Surplus Lines Market in the Shifting Regulatory Sands

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Surplus Lines Marketin the Shifting Regulatory
Sands
Steve Stephan Napslo
Dan Brown SONNENSCHEIN NATH ROSENTHAL LLP
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SURPLUS LINES OVERVIEW

• Market for hard to place risks
• Operates as a supplemental/secondary market to
  the admitted market
• REGULATED IN EVERY STATE

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ROADMAP FOR TODAYS DISCUSSION

• Brief History of Surplus Lines
• Certain Definitions
• Insurance Company Eligibility
• Eligible Risks
• Size and Nature of the Market
• Broker Issues
• Insurer Reporting and Recordkeeping
• Premium Taxation
• Limits to Regulation
• Applicable Federal and State Laws
• Stamping Offices
• Snapshot of the Market
• Future of the Market

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HISTORY OF SURPLUS LINES REGULATION

• 1752 Philadelphia Contributorship 1st PC Company
• protects houses from liability due to fire
• 1890s Lloyds of London a player in U.S.
  commercial property risks
• 1890 N.Y. enacts Americas 1st Surplus Lines Law
• designed to control not eliminate the market
• similar to law today with producer regulated
• few states follow N.Y. lead (notable exceptions
  IL MA)
• 1897 NAIC appoints Unauthorized Insurance
  Committee
• charge to study the problem of underground
  insurance

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HISTORY OF SURPLUS LINES REGULATION (cont.)

• 1900-1960 Misunderstood market and unresolved
  debate among Regulators
• NAIC Proceedings about undesirable lawless
  illegitimate
• 1960 U.S. Senates Antitrust and Monopoly
  Subcommittee Hearings
• inquiry into alien surplus lines prompts NAIC to
  act
• 1962 NAIC adopts Non-Admitted Insurers
  Information Office
• reviews financial condition, trust funds and
  deposits
• 1970s-mid-80s availability/affordability
  concerns in product and professional liability
  lines
• 1982 NAIC adopted the Surplus Lines Model Act
• some form of the Act in all states

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SURPLUS LINES DEFINED

• Insurance that the admitted companies (the
  market) will not write
• Ebbs and flows with the market
• Nonadmitted means not licensed aka unauthorized
• Not transacting business in the state where the
  risk is located/resides
• Current dispute in California on this point
• Critical Supplemental/Secondary Market

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INSURER ELIGIBILITY

• Must be admitted in at least one state
• Exception Illinois
• Financial and statutory requirements vary by
  state
• Specialized knowledge and expertise
• White lists

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ELIGIBLE RISKS

• Mostly commercial
• Capacity driven
• Distressed risk driven
• Focus is on unique, exotic, novel, or unusual
  risks
• Diligent search required (to maintain the focus)
• Broker affidavits required (to confirm the focus)
• Export lists - export without diligent search
  permitted (but still subject to remaining surplus
  lines laws)

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SURPLUS LINES MARKET

• Nature of surplus lines business makes it
  difficult to get an accurate count
• There is no agreement on what makes up surplus
  lines premium
• What we do know
• Surplus Lines business goes by many different
  names
• Domestic, Foreign, Alien, Offshore, Onshore,
  Independent Procurement, Direct Procurement
• Lloyds of London is unique (70 Lloyds
  syndicates per NAIC Quarterly Listing of Alien
  Insurers)
• A.M. Best reported top 25 Surplus Lines Carriers
  represented 80 of the market with a premium
  volume of 30 billion

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ROLE OF THE BROKER

• Client eligibility
• Insurer selection
• Record maintenance
• Affidavits

• Surplus lines placements filings
• Collect and remit taxes and fees
• Policyholder disclosure

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BROKER LICENSING REQUIREMENTS

• Surplus lines licenses - required for brokers to
  place business
• Courtesy filings less common
• Independent procurement the i insureds place
  business ii directly with Surplus Lines carrier
  iii from outside the state iv without broker
  involvement

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INSURER REPORTING REQUIREMENTS

• 21 states require reports from insurers
• Report format and deadlines vary by state
• Data calls do they apply to surplus lines
  (nonadmitted) insurers?
• NAIC Medical Malpractice Data Reporting
• 2007 CA Wildfire Data Call

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STATE REPORTING DUE DATES AS OF 12/31/07
AL 3/1 LA 4/15 NV 3/1
CO 3/1 MA 3/1 NY 3/15
CT 3/1, 5/15, 8/15, 11/15 MO 6/1 OK 3/1
FL 3/31, 6/1, 9/30, 12/31 MT 4/1 RI 7/31
HI 3/15 MS 3/1 SD 4/1
IA 4/30 NH 4/30 TX 3/31
KS 5/1 NM 3/1 VI 5/30
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SUGGESTED BEST PRACTICES FOR INSURERS

