Surplus Lines Insurance

The spectrum of insurance coverage offered to consumers by admitted insurers is, however, incomplete. For a variety of reasons, including their required adherence to state form and rate regulations, admitted insurers do not write policies for certain types or levels of risk. If the admitted market were the sole source of insurance coverage, many consumers ' particularly those seeking coverage for unusual risks or high levels of risk ' would be left uninsured or would have to seek coverage from overseas markets.

To avoid this result, states have passed limited statutory exceptions to the prohibition against the purchase of insurance coverage from non-admitted insurers. These laws allow consumers who cannot find the coverage they seek in the admitted market to insure their risks with non-admitted (or 'surplus lines') insurers. A typical example of such a provision appears in the Louisiana Insurance Code, which provides that '[i]f certain insurance coverages cannot be procured from authorized insurers, such coverages, hereinafter designated as 'surplus lines,' may be procured from unauthorized insurers. … ' La. Rev. Stat. Ann. '22:1257. See also Cal. Ins. Code '1763 ('A surplus line broker may solicit and place insurance, other than as excepted in Section 1761, with non-admitted insurers only if that insurance cannot be procured from insurers admitted for the particular class or classes of insurance and that actually write the particular type of insurance in this state.') Through such laws, surplus lines insurers fill the coverage voids left by a state's admitted insurers.

Unlike admitted insurers, surplus lines insurers are not licensed by each of the states in which they issue policies, but are typically licensed only in their state of domicile. Nor are they regulated by the various states to the same extent as admitted insurers. Importantly, surplus lines insurers are not subject to the form or rate regulations imposed by states upon admitted insurers. The lack of such regulatory oversight provides surplus lines insurers the freedom to develop their own policy forms and set their own rates to meet the needs of consumers. It is because of this flexibility that surplus lines insurers are able to insure unique and difficult risks that admitted insurers cannot or will not cover. This freedom from form and rate regulation also allows surplus lines insurers to quickly respond to changes in the marketplace and to develop new and innovative types of insurance.

This is not to say that surplus lines insurers are completely free from regulation or that the surplus lines market is governed only by the principle of caveat emptor. To the contrary, both the insurers and their market are heavily regulated. Surplus lines insurers are regulated for solvency by the state in which they are domiciled. Moreover, and perhaps more importantly, the issuance of their policies is monitored by the states in which the risks being insured are located, although the degree of supervision does vary by state.

California ' the state that historically sees the largest amount of surplus lines premium dollars in a given year ' has enacted a regulatory scheme that can be viewed as an example of how numerous states regulate the issuance of policies by non-admitted insurers. Under the California Insurance Code, insurance on a risk in California can be purchased from the surplus lines market only through a surplus line broker who has been licensed by the state. See Cal. Ins. Code '1761. The surplus line broker must make a diligent search for an admitted carrier willing to insure the risk. See Cal. Ins. Code '1763(a). If unable to procure the insurance through an admitted carrier, then the broker may insure the risk through a surplus lines insurer. Within 60 days of the issuance of a surplus lines policy, the broker must submit to a state agency (known as the 'surplus lines stamping office') documentation regarding the transaction and the broker's efforts to place the insurance in the admitted market. Id. The surplus lines stamping office reviews the documents to verify that the broker complied with its statutory obligations and placed the insurance correctly.

But the regulation of this industry is not limited to when and how surplus lines coverage is procured; states also determine which surplus lines insurers may insure risks within their state, with some states placing the burden upon the surplus lines broker rather than a state regulatory agency to ascertain the financial stability of surplus lines insurers. With limited exceptions, a surplus lines broker in California can only procure surplus lines coverage from an insurer that has met certain standards imposed by the state so as to be included on the California Department of Insurance's List of Eligible Surplus Line Insurers (LESLI). See Cal. Ins. Code '1765.1(k).

