Understanding Surplus Lines

Staying out of errors and omissions trouble while selling and servicing surplus lines insurance can be an art as well as a science. A review of the top ten causes of E&O losses reported to IIAT makes it apparent that an agency's risk of incurring a loss is increased when the agency is dealing in surplus lines insurance. The reasons are obvious: Policy forms are different, the agency's relationship with the insurer is different, insurance laws regarding surplus lines are different, and more parties are involved in the transaction.

To operate skillfully, professionally, and within the law in the nonadmitted marketplace, agency staff should be familiar with applicable statutes and rules. They should also understand the array of special provisions in surplus lines insurance contracts that are available in the marketplace.

Texas Surplus Lines Regulations

Surplus lines insurers are not licensed by the Texas Department of Insurance to write insurance in Texas, but they are authorized by law to conduct business by meeting minimum financial requirements and operating through surplus lines agents. The Texas surplus lines insurance laws, like similar laws in other states, are designed to protect the public as well as to protect licensed insurers from unfair competition. According to the law, any competition by a surplus lines insurer with a licensed insurer is unfair because licensed insurers must meet stricter standards.

For example, surplus lines insurers are not required to file their rates and forms. They also don't participate in any pools, plans, or funds - such as the Texas Automobile Insurance Plan Association, the Texas Windstorm Insurance Association, or the Texas Property and Casualty Insurance Guaranty Association - that subject licensed insurers to additional expenses. Exemption from these requirements allows surplus lines insurers to operate at lower expense levels. But the laws regulating placement of surplus lines insurance prohibit surplus lines insurers from using these lower expenses to compete with licensed insurers.

The law recognizes the need for agents to provide insurance markets for customers unable to obtain insurance elsewhere, but it prohibits placement with a surplus lines insurer "unless the full amount of insurance required is not procurable" and "after a diligent effort has been made to do so" from a licensed insurer.

What does the law mean when it refers to "the full amount of insurance?" Certainly, it's referring to limits; if an admitted insurer won't or can't provide the total limit needed, it's permissible to place the excess limits in a surplus lines insurer. In addition, documented differences in coverage may be sufficient to meet the requirements, according to legal sources at the Texas Department of Insurance. An agent must have the file documented sufficiently to prove that the coverages offered by the surplus lines insurer represent an overall enhancement to the policyholder, compared to the coverage offered by the admitted insurer.

While the law holds the surplus lines agent responsible for determining when a piece of business is eligible for nonadmitted markets, as the originating agent, you may find it practically impossible to defend against an E&O claim that arises out of a surplus lines policy without documented proof of your own "diligent effort" to locate a standard company.

Disclosure to the Policyholder

When your diligent effort to place the account with a licensed insurer fails and you are ready to make a proper surplus lines placement, you should advise your customer about the differences between a surplus lines insurer and a licensed insurer, as well as any unusual provisions in the policy.

When quoting surplus lines insurance, disclose that the insurer is not licensed to do business in the state and that its policyholders will not be protected if the company is declared insolvent. Tell your client the insurer's Best rating or other important financial information. When the policy is written, document the insured's decision with a signed waiver indicating his or her understanding of the risk.

The surplus lines law requires that each policy or evidence of coverage contain disclosure wording. This wording is usually stamped or inserted on the declarations page or to a separate page directly underneath the declarations. While the law requires the surplus lines agent to affix this disclosure to the policy, retail agents may be held liable as well for not ensuring that the wording appears on the policy. The prescribed wording is as follows:

"This insurance contract is with an insurer not licensed to transact insurance in this state and is issued and delivered as a surplus lines coverage pursuant to the Texas insurance statutes. The Texas Department of Insurance does not audit the finances or review the solvency of the surplus lines insurer providing this coverage, and this insurer is not a member of the property and casualty insurance guaranty association created under Chapter 462, Insurance Code. Chapter 225, Insurance Code, requires payment of _____ (insert appropriate tax rate) percent tax on gross premium."

Coverage Differences

Unusual coverage differences in surplus lines policies present another potential exposure. Because surplus lines insurersare not required to file their forms for approval, you should find out the differences between the policy form you are quotingand others and disclose any unusual features. Coverage checklists and standardized disclosure forms can minimize your exposure.

Surplus Lines "Due Diligence" Under Federal Law

The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act contains some insurance provisions related to surplus lines. Section 525 of Title V, entitled "Streamlined Application for Commercial Purchasers, effective July 21, 2011, preempts the "due diligence" provision of the Texas surplus lines law under certain conditions. For more information, see this article: Surplus Lines "Due Diligence" Under Federal Surplus Lines Law.

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.

Reference Sources:

Additional Resources A Primer on the Surplus Lines "Diligent Effort" Duty - A TSLA Reference