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Insurance purchased through the surplus lines market is provided by nonadmitted insurers, which are not licensed to operate in the insured’s home state. Under each state’s surplus lines law, licensed surplus lines brokers are permitted to place insurance with approved, nonadmitted insurers for risks that cannot be placed in the admitted market. Nonadmitted insurers typically are not required to obtain approval for their rates, forms, and underwriting rules. As a result, they can modify coverage and pricing in ways that allow them to underwrite special risks profitably. This benefits consumers by providing them with coverage that would otherwise not be available. Many businesses and not-for-profit organizations would be unable to operate without these surplus lines coverages.

Between 2001 and 2010, direct premiums written (DPW) for the surplus lines market averaged 6.6% of DPW for the total property-casualty industry. In 2010, surplus lines premiums totaled $31.7 billion, while the total property-casualty industry developed $481 billion in premiums.

Almost any coverage that cannot be written in the standard market is eligible for placement in the surplus lines market. The surplus lines market writes a wide variety of risks and coverages; 

Risk examples include 

• airports, 
• amusement parks, 
• drug and alcohol treatment centers, 
• hazardous waste facilities, 
• medical centers, 
• mobile home parks, 
• railroads, 
• security services, and 
• sports facilities. 

Coverage provided may include, among others, 

• professional liability, 
• environmental impairment liability, 
• excess and umbrella liability, 
• kidnap and ransom, and 
• event cancellation. 

To a lesser extent, individuals and families may have loss exposures that can be insured only in the surplus lines market, such as a valuable art collection or homes in areas prone to hurricanes or earthquakes.

Almost any coverage that cannot be written in the standard market is eligible for placement in the surplus lines market. However, state laws generally require workers compensation and automobile liability coverage to be placed with admitted insurers.

A traditional method of classifying risks insured in the surplus lines market uses three broad categories to describe the characteristics that make risks unacceptable in the standard market:

• Distressed risks : A property risk with a large recent loss attributable to the property. A risk characterized by unfavorable attributes that have made it unacceptable to admitted insurers.
• Unique risks : Admitted insurers are generally unwilling to insure unique risks for a number of reasons. Typically, their staff does not have the specialized skills to underwrite and price the coverage, and they may not have a policy form that appropriately covers the exposure. Moreover, they do not expect to insure an adequate number of similar risks. The premium they can charge may not justify the administrative expense of underwriting and rating the risk. A risk that is so specialized or unusual that admitted insurers are unwilling to insure it.
• High-capacity risks : represents a significant loss exposure that standard insurers prefer to avoid. A risk that requires high limits of insurance that may exceed the underwriting criteria of admitted insurers.

Closely related to unique risks is the fourth category of new risks. Because surplus lines insurers are not subject to rate and form filing regulations, the surplus lines market has the flexibility to respond to new or emerging risks more quickly than the standard market

Unlike Admitted insurers, nonadmitted insurers can modify coverage and pricing in ways that allows them to underwrite special risks profitibaly.

Admitted insurers in the standard market do not have the flexibility required to underwrite high-risk loss exposures profitably because they cannot deviate from their approved filings, admitted insurers in the standard market do not have the flexibility required to underwrite high-risk loss exposures profitably.

Surplus Lines Market Functions 

The purpose of the surplus lines market is to provide insurance protection for distressed, unique, high-capacity, and new risks that cannot obtain coverage in the standard market. The surplus lines market functions effectively in the United States because it is supported by surplus lines laws in all states and because of attributes of the market itself.

Several factors allow the U.S. surplus lines market to accomplish its purpose:

• Surplus lines laws
• Freedom from form and rate filing requirements
• The surplus lines distribution system
• Surplus lines insurers
• Surplus lines insurance products

History of Insurance : The first property insurance company in Colonial America was the Philadelphia Contributionship, which began operations in 1752. Although individual states enacted insurance laws before 1800, it was not until the mid- to late 1800s that the growing industry began to be actively regulated. States licensed insurers and, to protect the insurance-buying public, regulators worked to prevent unlicensed insurers from underwriting risks in their jurisdictions.

Eventually, insurance regulators recognized the importance of a supplementary market and enacted surplus line laws, the first of which was passed in 1890 in New York. Although regulators continued to debate the need for the surplus lines market, it has proved to be essential.

