De-Mystifying Surplus Lines Insurance
Copyright 2024, Charles F. Barr, Esq.
Two Methods for Obtaining an Unregulated Form of Insurance. There are two avenues for obtaining an unregulated form of coverage from insurers not licensed in the insured’s state. One (“surplus lines”) is a transaction regulated by the state law of the insured because the insurer agrees to be regulated. The other (“nonadmitted insurance”) is entirely unregulated because the insurer chooses not to be regulated in the US. Surplus lines transactions must involve a specially licensed US broker and the purchase is transacted within the US. Nonadmitted transactions cannot involve a US broker and the self-procurement by the insured must take place outside the US (or meet an “industrial insured” exception).
Coverage is “surplus lines insurance” if: the unregulated form of coverage is obtained via a regulated transaction from an insurer regulated in the US; a specially licensed US broker must be involved; and the insured can purchase it from home.
Coverage is “nonadmitted insurance” if: the unregulated form of coverage is obtained via an unregulated transaction from an insurer not regulated within the US; a US broker cannot be involved; and the insured must leave the US to purchase the coverage (unless meeting an exception).
Regardless of the delivery differences, the form and price of the coverage are unregulated and could be the same in either transaction. The bulk of regulatory rules cited below apply only to surplus lines insurance; pure agency law applies to both, with certain credit risk-shifting exceptions.
Surplus Lines insurers and Nonadmitted insurers are interchangeably referred to as unlicensed, unauthorized or nonadmitted. A US insurer is referred to as “foreign” by other states and a non-US insurer is referred to as “alien”.
Categories of Insurers. The three categories of insurers offering this unregulated form of coverage are: (a) a US insurer licensed in its domicile state and qualified in foreign states via a state-by-state process (coverage must be accessed via a licensed broker); (b) an alien insurer “qualified” by the NAIC in a one-step national process – recognized by most states’ surplus lines laws (coverage must be accessed via a licensed broker); or (c) an alien insurer unregulated by the US (coverage must be obtained without using a US broker, by self-procuring while outside the US).
Broker Participation – Surplus Lines Only. The prohibition against using a US broker for nonadmitted insurance is because a license is needed to “transact the business of insurance in a state” (by an insurer or middleman, either from within or from outside that state). If the alien insurer is not licensed in the insured’s state – or is not qualified under the surplus lines law of the insured’s state (directly or indirectly via the NAIC Qualified Alien List) – any US broker or middleman placing insurance with that nonadmitted insurer would be “aiding and abetting the unlicensed transaction of insurance in the state”. Which is unlawful for both the alien insurer and any US middleman which assisted that unlicensed alien. Further, state law can even make the offending broker liable to pay the policy benefits as if it were the insurer.
A. Methods for Qualifying as a US or an Alien “Surplus Lines Insurer”. A US insurer can conduct a surplus lines operation using one of two business models. An alien insurer has one business model.
1a. US Surplus Lines Insurers – Original state-by-state model. Still applicable in thirty states, a US insurer can become fully licensed in its domicile state and qualify as “an eligible surplus lines insurer” (or be “white-listed”) in a chosen number of foreign states where its insureds would be located. In the domicile licensed state, it can only conduct business on an admitted basis (i.e. regulated as to rate, form and market conduct). It contracts with insureds located in foreign states from outside that insured’s state on a surplus lines basis (i.e. no regulation of rate, form or market conduct). In order for an insurance group to operate on a surplus lines basis in all 50 states, it would domicile a second insurer in one of the other 49 states so that second insurer could operate on a surplus lines basis in state number one. That “1 & 49” business model requires two surplus lines insurers. The qualification as an “eligible surplus lines insurer” in foreign states is accomplished state-by-state and can take months or years to complete.
1b. US Surplus Lines Insurers – Domestic Surplus Lines Insurer. In the last decade more than twenty states have authorized a “domestic surplus lines insurer” by which a US insurer can operate on a surplus lines basis both from within its domicile and with respect to other states where it so qualifies and operates from outside those states.
2. Alien Surplus Lines Insurers. An alien insurer can choose to qualify with the NAIC (via a filing and the funding of a US trust account to collateralize its obligations) and appear on the NAIC Quarterly Listing of Alien Insurers. That is essentially a one-step “national qualification” allowing the alien insurer to be considered an “eligible surplus lines insurer” by most states without any state-by-state qualification. This allows access to the alien via a licensed surplus lines broker in the insured’s state.
