SPECIAL REPORT: Surplus Lines

With the eyes of Congress turning to insurance reform, most commentators are focused on how change might affect the overall insurance industry and agents. But the often-overlooked surplus lines segment of the industry could end up looking different, maybe even better, if certain reforms pass.

This year, industry lobbyists on Capitol Hill say there are two insurance reform drafts that may be brought before Congress. They are the SMART Act, or the “State Modernization and Regulatory Transparency Act,” and the National Insurance Act, otherwise known as “Optional Federal Charter.”

The two legislation drafts-while charged with the same task of modernizing and improving the efficiency of insurance regulation-are vastly different in scope.

The surplus lines market, or the non-admitted market, enjoys freedom from rate and file regulation requirements in order to provide property/casualty insurance not available to consumers in the standard market. Surplus lines insurers and brokers are often dubbed the innovators due to their ability to quickly change and provide emerging coverages for new classes of business or tough-to-insure markets.

Surplus lines industry players are determined to participate in the debate in Washington. They not only want to assure that this flexible, innovative surplus lines market the industry has come to know is not harmed by whatever Congress decides to do, but also that any opportunities that might surface in the debate to improve the current system are seized.

“It would depend on how the regulation is enacted,” according to Richard Bouhan, executive director of the National Association of Surplus Lines Offices, a national trade association representing the surplus lines industry and the wholesale insurance marketing system, when assessing what might lie ahead.

Getting SMART

The SMART Act, sponsored by Congressmen Michael Oxley (R-Ohio), and Richard Baker (R-La.), aims to bring national standards and increased uniformity to state-based insurance regulation, but the original draft legislation initially did not address the specific concerns of the surplus lines industry.

NAPSLO, along with several other insurance industry associations, weighed in on the SMART Act discussions with the House Financial Services Committee last year to offer its views on the parts of the draft that could significantly impact the surplus lines industry.

“We recognized that there is a problem that exists within the state regulation system,” Bouhan said. “And if efforts were going to be made to set up federal standards to overcome inconsistencies, then we had some areas within the surplus lines market that we thought should be addressed because there are also problems with uniformity and consistency in the surplus lines market.”

One problem that has greatly hindered the efficiency of surplus lines is the way surplus lines brokers must remit premium taxes when they write risks in multiple states.

“The remittance of taxes is an absolute mess because there’s no common allocation formula and [there are] conflicts between the state laws and no consistency in the procedures involved in remitting these taxes,” Bouhan said.

A second area that was of concern to the surplus lines industry involves multi-state compliance issues for brokers.

The Gramm-Leach-Bliley Act (GLB) of 1999-which broke down walls between insurance and banks and also made it easier for surplus lines brokers to obtain licenses in other states-created multi-state compliance problems for brokers whose customers had operations in many states.

“Since the advent of GBL and the availability of surplus lines non-residence licenses in virtually every state, we now have a situation in which surplus lines brokers are getting licensed in a number of states; and when they get licensed they agree with the states that they will adhere to the states’ surplus lines laws,” Bouhan said. “Now when they have a multi-state risk (a growing trend for U.S. businesses, according to Bouhan) some problems started to evolve,” he said. “Now, I have to comply with virtually every state with which there’s an exposure.”

A third issue that is important to the surplus lines industry when dealing with regulation reform involves “automatic export” or the ability to bypass the “diligent search” requirement to access a surplus lines product when dealing with a “sophisticated buyer.”

“We believe the consumer is better served to have available both the admitted and surplus lines market-and to allow the consumer the opportunity to determine where they would like to have their insurance,” Bouhan said. “So we were asking when you have a sophisticated buyer as defined in the [SMART] Act that the diligent search requirement would be eliminated for that risk so it could be placed in the surplus lines market without a search.”

The SMART Act defines a sophisticated buyer as having: a net worth of more than $50 million; net revenues or sales of more than $100 million; has more than 500 employees, procures its life insurance through the use of a risk manager; aggregate amount of premiums paid for insurance on an annual basis exceeds $500,000; and that they are either a nonprofit organization or a private entity that has an annual operating budget or assets of not less than $45 million, or is a municipality with a population of more than 50,000.

