Surplus Lines Insurance: Background and Current Legislation
Released: 2010-07-22T00:00:00

Background on Insurance Regulation1

Insurance is regulated almost exclusively at a state level, unlike the other primary sectors of the financial services industry, banking and securities. Although the Supreme Court has ruled that Congress has the power to regulate insurance, the 1945 McCarran-Ferguson Act devolved this power to the individual states, and this was specifically reaffirmed in the 1999 Gramm-Leach-Bliley Act. It has long been recognized that some uniformity in insurance regulation is desirable as it allows greater efficiencies in the insurance market. This argument has grown stronger as insurers compete more with banks and securities firms, who do have uniform regulation, and as capital markets have become more globalized. Insurers rely increasingly on global capital markets both as a place to invest premiums that are not quickly paid out in claims and as a source of funding, particularly after a catastrophe that causes large losses.

Recognizing the need for relatively standardized regulation, the individual states have developed model rules and regulations through the National Association of Insurance Commissioners (NAIC) and the National Conference of Insurance Legislators (NCOIL). Harmonization efforts by the states, however, have been hampered by the lack of authority invested in either the NAIC or NCOIL. Although both are made up of public officials, the organizations themselves are voluntary, non-governmental associations and cannot require that any states enact their models. As a consequence, there is significant variation in how different states regulate insurance and there have been various calls for Congress to act through a federal charter or some other kind of federal intervention. The recent financial crisis added an additional argument for increased federal attention to the regulation of insurance, particularly with the failure of AIG, a company that happened to be the largest surplus lines insurer in the United States.

Regulation of Surplus Lines Insurance

Surplus lines insurance regulation differs from other insurance regulation both in substance and in the primary focus. In regulating regular insurance transactions, much of the state's focus is on the insurer itself. States have specific requirements for financial solvency, including how much capital an insurer must hold, and how the insurer can invest this capital. In cases of insolvency, states have established guaranty funds, funded by the rest of the insurers in the marketplace, to pay off the insolvent insurer's claims. The states also regulate both the substance of an insurance policy and the price of that policy, with many states requiring specific state approval before policy terms or prices can be changed. In surplus lines insurance, states have some oversight on the solvency of insurers, generally requiring that financial information be filed by surplus lines insurers to judge whether the insurers are sufficiently capitalized. There is, however, no participation in state guaranty funds by surplus lines insurers, nor state oversight of policy terms and prices charged.

Most surplus lines transactions revolve around an intermediary, typically an insurance broker, who may specialize in the unusual risks that require such coverage. Because they have relatively little oversight on surplus lines insurers themselves, the states generally focus their attention on these intermediaries in regulating surplus lines insurance. To operate as a surplus lines broker, most states require an additional license on top of the license required for insurance brokers in general. To retain this license, surplus lines brokers are required to take various steps with surplus lines transactions that are not required in regular insurance.

The first step in a surplus lines transaction is generally a state-required "diligent search" of the regular insurance marketplace to establish that there is no licensed insurer available to offer the required coverage. Typically, this requirement is satisfied by having some number, usually three to five, licensed insurers decline to offer coverage with the broker being responsible for an affidavit describing the search and certifying that no coverage is available in the licensed market. In some cases, states have established lists of coverages that are almost always placed in the surplus lines market and thus are exempt from the diligent search requirements.

Once the consumer's eligibility to use the surplus lines marketplace is established following whatever state rules are in place, the broker would then approach various surplus lines insurers seeking the desired coverage at a suitable price. At this point, while the consumer is outside of the regular insurance market, the states generally continue to establish standards to protect consumers against surplus lines insurers who might be unable to pay claims that are made. Some states establish a list of eligible surplus lines insurers, and state-licensed brokers are only allowed to transact with insurers on that list. Others take the opposite approach and issue a list of ineligible insurers that may not be used by state-licensed brokers. A third approach is to make the brokers responsible if a surplus lines insurer refuses or is unable to pay legitimate claims; this is seen as causing the broker to be more cautious as to which insurance companies are used. States also generally require that brokers provide specific disclosure statements to clients purchasing surplus lines insurance detailing that the insurance is not subject to the same regulatory oversight as insurance bought from state licensed insurers.

