State implementation of the Nonadmitted and Reinsurance Reform Act (NRRA), effective July 21, 2011, proceeded relatively smoothly during 2012, albeit with a few hiccups as industry and regulators navigated the transition to home state taxation and regulation of surplus lines transactions.
The big issues for 2013 are market security and surplus lines premium tax audits.
The NRRA’s surplus lines insurer eligibility standards for foreign (domiciled in the United States or certain U.S. territories) and alien (offshore) nonadmitted insurers expose the industry and consumers to the risk that unscrupulous nonadmitted insurers may enter the market based on creative financial statements or may otherwise skirt the system undetected.
After all, fraudsters need not announce their presence by making required regulatory filings.
As for premium tax audits, 2013 will be the second full year of surplus lines premium tax data under the NRRA. In search of premium tax revenues, the states can be expected to closely scrutinize broker compliance with home state taxation and regulatory requirements.
The surplus lines broker is responsible for due diligence of security of nonadmitted markets with which the broker places risks. For the past two decades, security due diligence has relied heavily on state “white lists” of “approved” nonadmitted insurers.
The system was effective. There have been no insolvencies of nonadmitted insurers in recent memory.
The NRRA set two criteria for surplus lines insurer eligibility: a) for insurers domiciled in the United States, capital and surplus of $15 million or such higher amount as the home state may require or b) for insurers domiciled outside the United States, eligibility is defined by whether they appear on the NAIC’s Quarterly List of Alien Insurers.
The domiciliary state regulator is responsible for solvency regulation of foreign nonadmitted insurers. The NAIC is responsible for solvency regulation of alien nonadmitted insurers.
Foreign Nonadmitted Insurers
By definition, the surplus lines insurer is domiciled in some state other than the home state of the insured. The home state taxes and regulates the transaction; the domiciliary state of the insurer is responsible for guarding the policyholders’ money.
Surplus lines insurers typically write little or no premium in their domiciliary state. The domiciliary regulator, even though fully accredited for sound financial regulation by the NAIC, may therefore have little reason to give more than routine attention to an insurer that writes business only outside its jurisdiction.
The NRRA defines “state” to include Puerto Rico, Guam, the Northern Mariana Islands, the Virgin Islands and American Samoa. A nonadmitted insurer domiciled in any of these jurisdictions is free to write business nationwide, subject to home state threshold financial eligibility requirements.
Of these five jurisdictions, only Puerto Rico has satisfied NAIC accreditation requirements for sound financial solvency regulation. U.S. regulators and surplus lines brokers therefore have good reason for pause regarding the financial underpinnings of “eligible” surplus lines insurers newly formed or that have changed hands in nonaccredited jurisdictions post-NRRA.
Pre-NRRA, the states representing the bulk of surplus lines premium closely screened nonadmitted insurers who wished to insure consumers in their state. The major surplus lines states drew heavily on the expertise of state stamping offices, as well as on the informal industry network that has served as an early warning system for years.
Working together over the past two decades, state regulators, stamping offices and industry have successfully kept the bad guys out.
Alien Nonadmitted Insurers
Under the NRRA, Congress delegated to the NAIC responsibility to review and approve the financial and other bona fides of alien nonadmitted insurers. Pre-NRRA, state regulatory screening of alien nonadmitted insurers usually concurred with the NAIC’s assessment, although not always.
Through its International Insurance Department (IID), the NAIC performs essentially an administrative function to ensure that alien insurers satisfy defined criteria. It is an important job that the IID has done well for years.
But the IID alone cannot substitute for the financial and market surveillance system in place pre-NRRA. To protect U.S. consumers and the integrity of the surplus lines market, it is incumbent on the NAIC to ensure that the IID takes full advantage of the breadth and depth of expertise of state regulators, stamping offices and industry.
Market Security Observations
The surplus lines industry and state regulators have a common interest in protecting the integrity of the surplus lines market.
There is nothing wrong with the NRRA; it is merely a different regulatory paradigm. Core regulatory considerations have not changed. Effective market security can be accomplished well within the framework of the NRRA. Congress never intended to preempt common sense.
Once home state regulators are comfortable that the NRRA does not put their consumers at risk, they should be much more open to measures that would realize the NRRA’s promise of nationwide uniformity for taxation and regulation of the surplus lines market.
Premium Tax Audits
It is common knowledge that the states are desperate for cash and no surprise that they are suspicious that the NRRA has cut into their surplus lines premium tax revenues.
One would expect surplus lines premium tax auditors to focus mainly on two areas: a) whether premium tax was remitted to the correct home state and b) whether the tax was properly calculated. If the surplus lines broker failed to remit tax to the correct home state, the broker is also potentially exposed to fines and penalties for failing to comply with the home state’s licensing and diligent search requirements, among others.
The states, however, must recognize that 2012 largely continued the complex transition to home state taxation that began on July 21, 2011.
Even the most sophisticated and diligent surplus lines brokers struggled to comply with ever-changing tax rates and premium allocation methods as various states joined or withdrew from multi-state tax sharing arrangements, such as the NIMA Clearinghouse.
The dust only recently began to settle.
Simple fairness suggests that the states should forbear from imposing fines or penalties for 2011 and 2012 transactions where the surplus lines broker made a good faith effort to comply in reliance on the regulatory guidance available at the time. Instead, the states should look to 2011 and 2012 for lessons learned and whether further clarification of regulatory guidance is warranted.
But the shakedown cruise is over. For 2013, the states have every reason to expect full compliance with the new surplus lines rules.
A prior version of this article was published by the AAMGA in the Winter 2012 edition of WIN Magazine.