To be included on the list, a non-admitted insurer must maintain at least $15 million in capital and surplus, and it must submit to the Department of Insurance (DOI) satisfactory evidence of its financial stability, reputation and integrity. See Cal. Ins. Code '1765.1(a)(1), (a)(2). The insurer seeking inclusion on the LESLI also must provide to the DOI several financial and business-related documents, including the insurer's annual statement and audited financial report, a certificate of good standing from its state of domicile, a statement from the insurance regulatory office of the insurer's state of domicile concerning the insurer's record regarding market conduct and consumer complaints, and documents confirming that the insurer holds a license to issue insurance policies in its state of domicile and that it has actively transacted insurance for 3 years. See Cal. Ins. Code '1765.1(c)(1), (c)(2), (c)(5), (e)(3), (e)(4). The stringency of such standards are exemplified by the fact that as of April 8, 2003, 148 insurers (exclusive of Lloyd's of London syndicates) were included on California's LESLI while another 173 had been denied inclusion on that list. See Surplus Line Association of California, www.sla-cal.org/carrier_info/lesli/ (acceptable nonadmitted carriers) and www.sla-cal.org/carrier_info/unaccepted_carriers/ (unaccepted nonadmitted carriers),6/24/03. Thus, although the states do not directly regulate surplus lines insurers, they do regulate the surplus lines market.

While not all states impose the same limitations as California upon the issuance of surplus lines insurance, all have passed some legislation to define and regulate this market. Through such laws, states are able to protect the interests of their citizens while at the same time allow them access to insurance coverage that is unavailable from admitted insurers. Indeed, states generally promote the surplus lines market as a way to reduce the uninsured risks within their borders and, to this end, place surplus lines insurance policies on equal footing with insurance policies from admitted carriers. See, e.g., La. Rev. Stat. Ann. '22:1259 ('Insurance contracts procured as surplus lines coverage from unauthorized insurers in accordance with this Part shall be fully valid and enforceable as to all parties, and shall be given recognition in all matters and respects to the same effect as like contracts issued by authorized insurers.')

The principal exception to this rule is the protection afforded to policyholders by state guarantee funds. State guarantee funds, which are used to pay a portion of any outstanding claims by policyholders of a licensed insurer should that insurer become insolvent, are not available to surplus lines policyholders (except in New Jersey). However, the practical effect of the absence of guarantee fund protection has proven to be relatively minimal over the past 30 years. Since 1972, surplus lines insurer insolvency rates have mirrored those of traditional insurers, with an average failure frequency rate of less than one percent. See AM Best, Annual Review of the Excess & Surplus Lines Industry, Sept. 2002, at 5. Moreover, of the 69 surplus lines insurers that have failed since 1969, approximately half have been small companies that maintained a surplus of less than $5 million; more than 70% maintained a surplus of less than $10 million. Id. at 29-30.

All in all, the foregoing surplus lines laws have resulted in the development of a significant, and successful, niche in the insurance industry. Surplus lines insurance is now written by hundreds of insurers, with many well-known insurers such as AIG, Zurich and Travelers having subsidiaries and/or affiliates that write surplus lines insurance. Indeed, the market is dominated by such larger carriers, with the top 25 insurance groups commanding an 86% share of the surplus lines market in 2001. Id. at 3. Moreover, this market's importance to the insurance industry and to consumers is confirmed by its rapid growth over the past few years. The surplus lines market experienced a 35% increase in direct premium volume in 2001, bringing its premium intake for that year to $15.7 billion. Id. at 3, 10. And while the industry-wide totals for 2002 have not yet been reported, California's 104.5% increase in surplus lines premium totals for 2002 suggests an even stronger year for the industry as a whole.

Next month, the second part of this series will provide advice for counsel representing surplus lines carriers in coverage disputes.

Ralph S. Hubbard III is a partner and Joseph P. Guichet is a senior associate at Lugenbuhl, Wheaton, Peck, Rankin and Hubbard in New Orleans. Both attorneys specialize in insurance coverage litigation, with an emphasis on complex and environmental coverage litigation. Mr. Hubbard is a frequent lecturer in the areas of insurance law and environmental law and is a co-author of The Louisiana Environmental Handbook (Lawyers Cooperative Publishing).

Part 1 of a 2-part series

Surplus lines business is booming. Last year, California witnessed an astounding 104.5% increase in surplus lines premium totals from 2001, according to the Surplus Lines Association of California. Other states also saw the number of surplus lines policies issued in their state soar.Yet many corporate representatives and coverage attorneys are unfamiliar with this rapidly growing niche within the insurance industry. Whether you are placing insurance for your employer or serving as counsel for an insurance-related client, it is imperative that you possess a good understanding of the role surplus lines insurers play in the insurance industry and how the states regulate the surplus lines market.

