According to the report, the last double-digit drop occurred in 1988, when the decline was 10.4 percent.

Report author David Blades, a Best senior financial analyst, said he's been a little surprised by the fact the soft market has dragged on so long, and by the lack of deals getting done.

In an interview before the official release of the report at the NAPSLO annual conference, Mr. Blades said a lot of due diligence is still being done by company management teams intent on making acquisitions. That's to be expected, given the continuation of a soft market that's impeding the possibility of organic growth.

“There's a lot of activity behind the scenes, but the actual [merger] deals getting done still seem to be a little bit slower than in previous years,” Mr. Blades said.

A lot of insurance organizations still have solid balance sheets, “so there is capital there to make smaller acquisitions on the company side–to buy an MGA, to buy an underwriting manager,” if the insurer has its sights on expanding into a certain type of business in which it's not currently involved. “I think that's where the focus is right now, but even those deals don't seem to be as frequent as in the past,” he added.

He said he believes most potential deal activity hasn't moved past the interested-shopper stage because of concerns about the investment markets overall.

“There was trepidation at the start of the year as to how bad investment losses would still be–whether the markets would come back. What capital you had you wanted to hold a little bit closer to the vest,” he said.

Company managers who weren't sure investments were “going to come back didn't want to go using the capital” they had–capital that “could actually be used to fill in some holes if they had more realized investment losses.”

That conservatism meant that only small deals–those that could be executed using disposable capital–could get done. While Mr. Blades believes the conservatism was well placed given the volatility of the investment markets, he also believes that if insurance companies are going to make deals, now is the time to get them closed–before year-end.

“If conditions do start to turn around, and the market looks a little more favorable from an underwriting standpoint, then there might be some opportunities for which the price will only go up,” or deals might be taken off the table entirely, Mr. Blades reasoned.

“So for those companies that do have the capital, the balance sheet strength to go out and purchase somebody–a smaller competitor or an MGA, maybe even one of some size–it may be easier to do that now,” he said.

SLUGGISH MARKET

How quickly soft insurance market conditions will start to turn around, of course, remains an open question.

“We said a year ago that we really anticipated the market having a definitive change–some sort of a hardening by this point. The more people we talk to in doing research, however, the more we realize how far that's getting pushed out now,” he said, noting that many market participants don't see a turn happening until late in 2010.

In addition to a recessionary economy, Best analysts highlighted three factors at work sustaining a competitive market and pushing E&S insurance premiums downward in 2008 and 2009:

o Standard carriers competing for E&S business.

o Efforts by the E&S companies of American International Group (now known as Chartis) to protect renewals.

o The pursuit of top-line growth by Bermuda-based carriers.

Mr. Blades confirmed that Best believes the most significant factor is the behavior of standard markets companies.

“It's amazing how the industry came through the second half of last year and even the first half of this year,” he said.

Although investment and catastrophe losses definitely pushed policyholders' surplus down–for both standard and E&S carriers–individual company balance sheets remained strong in both sectors despite the hits, he noted. “That being the case, from the standard market perspective, it allows them to still have interest in these borderline surplus lines businesses.”

Bermuda capital is also considerable, he said, noting that both the companies created early in the decade–the Class of 2001 created in the wake of the 9/11 attacks, and the Class of 2005 start-ups launched after Hurricane Katrina–are participating in the U.S. surplus lines market. Class of '01 insurers Arch and AXIS, in fact, are among the top-25 E&S insurers ranked by direct U.S. E&S written premiums.

Mr. Blades explained that in the early weeks after news of the near-bankruptcy of their AIG parent, some Chartis company business–in particular, portions of layered insurance programs on large accounts–began moving away from Lexington Insurance and other Chartis E&S insurers.

Those insurers have historically “been stalwarts in the surplus lines [segment]. They built up very good, very solid businesses,” he said–noting, however, that insureds became less comfortable with having 60-to-70 percent of a program with AIG insurers.

“I think in reaction to that,” the Chartis E&S companies, “because they like the business, began to compete very hard to retain as much of it as possible,” Mr. Blades said. “You hear this anecdotally and you can see it in the numbers.”

