Surplus lines deal latest buyout twist

RICHMOND, Va.—The proposed $575 million sale of surplus lines insurer James River Group Inc. to an investment firm reflects growing interest from capital markets in U.S. commercial insurance entities beyond brokers and reinsurers, observers say.

Though not unprecedented, D.E. Shaw Group's plan to take the insurer private is unusual and may signal more deals in the sector, they say.

However, the softening excess and surplus lines market may dampen the enthusiasm of other private equity investors considering the sector, some say.

The $575 million cash deal announced last week, if completed, would give D.E. Shaw a stake in the E&S market as well as the workers compensation market. New York-based D.E. Shaw is often cited as one of the nation's largest hedge fund managers, but the company says it is more than a hedge fund and calls itself a global investment firm.

James River Group is a holding company founded in 2002 and the parent of James River Insurance Co., a Richmond, Va.-based E&S insurer. The unit accounted for $249 million of the $297 million in gross written premiums the holding company reported in 2006. Another unit, Stonewood Insurance Co., accounts for the remainder. Stonewood is a Raleigh, N.C.-based workers comp insurer focusing primarily on North Carolina and Virginia residential construction.

James River companies write in 48 U.S. states for accounts that produced $21,000 in average annual premiums last year.

Once the deal is completed, which is expected in the second half of the year depending on regulatory approval and barring a superior bid, the group expects to merge the operations into a Bermuda-based holding company and form a Bermuda-based reinsurer.

The deal would mark an unusual twist to recent private equity investments in the insurance industry. Until now, most of those investments have focused on either buying retail and wholesale brokerages or funding reinsurance operations.

"There really hasn't been a lot" of capital market purchases of surplus lines insurers, said Mark Dwelle, an analyst at Ferris, Baker Watts Inc. in Richmond, Va. "Compared to owning brokers, and certainly compared to owning reinsurance or offshore arrangements, it is the less common breed."

Equity firm interest in purchasing surplus lines insurers is expected to continue, said David Blades, senior financial analyst specializing in surplus lines and specialty companies for A.M. Best Co. Inc. in Oldwick N.J.

Funding reinsurers and purchasing brokers has shown private equity investors and hedge funds that insurance operations returns can be substantial. Several observers, therefore, agree there is potential for more capital markets investments in risk-bearing entities such as surplus lines companies.

"I do see a lot more of this to come because there is upwards of $2 trillion in the hedge fund area that is looking for returns," said Steve McElhiney, president of Dallas-based EWI Inc., a reinsurance intermediary.

Others say, however, that the softening insurance market will reduce the investment returns from surplus lines insurers and that could dampen hedge funds' appetite for the entities.

Surplus lines rates began falling significantly during the last quarter of 2006, said Alan J. Kaufman, chairman, president and chief executive officer for Burns & Wilcox Ltd., a managing general agent and surplus lines broker based in Farmington Hills, Mich.

"Challenging" market conditions for the surplus lines industry are expected to continue, Mr. Kaufman and others say.

Hedge funds typically look for a 30% return on their investments, but E&S insurers typically earn 20% during good times and can produce negative results when markets soften, said Steven Bolland, president of reinsurance intermediary Gill & Roeser Inc. in New York.

That makes D.E. Shaw's planned purchase a bit of "a head-scratcher," Mr. Bolland said.

But D.E. Shaw also appears to have achieved a relatively low price for James River and could wait a few years for surplus lines markets, then flip the insurer, Mr. Bolland said.

James River has been successful in executing its business plan for delivering earnings and revenue growth, said Mr. Dwelle of Ferris, Baker Watts, who said the amount D.E. Shaw would pay is a "fair" price for the insurer. The sale is not surprising because James River's management has a history of building and selling insurers, Mr. Dwelle added.

In particular, J. Adam Abram, James River's president and CEO, is credited with building what is now Colony Insurance Co. and selling the surplus lines operation to San Antonio-based Argonaut Group Inc.

Mr. Abram is also a successful real estate developer, Mr. Dwelle said.

D.E. Shaw declined to discuss its plans for James River.

However, the plan to form a reinsurer could signal a potential strategy, observers said. D.E. Shaw may opt to transfer the premiums from James River offshore through a reinsurance transaction, Mr. McElhiney of EWI said. Then it could invest the funds, which it may hold for some time given the long-tail nature of much of James River's book, in alternative investments and reap the tax benefits of offshore operations, observers said.

It is not the first time that a capital market entity has purchased a surplus lines insurer and created a reinsurer.

Foster City, Calif.-based Fox Paine & Co. L.L.C. in 2003 bought United National Group Ltd., which is now a holding company named United America Indemnity Ltd. (BI, March 24, 2003). United America's U.S. operations include specialty and E&S insurers United National Group of Bala Cynwd, Pa., and Hatboro, Pa.-based Penn America Group Inc.

United America also owns Bermuda-based Wind River Reinsurance Co. Ltd., which reinsures E&S coverage and specialty property/casualty business.