Coming To The Rescue

Bernd (Bernie) G. Heinze, executive director of the American Association of Managing General Agents (AAMGA), recalls a perfect example of the regulatory difficulties the surplus lines industry faces. A colleague at a Congressional hearing he attended produced a stack of paper one and a half feet thick, all of it necessary to place one multi-state risk.

The mountain of paperwork, coupled with the equally large burden imposed by non-resident producer licensing requirements, directly affects the surplus lines industry’s efficiency and costs. In addition, contrary to most insurance policies, surplus lines brokers rather than carriers are responsible for paying any taxes due, which is not only costly, but also leads to abuse.

Surplus lines direct premiums rose from $6.532 billion in 1990 to $33.287 billion in 2005, according to A.M. Best. During that time, states have introduced regulations for non-resident brokers, for verifying the financial strength of non-admitted carriers, and for collecting their portion of the taxes applicable to the risks covered in their states. “Some of the major brokers have 50,000 licenses,” said Dan Maher, executive director of the Excess Lines Association of New York (ELANY). “How manageable is that?” he asked.

While these regulations were more or less well intended, they have produced a minefield of rules — many conflicting with one another — that make placing multi-state risks increasingly cumbersome and expensive. However, addressing the problem evokes fundamental questions over how the insurance industry in general and the surplus lines industry in particular should be regulated: federal vs. state; local vs. national; the rich and powerful vs. the small independents. Finding a compromise solution has not been easy.

The federal proposal

Last year the U.S. House of Representatives passed by unanimous vote H.R. 5637, the “Non-admitted and Reinsurance Reform Act.” The bill’s provisions would have streamlined the current procedures under which the surplus lines industry operates by introducing greater electronic processing, eliminating filing redundancies, and taxing insurance transactions in one “home” state where the insured is located. While the bill passed the House, it was not brought up for consideration by the Senate.

On Feb. 15, 2007, a virtually identical bill, the “Nonadmitted and Reinsurance Reform Act of 2007,” was reintroduced in the current session.

AAMGA’s Heinze emphasized the federal bill is not a call for federal regulation. While AAMGA has not taken an official stand on that question, Heinze says the reform is simply a long-needed step towards modernizing the way surplus lines are regulated, making it easier and cheaper for the ultimate consumer — the retail agent’s clients — to obtain the coverage they need. “It’s a bill for consumers,” he said.

Richard Bouhan, executive director of the National Association of Professional Surplus Lines Offices (NAPSLO), agrees. In a recent bulletin the organization said it is “contacting members of House Financial Services Committee and Senate Committee on Banking, Housing and Urban Affairs to urge Congress to enact the surplus lines and reinsurance reform bill.”

Bouhan said that NAPSLO’s “top legislative priority” in this Congress is the passage of the “Nonadmitted and Reinsurance Reform Act” and added, “we are pleased that the first step has been taken in the 110th Congress, to enact this legislation. NAPSLO hopes the House, again, endorses the bill and the Senate takes it up, shortly.”

NAPLSO opposes giving the federal government primary authority to regulate the surplus lines industry. However, the organization warns, “the current state-based system must become more uniform and more efficient.”

There’s agreement on that, but as usual “the devil’s in the details.” If federal regulation in a form acceptable to the surplus lines industry cannot be achieved, there is another way. States are showing they may come to the rescue by offering their own solution.

State move forward on a solution

“Regulatory modernization is a watchword,” ELANY’s Maher said. “We have to streamline the regulations and make them more uniform.” While he and state regulators recognize the possible value of a federal statute, they’re not entirely sure that will happen, and they’re concerned about what form it may take. “H.R. 5637 is one approach,” Maher said, “but the language needs to be tightened and improved.”

So a number of states are taking matters into their own hands. In conjunction with the National Association of Insurance Commissioners (NAIC) and the National Conference of Insurance Legislators (NCOIL), they are seeking ways to modernize what Maher describes as “somewhat antiquated” surplus lines laws among various states. They have formed the Task Force Committee of the Multi-state Compact Working Group. In the minutes of the latest meeting Maher described their goal as the establishment of “one set of compliance requirements for all multi-state surplus lines risks by which all compacting states jointly regulate the transaction.”

“The key states, New York, California, Texas and Florida, who account for over 50 percent of the surplus lines business in the U.S., are aware of the problem, and we’re committed to doing something about it,” Maher said.

Producer licensing regulations and the placing of multi-state risks are the two areas they’re focusing on, with a first priority being the “multi-state risk” problem, “but licensing is definitely being considered as well,” Maher said. “There just has to be a better way to do it.”

Maher suggested that the Gramm-Leach Blilely Act (GLBA), which Congress passed in November 1999, could serve as a starting point to address both licensing and multi-state risk problems. GLBA repealed the Glass-Steagall Act and set new rules for regulating interstate financial transactions. It also recognized the principle of having one “home state” that scrutinizes financial soundness, provides the application forms and cashes the checks.

“What we’re suggesting is an interstate compact,” Maher continued. “It would implement national standards, but their control would rest with the states.” Such a solution would make the “home state,” i.e. the state with the “greatest nexus relative to the risk,” responsible for policing the placing of the risk at the outset in accordance with agreed upon regulations.

Once placed, those states with an interest in the policy — e.g. where part of the coverage relates to risks in that state — would accept the application forms and licenses, as well as the determination of the financial soundness of the carrier as fulfilling their own requirements. Each state would also receive its share of tax due in proportion to the risk covered in that state.

An alternative proposal envisages a “national clearing house” that would receive and apportion tax revenues from a multi-state surplus lines insurance policy according to the percentage of risk covered in each state.