• Provide policyholder disclosure noticeswith all
  policies
• Track info on surplus lines placements for all
  states
• Request at time of binding
• Update continuously
• Create reporting database

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SAMPLE COMPANY DATABASE

• Policy number
• Name/address of Insured
• Premium Commission paid
• Policy Eff. Date / Exp. Date Limits
• Account producer and contact info
• Surplus lines licensee, contact info, license
  number

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PREMIUM TAX ISSUES

• Broker collects taxes remits to states
• Amount of tax varies by state
• Multi state exposures present complex tax
  allocation issues
• Various parties seeking to resolve (to be
  discussed)

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LIMITS TO REGULATION

• U.S. Constitution requires due process
• Todd v Shipyards (U.S. Supreme Court - 1962)
• tax case
• transacting business within vs. outside the state
  where the risk is located
• Numerous state cases have followed
• taxation and regulation
• Notable N.J. established a guarantee fund
• Evanston Ins. Co. v Merin (N.J. 1984) challenge
  failed

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APPLICABLE LAWS

• Federal Liability Risk Retention Act of 1986
  specifically allows surplus lines availability to
  purchase groups
• State Laws or Regulations - Do they Apply?
• Solvency
• Claims Handling
• Unfair Trade Practices
• Fraud Reporting
• Cancellation Laws
• Special Assessments
• Rate and Form Filings
• Essex Insurance Co. v Zota (Florida)

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STAMPING OFFICES

• Stamping Offices - 15 states (MN added 1/09)
• Surplus Lines Brokers become members of Surplus
  Lines Association
• Quasi-regulatory agencies
• Financial security review and market conduct of
  surplus lines brokers
• Collectors of surplus lines taxes

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STATES WITH STAMPING OFFICES AS OF 6/15/08
Source U.S. Stamping Office Directory Courtesy
of the Surplus Lines Stamping Office of Texas and
the Excess Lines Association of New York (ELANY)
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COMPOSITION OF THE SURPLUS LINES MARKET TODAY

• Alternative Market or Market of Choice
• U.S. Surplus Lines Share of Commercial Lines in
  2006 was 14.4 vs 85.6 for Admitted Carriers
• Surplus Lines grew 173 among U.S. domestic
  carriers over the past 5 years
• Far outpacing the total U.S. Property Casualty
  Industry
• 2001 and 2002 saw a dramatic increase in surplus
  lines writings up 35.7 and 61.7 respectively
• 2007 had a drop of -3.5
• Backbone of Surplus Lines business is experienced
  underwriting
• Nimble and innovative with forms
• Nimble and flexible with rates

Source A.M. Best Research 2008 Special Report
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SURPLUS LINES OF THE FUTURE
THE MARKET
Surplus Lines Business
Self Insured Risk Retention Groups Captives Wall
Street Insurance
Standard Carriers
Surplus Lines IndustryWill Remain StrongIFIt
Remains Nimble
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SUMMARY

• Surplus lines is regulated brokers and insurers
  have specific responsibilities
• Designed to be a supplemental/secondary market
• Maintain complete and accurate records
• Update records and monitor reporting requirements
  continuously
• Communicate with brokers
• Complex interplay of state and federal laws

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Surplus Lines Regulatory ReformPresented at
AICP New England Chapter May 15, 2009Norwood,
Massachusetts

• Steve Stephan
• NAPSLO

Steve Stephan Director of Government
Relations NAPSLO 200 NE 54th St. 200Kansas
City, MO 64118816-741-3910 (direct)steve_at_NAPSLO.
org
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WHY ARE NRRA REFORMS SOUGHT?

• State Surplus Lines laws never modernized
• GLBA had unintended consequences for nonresident
  Surplus Lines producer
• Surplus Lines tax system is dysfunctional
• Surplus Lines placement laws could have
  unintended consequences
• NRRA act of congress means instant nationwide
  reform
• Other reform efforts failed

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Multi-state risks equal mission impossible

• Single state risk is clear
• Multi-state Mono-line property based upon
  property values - manageable except for 10 gross
  premium states
• Typical statute allocate taxes based upon risk
  exposures in state at state tax rate
• Package, excess, umbrella, casualty, EO, DO
  result in best guess
• Allocation methodologies could include revenue,
  payroll, loss history, number of employees, man
  hours, and other criteria

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SURPLUS LINES REFORM HISTORY