All states levy specific premium taxes on insurance and generally require a licensed insurer to collect and remit these taxes as a condition of licensure. With the absence of licensure requirements on surplus lines insurers, the requirement to remit taxes is placed on the state-licensed broker. The precise amount of the tax depends on individual state laws. The situation becomes somewhat unclear, however, when the consumer, the broker, or the insured property are in different states. Such a multi-state situation requires apportioning the premium taxes among the different states. State laws, however, differ significantly not only on the amount of such taxes but also on what exactly is to be taxed and how that tax should be apportioned among the multiple states.

The Surplus Lines Marketplace

The property/casualty insurance market has been marked by the so-called insurance cycle, a tendency to have alternating periods of high prices and short supply ("hard markets") with periods of low prices and plentiful supply ("soft markets"). The size of the surplus lines market has been significantly affected by these cycles, with surplus lines growing faster than the entire market in hard markets and more slowly in soft markets. In the past 30 years, there have been generally hard markets in four periods: the late 1970s, the middle 1980s, the early 1990s, and the early 2000s. Growth in net premiums for U.S. professional surplus lines insurers in three of these four periods has reached 70% at the peak and then dropped to nearly zero or below within a few years afterwards. In 2008, surplus lines direct premiums totaled $34.4 billion, 13.8% of the total commercial lines premiums of $249.3 billion. The surplus lines market in the United States has two large groups, AIG and Lloyd's of London, which had 23.5% and 19.7% of the market respectively. The next largest is Zurich Financial with 5.0% market share, which was followed by a number of companies in the 2% to 4% range. The 10 th -largest company had a 2.1% share, whereas the 20 th had a 1.1% market share.

Legislation

109th Congress

The National Insurance Act of 2006 (S. 2509/H.R. 6225)

Senators John Sununu and Tim Johnson introduced S. 2509 on April 5, 2006, and it was referred to the Senate Banking, Housing, and Urban Affairs Committee. The committee held two hearings on general insurance regulation in July 2006 where the bill was discussed, but it did not take other action on S. 2509 . Although not directly addressing surplus lines insurance, the bill could potentially have had a significant impact on the operation of the current surplus lines market. S. 2509 would have created a federal charter for insurers and insurance intermediaries and given them the choice of operating under the federal system instead of the state system. Holders of a federal license would have been able to operate throughout the United States without separate state insurance licenses. In addition, the National Insurance Act would have preempted state laws requiring product and price approvals for federally chartered insurers. A federal charter as envisioned in S. 2509 would thus offer many of the same freedoms currently enjoyed by surplus lines insurers, namely, the ability to sell insurance across the country without individual state licenses and with product and rate flexibility. At the same time, S. 2509 would have offered the possibility of avoiding the conflicting state regulatory system that surplus lines insurers currently point to as a significant burden.

Representative Ed Royce introduced H.R. 6225 on September 28, 2006. It was jointly referred to the House Committees on Financial Services and on the Judiciary. Although not identical to S. 2509 , the bill was essentially similar and would have created the same dual regulatory system with both federal and state charters available for insurers and insurance intermediaries. No committee hearings were held on H.R. 6225 .

Passage of either version of the National Insurance Act of 2006, however, would not have offered a uniformly positive federal option from the viewpoint of surplus lines insurers. Unlike current state laws for surplus lines insurers, insurers with a federal charter would have been required to participate in state guaranty funds. In addition, federally chartered insurers would likely have had more stringent financial oversight than the states currently undertake with surplus lines insurers. It is difficult to predict whether large numbers of surplus lines insurers would actually opt out of the state system until the details of a federal chartering system were put in place. The largest surplus lines insurer, AIG, would seem very likely to become a national insurer, as its then-chairman testified before Congress supporting an optional federal charter in 2002. A.M. Best's 2006 survey of the surplus lines industry concluded, however, that "whether or not the National Insurance Act becomes a reality, surplus lines insurers will continue to play a major role in providing specialty coverage to commercial insurance consumers."

