreat Amer Protection Insurance Co X X X XGreat American E&S Insurance Co X X X X XGreat American Fidelity Insurance Co X X X X XGuideOne National Insurance Co X X X X XGuilford Insurance Co X X X X XHallmark National Ins Co X XHallmark Specialty Insurance Co X X X X XHamilton Specialty Ins Co XHCC Specialty Insurance Co X X X X XHomeland Insurance Co of DE X X X X XHomeland Insurance Company NY X X X X XHousing Specialty Insurance Co. Inc. X X XHouston Casualty Co X X X X XHouston Specialty Insurance Co X X X X XHSB Specialty insurance Co X X X X XHudson Excess Insurance Co X X X X XHudson Specialty Insurance Co X X X X XIllinois Union Insurance Co X X X X XIndian Harbor Insurance Co X X X X XInterstate Fire & Casualty Co X X X X XIronshore Specialty Insurance Co X X X X XJames River Casualty Co X X X X XJames River Insurance Co X X X X XKinsale Insurance Co X X X X XKnight Specialty Insurance Co X X X XLandmark American Ins Co X X X X XLexington Insurance Co X X X X XLiberty Surplus Ins Corp X X X X XMaiden Specialty Insurance Co X XMaxum Indemnity Co X X X X XMedical Security Insurance Co X X X X XMerchants National Ins Co X X X X XMesa Underwriters Spec Ins Co X X X X XMid-Continent Excess & Surplus X X X X XMSA Insurance Co X X X X XMt Hawley Insurance Co X X X X XMt Vernon Fire Insurance Co X X X X XMt. Vernon Specialty Ins Co X X XNAMIC Insurance Co, Inc X X X X XNational Fire & Marine Ins Co X X X X XNational Guaranty Ins Co of Vermont X X X X XNautilus Insurance Co X X X X XNavigators Specialty Ins Co X X X X XNevada Capital Insurance Co XNoetic Specialty Insurance Co X X X X XNorth American Capacity Ins Co X X X X XNorth Light Specialty Insurance Co X X X X XNorthfield Insurance co X X X X XNutmeg Insurance Co XOklahoma Specialty Ins Co X X X X XOld Republic Union Ins Co X X X X XPacific Insurance Co, Ltd X X X X X

56


Company Name 2013 2014 2015 2016 2017Peleus Insurance Company X X X X XPenn-America Insurance Co X X X X XPenn-Patriot Insurance Co X X X X XPenn-Star Insurance Co X X X X XPrime Insurance Co X X X X XPrinceton Excess & Surp Lines X X X X XProAssurance Specialty Ins Co X X X X XProfessional Security Ins Co X X X X XProtective Specialty Ins Co X X X X XQBE Specialty Insurance Co X X X X XRadnor Specialty Insurance Co XRepublic-Vanguard Ins Co X X X X XRockhill Insurance Co X X X X XSafety Specialty Insurance Co X XScottsdale Insurance Co X X X X XScottsdale Surplus Lines Ins X X X X XSeneca Specialty Ins Co X X X X XSouthwest Marine & General X X X X XSPARTA Specialty Insurance Co X XSt. Paul Fire & Casualty Ins XSt. Paul Surplus Lines Ins Co X X X X XStarr Surplus Lines Ins Co X X X X XStarStone Specialty Ins Co X X

Company Name 2013 2014 2015 2016 2017Steadfast Insurance Co X X X X XTDC Specialty Insurance Co X X X X XTokio Marine Specialty Ins Co X X X X XTorus Specialty Insurance Co X XTravelers Excess & Surp Lines X X X X XTudor Insurance Co X X X X XUnited National Insurance Co X X X X XUnited National Specialty Ins Co XUnited Specialty Insurance Co X X X X XUS Underwriters Insurance Co X X X X XUtica Specialty Risk Ins Co XVerTerra Insurance Company X XVoyager Indemnity Ins Co X X X X XWatford Specialty Insurance Co X XWestchester Surplus Lines Ins X X X X XWestern Heritage Insurance Co X X X X XWestern World Insurance Co X X X X XXL Select Insurance Co X X X X* Merged into Evanston Insurance Company effective December 31, 2015.** Merged into Evanston Insurance Company effective July 1, 2016.Source: A.M. Best data and research

Appendix BDomestic Professional Surplus Lines Companies, 2013-2017X denotes domestic professional surplus lines companies, defined as those whose direct premium from the surplus lines business constitutes more than 50% of total premium.

