Surplus Lines, The Industry’s Safety Valve

It is a rare occurrence today, but not so long ago tying down the safety valve was viewed as an acceptable way to improve a steam boiler’s performance when demand peaked. The objective was to increase the boiler’s output to meet demand that temporarily outstripped its rated capacity. The result all too often was just the opposite, a devastating explosion that destroyed the plant that the boiler supplied and caused unnecessary loss of life.

The insurance industry, like a steam boiler, needs a safety valve, and has one in the excess and surplus lines market.

The arrival of a hard market after policyholders have had their own way for 15 years has built up enough pressure on standard lines insurers to open that safety valve wide. One result has been sticker shock, especially for policyholders who are moving from the standard market to E&S insurers. Concern about price increases has combined with unrelated developments that occurred coincidentally just as the market tightened, controversies over the application of exclusions for losses caused by mold and terrorist acts, to raise a hue and cry for tighter regulation of all insurers, including excess and surplus lines carriers. This sort of regulation, surplus lines professionals acknowledge, would be devastating to their operations, but they do not, for the most part, see it on the horizon. As strange as it seems, there are insurance company executives who really believe that Congress and state legislatures have too much sense to tie down the safety valve that keeps the insurance mechanism functioning safely when times are hard.

In its role as a safety valve, the E&S market offers a home to distressed risks that cannot find coverage at any price in the standard market. Differences in the way states regulate admitted and non-admitted insurers give E&S underwriters the one tool that they consider indispensable to performing well in their role as a safety valve: freedom from regulation of rates and forms. “If a retail insurance broker cannot place a commercial lines insurance consumer they will typically go to wholesale insurance brokers that have a special license to deal with non-admitted companies,” explained Ted Pierce, executive director at the Surplus Lines Association of California (SLA), “and they get that coverage written in the non-admitted marketplace because of the freedom of rate and form that those companies have.”

As a result, the E&S market tends to be countercyclical in some ways, expanding when the standard market becomes tighter and contracting during a soft market. “It’s the market that is gone to when the admitted market starts to become difficult,” commented Richard M. Bouhan, executive director of the National Association of Professional Surplus Lines Offices (NAPSLO).

The ability to respond when standard carriers become less receptive makes the E&S market indispensable, according to Mac Wesson, president & COO at U.S. Risk Insurance Group Inc., Dallas, who co-chairs NAPSLO’s legislative committee and is a member of the Texas Surplus Lines Association. “I would characterize it as an essential complement to the standard market,” he offered. “It provides a very necessary access to various insurance coverages that do not exist in the standard market.”

The key to providing that access is the ability of E&S carriers to adjust the coverage they provide and the prices they charge to the prevailing conditions. “What typically happens is that retail agents find themselves unable to place particular clients in the standard market,” said Jim Griffith, president, Princeton Risk Managers and co-chair of the NAPSLO legislative committee. “They’ll call a wholesale broker and the risk will be marketed to the surplus lines sector. Usually a quote is able to be obtained because that sector has freedom of rate and freedom of form.”

Absence of the most prominent aspect of insurance regulation does not, however, produce a totally unregulated marketplace. “It is an absolute misnomer that surplus lines companies are not regulated,” Pierce argued. In at least one area, regulation of E&S underwriters is typically more stringent than regulation of their counterparts in the admitted market. “The regulation of alien non-admitted companies, in terms of financial solvency regulation, is more severe in California than admitted companies,” Pierce reported. The same situation prevails in most other states. Wesson pointed out that minimum surplus requirements are typically higher for E&S companies than for admitted carriers.

Andrew S. Frazier, president of Western World Insurance Group and co-chair of the NAPLSO legislative committee, pointed out that in many important ways, domestic E&S insurers (those domiciled in the United States) are subject to the same regulatory regime as admitted carriers. Their domiciliary states subject them to exactly the same regulation for solvency as any other insurance company. “The principal difference is that we’re not regulated on rates and forms,” he explained, “but that’s the whole point of the market. When there are frictions in the marketplace, the surplus lines market is a safety valve and they need to respond very quickly.”