B. Operating as an Alien “Nonadmitted Insurer”. Alien insurers which neither submit to US regulation or oversight via qualification in each state nor via appearance on the NAIC listing are unable to transact business from within the US or be accessed by a US broker. They cannot be a “surplus lines insurer”. Thus, “surplus lines insurance” is not obtainable from such unregulated alien insurer, which can only issue “nonadmitted insurance”.
US insureds who leave the country to purchase the nonadmitted insurance from the alien on a self-procured basis while outside the US suffer obvious inconveniences. They typically must travel. They are liable to pay on their own the insured’s home state a self-procurement premium tax (often equal to the surplus lines premium tax). They possibly might have to deal with the 4% Federal Excise Tax (FET) owed by the nonadmitted insurer if the alien insurer’s country does not have an appropriate tax treaty with the US. FET is an obligation of the alien (which is not a US taxpayer) and is a surrogate for the alien not paying federal income tax. States with an “industrial insured” provision (see below) can exempt a sophisticated US insured from the need to leave the country to self-procure the policy, but the exemption does not eliminate the state premium tax liability and doesn’t resolve the alien’s IRS issues.
Exporting Surplus Lines Coverage. SL insurers do not “transact the business of insurance from within those states” where their insureds are located. They are not present in, or doing business within, the insured’s state. To do so, they would need to be licensed and pay premium tax. The SL insurer instead operates from outside the insured’s state. It accepts placements of insurance “exported” from within the state where both the insured and its licensed surplus lines broker are located.
Surplus lines insurance is purchased from within a state by an insured and its SL broker on essentially a “mail-order basis” from the out of state SL insurer. The premium tax is paid by the insured to its resident state because the SL insurer cannot lawfully be taxed, since it is not present. The SL broker uses its special license to “export” the insurance to the SL insurer’s state via the SL broker applying for the coverage and collecting and remitting to the insured’s state both the premium tax and an “affidavit of unavailability” (i.e. a certification the broker unsuccessfully searched the admitted market for the coverage before exporting it). States usually have a “Stamping Office” to receive tax and affidavits.
No such affidavit is required if the coverage is on an “Exportable List” published by the Department of Insurance, i.e. those coverages the DOI has determined to be unavailable in the state. Nor is an affidavit required if the insured is an “exempt commercial purchaser” or an “industrial insured”, which the state defines to be an insured of a size or sophistication (e.g. employs a risk manager; pays considerable premium) that it can request placement with a SL insurer regardless of availability of admitted coverage.
“Unavailability” is based on coverage terms, not pricing; allegedly being “unaffordable” does not constitute being “unavailable”. Theoretically, SL coverage costs more and delivers less. Certain lines of insurance are not exportable (in part because they are available) if the state has a residual or assigned-risk market (FAIR plan fire coverage, assigned-risk Workers Compensation or auto, etc.). Accident & health insurance is typically not exportable.
Types of Insurers.
Licensed insurers are regulated by the domicile for fitness of their ownership, financial condition and the terms of any material transactions with affiliates (to avoid “looting” or unfair terms). They are also regulated by each licensing state for market conduct, premium rates and coverage forms. They pay federal income tax and pay premium tax in lieu of state income tax. They must participate in residual or assigned-risk markets. They must participate in post-insolvency guarantee funds, which assess licensed insurers in order to pay limited amounts to an insolvent insurer’s claimants and insureds.
Surplus Lines insurers exist in three forms as described above: the “1 licensed state & 49 qualified states” model; the domestic surplus lines insurer model; and the NAIC Listed Alien model.
Nonadmitted Insurers are those aliens who eschew US regulation and thus cannot be present in the US. Consequently, they transact business outside the US and are accessed by US insureds who leave the country to self-procure coverage (unless an industrial insured exemption applies) without assistance from a US broker. They owe 4% FET as a surrogate for US income tax; it’s collection and remittance is uncertain. Their US insureds owe a self-procurement premium tax to the insured’s state.
Guaranty Funds. In most states, insureds and claimants of an insolvent SL insurer cannot obtain any guaranty fund recovery (which is understandable, since the SL insurer did not contribute to insolvencies of licensed insurers, because it is not licensed or present in the state). Although recovery from a guaranty fund is limited (e.g. $300K per claim), it can be valuable. Lack of guaranty fund protection is a possible negative to marketing a SL insurer. One technique to address that negative is an insurance group can include its SL insurer(s) in its “gross” inter-company reinsurance pool.
