The Problem with Domestic Excess and Surplus Lines Insurers

It has been more than five years since states, beginning with Illinois, began to enact laws permitting the formation and licensing of domestic excess and surplus lines insurers. To date, these initiatives have gotten very little traction in the insurance industry and, at first blush, it is difficult to understand why this is. The traditional regulatory scheme for excess and surplus lines was a model of inefficiency.

Under the prior scheme, in order to operate as an excess and surplus lines carrier, an insurer was required to be admitted as a licensed carrier in one state. Although the carrier could operate on a nonadmitted basis in the remaining states, it could not operate as an excess or surplus lines carrier in the state in which it was admitted (State A). To write business in State A, the carrier’s group would be forced to form a second company and license it in another jurisdiction (State B). The carrier licensed in State B would then write on a nonadmitted business in State A. The group was therefore subject to multiple regulatory regimes and the internal costs of maintaining two carriers.

In an attempt to address the inefficiencies of the traditional regulatory system, states including Arkansas, New Jersey, Illinois, Oklahoma, North Dakota and Delaware have adopted domestic surplus lines laws. In a state with a domestic surplus lines law, a company domiciled in the state can be designated a domestic surplus lines insurer and write surplus lines business in both its state of domicile and every other jurisdiction, all on a nonadmitted basis.

Domestic Surplus Lines Licensing

Many have questioned why the insurance industry has been so reluctant to avail itself of the new domestic surplus lines licensing category.

For example, the most recent white list of surplus lines insurers in New Jersey is comprised of 129 eligible surplus lines insurers and only two domestic surplus lines insurers. Illinois, the state with the oldest domestic surplus lines law, listed just seven premium writing domestic surplus lines companies in 2012, the last year for which data was available. The reason likely lies in the fact that the domestic surplus lines initiatives are in conflict with existing state laws and another law that also aimed to modernize and streamline state regulation of the insurance industry — the Nonadmitted and Reinsurance Reform Act of 2010 (the NRRA), 15 U.S.C. §§ 8201 et seq.

Part of the reluctance to license an insurer as a domestic surplus lines insurer stems from a fear that becoming a domestic surplus lines insurer will cause the insurer to have an uncertain status that may preclude the company from accepting business altogether. Section 5.A(2) of the NAIC Nonadmitted Insurance Model Act (the Model Act) states that insurance business may not be placed with an excess or surplus lines insurer unless the insurer is “authorized to write the type of insurance in its domiciliary jurisdiction.” A version of the Model Act has been adopted in most states.

For example, a company cannot write excess of loss coastal flood insurance on a nonadmitted basis in most states unless it is authorized to write property insurance in its state of domicile. A domestic surplus lines insurer is not “authorized” to write any direct business in its domiciliary state — it is only eligible to write surplus lines insurance in its domiciliary state. A circular reference is therefore created at the intersection of the domestic surplus lines laws and the Model Act. The industry is concerned that domestic surplus lines insurers may be found to be ineligible to write nonadmitted business in particular jurisdictions with versions of the Model Act.

NRRA Conflict

The conflict between domestic surplus lines laws and the Model Act is exacerbated by the NRRA, which was enacted by Congress to address inconsistencies in state regulation of excess and surplus lines insurance and reinsurance. In the excess and surplus lines arena, the NRRA made the following welcome reforms:

Prior to implementation of the NRRA, double taxation of surplus lines premium was a constant concern for surplus lines carriers. This was largely due to vagueness of, and inconsistencies among, various state laws imposing surplus lines premium taxes as well as lack of coordination among the states with respect to surplus lines premium taxes. To cut the knot, the NRRA provides that only the insured’s home state may impose a premium tax on a nonadmitted insurer.

In other words, state laws that impose a surplus lines premium tax based on location of the risk insured, or were interpreted that way by regulators in the absence of clear statutory language, are pre-empted. The NRRA encouraged states to enter into an interstate compact as a means for divvying up surplus lines premium among the states.

Under the NRRA, placement of nonadmitted insurance is subject to the sole regulation of the insured’s home state. Any law to the contrary in any state is preempted. Further, nationwide standards for surplus lines eligibility based on the Model Act were mandated by the NRRA.

The NRRA provides that no state other than an insured’s home state may require a broker to be licensed to place business with an excess or surplus lines carrier. Additionally, it creates incentives for the state to standardize and coordinate broker licensing. Therefore, potentially contradictory and confusing laws requiring multiple licenses to place surplus lines insurance are pre-empted. These provisions also addressed an issue which had simmered for years in the brokerage community; that is, the perception among producers that many states’ licensing requirements were unfairly biased in favor of in-state brokers.

The NRRA has been generally viewed favorably by the insurance industry. This contributes to the concern that because the ability of domestic surplus lines insurers to do business under the Model Act and the NRRA is unclear, status as a domestic surplus lines insurer leaves a company in legal limbo with respect to the NRRA. States including Illinois, Arkansas and North Dakota include in their laws the provisions that a domestic surplus lines insurer is considered a nonadmitted insurer, as the term is defined in the NRRA, with respect to risk insured in the state. This does not provide a solution.

First, the problem lies with states that require an excess or surplus lines insurer to be licensed in its domiciliary jurisdiction, not in the licensing state of the domestic surplus lines insurer.

Second, the NRRA provides that a state may not impose eligibility requirements on a nonadmitted insurer domiciled in a U.S. jurisdiction other than the criteria contained in the Model Act. As the provision creating an extraterritorial eligibility category for a domestic surplus lines insurer is not in the Model Act, it is likely pre-empted by the NRRA and unenforceable.

To carry out the intended effect of domestic surplus lines laws and the NRRA, and to protect those companies that have become domestic surplus lines insurers or are in the process, it is imperative that Section 5.A(2) of the Model Act be amended to provide that surplus lines insurance may be placed with an insurer that is, “authorized to write the type of insurance in its domiciliary jurisdiction or designated a domestic surplus lines insurer in its domiciliary jurisdiction.” Corresponding changes to state insurance laws would clarify the status of domestic surplus lines insurers and protect insurers, brokers and policyholders.