Regulation and surplus lines activity

Surplus lines insurers play a crucial role in the marketplace. These companies commonly provided coverage for high capacity, distressed or unique risks, as well as new or emerging risks for which coverage is not available in the admitted market. Though surplus lines insurers play a valuable role in the marketplace and business written by these insurers have grown over time, there has been little academic literature that focuses on this segment of the industry. In this study, we examine whether surplus lines activity differs across regulatory environments, where activity is measured by surplus lines premiums, the number of active surplus lines companies and the concentration of the surplus lines market within each state. We find a positive correlation between premiums written and several regulatory measures, such as greater capital and surplus requirements, higher premium taxes and the existence of state surplus lines associations. The positive correlation with capital and surplus requirements and surplus lines associations is also observed when examining the proportion of surplus lines insurers in states. Finally, we find strong correlations between the concentration of the surplus lines market in states and all regulatory measures considered. 1 Journal of Insurance Regulation © 2018 National Association of Insurance Commissioners Introduction There are several different types of insurers operating in the marketplace today. These insurers can serve different purposes, and each has unique advantages relative to other structures. While most insurance is placed in the standard or admitted market, there are risks the admitted market is unable, or unwilling, to insure. Excess and surplus lines companies commonly insure these risks. Prior literature recognizes the importance of surplus lines insurers within the overall insurance economy, suggesting that the surplus lines market functions as a safety value to the standard market, specifically because surplus lines insurers are capable of solving market availability issues (Brockett, Witt, and Arid, 1990).1 Thus, one could argue the most salient feature of the surplus lines market is ensuring the availability of insurance coverage to all consumers who wish to purchase. Surplus lines insurers play a crucial role in the marketplace, primarily providing coverage for high capacity, distressed or unique exposures, as well as emerging risks. Often, coverages originally developed by surplus lines insurers will be offered by admitted carriers in the future. For example, while consumers can now purchase employment practices liability, directors’ and officers’ liability, medical malpractice, and cyber-risk policies in the admitted market, these coverages were initially written only by surplus lines insurers (ISLM, 2017). More recently, surplus lines insurers began providing coverage for ride-sharing services and drone activities (A.M. Best, 2017). Relatively speaking, the surplus lines market is deregulated. That is, surplus lines insurers are free from certain aspects of insurance regulation imposed on their admitted counterparts, the most widely recognized of which is the freedom from rate and form regulation. This enables surplus lines carriers to charge a premium that is appropriate for a given degree of risk. Without this ability, surplus lines insurers would be unable to offer coverage for high risk exposures or unique and emerging risks and, therefore, would be unable to fulfill their role of ensuring availability within the insurance economy. Schwartz and Mendelson (1989) evidence this phenomenon through their examination of physicians that, due to excessive losses, were forced to purchase insurance from the surplus lines market. The authors acknowledge that premiums charged by the surplus lines companies are typically several times higher than what the physicians were charged when covered in the admitted market. The policies offered by surplus lines insurers also frequently contained very large deductibles. Like admitted insurers, surplus lines carriers are required to maintain specified levels of capital and surplus, and their premiums are also subject to taxation.2 In 1. The authors also note that some consumers may be forced into the surplus lines market if stringent rate regulation causes admitted insurers to temporarily cease writing new business. 2. The regulation of capital and surplus requirements, as well as taxes, within a given state can differ substantially between the surplus lines and admitted markets. This analysis focuses solely on the regulatory requirements affecting surplus lines insurers. 2 Regulation and Surplus Lines Activity © 2018 National Association of Insurance Commissioners addition to these regulations, surplus lines insurers face some impediments in terms of market access in that they must sell their insurance through a broker (GAO, 2014). These wholesale brokers, intermediaries licensed by the states, place business with surplus lines carriers. They are responsible for selecting eligible insurers, submitting premiums taxes due to states, reporting their transactions to regulators, and ensuring compliance with all requirements (GAO, 2014). Historically, states either maintained a list of eligible surplus insurers with whom brokers could do business, maintained a list of surplus lines insurers with whom brokers could not do business, or allowed brokers to exercise their own due diligence in identifying an appropriate surplus lines insurer. The regulation of surplus lines insurers has been affected recently with the passage of the federal Nonadmitted and Reinsurance Reform Act (NRRA), found within the federal Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). Becoming effective in 2011, the NRRA stated that, generally, “the placement of nonadmitted insurance shall be subject to the statutory and regulatory requirements solely of the insured’s home State” and that “no State other than the home State of an insured may require any premium tax payment for non-admitted insurance” (NRRA, Sec. 522 (a); Sec. 521 (a), 2010). The NRRA generally defined the home state as the state in which the insured’s principle place of business was located, or in the case of individuals, the primary residence of the insured. The NRRA was designed to simplify the regulation of surplus lines insurers. The impact on specific areas of regulation relevant to the current study are discussed in later sections. Though the surplus lines market serves a valuable function within the insurance marketplace, there is little academic research that focuses on this segment of the industry. Historically, business written by surplus lines insurers made up a small portion of total insurance premiums, which may explain the lack of interest up to this point in this group of insurers. However, the surplus lines market has shown active growth in recent years. In 1994, surplus lines insurers wrote barely 6% of all commercial lines premiums. However, by the end of 2014, this number had more than doubled, climbing to approximately 14% (A.M. Best, 2015). The purpose of this study is to examine the existing regulation of surplus lines insurers and provide insight into how regulation has changed over time. In addition, we explore differences in surplus lines activity across different regulatory environments. First, we establish thresholds identifying individual states, over time, as either stringently or non-stringently regulated in each of the four regulatory areas examined. Next, we use a series of t-tests to compare means to determine whether there are significant differences in surplus lines activity across regulatory climates. We capture surplus lines activity using three measures: 1) the percentage of premiums written in each state that can be attributed to the surplus lines market; 2) the proportion of firms operating in the state that are classified as surplus lines insurers; and 3) the concentration of a given state’s surplus lines market. 3 Journal of Insurance Regulation © 2018 National Association of Insurance Commissioners Prior literature has long since recognized the potential impact of regulation on market structure. The number of insurers operating in a state, as well as the volume of business insurers are willing to write in particular states, have been identified as specific areas that could be affected by the stringency of regulation (e.g., Harrington, 1992; Browne and Hoyt, 1995; Suponcic and Tennyson, 1995; Tennyson, 1997; Bikker and Spierdijk, 2017). The number of firms within a market serves as one measure of market competition (see, for example, Vives, 2008 and Schmidt et al., 2017). However, a recognized limitation is that a market could be characterized by many active insurers, yet a small number of those insurers might possess significant shares of the market (Cole, He and Karl, 2015).3 For this reason, we examine both the number of surplus lines insurers operating in states, as well as the concentration of each state’s surplus lines market. We find a positive correlation between premiums written and several regulatory measures, such as higher capital and surplus requirements, higher premium taxes, and the existence of state surplus lines associations. With respect to the proportion of surplus lines firms operating within a state, we find similar results with one exception: We do not observe any differences in the tax comparison. Finally, we find more concentrated surplus lines markets in states with greater capital and surplus requirements and in states that do not use eligibility lists to identify surplus lines insurers that have been preapproved to sell coverage in the state. States without surplus lines associations and lower tax rates are also more concentrated. The paper is organized as follows. The following section describes the resources used to obtain information on the regulation of surplus lines insurers, as well as surplus lines