Developing niche lines of business: The garage sale closed

When the “garage sale” begins and market players undercut one another, nowhere is the reverberations felt any stronger than the specialty lines business. Niche operators want the message to be clear: “Stay out of out of our business”. More to the point, it is not competition they fear but the disruption brought to the market by players not aware of the pitfalls involved. The cry going out to new entrants is to please examine the markets they will be attacking before prejudicially slashing rates to acquiring top line market share while sacrificing bottom line profit margin. The specialty lines industry is not getting smaller, it is a market expanding to accommodate emerging risks that traditional products cannot handle. But it is also a market full of operators who understate its potential, fearful that one too many non-scientific operators could topple an already fragile market.

The market cycle affecting niche and specialty lines insurance is fairly similar to that of standard property & casualty business, primarily driven by intense competition and price-cutting. What does separate the two sectors is that specialty lines has significantly greater bottom-line disintegration potential and it often bears witness to repeated optimistic attempts by generals insurers trying to get into the game — and end up getting burnt.

It is a business featuring niche operators who have underwritten their specialty business for many years, and have seen big-gun insurers and reinsurers jump into the waters, engage in a price war, destroy profitability, and leave just as abruptly as they came.

The cycle is a product of an insurance marketplace which stresses marketshare over profitability, says one observer. “We have company executives being told to grow their book by 10% a year, despite an already saturated p&c market. They pick up a Canadian Underwriter’s Statistics issue and salivate over the premium volume being accumulated by specialty business. They go in, they undercut the current players, they kill the sector’s profitability. Kill their own…and eventually retreat.”

Good craft, good profit

The real value of the specialty lines segment, according to rating agency A.M. Best, is not the underwriting profit potential of the market but rather the expertise of the specific insurers serving it. The sometimes healthy balance sheets and income statements of specialty insurers lures standard operators into a field of underwriting that they simply do not have adequate skills to handle.

A.M. Best vice president Marty Sheffield, and assistant vice president Jon Andre, recently evaluated specialty lines companies across the U.S., grouping insurers who offer a differentiation from standard companies in the areas of either product, distribution, targeted customer or service. In evaluating over 200 such companies, Sheffield and Andre find niche companies, because of their specialization, feature a defensible market position, outstanding persistence in their market, favorable rating, underwriting quality, an expense advantage and brand recognition within their sectors.

A.M. Best company rating grades seem to verify the advantageous situation many veteran niche operators enjoy, with the operating performance of specialty carriers averaging A+ and A++, versus the A- average of standard carriers. “Despite their size, we find that specialty companies tend to write for an underwriting profit with sound reserving each year. The general overall industry, to compare, hasn’t really seen much of an underwriting profit in twenty years,” says Andre. Sheffield maintains the reason lies not in the nature of the business but in the specialty underwriting ability only years of experience and actuarial science can bring to the table. “If they are a niche business because of their distribution mode — a wholesaler for instance — their expense margin might be down relative to the rest of the market. If they have a niche skill set, they can more appropriately price the market over competitors.”

Both Andre and Sheffield cite the example of American Livestock, a specialty operator insuring animal mortality. The company has been in operation since 1953, they say, experiencing only three or four years of underwriting losses with a present policy volume of roughly 50 million.

The lesson of specialization could be having an impact on standard operators, who presently appear to be moving away from dabbling in all lines everywhere. The recently announced merger between CGU and Norwich Union will see CGU cutting away its p&c lines in the U.S. “We saw it also with St. Paul last year. Where we used to see companies trend towards offering all lines all the time, we are now seeing, that if it is not core business or ideal strategic center, companies are shying away from it,” says Andre.

Sheffield believes though that the true niche companies are not overly affected by entries of other market players. “The true niches will not find it a problem. When you have the other market players coming in, there is enough trust in the existing relationships that price will not be the only distinguishing characteristic that a cannibalistic company can come in with.”

Long-haul losses

Niche players and specialty lines observers might argue with Sheffield’s contention. Don Smith, president of Canadian Insurance Consultants, sums up the sentiment of most niche operators in describing the market cycle. “The specialty business is a moving target. It’s a strange market where some have succeeded well, but then some idiot will always step in and screw it up for everyone else.”

Most industry insiders point to the long-haul trucking sector as a prime example of the niche business market cycle, or, as an observer notes, “it is a sector that could also be called, when unknowledgeable underwriters strike”.

Already a competitive arena, long-haul trucking is not among the most profitable of risk classes. According to Mark Ram, president of Markel Insurance Company of Canada (which only writes long-haul business), a bad year in long-haul means a combined ratio anywhere between 150% to 200%. This compares to traditional p&c business where the downside combined ratio would be around 115%.