A gross inter-company pool has each group insurer cede 100% of its business to the largest licensed insurer in the group (prior to each insurer purchasing any third party reinsurance; since such a purchase would make it a “net” pool). The pool leader then cedes reinsurance of the entire group’s business to third party reinsurers. The net of that cession on behalf of the entire pooling group is then retroceded to each pool member – in a chosen amount appropriate for each insurer’s policyholders surplus. By including the SL insurer in such pooling, it continues to not have access to any insolvency guaranty fund, but its policy obligations have been 100% reinsured to the strongest licensed group member, which virtually guarantees the SL insurer’s group will not allow it to become insolvent.
Lloyd’s of London filed on behalf of its syndicates in Illinois (as Lloyd’s Corporation’s “port-of-entry”), i.e. as if the syndicates collectively were a domestic insurer. That filing (along with the existence of the Lloyd’s Central Fund covering insolvent syndicates and a separate security deposit made with the Illinois DOI) qualifies Lloyd’s syndicates, collectively as a group, to be the equivalent of a licensed insurer there, which permits the syndicates as a group to be an eligible SL insurer in other states. Further, many Lloyd’s syndicates have registered with the NAIC and become eligible surplus lines insurers by appearing on the NAIC’s Quarterly Listing of Alien Insurers – which by itself essentially makes them “eligible surplus lines insurers” in most states.
Nonadmitted and Reinsurance Reform Act of 2010. This federal law (with most states adopting a version) streamlined and centralized the qualification of SL insurers, the licensing of SL brokers and the payment of surplus lines premium tax. The NRRA permits only one relevant state (with the most contacts to the transaction): to regulate the transaction; to collect 100% of the premium tax (no longer allowing a split among several states); and to require licensing of the SL broker.
Middlemen.
The only parties to an insurance contract are the two principals, the insured and the insurer. All others are middlemen, intermediaries or representatives (agent, broker, producer, MGA, MGU, reinsurance intermediary – broker or manager) or service providers (TPAs, consultants, adjusters, etc.). A licensed middleman is required in surplus lines transactions since that is the mechanism for a state to regulate the export process and the collection of premium tax paid by the insured. The legal consequences of a middleman’s involvement depend upon which principal it represents at the time of the relevant transaction and issues are typically resolved using traditional agency law – subject to any overriding re/insurance laws such as those which can shift credit risk for payments via middlemen.
An “insurance agent” is licensed by the state and appointed as agent by a licensed insurer and represents that licensed insurer for all but one function. That agent typically has binding authority granted via an agency agreement with the licensed insurer (i.e. power to accept coverage on its behalf). Notice from the insured to the insurance agent is deemed notice to the licensed insurer it represents; payment to the insurance agent is deemed payment to the licensed insurer it represents. The reverse follows: i.e. the insurer’s notice or payment to an insured must be actually received by the insured to be effective (since notice or payment by a licensed insurer to its own insurance agent – if it stopped there – is merely notice/payment to the licensed insurer itself).
The one function where the insurance agent temporarily represents the insured and not the licensed insurer is for the recommendation to the insured of types, limits and terms of insurance coverage. That involves professional advice given by the agent to the insured as the agent’s limited client. Otherwise, every error and omissions claim due to under-insurance or wrong insurance would obligate the insurer to revise the coverage due to its alleged representative’s alleged error at the point of sale. Those coverage recommendations of the insurance agent of a licensed insurer are made as a temporary and limited representative of the insured.
A ”surplus lines broker” is specially licensed by the state where the insured resides (variously called a SL ‘agent’, ‘broker’ or ‘producer’). This “SL representative” is purely a “broker”, i.e. it represents the insured. It may or may not have a contractual relationship with any SL insurer (see below). It often is called a “wholesaler”. It appears in the chain of production between the insured’s traditional broker (the “retail broker”) and the SL insurer. The traditional or retail broker is always the representative of the insured – and has personal contact with the insured it represents. The SL broker or wholesaler is also the insured’s representative – even if the SL broker deals only with the retail broker and does not have direct communications with the insured (and even if it is unknown to the insured). This is a possible derivation for the term “wholesaler” – because that generic position in a chain of commerce might not interface with retail customers – and doesn’t have to. Any lack of direct interface should be inconsequential legally.
In my opinion a SL broker does not cease to be a representative of the insured even if not in direct contact with the insured (and even if not known to the insured to exist). Such anonymity, by itself, should not make the SL broker an “agent” (generic usage) or a representative of the SL insurer for two reasons: (a) the insured, the retail broker and the SL broker, as a team, are approaching an out of state insurer for the benefit of the insured, not vice-versa; and (b) a SL insurer by law is not licensed or present within the insured’s state and, therefore, that SL insurer may not legally have a representative in the insured’s state. This is because a principal having a representative (or proxy) in the state is the legal equivalence of “the principal being present therein” (but without a license). Further, any representative of that out of state SL insurer, if such a middleman were present in the state, would result in that middleman “aiding and abetting” an unlicensed insurer to transact business within the state, which is a violation of the state’s insurance law by both the insurer and the middleman.