“What we’re hoping to do,” Maher said, “is modernize the surplus lines regulations along those lines without lowering consumer protections. The industry spends millions on filling out forms and compliance statements, which not only adds to the cost of coverage, but also creates no additional value.”

Since the goal is similar to the proposed federal surplus lines regulation, its proponents are hoping to convince individual states to adopt the changes. That’s a challenge unto itself.

The conflicts involved

Even though the larger states support reforming the system, they remain leery of ceding too much regulatory authority. “We’re working in conjunction with New York, California, Florida and other states to try to reach some consensus on simplifying the procedures for multi-state risks,” said Kathy Wilcox of the Surplus Lines Office of the Texas Department of Insurance (TDI). She handles registration, surplus lines, foreign risk retention groups and purchasing groups. “There are a number of pros and cons that have to be weighed.” Her chief concerns are how to make certain that Texas consumers are adequately protected when coverage is placed through “non-resident” entities, and how tax revenues will be allocated.

“Texas started a similar process even before the federal bill,” Wilcox said. Representatives from the TDI have participated in the working committees and with the NAIC on formulating proposals. She stressed that each state has its own special concerns. “Texas is a niche market for oil and gas risks,” she explained, in reference to the high concentration of energy companies in the state and off its coast. Their needs are probably “best handled locally.”

Texas certainly isn’t alone. Insurance, like politics, can be local in that the risks and the clients often differ from state to state. Any multi-state compact will have to take that into account.

“There’s lots of contradiction [in the current regulatory system] and the compliance burden is on the broker; sometimes there’s really no right way to do it,” said Todd Teitell, president of Dallas-based Colemont Insurance Brokers and member of the board of directors of the Texas Surplus Lines Association, who’s been working closely on the question. His business is directly affected by current surplus lines regulations. “I have about 50 licenses and I probably need a 100,” he noted. As an example, he explained that a complicated risk “may have 10 different carriers, and each one needs an endorsement. If there are 20 states involved, that’s 200 endorsements.” Multiply that by the thousands of surplus lines policies that are written each year and the scope of the problem becomes clear.

“However,” Teitell continued, “the state regulators and the state legislatures have to approve any changes. They’re worried about the effect on revenues, and there’s no way to gauge what effect [legislative] changes may have; there’s no database to pull it from.”

The current system, however, as a number of surplus lines professionals have candidly (but privately) admitted, bolsters the tendency of brokers to simply pay any tax due to the “home state” where coverage is placed, and ignore any amounts that might accrue to other states. A national clearinghouse, or a mandate to share revenues, would therefore benefit a number of states — mostly the smaller ones now losing out on their share of tax revenues. But it could also hurt the larger states that now tend to keep a disproportionate share of that revenue.

In addition to the tax conundrum, Teitell pointed out that in order to get approval for reforming surplus lines procedures, first legislators have to understand the problem. “They see things like ‘unregulated’ and ‘non-resident’ and, until it’s explained to them, they worry about the consequences [of voting for changes in the regulations].”

Clearing the hurdles to reform

Thus, while practically everyone involved in the surplus lines industry recognizes the need for modernization of the rules, potential stumbling blocks remain at both the state and national levels.

“The pressure is definitely on the surplus lines industry to come up with a solution,” said Ted Pierce, executive director of the Surplus Lines Association of California. “The biggest problem is how to solve the tax issue.”

Pierce favors “home state” collecting and reporting rather than a national clearinghouse. He’s also concerned that some blanket regulation could end up weakening stronger state standards. “California’s the largest surplus lines market in the U.S.,” Pierce said. “We shouldn’t lower our standards; any changes in eligibility should leave us as strong as we are now.”

He pointed out that there are 14 states with official “stamping offices” — the regulatory authority charged with assuring the financial soundness of the carriers that write surplus lines policies in their respective states. According to A.M. Best’s 2005 report on the surplus lines industry, the 25 leading surplus lines groups accounted for “82.5 percent of the total surplus lines direct premiums in 2005.” AIG and Lloyd’s alone are responsible for around 35 percent.

The stamping offices don’t have too many worries over the big carriers, but they do when it comes to smaller operations. However, those smaller companies are often the ones that specialize in niche markets, under served by the bigger carriers. They are therefore an important component in many local markets. As Wilcox noted, Texas, with its energy risks, needs regional carriers as well as national companies. A broker who places an energy risk with a Texas-based company, however, faces a potential problem if the insured also operates in California.

If those problems can be solved, surplus lines modernization may happen. “We hope to have the first draft [to present to the NAIC’s Surplus Lines Working Group] ready next month [March],” Maher said, “and we’re very encouraged.” He pointed out that previous problems — notably countersignature laws and to some extent surety bond requirements — have been successfully addressed. “Now we’re on the way to creating something more efficient,” he continued. “Taxes will be better allocated [so smaller states can receive their share] and regulatory oversight will be assured. Then we can tackle the producer licensing system.”

Maher is optimistic but, as he pointed out in discussing the submission of the proposals, there’s more road to travel. “Now they’ll tell us what they don’t like,” he said.

Teitell thinks the state compact plan has “about a 50-50 chance,” while Pierce is less optimistic. “I’m not sure it’s a big enough problem [for the individual states to act on],” he said. “I think you’re also going to need some form of federal regulation to push for it.”

Combining the two reform plans — federal and state — could work, as they are quite similar. “There’s broad industry support,” Teitell said, referring to the initial meeting held in St. Louis last September. “All segments of the industry were there — Marsh, Aon, the carriers, the NAIC and lots of brokers. They all recognized that the system’s not working, and we need to make it better. That’s encouraging in itself.”

Topics California Carriers Texas New York Legislation Agencies Excess Surplus Reinsurance