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200 State St.,

Boston, Mass. 02109;

617-330-1100; fax: 617-772-4588

1997 1996

Gross premiums $1.31 billion $1.35 billion

Non-admitted $1.03 billion $1.11 billion

Commercial risks 97.2% 98.2%

Net premiums $461,839,259 $626,671,017

Paid-in capital $5,000,000 $5,000,000

Capital & surplus $1.22 billion $1.06 billion

Employees 260 260

Combined ratio 98.6% 99.9%

Rating agency 98.4% 99.8%

Net income $172,994,444 $131,555,192

Best's rating A++ A++

S&P rating AAA AAA

The still softening property/casualty market is forcing Lexington Insurance Co. and other surplus lines insurers to separate the wheat from the chaff in their portfolios.

Lexington, a unit of American International Group Inc., is working to identify areas producing inadequate profit margins so it can shift its resources to better-performing lines.

That process is causing Lexington to walk away from certain property risks where rates have fallen too far to generate adequate returns.

"Our approach on the property business is to focus on profitability," noted Kevin H. Kelley, the insurer's chairman.

Lexington is taking the same approach to its casualty business, though Mr. Kelley sees more growth opportunities in specialty liability lines.

The insurer also is focusing on providing risk management and loss control services and expanding its distribution channels.

"We have our eyes and ears wide open for opportunity. The company that's going to be successful with that opportunity is going to have to understand its customers and understand distribution," Mr. Kelley said.

Perennially the largest U.S. surplus lines insurer, Lexington's gross written premium volume declined last year for the first time since the early 1990s, dropping 3.2% to $1.31 billion in 1997. Direct non-admitted premiums fell 7.4% to $1.03 billion.

Liability lines, traditionally the bulk of Lexington's business, led the decline with a 9.7% drop to $665.5 million last year. After falling for three years, casualty volume last year was nearly even in 1997 with Lexington's property gross premium volume of $608.4 million.

The trend continued in the first half of this year, with casualty direct premiums down 9.1% to $254.7 million from $280.3 million a year earlier.

Lexington's casualty book consists of roughly 65% excess and umbrella risks, 20% transportation business written on an occurrence form, and 15% primary liability risks.

The insurer can offer a gross line on excess casualty business of up to $50 million with facultative reinsurance support. It also offers up to $5 million in limits on directors and officers liability coverage and up to $5 million on primary liability, though most primary policies carry limits of about $1 million, Mr. Kelley said.

The soft market has shifted Lexington's focus to specialty casualty lines. These include architects and engineers professional liability, specialty contractors, employment practices liability, transportation and railroad risks, and health care-related risks, such as provider stop-loss protection and pharmaceutical and biotechnology products liability.

Lexington also has built an array of risk management and loss control services for its policyholders. These services weren't intended to become a new profit center for Lexington but instead are offered as a benefit to clients -- and a way to control Lexington's own losses.

This summer, for example, the insurer unveiled a new EPL policy providing limits of up to $100 million, including coverage of punitive damages. Along with the coverage, Lexington is offering optional free risk management services, including an employment practices audit by law firm Baker & McKenzie, toll-free phone access to an employment practices consultant and use of an electronic human resources reference system.

Meanwhile, Lexington's property volume -- which skyrocketed during the mid-1990s run-up in catastrophe pricing -- is shrinking as rates continue to slide. Gross property premiums rose a modest 2.4% last year to $608.4 million. However, Lexington significantly boosted the amount of property business it cedes to reinsurers. The result was a 46.3% drop in property net written premiums to $176.2 million last year.

The slide in property business continued in the first half of 1998, with gross direct premiums falling 13.3% to $191.3 million the year before.

Along with catastrophe-exposed property risks, Lexington specializes in energy -- including petrochemical, pipeline and refinery risks -- and high-value locations, such as bridges, dams, tunnels, mining and railroad risks.

The insurer can provide up to $20 million in net and treaty limits on property business, which can be expanded to $25 million with facultative reinsurance support.

Falling rates and poor claims experience have led Lexington to cut back its property underwriting in some locations and in certain lines, Mr. Kelley said. "I would say it's pretty much across the board," he said.

One of Lexington's fastest-growing segments continues to be one of its smallest: property and liability combined lines, which jumped 48.1% last year to $31.5 million and which continues to grow rapidly this year. Much of this business consists of high-value coastal Florida homeowners' risks, he said.

Along with individual risk property and casualty accounts, Lexington writes business through several specialized divisions, including:

* A special accident division, which writes stop-loss coverage mainly for health care providers.

Last month, Lexington and J&H Marsh & McLennan Inc. jointly launched a program covering non-profit health care providers for liabilities arising from unintentional violations of Medicare and Medicaid claims reporting rules. Lexington will write limits of up to $50 million, while policyholders must carry a self-insured retention and coinsurance percentage. The insurance does not cover intentional acts. The program includes a risk management audit of a policyholder's Medicare and Medicaid compliance plan, which is a prerequisite for coverage.

* An international division, which handles the U.S. and overseas exposures of non-North American multinational corporations.

Volume in this division is down substantially because of a cutback in international property business that contributed to an unusual net

underwriting loss for Lexington in the first half, Mr. Kelley reported.

* A program division, which writes primary and excess property and liability coverage for trade and professional groups.

* A captive division, which offers fronting and excess insurance programs for captives.

Along with developing new market niches and offering expanded services to clients, Lexington also has tried to shore up its position in the soft market by expanding its distribution network. The insurer in recent years has added many producers, accepting business from retail and wholesale brokers, managing general agents, reinsurance intermediaries and London brokers. A large part of its business is produced through Risk Specialist Cos. Inc., an AIG agency unit with more than two dozen U.S. subsidiaries.

Lexington has continued to grow its bottom line despite market conditions. Earned premiums last year fell 16% to $465.6 million. Losses and underwriting expenses also dropped, though, and the insurer finished the year with an underwriting gain of $7.7 million, compared with an underwriting loss of $6.6 million in 1996.

After investment gains, other gains, losses and taxes, Lexington reported net income of $173 million, up 31.5% from 1996.

The insurer paid a $31 million dividend to its AIG-affiliated shareholders last year; after this and other adjustments, Lexington registered a 15.3% gain in policyholder surplus to $1.22 billion at year-end 1997.

First-half 1998 results were not as good. Earned premiums fell 15.7% to $198.7 million. Losses and expenses didn't fall at the same rate, though, and Lexington experienced a $22.9 million underwriting loss in the first half, compared with a $5.4 million underwriting gain a year earlier.

Mr. Kelley ascribed much of the loss to international property business written in London and the United States that he said Lexington is now "winding down" because of inadequate rates.

After investment income and other gains and losses, net income dropped 1.5% to $73.7 million from $74.8 million in the same period last year.

As of June 30, Lexington's surplus stood at $1.28 billion.

Lexington has undergone one change in its top management: In January, AIG had named John Iannucci as president of Lexington, taking over the title from Mr. Kelley, who became chairman and chief executive officer. Mr. Iannucci, a former CEO of two Gryphon Holdings Inc. underwriting units, resigned from Lexington several months later and was replaced by John Keough, formerly an officer with AIG's domestic brokerage unit.

In addition to Messrs. Kelley and Keough, other Lexington officers include Richard Bucilla and Richard Jodoin, executive vps; and Nicholas Anselmo and Michael Castelli, senior vps.

Lexington carries AIG's group rating of A++ from A.M. Best Co. and individually holds a AAA claims-paying ability rating from Standard & Poor's Corp.