• MULTI-STATE RISKS CAUSE PROBLEMS
• NRRA Pending in the Senate as S 929 since 2007
• Passed the House as HR 5637 in 2006 (no Senate
  action) Congress adjourned without action
• Passed the House as HR 1065 in 2007
• Senate held hearings summer 2008 with a
  favorable review of surplus lines reforms
• NAIC testifies in support of NRRA with changes
• No Commissioners are openly opposing NRRA at this
  time

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Gross Premium Statutes Make Compliance Literally
Impossible

• Ten States have statutes that tax gross premium,
  but very few follow the statutes but there are
  exceptions
• If Gross premium paid to the home state, there
  is nothing left to allocate to the other states
• Should surplus lines broker pay gross premium or
  allocate the taxes not clear
• State insurance departments audit insurers
  expecting the annual statement to reconcile with
  broker filings
• The two sets of records never reconcile for
  multi-state risks, but a lot of time is expended
  by all parties in the reconciliation effort

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Reform efforts at NAIC

• 1995 SL multi-state tax working (MSTWG) group
  formed
• 1995 NITCH non-admitted tax clearinghouse
  abandoned
• 1995 NAIC model regulation for allocation of
  multi-state tax adopted by NAIC but never gets
  state support
• 2000 MSTWG reconstituted asks all stated to
  adopt allocation laws instead of gross premium
  laws abandoned in 2002
• 2005 NAIC MSTWG reconstituted again and surplus
  lines task force asks industry/regulatory
  representatives to investigate a multi-state
  compact to allocate taxes
• 2008 industry representatives complete draft
  compact, but NAIC SL task force personnel have
  changed and opt to reconstitute the MSTWG yet
  again and explore options other than a compact.
  They subsequently indicated they could
  investigate a light version of a compact.
• MSTWG Group Leader does not want to seek
  legislative changes.

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NRRA REFORMS

• Single-State Tax Remittance
• Single-State Placement Compliance
• Uniform Nationwide Definition of Exempt
  Commercial Purchaser
• Uniform Nationwide Definition of Insureds Home
  State
• One Surplus Lines Brokers License from the home
  state needed for multi-state placement

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NRRA OTHER PROVISIONS

• States encouraged to join a compact or other
  procedure to divide taxes
• Uniform insurer eligibility
• Participate in NIPR within 2 yr
• GAO study of surplus lines market required
• Applies to independently procured insurance

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NRRA STATUS

• NAIC reportedly supports core provisions of
  Surplus Lines portions of the bill
• NAIC seeks change to definition of home state,
  insurer eligibility, other provisions
• Some regulators want reinsurance title severed
  but negotiations continue
• Some want uniform Co. eligibility revised
• Some want stronger provisions to encourage states
  to divide taxes

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SLIMPACT

• CREATED BY GROUP OF 60 VOLUNTEERS
• MANY REFORMS SIMILAR TO NRRA
• Single-state placement compliance
• One producer license for a multi-state risk
• Differs from NRRA in that taxes remitted to all
  states by broker based upon uniform formula
  adopted by compact
• States must select from four optional uniform
  payment dates
• States can opt out of placement compliance rules
  not tax allocation rules
• Optional uniform placement compliance rules

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SLIMPACT REFORMS

• Formation of a compact commission
• Centralized data clearinghouse
• Slimpact does not impact company licensing
• Definition of home state differs
• 4 optional tax payment dates
• Mandatory rules for tax formula, data
• Surplus Lines policy in home state is deemed
  Surplus Lines in all compacting states

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SLIMPACT OPTIONAL RULES

• COMMISSION CAN ADOPT OPTIONAL RULES (SUBJECT TO
  OPT-OUT) FOR
• Diligent search
• Banking, bond, record keeping
• Policyholder notice
• Transaction documentation
• One tax rate for all non-admitted insurance
• Preempts inconsistent state laws

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CHANCES OF SUCCESS

• My view NRRA good chance
• If NRRA joined with other bills such as NARAB,
  OII, NICPA, Systemic Regulator?
• SLIMPACT better chance if NRRA encourages
  states to join
• SLIMPACT stand-alone more difficult
• SLIMPACT would need largest Surplus Lines states
  to take initiative

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QUESTIONS
Steve Stephan Director of Government
Relations NAPSLO 200 NE 54th St. 200Kansas
City, MO 64118816-741-3910 (direct)steve_at_NAPSLO.
org
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This concludes our presentation. Thank you!
Dan Brown SONNENSCHEIN NATH ROSENTHAL LLP
Steve Stephan Napslo