Retail brokers may start seeking larger cuts of the commissions paid out on surplus lines transactions as the soft market continues, a specialty lines insurance executive suggested recently.

"Be more accessible to your retailers," said John Molbeck, president and CEO of HCC Insurance Holdings, a Houston-based holding company for specialty insurance carrier and managing general agency operations, advising wholesalers and MGAs on one way to avoid the inevitable commission pressure.

Mr. Molbeck delivered his comments at the S&P Insurance Conference in early June in New York, where more than a dozen insurance and reinsurance company executives described strategies for coping with market pressures and predicted that a broad-scale pricing turn--beyond the offshore energy insurance market--is at least a year away.

After describing his organization's strategy for navigating the underwriting operations through both hard and soft markets--a strategy that in large part hinges on expense control--Damien Magerelli, and S&P director and the panel's moderator, asked Mr. Molbeck about potential expense structure changes that could impact the brokerage community.

"If you look at the retail brokerage industry, there's been a sea change. Some people say it's been McKinseyized," Mr. Molbeck responded, referring to the management consulting firm known for helping clients cut costs.

"Before Spitzer, [broker] margins of 25- and 35 percent were not unheard of," he said, referring to the environment before former New York Attorney General Eliot Spitzer exposed retail broker involvement in bid-rigging activities in the insurance industry. "But what we've seen over the last few years is expense control--cutting very, very close to the bone--at all publicly traded retail brokers," he said, identifying Aon, Marsh and Willis as examples.

"The expense cutting is over. Now what are they going to do?" Mr. Molbeck wondered. "The low-hanging fruit, in my opinion, is the commissions they pay to the wholesalers and the MGAs."

"It's just a natural evolution, and they're going to want to trap that income within the retail distribution," he asserted, suggesting that retailers might seek to cut out wholesalers entirely.

The inevitable change is "going to put a lot of pressure on wholesale distribution," Mr. Molbeck believes. "So the strategy has to be more that you [wholesalers] have to be accessible to retail distribution or the various portals that you might have to sell your products online," he said. "I do think that's going to be the big difference in the next couple of years."

(Editor's Note: For a more precise discussion of wholesaler compensation, see the whitepaper, "Wholesale-nomics," written by David Pagoumian, CEO of Iselin, N.J.-based wholesaler NAPCO, available on NAPCO's website at http://www.napcollc.com/articles/WholesalenomicsWhitePaper.pdf, and on the website of the National Association of Professional Surplus Lines Offices at http://www.napslo.org/imispublic/PDF/Publications/Wholesale-nomics.pdf.

The whitepaper--arguing against the notion that using a wholesaler adds costs to a specialty insurance placement--explains that wholesale brokers are compensated by commissions paid by the insurance company, and that an agreement between the placing wholesaler and producing retailer determines how the commission or fee is allocated between the parties.)

RATES STAY SOFT FOR NOW

What will not be different for at least a year is the soft pricing cycle, said executives speaking at S&P and during a separate Oppenheimer Insurance CEO Summit early this month. Although some suggested that the BP Deepwater Horizon disaster is fueling price hikes in the energy market that could spill over into the broader specialty lines sector, for the most part they pointed to excess capital and adequate reserve levels for the property and casualty industry overall to support their views of continued softness.

At S&P, Mr. Molbeck added the absence of American International Group's historical price leadership to the list of factors keeping the market soft. In the past, "when AIG decided to change the pricing, the market was able to follow along," he said.

"This will be the first market cycle where we don't have that event."

"I think we have to accept the fact that we may be at a new normal," he added.

(For more of Mr. Molbeck's comments on AIG's former price leadership, and reaction from John Doyle, president and CEO of Chartis U.S.--the U.S. p&c operations formerly part of AIG--see the related article in the June 21 print edition of National Underwriter magazine, page 6, available at http://property-casualty.com/Issues/2010/June-1421-2010/Pages/No-Turn-Without-AIG-Price-Leadership-Carrier-Exec-Says.aspx.

Turning to the issue of reserve adequacy, Mr. Molbeck predicted that some deficiencies are bound to show up for the accident years 2009 and 2010 in the liability lines, as a corollary to inadequate pricing in those years.

"Having said that, I look at some of the loss ratios that some of our peers are putting up and I think they may be excessively high," he noted. He reasoned that with p&c insurer stock prices trading at low values, "there's no premium in having a great loss ratio or great combined ratio. [Therefore,] the mentality of some managements may be to put money away and release reserves at some future date."

William R. Berkley, chair and chief executive officer of a Greenwich, Conn.-based W.R. Berkley Corp., gave a contrasting view at a press luncheon late last month, suggesting that reserve releases are "rapidly coming to an end."

Historically, "the cycle is driven by reserve development and how it changes," he said, predicting that with loss reserve releases dwindling, prices will rise between 6- and 8 percent by fourth-quarter 2010.

Mr. Berkley estimates that over the course of the years 2009 and 2010, "the industry is probably creating $30-to-$40 billion of deficiencies, "offsetting whatever redundancies [had] accumulated prior to that, less what they've [already] taken down."