New operators in long-haul trucking — as in many of the niche areas — are not as familiar with the market, says Ram, leading to rate prices which do not adequately cover real potential liabilities. “What has happened in this line is that there is now a lot of U.S. exposures involved, business has expanded to flow “north-to-south” as opposed to “east-to-west”.

Insurers are now dealing with the U.S. legal system, something many new long-haul underwriters don’t understand, he explains. A truck-involved fatality could result in a $200,000 liability pay-out in Canada, the same incident could cost insurers $2 million (in U.S. dollars) in the more litigation-friendly U.S. “In Canada, companies get into the business, they reserve a potential liability that won’t see court-time for a few years at $200,000. When they get to the U.S. court, they’re destroyed.”

Gnawing away at the foundations of the business is ongoing price-cutting by unseasoned insurers trying to capture new business or open a new market. The result is everyone ultimately loses in a subsequent price war.

Long-haul, like many specialty lines, is emerging from a protracted soft period where rates dove and company losses mounted. Bill Star, president of Kingsway General Insurance Company, which underwrites some long-haul risk, says five years of non- profitability has scared away many threats to the sector. “There is a hardening of the market in the U.S. right now and Canada will follow quickly. The specialty markets are definitely being more careful now.”

Still, Ram believes that, although the market is showing spotty signs of turning, it’s still only in isolated pockets and it will take a couple of years of price increases to come anywhere near profitability as an industry.

According to insiders, the five-year soft rate run has cost long-haul entries dearly. Market rumor has it that AXA Insurance is leav ing the sector with a running combined ratio in the high hundreds. Stories allege American International Companies may have run its operating ratio up to 300 in long haul trucking. “You just can’t sell shoes at $5 that cost $8 to make,” a market observer reasons, pointing out that most insurers may not realize their true losses as they combine their long-haul trucking losses with their auto book.

Market outlook

“In the rising market, everybody starts to do better. They start to look for growth, and then they cut prices. And lose money. They then begin to practice restraint, and it all starts again,” summarizes ING Wellington Ontario manager Michael Roche. “The only real question regarding any particular cycle is whether it’ll be longer or shorter than the ones before and after it.”

Roche, like others, believes prices have bottomed out and the market is heading toward a hardening of rates. However, the underlying fear is that the big standard insurers will soon be back wooing clients in the specialty risk class. “What happens will depend on how quickly the rate increases flow to the bottom line. We’re half way into the first quarter, we’re not going to see any real results of new rates until June and even then, we’re only seeing half a year’s work.”

Smith suggests insurers could be back into the niche game sooner than later, but in a modified form that would involve less risk but offering a wide-spread product breadth nevertheless.

He says brokers need more products to compete with the convergence of financial pillars, and insurers are scrambling to offer them a larger array of products, all the while weary of the losses piled up recently in specialty lines. “Brokers and insurers want to offer further products to the clients but don’t want to take the risks themselves. I could see an insurer making a deal with a niche operator to offer non-standard business to brokers. They won’t take the risk but they will be offering more value to their markets.”

K.K. Leong, director of commercial marketing at American International Companies, says that, while his company designs its niche products from the ground-up, just having the product available to their broker force is imperative. “In this type of business, like any other, you’re either in or your out. We like to offer a broad range of specialty products to keep our clients and brokers happy.”

A warning of sorts for both new entrants and established players — even companies that excel in specialty business can hit their roadblocks. Kingsway General Insurance Company has been offering residual value insurance for dealerships looking to ensure stated buyback value for vehicles reaching the end of their lease period. The business has been profitable for the company since its debut in 1997 but could be stopped this year after the company took an average loss of $1500 per vehicle because of a glut of 1997 minivans that flooded onto the market. “We have big enough volumes in our other business that we can absorb the loss. As for continuing the line, it’s still up in the air,” says Star.

New technology risk game

The Internet has brought a new array of risk including data security, systems failures that can affect earnings and an array of other technology related concerns. The specialty lines operators are scrambling to create new products to hedge these risks. While historical information is not yet available to readily gauge and price these risks, the market mood indicates new operators will step forward. Lloyd’s of London and AIG have already begun offering programs geared towards cyber-companies, and smaller niche players are also moving in that direction.

Roche notes the big companies usually begin developing products for the emerging businesses, with the reserves available to offset losses that are not readily predictable. “Without any track record, or actuarial record, these are areas that will probably lead to losses,” Roche says. “But you have to test out the price. Most of this business goes to the markets that have a risk appetite”.

In the long-run, Smith and other specialty insurers acknowledge that these “emerging areas of risk”, and therefore potentially lucrative new areas of business, will eventually fall prey to the industry’s vicious pricing cycle. This clearly troubles him. “There are so many unique things you have to do to make profit in a book of business and then some jerk will almost definitely come along and write the same risk at half the price.”cu