A practice tip is to refer to the role of the surplus lines broker as a generic “representative” of the insured – and never refer to it as “agent” in a generic sense. The generic term “agent” is too imprecise and unclear for use when technically addressing a surplus lines transaction since that word is a term of art with independent significance in the business of insurance. “Agent”, in the context of re/insurance, should connote and only mean “insurance agent”, i.e. the representative of a licensed insurer. The generic term “representative” can safely and accurately describe the role of the SL broker – whose client is the insured. This imprecision surrounding the word agent can be exacerbated by state law which sometimes refers to the surplus lines representative as a “surplus lines agent”.
The law of agency is critical when discussing the legal effect or result of a principal in the insurance policy (i.e. the insured or the insurer) giving notice or making payments through a middleman to the other principal. Agency law should not become unclear or imprecise by simply referring to the middleman as a “representative” of one of the principals, instead of as its (generic) ”agent”. Referring to the SL middleman as a “representative” should contribute to legal clarity.
Notice. For purpose of notice to a party, surplus lines insurance has two middlemen, and both are representatives of the insured (i.e. its retail broker and its SL broker or wholesaler). Thus, notice from the insured to a SL insurer, which is intended for delivery via the insured’s middlemen, is not received unless actually received by the SL insurer as the other principal in the policy contract. In reverse, the SL insurer’s notice to either middleman representing the insured should constitute notice to the insured – whether actually received by the insured or not.
Binding Coverage. Unlike insurance agents representing a licensed insurer, SL brokers typically do not have binding authority, i.e. the “power to commit to coverage” (more specifically, the power to decide coverage). Whereas a SL broker can and must communicate to the insured that coverage has been bound by the SL insurer. The latter process is a matter of communicating the SL insurer’s decision – and is not because the SL broker made the decision itself.
If the SL insurer grants binding authority to a middleman – or if it has an office in a state where it is not licensed – or uses an affiliate licensed insurer’s office and staff – technically, that SL insurer could be “transacting business within a state without a license”. And any middleman with the binding authority, or the affiliate licensed insurer sharing an office, could allegedly be “aiding and abetting” an unlicensed insurance operation being conducted by the unlicensed SL insurer. Curiously, several state’s laws explicitly allow a middleman to have binding authority from a SL insurer – generating a bit of cognitive dissonance, which can happen within 50 different sets of state law. It appears that for several decades regulators have not been trolling to enforce this possible issue.
Payment Receipt. For receipt of premium purposes, surplus lines transactions – like reinsurance transactions – have by law, contract and practice and as a matter of “fairness”, shifted to the insurer the credit risk of the insured’s chosen middleman or intermediary. The “credit risk issue” in surplus lines transactions is: “who suffers if the insured pays premium to its own representative, which does not pay the insurer?” That credit risk of the “insured’s middlemen” can arise from: (a) premium payment made to the SL insurer via the insured’s middlemen, when the payment doesn’t reach the SL insurer (due to fraud or insolvency); and (b) loss payments or return premium payments made to the insured via the insured’s middlemen, when such payments aren’t received by the insured (due to fraud or insolvency).
If there were no shifting of credit risk by law or contract, the loss from undelivered money paid to a middleman would fall to the principal whose chosen middleman didn’t deliver the money. As a matter of pure agency law.
However, surplus lines law, contract and practice have shifted the credit risk of the middleman to the SL insurer (as more famously done in the case of reinsurance). Thus, any payment by the insured to its own chosen middlemen is deemed received by the insurer whether the insurer actually receives the payment or not (absent fraud by the middleman, as discussed below).
It makes sense that the reverse would also be true, meaning a loss payment or return premium amount that is sent by the insurer to the insured through the insured’s chosen middlemen should be deemed received – only if actually received by the insured. That reverse payment scenario is explicitly addressed in the “reinsurance intermediary clause” located in reinsurance treaties (as an NAIC financial condition examination requirement in order for the cedent to get annual statement credit for the reinsurance). The reinsurance intermediary clause addresses payments in both directions which are made through reinsurance intermediaries. Inbound payments to an insurer are deemed received when paid to the intermediary; reverse payments from reinsurer to cedent are deemed received only if actually received by the ceding insurer.