The operation and governmental regulation of the typical licensed (or admitted) insurer are well known. Insurers are licensed and regulated by the states. If an insurer wants to insure risks in a particular state, it must obtain a license and consent to the regulatory oversight of several aspects of its underwriting operations by that state's Department of Insurance or similar regulatory agency. Regulatory oversight of admitted insurers typically includes regulation of what policy-related forms can be issued in the state and what rates the insurer can charge in the state. The licensing state also monitors the finances and conduct of the insurer to make certain that the interests of the policyholders in the state are protected. Such admitted insurers place the lion's share of insurance written in a particular state. Indeed, states generally preclude the insuring of any risk located in their state through a non-admitted insurer. See, e.g., Cal. Ins. Code '1761 ('Except as provided in sections 1760 and 1760.5, a person within this State shall not transact any insurance on property located or operations conducted within, or on the lives or persons of residents of this State with non-admitted insurers, except by and through a surplus line broker licensed under this chapter and upon the terms and conditions prescribed in this chapter.')

The spectrum of insurance coverage offered to consumers by admitted insurers is, however, incomplete. For a variety of reasons, including their required adherence to state form and rate regulations, admitted insurers do not write policies for certain types or levels of risk. If the admitted market were the sole source of insurance coverage, many consumers ' particularly those seeking coverage for unusual risks or high levels of risk ' would be left uninsured or would have to seek coverage from overseas markets.

To avoid this result, states have passed limited statutory exceptions to the prohibition against the purchase of insurance coverage from non-admitted insurers. These laws allow consumers who cannot find the coverage they seek in the admitted market to insure their risks with non-admitted (or 'surplus lines') insurers. A typical example of such a provision appears in the Louisiana Insurance Code, which provides that '[i]f certain insurance coverages cannot be procured from authorized insurers, such coverages, hereinafter designated as 'surplus lines,' may be procured from unauthorized insurers. … ' La. Rev. Stat. Ann. '22:1257. See also Cal. Ins. Code '1763 ('A surplus line broker may solicit and place insurance, other than as excepted in Section 1761, with non-admitted insurers only if that insurance cannot be procured from insurers admitted for the particular class or classes of insurance and that actually write the particular type of insurance in this state.') Through such laws, surplus lines insurers fill the coverage voids left by a state's admitted insurers.

Unlike admitted insurers, surplus lines insurers are not licensed by each of the states in which they issue policies, but are typically licensed only in their state of domicile. Nor are they regulated by the various states to the same extent as admitted insurers. Importantly, surplus lines insurers are not subject to the form or rate regulations imposed by states upon admitted insurers. The lack of such regulatory oversight provides surplus lines insurers the freedom to develop their own policy forms and set their own rates to meet the needs of consumers. It is because of this flexibility that surplus lines insurers are able to insure unique and difficult risks that admitted insurers cannot or will not cover. This freedom from form and rate regulation also allows surplus lines insurers to quickly respond to changes in the marketplace and to develop new and innovative types of insurance.

This is not to say that surplus lines insurers are completely free from regulation or that the surplus lines market is governed only by the principle of caveat emptor. To the contrary, both the insurers and their market are heavily regulated. Surplus lines insurers are regulated for solvency by the state in which they are domiciled. Moreover, and perhaps more importantly, the issuance of their policies is monitored by the states in which the risks being insured are located, although the degree of supervision does vary by state.

California ' the state that historically sees the largest amount of surplus lines premium dollars in a given year ' has enacted a regulatory scheme that can be viewed as an example of how numerous states regulate the issuance of policies by non-admitted insurers. Under the California Insurance Code, insurance on a risk in California can be purchased from the surplus lines market only through a surplus line broker who has been licensed by the state. See Cal. Ins. Code '1761. The surplus line broker must make a diligent search for an admitted carrier willing to insure the risk. See Cal. Ins. Code '1763(a). If unable to procure the insurance through an admitted carrier, then the broker may insure the risk through a surplus lines insurer. Within 60 days of the issuance of a surplus lines policy, the broker must submit to a state agency (known as the 'surplus lines stamping office') documentation regarding the transaction and the broker's efforts to place the insurance in the admitted market. Id. The surplus lines stamping office reviews the documents to verify that the broker complied with its statutory obligations and placed the insurance correctly.

But the regulation of this industry is not limited to when and how surplus lines coverage is procured; states also determine which surplus lines insurers may insure risks within their state, with some states placing the burden upon the surplus lines broker rather than a state regulatory agency to ascertain the financial stability of surplus lines insurers. With limited exceptions, a surplus lines broker in California can only procure surplus lines coverage from an insurer that has met certain standards imposed by the state so as to be included on the California Department of Insurance's List of Eligible Surplus Line Insurers (LESLI). See Cal. Ins. Code '1765.1(k).

