CHICAGO -- The Illinois Insurance Exchange's biggest challenge is convincing buyers and brokers that major changes, including tripling capitalization requirements, will revitalize the dwindling surplus lines market.

The initial goal of the exchange -- recently renamed INEX to signal a new direction -- is to expand its product offerings and to assure the stability that will rebuild customer confidence.

As a first step, Kemper National Insurance Cos. plans to write its first surplus lines coverages by year end through three new syndicates that will take advantage of the exchange's authority to write primarily surplus lines coverages in about 36 states (BI, Nov. 17).

Restoring public confidence is crucial to achieving INEX's goal of delivering "a full range of global risk solutions," including risk securitization, specialty programs and agency captives, said William D. Smith, 53, president and chief operating officer of Long Grove, Ill.-based Kemper. As the newly elected chairman of INEX's 13-member board, he is spearheading implementation of the changes, which build on a vision that exchange President James E. Tait has been urging for months (BI, Sept. 15).

However, before realizing those ambitious goals, INEX must address several issues, including assuring buyers of the independence of the board's new, three-member executive committee.

Elected to that committee were: Michael D. O'Halleran, Aon Group Inc. president and chief operating officer; Daniel R. Toll, an outside director on Kemper's board; and Robert B.D. Batlivala, Amoco Corp.'s director of regulatory economics.

A state law tightening governance procedures, which goes into effect Jan. 1, requires that at least five "public trustees" be elected to the exchange board and that three serve as members of the executive committee. The executive committee will oversee the exchange's daily operations and its decisions are subject only to a supermajority, or nine-member recorded vote, of the board.

The concept of public trustees generally is to provide "non-management viewpoints and non-insider viewpoints" as "a check and balance," said Arnold Dutcher, chief deputy director of the Illinois Insurance Department.

While the law does not specifically define the role of public trustees, it does define who may serve: They must be "individual persons who are not insurers, subscribers, exchange brokers, or employees of insurers, subscribers, exchange brokers, syndicates or affiliates thereof." According to the law, subscribers are essentially stockholders.

In that context, the law limits Aon's role to that of a sideline adviser and raises questions about the appropriateness of allowing an outside director on Kemper's board to serve as a public trustee. While the an appointment of Mr. Toll doesn't violate the letter of the law, it challenges its spirit.

An independent governing structure is important because some of the exchange's previous problems stemmed from board members changing the rules to suit individual syndicates' needs, said former IIE President James M. Skelton.

Public perception of the exchange's viability was deeply shaken by three syndicate insolvencies in eight months (BI, March 10).

Until INEX emerged earlier this month, exchange officials were pinning their hopes for revival on the new state law that increased regulatory oversight of syndicate and exchange financial reports.

Mr. O'Halleran's participation on the executive committee apparently disqualifies Aon from actively participating in the exchange as a broker or insurer, Messrs. Dutcher and Tait confirmed.

Mr. O'Halleran, who was reached while traveling in Tokyo, initially said he was excited about the prospects INEX offered "our clients." When questioned about the legal restrictions, he declined to comment on Aon's ineligibility to be an active exchange participant, until he returned to Chicago and could consult an attorney.

After returning to Chicago, he said Friday: "I will continue as an executive committee member but will be evaluating any areas of conflict in the months ahead in regards to Aon's ability to get more involved with the exchange. If I feel there are conflicts, I will, of course, come off the executive committee."

Mr. Toll, 69, meets the letter of the law because he is not an employee of Kemper. However, he is closely affiliated with the insurer after having served as an outside director since 1986. Mr. Toll was president of Chicago-based Heller International Corp., when he left the banking and finance company in 1985 after 15 years. He also has served on several corporate and civic boards for the past several years.

Despite his close ties to Kemper, having Mr. Toll as a public trustee on the executive committee doesn't bother INEX board member Rick J. Lindsey, president of the recently renamed Prime Insurance Syndicate Inc. in Salt Lake City. "If the exchange had a weakness before, it was a lack of people with the necessary insurance background," he said.

The other public trustees on the board include: State Sen. Stephen R. Windom, a partner in Sirote & Permutt; Thomas E. Payne, vp at The Harris Bank; and Eugene Lerner, president of Disciplined Investment Advisors.

The exchange is expected to submit the names of all public trustees to state Insurance Director Mark Boozell for approval, as required by law. Mr. Boozell, former head of Gov. Jim Edgar's legislative office, was appointed insurance director in 1995.

The Insurance Department "will take a look at the qualifications of public trustees" before the names are submitted to Mr. Boozell for approval, Mr. Dutcher said.

The other Kemper-affiliated trustees include Vp William A. Hickey, 38, and Steven H. Lesnik, 57, a major contributor to Gov. Edgar's 1994 campaign. He is chairman and CEO of Lesnik & Co., which operates KemperLesnikCommunications in Chicago. That public relations firm, which is disseminating information locally about the formation of INEX, is affiliated with the son of Kemper founder James S. Kemper Sr.

Kemper National's involvement is increasing the capital base of the exchange because its three new syndicates will have a total capitalization of $60 million.

In addition, the INEX board decisively demonstrated its new direction last week when it voted to increase to $15 million from $5 million the minimum capitalization requirements for any new "exchange participants." The board recently removed the requirement that participants' names include the word "syndicate," which sets the stage for broader participation by other types of entities, Mr. Smith said.

The four surviving IIE syndicates are not required to comply with the new minimum capitalization requirement.

"The board's fast action is a solid step toward realizing the full potential of this dynamic facility," said Mr. Tait.

It also should improve the exchange's dwindling financial results. The IIE's syndicates wrote $85.4 million in gross premiums in 1996, down 6.5% from a restated $91.4 million in 1995. The premiums were restated to reflect the prior writings of active syndicates. Last year's results were 71% below the record $294.7 million the IIE reported in 1994.

In 1997, gross written premiums were $17.9 million for the first half and $24.5 million for the third quarter alone, according to exchange figures.

The exchange's revitalization is receiving favorable comment from some observers.

"These developments certainly enhance the prospects of the exchange," said Richard Bouhan, executive director of the National Assn. of Professional Surplus Lines Offices in Kansas City, Mo. "The problem with the exchange board since the beginning had been that it was both promoter and regulator," he said. "The change in the law appears to redress the balance and puts objective regulatory authority in the hands of state insurance officials. That is a positive thing."

Kemper, which is rated A by A.M. Best Co., expects buyers to seek out its excess casualty and excess environmental coverages because there is "considerable demand" for the claims-made version of the coverages, which are best written through surplus lines markets like that available through the exchange, Mr. Smith said. That allows buyers to avoid regulations in many states that require admitted insurers to offer unlimited discovery, which increases the buyer's exposure, he said.

Kemper's involvement with the exchange is good for the company, especially for Lumbermen's Mutual Casualty Co., its largest unit, said Vandana Sharma, associate director of Standard & Poor's Insurance Rating Services in New York. "It expands their ability to write lines of business that they would not have had access to previously," she said. S&P gives the pooled Kemper companies an A+ claims-paying ability rating.

Revitalization of the existing insurance exchange is expected to interest the Chicago Board of Trade, which is studying the feasibility of a second insurance exchange that would essentially allow it to write risks and offset them through insurance futures contracts, though a CBOT spokesman was unable to comment last week. "We would love to have them here," Mr. Smith said.

However, he said he considers the Bermuda Commodities Exchange to be INEX's main competitor (BI, Oct. 20).