That reverse payment scenario may or may not be explicitly addressed by contract in surplus lines transactions. I have not seen it addressed by statute (which only addresses payments inbound to the insurer). But the theory of credit risk-shifting (and the existence of the reinsurance intermediary clause counterpart) supports the result that reverse payments by the insurer to the insured should only be deemed received if actually received by the insured.
Apparent Authority, Actual Authority and Fraud. Payments made by an insured to its retail broker or SL broker do not result in a legal shift of credit risk to the SL insurer unless and until the transaction is made bonafide via the SL insurer binding the coverage produced by the insured’s two middlemen. That qualification is necessary to combat fraud by a middleman. Once a retail or wholesale representative accurately proclaims it has secured coverage that was bound via a decision of the SL insurer, that transaction has become legitimate. Which allows the middlemen representing the insured to deliver to the insured the coverage decision of the SL insurer (aka the binder) and it activates the credit risk-shift.
Unless such decision and legitimization by the SL insurer is required by the law in order to accomplish the credit risk-shifting, it would mean a fraudster middleman could falsely proclaim it had authority to bind coverage and receive premium on behalf of the SL insurer. Which ostensibly would stick the SL insurer with coverage without receiving payment.
This “bonafides of the middleman” issue, arising when there is no actual authority, implicates the issue of whether there was “apparent authority” that might bind the unpaid SL insurer to coverage even if there was no actual authority. However, “apparent authority” cannot be created solely by the fraudster middleman; it may only be created by the acts of the principal itself (i.e. the SL insurer). Such acts could include oral statements, written correspondence or emails, prior conduct or trading relations, etc. Apparent authority allegedly created only by the fraudster middleman, and thus ineffective, should not bind the SL insurer to the fraud – which will leave the duped insured without coverage or premium.
Broker Agreement. Insurance agents have written agency agreements with licensed insurers which articulate their authority on behalf of the licensed insurer (power to bind coverage, authority to receive notice and payments, credit terms, etc.). A retail broker or SL broker who represent the insured is not obligated to have a contract with the SL insurer, but the SL insurer (for its own protection) should create one for at least three reasons:
(1) to articulate that the broker does not have authority to bind or modify coverage (i.e. the middleman cannot make the coverage decision; and can only communicate to the insured the decision of the SL insurer). With brokers, it can be as important to clearly state what authority they do not have, in addition to the authority they do have.
(2) to create the concept of “unearned brokerage” to overcome state law or contract law stating the broker earns the brokerage in full upon coverage placement. Without creating the concept of unearned brokerage, the SL broker would fully earn a year’s brokerage at placement. That would mean the SL insurer would be obligated to return 100% of the unearned premium to the insured on a pro-rata basis (e.g. returning half the premium if coverage is terminated mid-policy year), but the middlemen would not be obligated to contribute any portion of the full brokerage (because brokerage was fully earned at placement). Thus, the SL insurer (as principal in the policy) would have to return more than it received because of the disparate earning result – unless modified by contract.
(3) to set the premium collection timing to protect the SL insurer’s balance sheet. “Premium in the course of collection not 90 days past due” is an Admitted Asset of a US insurer. That is why there is a timeline for premium payments between insured to insurer when premium passes through one or more middlemen. SL insurers need to receive premiums as scheduled to meet the 90-day rule and preserve the asset; or possibly make the middleman liable by contractual terms for the premium debt if not timely collected.
Conclusion.
“Surplus Lines” is a regulated transaction that delivers a policy not regulated as to rate and form or market conduct. “Nonadmitted Insurance” is an entirely unregulated transaction that delivers a policy not regulated as to rate and form which should be procured outside the US. State law controls how surplus lines coverage is placed. A state’s chosen terminology and process can vary. Some statutes appear to consider an out of state SL insurer to have a “form of licensing” in the insured’s state – when more accurately it is merely a degree of qualification or eligibility to receive the coverage exported to it while the insurer operates outside the insured’s state. If truly licensed in the insured’s state, that state could compel the SL insurer to pay premium tax and could impose rate and form, market conduct, guaranty fund participation and other forms of regulation – but it doesn’t. An overview of 50 states’ surplus lines regulation strongly suggests the SL insurer is not meant to be present in the insured’s state, is not transacting insurance within that state, and is not regulated by that state. Instead, the state licenses the SL broker and regulates the exporting transaction and the insured must pay the tax.
Charley Barr has been in-house counsel for re/insurers and brokers and derivative dealers for 40+ years, 25 at groups with surplus lines insurers. He is an attorney, former casualty underwriter, CPCU and ARM, arbitrator and expert witness and has worked in Stamford, Hamilton, London and Cologne.