Trimming a surplus: only companies with sound balance sheets can absorb the kinds of claims that result from unexpected losses, and that's going to mean consolidation in the not-too-distant future, says Kevin H. Kelley, CEO of Lexington Insurance Co., the world's largest excess and surplus carrier. Risk & Insurance® interviewed Kelley in his Boston office

Risk & Insurance, Jan, 2005 by Jack Roberts

What is your assessment for the markets in terms of capacity and pricing, and where do you see the business going in 2005?

I'd say '05 is still pretty much undetermined. What we're seeing in the property side is a market that is in transition. Rates are continuing to move down in the 4th quarter but not by as much as they were dropping earlier in the year. I think that is a result of several things. One, the hurricanes that we had in the 3rd quarter and two, as a result of that, the catastrophe costs that are bound to go up for the property insurers. In addition to that, I think there continues to be a lot of uncertainty around the renewal of the Terrorism Risk Insurance Act and what that might do to geopolitical risk.

I was going to ask you about TRIA in terms of what you think will happen, and how that may play out in the markets as far as you're concerned?

I think it's a tough read on whether it's going to be renewed or not. I think that right now the insurance industry is not particularly popular in Washington and obviously customers of insurers are always much more popular. Given the recent issues that the industry's facing right now, I think TRIA renewal might be problematic. What we are noticing is an increase in the take-up rate at which policyholders are buying terrorism coverage, and so I think there's increased concern by the general policyholder about geopolitical risk.

You offer a product in that market that doesn't depend on TRIA. Does that give you any indication of how buyers are reacting to the TRIA program itself?

The people that buy our product are pretty unique in several ways in that they tend to have very large values. They tend to have mortgages on those properties and the lenders to that policyholder generally insist on some coverage.

One of the biggest interest groups that helped pass TRIA the last time were real estate groups where coverage is critical and essential to them, but they seem to have found a way to survive regardless of what has happened?

A lot of our policyholders are those real estate firms so they are buying coverage that is different than what TRIA would offer, and buying it from a commercial marketplace.

Do you think there's any chance that a federal regulatory proposal may pass in Congress and how--if it were passed--that would have any impact on the excess markets?

The surplus lines industry is pretty much there because of the way insurance is regulated by the states. The fact that you have 50 different regulators of insurance creates the environment for a surplus lines company to be in the marketplace. It may have an impact on the surplus lines business, but I think the surplus lines industry has evolved well beyond where it was 50 years ago when it was really in its infancy.

The Bush Administration has been making noise about workers' comp and health care reform. What do you think that would do to the excess and surplus market?

I think it all depends on what you pass. We've been a major advocate of the president's position regarding health care liability and malpractice reform. It is very, very clear, if you take a look at California, which has had a cap on noneconomic damages for a period of time, that the results there are very different vs. the states where such a cap does not exist. The No. 1 recommendation is to impose a cap of some kind on noneconomic damages, and to do it in a way that would stand up to a constitutional test. Texas has done that. That gives underwriters some certainty in an environment that still has a ton of uncertainty associated with it because, as we all know, medical inflation is a big driver of tort liability costs.

How would you characterize the markets these days in terms of excess issues. Is it healthy?

If you believe in the underlying motto that you have to expect the unexpected and the unexpected today results in big claims, then you must have a balance sheet that allows you to sustain that kind of catastrophe. Therefore, one would believe that you'd be seeing much more consolidation in the business than you are currently seeing. I believe that is only temporary. Intermediate-term, I believe you'll see more consolidation in the surplus lines, specialty marketplace once balance sheets of companies have strengthened. Probably as a follow up to that point, what amazes me is how limits are determined, from a buyer's perspective, and how frequently they don't change in an environment that has substantially changed. That's what I really see occurring. I see a realization on the part of buyers that capacity demand is going to increase and then I see the market responding to meet that need. But in order to do that I think there's going to have to be some consolidation in order to do it in a way to create a balance sheet that can perform post-major event.

It's interesting you say that. I recently talked with a REIT that did a new analysis of its CAT risk and found that they were about $2 billion under what their real risk was but they were not aware of potential losses in certain locations and the escalation of those losses.