"So my guess is the industry will not at the end of this year have any consequential redundancies," he said.

Mr. Berkley's son, Rob Berkley, who is chief operating officer, gave further evidence of a near-term market turn based on his recent observations of competitor behavior.

This year, "the standard market is encroaching less on the E&S market," he said, describing one precursor to a market turn. "In fact, we're even seeing some changes within the E&S market," he added.

Elaborating on his last point, he said that "in the nonadmitted/specialty space, we're seeing some new entrants within the past 36 months, which came in with a very aggressive manner, reexamining whether they really want to be doing this."

"There are two just within the past two weeks that have decided to exit parts of the market that they had entered," he reported during the luncheon in late May.

In a follow-up conversation with NU last week, Rob Berkley confirmed the two departures from the nonadmitted market, although he declined to disclose the names of the carriers for publication.

Asked at the luncheon whether these recent entrants were from Bermuda or London, he said: "The answer is they're coming from any direction where they can find capital."

He went on to explain that after going out to amass a pool of capital to respond to some perceived dislocation in the market, these startups "end up raising more than they can put to work. But they need a [certain] minimum amount to get the ratings that they want" from credit rating agencies.

"So they get stuck with this excess capital," and one way to put the capital to work "is to start dabbling [in areas] beyond their expertise"--activities that have ultimately led to retreats, he said.

"As far as the standard market goes, we're not seeing them push any farther, and we're seeing isolated examples where the standard market is pausing to assess what they've actually taken on," he added.

IS ENERGY AN ISOLATED TURN?

At the luncheon, Rob Berkley also noted that offshore energy insurance prices were jumping 40-to-50 percent in the wake of the Deepwater Horizon disaster in the Gulf--an assessment repeated by other specialty lines insurance executives two weeks ago at the Oppenheimer Summit in New York, which was simultaneously webcast.

Stanley Galanski, CEO of Rye, N.Y.-based Navigators Group, drew a parallel between the latest disaster and the sinking of the Petrobras rig off the coast of Brazil in first-quarter 2001.

While Hurricanes Katrina and Rita in 2005 helped pushed offshore energy rates up over the last 11 years to a level that is two- or three-times what they were at the 1999 cycle bottom for the segment, Mr. Galanski said the real "market-changing event" was the sinking of the Petrobras rig.

"It strikes me that Deepwater Horizon in the energy market is exactly that," he said. Deepwater Horizon isn't just changing the energy market in the Gulf, he explained. "It's an international energy event."

Last year, he noted, there were seven major risk losses over $10 million in the offshore energy insurance sector--amounting to $2.4 billion in an industry that writes $2 billion in premium.

"In the absence of any activity in the Gulf, you still looked at an industry running a 120 percent loss ratio," he said. "So rates have gone up and need to go up," he said.

"We saw rates deteriorating in the first quarter, [but] around the globe, in the last 30 days, we're seeing what looks like 25-to-50 percent rate increases," he added.

Mr. Galanski reported that the hikes have not translated into onshore energy insurance increases, and agreed with another presenter--Michael Stone, COO of Peoria, Ill.-based based RLI Corp.--that the Deepwater Horizon catastrophe is not a p&c insurance "industry-changing event."

Mr. Stone said he hasn't witnessed any broad-scale rate movement outside of specialty energy business, noting that global reinsurance rates were down 10-to-15 percent on June 1 renewals.

With BP uninsured, "I am less concerned about the direct loss to the insurance industry than I am in the event that there's a hurricane that spreads that oil along the Gulf Coast," Mr. Stone added. "I think there will be something Katrina-like that comes out of that."

Asked specifically about impacts related to business interruption insurance, Mr. Stone said there really shouldn't be any because direct physical loss is required for recoveries under business-income policies.

That said, according to Mr. Stone, "there is an opportunity for the employment of judicial risk. Who knows what courts will say about policy language in this space?"

Mr. Molbeck said he's seen energy pricing go up 20-to-50 percent "on strictly operating, not windstorm [coverage], for parties not involved in the loss."

There are not that many players in the offshore energy insurance business, he said, pointing to HCC and Navigators as members of the small group. "We'll get a kick up this year, [but] we may get a kick back down next year" on rates, he added.

While Mr. Molbeck said he agreed the BP spill is not an industry-changing event, he went on to predict some spillover of rate hikes on high-excess liability business precipitated by the Deepwater Horizon disaster.

"Liability pricing, especially coming out of Bermuda [on] high excess, [has] gone up 10-to-20-times," he said, referring to $100 million excess of $500 million, and excess of $900 million layers on energy accounts written by Bermuda markets.

"People now understand that you can have a $10 billion seepage and pollution loss, and I think that's going to roll into Fortune 500 pricing, too," Mr. Molbeck said.

Mark Watson, CEO of Bermuda-based Argo Group--who said his company participates on upper layers--reported that his firm has only seen rate changes on energy pricing so far, "not on excess liability business as a whole."

Observing that the rig disaster moved quickly from being a property event to a liability event, he said "it will be interesting to see if this remains an energy-focused change or if it expands beyond that."