By way of example, Frazier pointed to the high volume of submissions his company received in late June that needed coverage effective July 1. Surplus lines carriers, he reported, had to respond immediately. They did not have time to file forms or rates. He sees that flexibility as the key to performing well in the role of the insurance industry’s safety valve.

Although it is the rule, freedom of rate and form for E&S insurers is by no means absolute. California is the only state that imposes rate filing requirements on non-admitted insurance companies, part of the regulatory regime ushered in by Prop. 103. Despite calls for tighter controls from outside the industry, more regulation has not been the trend.

The insurance department opinion has raised some concern among surplus lines professionals. “That’s an issue that’s very much in the forefront of the industry news,” said Griffith. “In the surplus lines field we don’t want to be restricted in terms of the exclusions that we might choose to use.”

NAPSLO’s Bouhan sees another problem independent of the insurance department opinion. “The real concern that a surplus lines company has to worry about in applying the exclusion,” he said, “is that they may very well find that in a litigation context the courts or the juries will find that they shouldn’t have applied it and the standard fire policy language will be upheld.”

Wesson fears that regulatory moves of this nature could pose a serious threat to the E&S market’s ability to function effectively as a safety valve. “I think it would undermine it tremendously,” he said. “Those that don’t appreciate the nature of the E&S market, I think, feel that way because of a lack of full understanding of how it operates. Freedom of rate and form is what makes it work. Removing that freedom and imposing regulation would eventually destroy the E&S market.”

These developments have not convinced Bouhan that agitation to regulate the E&S market is new. It has always been there, he argued. The difference today is that expansion of the E&S market has made it more visible rather than more potent.

The greatest concern to surplus lines professionals comes not from more regulation but from less. Recent moves toward more federal regulation of the business of insurance in the form of federal chartering of insurance companies has raised more serious concern in the E&S community. “The more relevant debate is being shaped right now,” commented Bill Newton, president & CEO of Lemac Associates, Inc., a Los Angeles-based surplus lines broker, and member of California Wholesalers Association (CIWA) and the SLA, “and that is state versus federal regulation.”

The widespread expectation is that federally chartered insurers would be able to operate free of rate and form regulation, the characteristic that has set E&S carriers apart from the pack. “A pure system where all companies could seek a federal charter and have freedom of rate and form would definitely be a threat to surplus lines,” offered Pierce. “It would change the footing of surplus lines.”

Even that dark cloud, on the other hand, has a silver lining. The expectations that a federal charter will deliver freedom from rate and form regulation may not be entirely realistic, and there are important cultural differences between standard insurers and their counterparts in the E&S marketplace.

“I don’t think that you’re going to find a federal chartering proposal that those who promote that idea suggest will occur,” Bouhan argued. “It may not be rate form and form filing and approval as we know it today, but there are 535 social engineers in Congress. Insurance is too important a business, too intertwined with our social and financial structure, not to have those social engineers use this mechanism to try and effectuate certain social and economic goals. I think that ultimately that will lead to some type of form and rate regulation for the insurance business.”

Others base their projections of the future on the past.

Historically standard lines insurers have shown little interest in the kinds of business that E&S insurers write routinely, and Frazier does not expect that to change dramatically. The cultures of the two markets, he argued, are too different. “Standard lines is a lot more actuarially driven, and understandably so,” he said. “That’s their business. Surplus lines is a lot more judgmental. A judgmentally driven underwriting system doesn’t necessarily match a huge standard company business model. You really need flexibility, underwriting judgment and expertise to deal with the unusual and the exceptional, as opposed to relying upon the more traditional insurance concepts, the law of large numbers, etc.”

Mangan brings more than a quarter century of experience in property and casualty underwriting to his current position as consultant, author and editor. Mangan has authored four textbooks on commercial lines underwriting, and contributed to textbooks on personal lines insurance and insurance operations.