“If these clients had been AIG clients for a long time, I think they began to be very protective of their renewals,” he said. “That's not to say there was any kind of wholesale price slashing, but I think they competed hard for it–whether it was rate or promising more services or doing whatever needed to be done from a value-added perspective.”

“It only makes sense because from a reputational perspective they were getting beaten about the head and face, obviously, after all that had happened at the parent-company level,” he said–while emphasizing, however, that Lexington and other Chartis companies are “still very strong. We still have an 'A' rating out on those companies.”

From a numbers perspective, E&S premiums for the Chartis companies fell 12.8 percent in 2008, but Chartis retained its position as the lead writer with $7.2 billion in E&S premiums. Lloyd's and Zurich–ranked second and third, respectively–had smaller premium drops (4.7 percent and 6.2 percent), but most other groups on A.M. Best's top-25 list, like Chartis, saw double-digit premium declines.

Lloyd's, which hasn't ranked first since 2001, recorded $6.0 billion on U.S. E&S premiums recorded in 2008, according to the A.M. Best report.

How likely is it that Lloyd's will emerge as the leader when the rating agency publishes its next report for NAPSLO 2010?

“Where we stand right now, they might [be number one]. There is absolutely a possibility that might be the case,” he said, admitting that he hadn't actually contemplated the question before. “That will be a big story, even though those two are so separated from everybody else. It's not like AIG is going to drop down to third.”

Another unit of the rating agency recently published another report suggesting that Lloyd's has been the primary beneficiary of any insured movements away from Chartis, and Mr. Blades agrees.

While Lloyd's capital structure is difficult to understand, there's no question that the overall capital position is strong, he noted. “Insureds may have a comfort level with Lloyd's [from] an underwriting acumen standpoint and because they have the capacity to write this business,” he said.

PROFITS DESPITE CATS

For the E&S segment overall, premiums continue to drop through the first half of 2009, but the rating agency is expecting the segment will post an underwriting profit for 2009, Mr. Blades said.

“A key theme for the surplus lines companies is to wait out this part of the market–to continue being disciplined,” he said, giving one reason for the conclusion.

“The management teams of those groups in the top-25 are writing the lion's share of the business because they've been around for a while–they understand how the cycle goes. And I think a lot of people truly believe that at some point–maybe it will take another year–that there will be some sort of turn in the market.”

“I do believe that overall, there will be enough underwriting discipline to allow that business that is truly believed to be underpriced to leave [E&S company] books for another year with the knowledge that they'd be able to get it back once the market turns,” he said.

As has been the case for two decades, E&S insurers reported a lower combined ratio than the property and casualty industry overall, according to Mr. Blades, who reported that 74 domestic professional surplus lines companies tracked by A.M. Best posted a combined ratio of 93.6 in 2008–more than 11 points better than the industrywide result of 105.

Still, severe property-catastrophe losses drove the 2008 result for the E&S segment well above the 76.1 E&S combined ratio for 2007. In fact, information in the report suggests that in the absence of prior-year loss reserve takedowns–which shaved 10.7 points off the 2008 E&S combined ratio–the segment would have suffered an underwriting loss.

After the 2005 storms of Hurricanes Katrina, Rita and Wilma, more catastrophe-exposed business found its way to the E&S market, Mr. Blades said, explaining why E&S insurer underwriting results took such a blow from last year's natural catastrophes–events that included Midwestern storms and tornadoes early in 2008, and then Hurricanes Gustav and Ike later on.

All the events together added 16 points to the loss ratio component of the E&S combined ratio in 2008, he said.

As for loss reserves, the 10.7-point takedown is significantly higher than the comparable figure calculated for the overall industry by National Underwriter earlier this year–3.3 points (excluding some distortion related to financial guaranty lines).

The relationship is not surprising to Mr. Blades, who said the E&S insurers traditionally are more conservative when they put up reserves initially–because they deal in more hazardous lines–prompting larger takedowns as claims settle.

Overall, A.M. Best currently has a stable outlook on the E&S segment.

A.M. Best's 16th annual report on the surplus lines market was commissioned by the Derek Hughes/NAPSLO Educational Foundation, a foundation set up in 1991 to improve education about surplus lines.