57


Appendix CState Survey: Capital & Surplus Requirements for Surplus Lines Companies

State

Domestic Company Minimum Surplus

Alien Company Minimum Surplus

Pending Revisions

Alabama $15,000,000 $2,500,000 (2) NoAlaska $15,000,000 $15,000,000 &

$2,500,000 (1)No

Arizona $15,000,000 $2,500,000 (1), (2)

No

Arkansas $15,000,000 (1) NoCalifornia $45,000,000 (1), (2) NoColorado $15,000,000 (1) NoConnecticut $15,000,000 (1) NoDelaware $15,000,000 (1) NoDist of Columbia

$600,000 (14) (1) No

Florida $15,000,000 $15,000,000 (2) NoGeorgia $15,000,000 (1), (12) NoHawaii $15,000,000 (1),

$5,400,000 (2)No

Idaho $15,000,000 (1) NoIllinois $15,000,000 (1) NoIndiana (4) (1) NoIowa $15,000,000 (7) NoKansas $4,500,000 (1) NoKentucky $15,000,000 (1) NoLouisiana $15,000,000 (2), (7) NoMaine $15,000,000 (1) NoMaryland $15,000,000 (1) NoMassachusetts $15,000,000 (1) NoMichigan $15,000,000 (1) NoMinnesota $15,000,000 (1), (6) NoMississippi $15,000,000 (1),

$5,400,000 (2)No

State

Domestic Company Minimum Surplus

Alien Company Minimum Surplus

Pending Revisions

Missouri $15,000,000 $15,000,000(1) YesMontana $15,000,000 (1), (2) YesNebraska $15,000,000 (1) NoNevada $15,000,000 (3) NoNew Hampshire $15,000,000 (1) NoNew Jersey $15,000,000 $15,000,000 (5) N/ANew Mexico $15,000,000 (1) N/ANew York $46,000,000 (1) NoNorth Carolina $15,000,000 (1), (2) NoNorth Dakota $15,000,000 (1) NoOhio $15,000,000 (1) NoOklahoma $15,000,000 (1) NoOregon $15,000,000 (1)

$5,400,000 (2)No

Pennsylvania $15,000,000 (1), (8) NoPuerto Rico (7) (9) NoRhode Island $15,000,000 (1) NoSouth Carolina $15,000,000 (1) NoSouth Dakota (10) (1) NoTennessee $15,000,000 (1) NoTexas (7) (1), (2) NoUtah $15,000,000 (13) (1) NoVermont $15,000,000 (1) NoVirginia $15,000,000 (1) NoWashington $15,000,000 (1) NoWest Virginia $15,000,000 (11) NoWisconsin $15,000,000 (1), (15) NoWyoming $15,000,000 (1) No

(1) Surplus lines brokers may do business with nonadmitted insurers domiciled outside the US, (including Lloyd’s syndicates) that appear on the Quarterly Listing of Alien Insurers maintained by the International Insurers Department (IID) of the NAIC, and comply with minimum capital requirements in the state (generally $15,000,000, but $45,000,000 in California).(2) Approved alien insurers are required to maintain a trust fund in the US designed to reasonably protect all policyholders and containing a minimum amount set by state law. In Florida, Hawaii, Louisiana, Massachusetts, Oregon and Texas, the stipulated minimum is $5.4 million.(3) Insurers, including Lloyd’s syndicates, appearing on the Quarterly Listing of Alien Insurers maintained by the International Insurers Department of the NAIC are deemed approved in Nevada. An insurer not appearing on that listing may be eligible if it has and maintains in a bank or trust company (which is a member of the US federal Reserve System) a trust fund established pursuant to terms that are reasonably adequate to protect all of its policyholders in the US.(4) Indiana does not impose formal eligibility requirements other than a sponsoring broker requirement for foreign surplus lines insurers. A licensed surplus lines producer must request by letter or by email that a foreign (US) surplus lines insurer be added to the state’s eligibility list.(5) In establishing its trust fund, an insurance company must maintain such fund at, and enter into an agreement with, a qualified US financial institution. The agreement must contain provisions consistent with the IID model document, “Trust Agreement for Alien Excess or Surplus Lines Insurers.”(6) Trust required to be maintained under Minnesota 60A. 206, Subd.5.(7) Follows NAIC requirements.(8) If the company is listed on the Quarterly List of Alien Insurers maintained by the IID, a written request for surplus lines eligibility is required to include documentation evidencing its listing by the NAIC.(9) Puerto Rico no longer imposes a fee or financial premium or requires other information from a foreign or alien insurer for surplus lines eligibility purposes aside from the eligibility requirements set forth in the NRRA.(10) South Dakota requirements for a surplus lines insurer remain the same as before, aside from the requirements under the NRRA. Surplus lines insurers will be required to file the Unauthorized Insurer Business Written & Premium Tax Report along with the Schedule T & State Page for foreign companies. Alien surplus lines companies will be required to file the Unauthorized insurer Business Written & Premium Tax Report.(11) Listed with NAIC WVA Code 33-12C-5(d)(3).(12) Listed with NAIC GA Code O.G.C.A. 33-5-25(b)(1).(13) Must have evidence of compliance with NAIC Risk-Based Capital Requirements or have at least $15,000,000 in capital & surplus, whichever is greater.(14) The minimum capital & surplus requirement for a domestic P/C insurer in DC is $600,000, broken down in the applicable law as $300,000 in capital and $300,000 in surplus.(15) Wisconsin Stat. § 618.416(1)(b).Source: A.M. Best data and research

