The Basics of Surplus Lines Insurance
By: Maryssa Simpson
To many insurance professionals, surplus lines policies are a mystery, and carriers are relatively free from state insurance regulation. Further, policy forms and rates are unregulated, and capitalization requirements are far different from those imposed on admitted carriers. This article clarifies the basics of surplus lines insurance and highlights the key ways surplus lines insurance is regulated in the State of Texas.
Surplus lines insurance insures risks that may be too big, too unusual or substandard. Basically, surplus lines cover a unique risk in some way. A business must seek coverage through a licensed insurance agent (e.g., an intermediary/broker licensed by the state). The broker then approaches a surplus lines broker also licensed by the state. When the right insurer is found, surplus lines insurance is purchased.
The surplus lines insurer itself is regulated only indirectly, and only to a limited extent. Since the surplus lines insurer is not licensed in your state, they are not regulated by your state’s Department of Insurance in the same way licensed insurers are regulated (they are regulated in the state where they are domiciled). In many states, including Texas, the licensed agent/broker obtaining surplus lines insurance is required to make sure that the insurer meets certain financial standards before buying a policy from them.
Thus, in Texas, the focal point of the surplus lines market occurs through the licensing and regulation of surplus lines agents. A “surplus lines agent” is an agent licensed to procure an insurance contract from a surplus lines insurer. Tex. Ins. Code. § 981.002(8). The Texas Department of Insurance (“TDI”) carefully regulates licensed agents, by doing the following:
- TDI licenses and regulates surplus lines agents. A licensed surplus lines agent may place business only with eligible surplus lines carriers.
- TDI determines whether or not the non-admitted carrier is eligible to do business in Texas.
- TDI maintains a list of eligible surplus lines carriers.
- TDI keeps some track of the financial condition of surplus lines carriers.
- Insurance contracts entered into by eligible surplus lines carriers must be “stamped” so as to clearly indicate the surplus line nature of the policy.
If surplus lines insurance is not placed through a licensed Texas surplus lines agent, the transaction does not qualify as the lawful transaction of surplus lines insurance. See Strayhorn v. Lexington Ins. Co., 128 S.W.3d 772 (Tex. App.—Austin 2004), aff'd, 209 S.W.3d 83 (Tex. 2006); Lexington Ins. Co. v. Strayhorn, 209 S.W.3d 83 (Tex. 2006); Yorkshire Ins. Co., Ltd. v. Seger, 279 S.W.3d 755 (Tex. App.—Amarillo 2007, pet. denied).
In Strayhorn, eligible surplus lines Insurers brought an action against the Comptroller of Public Accounts and Attorney General for a declaratory judgment and refund of unauthorized insurance premium tax. Because the Insurers did not produce evidence that the policies were issued through licensed agents, they were liable for the tax.
Texas-licensed surplus lines agents must file a copy of every policy placed through them with the stamping office within sixty (60) days of a policy's effective or issue date. Tex. Ins. Code § 981.105. The policies in Strayhorn were not reported to the surplus lines stamping office by licensed Texas surplus lines agents. The burden is on the Insurers to prove they fall under one of the exemptions to the unauthorized insurance premium tax: that the premiums they collected were for (1) lawfully procured surplus lines insurance on which a tax had been paid or (2) independently procured insurance on which a tax had been paid.
Strayhorn was affirmed by the Texas Supreme Court in Lexington Ins. Co. v. Strayhorn, 209 S.W.3d 83 (Tex. 2006). The Supreme Court warned in Lexington that “surplus lines carriers often will not know whether insurance was available from a licensed insurer, whether the policy was properly reported, whether proper records were kept, or whether the premium tax was paid.” Id. at 89. The Court cautioned that agents are responsible for making sure that surplus lines policies comply with regulations. Id. The Texas Supreme Court also warned in Lexington that the consequences of treating a surplus lines policy as unauthorized insurance can be severe. Id.
Surplus lines insurers do not have to be licensed in Texas, but instead must be “eligible” to issue surplus lines insurance in the state. An insurer is an “eligible” surplus lines insurer if it meets certain minimum capital and surplus requirements outlined in the insurance code. See Tex. Ins. Code §981.002. If a surplus lines carrier loses its eligibility, it may be forced to post bond to file pleadings in Texas court. See Mid-Am. Indem. Ins. Co. v. King, 22 S.W.3d 321 (Tex. 1995).
It is clear that surplus lines insurers rely heavily on the licensed agents obtaining the policies. However, financial eligibility is a requirement which the insurer is responsible for, and for which the insurer will ultimately be penalized. Thus, both agents and insurers should be aware of applicable regulations in the state where surplus lines insurance is procured.