The Nonadmitted and Reinsurance Reform Act of 2006 (H.R. 5637)

Representative Ginny Brown-Waite, along with 16 cosponsors, introduced H.R. 5637 on June 19, 2006. It was referred to the House Financial Services Committee where hearings were held and the bill amended and reported on to the full House ( H.Rept. 109-649 ). H.R. 5637 was jointly referred to the House Judiciary Committee which held a subcommittee hearing on the bill, but took no further action. On September 27, 2006, the full House took up the bill under Suspension of the Rules and passed it 417-0. The Senate received the bill and referred it to the Banking, Housing, and Urban Affairs Committee, but took no further action.

H.R. 5637 was a relatively narrow bill, aimed directly at streamlining and addressing inconsistencies in state regulation in the surplus lines insurance market. It would have done this primarily through preempting various state laws. It generally would not, however, have replaced the preempted state laws with federal standards, but instead would have done so with laws from other states or model laws of the NAIC. The bill's first two sections would have given preeminent regulatory and tax authority to the home state of the insured, preempting the tax and regulatory laws of other states who might have a claim on the insurance transaction such as the home state of the broker or the location of some of the insured risk. Thus, for example, if a company in one state were purchasing a surplus lines policy that covered some risks in another state, the only state that could collect taxes on that transaction would be the home state of that company. The bill would, however, have allowed states to require reports detailing risks that may be covered by policies from other states as well as encouraged the creation of an interstate compact to develop a uniform formula to allocate surplus lines taxes among the states. H.R. 5637 also would have preempted state laws on eligibility requirements. In general, it would have preempted any state laws that are different from the NAIC's model law on nonadmitted insurance and required states to follow the NAIC's listing of alien insurers in allowing brokers to place insurance with companies from outside of the United States. It also specifically would have preempted state diligent search requirements for surplus lines purchases by "exempt commercial purchasers" as defined in the bill.

H.R. 5637 addressed reinsurance as well as surplus lines insurance. As with the surplus lines provisions, the reinsurance provisions had a similar "home state" approach to addressing inconsistencies of state regulation of reinsurance. The bill would have given preeminence to the home state of the insurer purchasing reinsurance with regard to the regulation of credit for reinsurance and other aspects of the reinsurance contract, while the home state of the reinsurer was given authority for the regulation of solvency of the reinsurer. In order for the home state to be given this primacy, the bill would have required the home state to follow NAIC standards with regard to reinsurance credit and reinsurer solvency.

110th Congress

The Nonadmitted and Reinsurance Reform Act of 2007 (H.R. 1065/S. 929)

Representative Dennis Moore, along with 43 cosponsors, introduced H.R. 1065 on February 15, 2007; Representative Moore was a lead cosponsor of H.R. 5637 in the 109 th Congress. Representative Ginny Brown-Waite, the sponsor of H.R. 5637 , was a lead cosponsor of the H.R. 1065 . H.R. 1065 was nearly identical to the bill that passed the House in the previous Congress. The only change was to the credentials necessary to be considered a "Qualified Risk Manager," which would be required for a company to be considered an "exempt commercial purchaser." The bill was considered under Suspension of the Rules on June 25, 2007, and passed the House by voice vote.

S. 929 also entitled the Nonadmitted and Reinsurance Reform Act of 2007, was introduced in the Senate on March 20, 2007, by Senators Mel Martinez and Bill Nelson. S. 929 was identical to H.R. 5637 as passed by the House during the 109 th Congress. It was referred to the Senate Banking, Housing, and Urban Affairs Committee as was H.R. 1065 once it was received in the Senate. Neither bill was acted on by the Senate in the 110 th Congress.