58


Appendix DState Survey – Stamping Office & Multi-State TaxationState Stamping Office Premium Tax Stamping FeeAlabama No 6.00% NoAlaska No 2.70% 1.00%Arizona Yes 3.00% 0.002Arkansas No 4.00% NoCalifornia Yes 3.00% 0.002Colorado No 3.00% NoConnecticut No 4.00% NoDelaware No 3.00% NoDist of Columbia No 2.00% NoFlorida Yes 5.00% 0.001Georgia No 4.00% NoHawaii No 4.68% NoIdaho Yes 1.50% 0.500%Illinois Yes 3.50% 0.00125Indiana No 2.50% NoIowa No 1.00% NoKansas No 6.00% NoKentucky No 3.00% NoLouisiana No 4.85% NoMaine No 3.00% NoMaryland No 3.00% NoMassachusetts No 4.00% NoMichigan* No 2.00% NoMinnesota Yes 3.00% 0.04%Mississippi Yes 4.00% 0.0025Missouri No 5.00% NoMontana No 2.75%** 0.0025Nebraska No 3.00% NoNevada Yes 3.50% 0.004New Hampshire No 3.00% NoNew Jersey No 5.00% NoNew Mexico No 3.00% N/ANew York Yes 3.60% 0.17%North Carolina No 5.00% 0.004North Dakota No 1.75% NoOhio No 5.00% NoOklahoma No 6.00% NoOregon Yes 2.3%*** $15.00Pennsylvania Yes 3.00% 20Puerto Rico No 9.00% NoRhode Island No 4.00% NoSouth Carolina No 4.00% NoSouth Dakota No 2.5%-3.0% NoTennessee No 5.00% NoTexas Yes 4.85% 0.15%Utah Yes 4.25% 0.0018Vermont No 3.00% NoVirginia No 2.25% NoWashington Yes 2.00% 0.001West Virginia No 4.55% NoWisconsin No 3.00% NoWyoming No 3.00% No* In Michigan, a 0.5% regulatory fee applies in addition to the premium tax.

** An additional 2.5% tax is applied to fire portions of surplus lines payments (annually).

*** This amount includes .3% collected for Oregon Fire Marshalls’ office.

Source: A.M. Best data and research, as of August 15, 2018


Market Segment Report

Published by A.M. Best

MARKET SEGMENT REPORTA.M. Best Company, Inc.

Oldwick, NJCHAIRMAN & PRESIDENT Arthur Snyder III

SENIOR VICE PRESIDENTS Alessandra L. Czarnecki, Thomas J. Plummer

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Best’s Financial Strength Rating (FSR): an independent opinion of an insurer’s financial strength and ability to meet its ongoing insurance policy and contract obligations. An FSR is not assigned to specific insurance policies or contracts.

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Rating Disclosure: Use and LimitationsA Best’s Credit Rating (BCR) is a forward-looking independent and objective opinion regarding an insurer’s, issuer’s or financial obligation’s relative creditworthiness. The opinion represents a comprehensive analysis consisting of a quantitative and qualitative evaluation of balance sheet strength, operating performance, business profile, and enterprise risk management or, where appropriate, the specific nature and details of a security. Because a BCR is a forward-looking opinion as of the date it is released, it cannot be considered as a fact or guarantee of future credit quality and therefore cannot be described as accurate or inaccurate. A BCR is a relative measure of risk that implies credit quality and is assigned using a scale with a defined population of categories and notches. Entities or obligations assigned the same BCR symbol developed using the same scale, should not be viewed as completely identical in terms of credit quality. Alternatively, they are alike in category (or notches within a category), but given there is a prescribed progression of categories (and notches) used in assigning the ratings of a much larger population of entities or obligations, the categories (notches) cannot mirror the precise subtleties of risk that are inherent within similarly rated entities or obligations. While a BCR reflects the opinion of A.M. Best Rating Services, Inc. (A.M. Best) of relative creditworthiness, it is not an indicator or predictor of defined impairment or default probability with respect to any specific insurer, issuer or financial obligation. A BCR is not investment advice, nor should it be construed as a consulting or advisory service, as such; it is not intended to be utilized as a recommendation to purchase, hold or terminate any insurance policy, contract, security or any other financial obligation, nor does it address the suitability of any particular policy or contract for a specific purpose or purchaser. Users of a BCR should not rely on it in making any investment decision; however, if used, the BCR must be considered as only one factor. Users must make their own evaluation of each investment decision. A BCR opinion is provided on an “as is” basis without any expressed or implied warranty. In addition, a BCR may be changed, suspended or withdrawn at any time for any reason at the sole discretion of A.M. Best. Version 021518

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