To be included on the list, a non-admitted insurer must maintain at least $15 million in capital and surplus, and it must submit to the Department of Insurance (DOI) satisfactory evidence of its financial stability, reputation and integrity. See Cal. Ins. Code '1765.1(a)(1), (a)(2). The insurer seeking inclusion on the LESLI also must provide to the DOI several financial and business-related documents, including the insurer's annual statement and audited financial report, a certificate of good standing from its state of domicile, a statement from the insurance regulatory office of the insurer's state of domicile concerning the insurer's record regarding market conduct and consumer complaints, and documents confirming that the insurer holds a license to issue insurance policies in its state of domicile and that it has actively transacted insurance for 3 years. See Cal. Ins. Code '1765.1(c)(1), (c)(2), (c)(5), (e)(3), (e)(4). The stringency of such standards are exemplified by the fact that as of April 8, 2003, 148 insurers (exclusive of Lloyd's of London syndicates) were included on California's LESLI while another 173 had been denied inclusion on that list. See Surplus Line Association of California, www.sla-cal.org/carrier_info/lesli/ (acceptable nonadmitted carriers) and www.sla-cal.org/carrier_info/unaccepted_carriers/ (unaccepted nonadmitted carriers),6/24/03. Thus, although the states do not directly regulate surplus lines insurers, they do regulate the surplus lines market.

While not all states impose the same limitations as California upon the issuance of surplus lines insurance, all have passed some legislation to define and regulate this market. Through such laws, states are able to protect the interests of their citizens while at the same time allow them access to insurance coverage that is unavailable from admitted insurers. Indeed, states generally promote the surplus lines market as a way to reduce the uninsured risks within their borders and, to this end, place surplus lines insurance policies on equal footing with insurance policies from admitted carriers. See, e.g., La. Rev. Stat. Ann. '22:1259 ('Insurance contracts procured as surplus lines coverage from unauthorized insurers in accordance with this Part shall be fully valid and enforceable as to all parties, and shall be given recognition in all matters and respects to the same effect as like contracts issued by authorized insurers.')

The principal exception to this rule is the protection afforded to policyholders by state guarantee funds. State guarantee funds, which are used to pay a portion of any outstanding claims by policyholders of a licensed insurer should that insurer become insolvent, are not available to surplus lines policyholders (except in New Jersey). However, the practical effect of the absence of guarantee fund protection has proven to be relatively minimal over the past 30 years. Since 1972, surplus lines insurer insolvency rates have mirrored those of traditional insurers, with an average failure frequency rate of less than one percent. See AM Best, Annual Review of the Excess & Surplus Lines Industry, Sept. 2002, at 5. Moreover, of the 69 surplus lines insurers that have failed since 1969, approximately half have been small companies that maintained a surplus of less than $5 million; more than 70% maintained a surplus of less than $10 million. Id. at 29-30.

All in all, the foregoing surplus lines laws have resulted in the development of a significant, and successful, niche in the insurance industry. Surplus lines insurance is now written by hundreds of insurers, with many well-known insurers such as AIG, Zurich and Travelers having subsidiaries and/or affiliates that write surplus lines insurance. Indeed, the market is dominated by such larger carriers, with the top 25 insurance groups commanding an 86% share of the surplus lines market in 2001. Id. at 3. Moreover, this market's importance to the insurance industry and to consumers is confirmed by its rapid growth over the past few years. The surplus lines market experienced a 35% increase in direct premium volume in 2001, bringing its premium intake for that year to $15.7 billion. Id. at 3, 10. And while the industry-wide totals for 2002 have not yet been reported, California's 104.5% increase in surplus lines premium totals for 2002 suggests an even stronger year for the industry as a whole.

Next month, the second part of this series will provide advice for counsel representing surplus lines carriers in coverage disputes.

Ralph S. Hubbard III is a partner and Joseph P. Guichet is a senior associate at Lugenbuhl, Wheaton, Peck, Rankin and Hubbard in New Orleans. Both attorneys specialize in insurance coverage litigation, with an emphasis on complex and environmental coverage litigation. Mr. Hubbard is a frequent lecturer in the areas of insurance law and environmental law and is a co-author of The Louisiana Environmental Handbook (Lawyers Cooperative Publishing).