The National Insurance Act of 2007 (S. 40/H.R. 3200)

Senators John Sununu and Tim Johnson introduced S. 40 on May 24, 2007, whereas Representative Melissa Bean and Ed Royce introduced H.R. 3200 on July 26, 2007. S. 40 / H.R. 3200 were substantially similar to S. 2509 / H.R. 6225 from the 109 th Congress. They would have created an optional federal charter for the insurance industry, potentially offering surplus lines insurers the choice of continuing to operate under the state system or to do so under the new federal system. Although S. 2509 / H.R. 6225 did not specifically address surplus lines insurance, S. 40 / H.R. 3200 included provisions doing so. In particular, S. 40 / H.R. 3200 included surplus lines insurance under the definition of an "insurance producer" and would have allowed a national agency to sell surplus lines insurance. Thus, under S. 40 / H.R. 3200 , an individual surplus lines broker or an agency specializing in surplus insurance could hold a national license and be exempt from the various requirements, such as diligent search, placed by the states on surplus lines brokers or agencies. In addition, S. 40 / H.R. 3200 would have allowed only the state in which an insured resides or maintains its principal place of business to tax a surplus lines transaction. S. 40 / H.R. 3200 would have also specifically exempted surplus lines insurers from a national guaranty fund should one be created. These bills were referred to committee, but no action was taken on them.

111th Congress

The Nonadmitted and Reinsurance Reform Act of 2009 (H.R. 2571/S. 1363/H.R. 4173/S. 3217/P.L. 111-203)

Representative Dennis Moore introduced H.R. 2571 on May 21, 2009, along with 20 cosponsors, including lead cosponsor Representative Scott Garrett. H.R. 2571 is substantially similar to H.R. 1065 , which passed the House in the 110 th Congress. It was referred to the House Financial Services Committee and Judiciary Committee. Although neither committee marked up the bill, the House took up H.R. 2571 on September 9, 2009, under suspension of the rules and passed the bill by voice vote. Representatives Moore and Garrett also offered the language of H.R. 2571 as a floor amendment to the Wall Street Reform and Consumer Protection Act of 2009 ( H.R. 4173 ). This language was included in an en bloc amendment by Representative Barney Frank ( H.Amdt. 529 ) that passed by voice vote on December 10, 2009. H.R. 4173 passed the House on a vote of 223-202 on December 11, 2009, with the language included as Title IX.

S. 1363 , which is identical to H.R. 2571 , was introduced in the Senate on June 25, 2009, by Senator Mel Martinez with three cosponsors. It was referred to the Senate Banking, Housing, and Urban Affairs Committee, which has not acted on this bill. The committee did, however, markup and order reported the Restoring America's Financial Stability Act of 2010 on March 22, 2010. Title V, Subtitle B of this bill is entitled the Nonadmitted and Reinsurance Reform Act of 2010 and contains language nearly identical to S. 1363 . The bill was reported as S. 3217 on April 15, 2010; after various floor amendments, none of which altered Title V, Subtitle B, the Senate inserted the language of S. 3217 into H.R. 4173 and passed the amended bill on a vote of 59-39.

The conference report on H.R. 4173 , now titled the Dodd-Frank Wall Street Reform and Consumer Protection Act, included the Nonadmitted and Reinsurance Reform Act as Title V, Subtitle B. The House agreed to the conference report on June 30, 2010, by a vote of 237-192 and the Senate agreed to the conference report on July 15, 2010, by a vote of 60-39. President Obama signed the legislation into law as P.L. 111-203 on July 21, 2010.

The National Insurance Consumer Protection Act (H.R. 1880)

H.R. 1880 was introduced by Representatives Melissa Bean and Edward Royce on April 2, 2009. It was referred to the House Financial Services Committee, Judiciary Committee, and Energy and Commerce Committee. This bill includes language similar to the previous National Insurance Act of 2007 that would (1) include surplus lines insurance under the definition of an "insurance producer" and allow a national agency to sell surplus lines insurance and (2) allow only the state in which an insured party resides or maintains its principal place of business to tax a surplus lines transaction. Like previous bills, H.R. 1880 allows for the federal chartering of insurers and insurance producers and loosens some restrictions on insurance rate and form regulation, so it might have an impact on surplus lines insurance as some insurers and producers may choose to become federally chartered, rather than remaining state-chartered surplus lines insurers. The specific provisions of H.R. 1880 , however, are different than the previous National Insurance Acts, including the creation of a systemic risk regulation and the provision that some insurers might be required to become federally chartered if judged to be systemically significant.