Surplus Lines "Due Diligence" Under Federal and Texas Surplus Lines Law

President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law on July 22, 2010. The 2,300-page bill was drafted in response to the financial crisis and includes a number of provisions intended to prevent future bailouts of financial firms, monitor systemic risk and regulate products such as derivatives, mortgages and credit cards. The majority of this legislation does not apply to insurance, but Title V contains some insurance provisions related to surplus lines and reinsurance reform. The law has little to interest retail insurance agents until Section 525 of Title V, which is entitled "Streamlined Application for Commercial Purchasers." This section, which goes into effect on July 21, 2011, preempts the "due diligence" provision of the Texas surplus lines law under certain conditions. And that's a good thing with regard to an agent's E&O exposure. Here's why.

As part of an effort to protect consumers, as well as admitted insurers from unfair competition by surplus lines insurers, Texas law prohibits placement with a surplus lines insurer unless "the full amount of required insurance cannot be obtained, after a diligent effort, from an insurer authorized to write and actually writing that kind of insurance in this state." This burden of making a "diligent effort" is placed on the surplus lines agent as well as the retail agent who directly represents the consumer in the transaction. What does the law mean when it refers to "diligent effort?" Unfortunately, this term is not defined or explained in the law. Agents – even independent agents – have access to a limited number of admitted insurers and have no way of knowing if some admitted insurer somewhere would be willing to provide the insurance.

It can be said generally that where insurance is available from both an admitted insurer and a nonadmitted insurer, the policyholder will pay a lower premium with the nonadmitted insurer. Consequently, the Texas Department of Insurance seldom becomes involved in enforcing this law because the policyholder does not complain. The law is more likely to be cited in a lawsuit against the insurer and agents when there is a problem after a claim has been filed on the policy. Then, the burden of proving "diligent effort" becomes very difficult and is not usually even relevant to the allegations in the lawsuit.

(A good example of how this "red herring" can be used in a lawsuit is found in the case of Prodigy Communications Corp. v. Agricultural Excess and Surplus Insurance Company. This lawsuit primarily concerned the issue of reporting a claim late on a claims-made policy. The policyholder reported a claim late and the insurance company declined to defend the claim due to late reporting. In an attempt to overturn the company's refusal to defend, the policyholder claimed in the lawsuit that the notice provision in the policy was unenforceable because the failure to market the policy to admitted carriers was a "material and intentional" violation of the surplus lines law. The surplus lines agent admitted that no effort was made to market the policy to admitted carriers. In the end, the case was decided on other issues and the Texas Supreme Court did not consider the policyholder's contention that the notice provision was unenforceable because the policy was sold in violation of the surplus lines statute.)

How can the new federal law reduce this potential E&O exposure in the future? The law allows an agent to place coverage for a large account in a surplus lines company (1) after making a disclosure to the policyholder that "such insurance may or may not be available from the admitted market that may provide greater protection with more regulatory oversight," and (2) the policyholder has subsequently asked the agent in writing to procure the insurance from a nonadmitted insurer.

The federal law defines a large account (an "exempt commercial purchaser") as a purchaser of commercial insurance that, at the time of placement, meets the following requirements:

  1. The purchaser employs or retains a "qualified risk manager" to negotiate insurance coverage; and

  2. The purchaser has paid aggregate nationwide commercial property and casualty insurance premiums in excess of $100,000 in the immediately preceding 12 months, and

  3. The purchaser meets at least one of the following criteria:

    • Possesses a net worth in excess of $20 million;

    • Generates annual revenues in excess of $50 million;

    • Employs more than 500 full-time or full-time equivalent employees per individual insured or is a member of an affiliated group employing more than 1,000 employees in the aggregate;

    • Is a not-for-profit organization or public entity generating annual budgeted expenditures of at least $30 million;

    • Is a municipality with a population in excess of 50,000 persons
The law defines "qualified risk manager" as a person who meets all of the following requirements:
  1. The person is an employee of, or third party consultant retained by, the commercial policyholder; and

  2. The person provides skilled services in loss prevention, loss reduction, or risk and insurance coverage analysis, and purchase of insurance; and

  3. The person

    • Has a bachelor's degree or higher from an accredited college or university in risk management, business administration, finance, economics, or any other field determined by a State insurance commissioner or other State regulatory official or entity to demonstrate minimum competence in risk management; and

    • Has 3 years of experience in risk financing, claims administration, loss prevention, risk and insurance analysis, or purchasing commercial lines of insurance, OR has one of the following designations: CPCU, ARM, CRM, RIMS Fellow, or any other designation, certification, or license determined by a State insurance commissioner or other State insurance regulatory official or entity to demonstrate minimum competency in risk management.

OR

    • Has at least 7 years of experience in risk financing, claims administration, loss prevention, risk and insurance analysis, or purchasing commercial lines of insurance; and

    • Has one of the following designations: CPCU, ARM, CRM, RIMS Fellow, or any other designation, certification, or license determined by a State insurance commissioner or other State insurance regulatory official or entity to demonstrate minimum competency in risk management.

OR

    • Has at least 10 years of experience in risk financing, claims administration, loss prevention, risk and insurance analysis, or purchasing commercial lines of insurance,

OR

    • Has a graduate degree from an accredited college or university in risk management, business administration, finance, economics, or any other field determined by a State insurance commissioner or other State regulatory official or entity to demonstrate minimum competence in risk management.

If the policyholder doesn't employ a risk manager, can an agency employee or producer with a Texas risk manager license who meets the education and experience requirements satisfy the definition for "qualified risk manager?" We don't see why not, but that person should enter into a written agreement with the policyholder to provide the required services for a fee.

If your agency places coverage in a surplus lines company for a customer who meets this criteria, and you make the appropriate disclosure and obtain a written request, then you will not be required to prove compliance with the Texas "due diligence" requirement. Implement procedures in your office to document the pre-qualification of the customer and risk manager, as well as the disclosure and written request requirements.

Texas Law

Texas law includes an “Industrial Insured” exemption that says certain insureds are automatically eligible for Surplus Lines placement. To qualify as an “Industrial Insured” an account must retain a qualified risk manager as defined in the law, and has paid $25,000 or more in property/casualty premiums or has more than 25 full time employees. The agent must disclose that comparable insurance may be available in the admitted market which is subject to more regulatory oversight. The agent must also mention that there are no Guarantee Fund protections for accounts written in Surplus Lines and the insured must request in writing that coverage be placed with the Surplus Lines Company. The Surplus Lines Company must have an A.M. Best rating of A- or better. A sample disclosure form can be found here.