According to Bouhan, all but one issue important to its NAPSLO surplus lines broker members has been added to the SMART legislation. A statement of rate and form freedom for surplus lines failed to make the cut, but Bouhan said “since all states really have that now, it’s not a crucial point.” Nevertheless, “We think the SMART Act is a better approach to deal with these problems,” Bouhan added.

While the SMART Act is not actual legislation yet, there’s been considerable work on the draft bill for more than a year, said Maria Berthoud, NAPSLO’s Washington based lobbyist. Berthoud added that the bill would have likely been introduced to Congress last year, but the Terrorism Risk Insurance Act extension and then Hurricane Katrina consumed the focus of the House Financial Services Committee and industry advocates.

“The staff got waylaid by the urgent,” she said. “However, I expect SMART to be introduced not immediately, but within the next three or four months.”

There is strong support particularly on the House side for SMART because the House has really tackled this issue before the Senate, Berthoud said. “The Senate is just starting to get up to speed while the House has had probably eight hearings in the past two years on the issue of insurance regulation,” she said. “So the House is really taking the lead and would be the ones to introduce a SMART bill.”

Competing against optional federal charter

Another insurance regulation reform theory hot on the minds of the industry is the National Insurance Act, a bill containing the framework for an Optional Federal Charter (OFC).

The draft of the National Insurance Act provides for the federal chartering, licensing and regulation of national insurers, national agencies and insurance producers as well as establishing the Office of National Insurance within the Treasury Department. All insurers, including surplus lines insurers, would have the opportunity to choose to be regulated by the federal government rather than the states.

The American Insurance Association is a staunch supporter of the OFC, while NAPSLO, the Independent Insurance Agents and Brokers of American and the Property Casualty Insurance Association of America back the SMART Act. The National Association of Mutual Insurance Companies neither supports nor opposes the SMART Act discussion draft but opposes OFC.

“Similar to the current dual regulatory system for banking, insurers then would have the option, depending on what best serves their customers, of being regulated at the federal or state level,” explained Gov. Marc Racicot, president of the AIA, in a recent article in Insurance Journal. “An optional federal charter is just that-an option. The state regulatory system (including state premium taxes and guaranty funds) would not go away.”

But NAPSLO contends that so far the National Insurance Act, and its OFC system, do not address the specific needs of surplus lines brokers.

“We don’t believe it is the way to go about solving the lack of uniformity and consistency in the marketplace,” Bouhan said.

“The OFC is a bill that has considerable amount of support from some significant trade associations and individual insurance companies,” Berthoud said.

Berthoud said that the OFC bill will likely be introduced to Congress in the next month or so by Sen. John Sununu (R-N.H.) and Sen. Tim Johnson (D-S.D.). “They plan to introduce a bipartisan bill that would create optional federal charters.”

Bouhan says that one way the OFC could address the same issues that SMART addresses regarding surplus lines broker concerns would be to establish a “national surplus lines license.”

According to Bouhan, if one license were created for surplus lines brokers and the holder of that license would: 1) be able to pay the tax on the transaction to one state and let the states allocate it to the other states properly; 2) if the holder of that license had a multi-state risk they could comply with one state for one state compliance; and 3) if there were a sophisticated buyer in a particular state in which the transaction was being conducted then the broker would be able to allow that buyer to access the surplus lines market without a diligent search.

“In other words, the national license addresses our issues,” Bouhan said, while pointing out that NAPSLO as an organization currently does not hold an official position on this issue.

How would reform change the surplus lines industry?

Under the SMART Act, as it’s written now, the problems associated with the remittance of surplus lines premium taxes would be solved, according to Bouhan. But the surplus lines industry as a whole “wouldn’t be that much different except the remittance of taxes would be a lot easier and would solve the multi-state tax problem,” he said.

But Berthoud noted that if the OFC were to be passed as it is now, it would “change the entire structure of the insurance regulatory system.”

Bouhan said that if the industry does go the route of optional federal charter then surplus lines issues need to be addressed. “The SMART Act really addresses our issues and the OFC does not,” he said.

Bouhan added that both reform legislation drafts are “still a in a state of flux” and there could be a lot of changes before either actually becomes legislation. “OFC is still more of a concept than a proposed legislation,” he said. Remember, he said, “Gramm Leach Bliley took 20 years to get passed.” Who knows when the insurance industry will actually be reformed.