Obtaining insurance from a surplus lines insurer is commonly referred to as “exporting” a risk to the surplus lines market. Surplus lines laws do not regulate the insurers to which risks are exported, because those insurers are not within the state’s jurisdiction or subject to its authority. Instead, surplus lines laws require licensing of the intermediaries that export risks to surplus lines insurers. When licensed in the insured’s home state, surplus lines intermediaries are commonly called “surplus lines licensees” or “surplus lines brokers.”

Surplus lines laws normally specify a diligent search requirement. The retail agent or broker must make certain that admitted insurers have had the opportunity to write the coverage before a risk can be exported to the surplus lines market. Following procedures set by each state, the surplus lines licensee must document that a diligent search has been conducted for an admitted insurer. After placing insurance with a surplus lines insurer, the surplus lines licensee is responsible for collecting the surplus lines premium tax stipulated in the surplus lines law and remitting the tax to the state.

Because insurance is almost always unavailable in the admitted market for certain types of risks, some states have established an export list. An export list simplifies surplus lines placements that involve coverage generally not provided by admitted insurers. State regulators periodically review and update these lists to reflect changes in market conditions.

All states have regulations requiring admitted insurers to file their policy forms and rates for most types of insurance with the insurance commissioner for approval. This is a major reason why admitted insurers are unwilling to accept the types of risks exported to the surplus lines market. The time and expense required to make the filing needed to properly handle such risks are seldom, if ever, justified by the resulting premium.

surplus lines insurers have the flexibility to adjust coverage terms and policy premiums as required to accept the types of risks submitted to them. In some cases, surplus lines insurers develop entirely new policy forms and rates for new or emerging loss exposures and other risks that require insurance from the surplus lines market. Freedom from form and rate regulation reduces the time and expense required to bring new insurance products to the market.

The agents and brokers representing insurance buyers are often referred to as “retail” agents or brokers, or simply “retailers.” Surplus lines insurance is distributed through licensed surplus lines intermediaries. Surplus lines licensees that serve as intermediaries between a retail agent or broker and a surplus lines insurer are often called “wholesale” brokers or “wholesalers”.

All states permit retail agents and brokers to obtain a surplus lines license or surplus lines authority, which allows them to place insurance directly with surplus lines insurers that accept business from retail licensees.

Licensed surplus lines intermediaries play an essential role in exporting risks to the surplus lines market. They are knowledgeable about exposures presented by distressed, unique, high-capacity, and new risks. They have established relationships with specialized insurers that accept these types of risks. In some cases, surplus lines intermediaries even perform the underwriting function for surplus lines insurers.

Licensed surplus lines intermediaries understand the exposures to be insured and have established relationships with insurers that accept these types of risks.

Not every nonadmitted insurer is a surplus lines insurer. The surplus lines law in each state restricts surplus lines licensees to placing coverage with insurers that satisfy specific criteria. The goal is to protect the public by verifying the financial strength and viability of nonadmitted insurers providing coverage. Surplus lines laws often refer to these insurers as eligible surplus lines insurers.

Freedom from form and rate filing requirements and expertise in assessing distressed, unique, high-capacity, and new risks make the surplus lines market the ideal source of new products and services. Without freedom from form and rate filing regulations, surplus lines insurers would not have the flexibility to accept the type of risks submitted to them.

Surplus lines insurers innovate in response to changes in buyer-driven needs, technology-driven needs, socially or environmentally driven needs, and regulatory-driven needs. In many cases, products developed in the surplus lines market are eventually adopted and offered by the standard market after these products and related loss experiences become better understood. Examples include employment practices liability coverage and environmental liability coverage. As a result, the surplus lines market must continue to develop new products to respond to changing needs. Cyber risk coverage, designed to cover losses arising from e-commerce, is an example of a recent surplus lines product innovation that has already begun to migrate to the admitted market.

Types of Surplus Lines Intermediaries

The surplus lines distribution system is a dynamic, evolving part of the insurance business that provides access to the surplus lines market for customers who cannot obtain coverage in the admitted market. The surplus lines market operates through a variety of intermediaries.

Distinguish among these different types of intermediaries in the surplus lines distribution system:

• Retail agents or brokers
• Independent wholesale brokers
• National wholesalers
• Managing general agents
• Underwriting managers
• Program managers
• Lloyd’s brokers

Surplus lines intermediaries are licensed individuals or agencies that place business with surplus lines insurers. The terms used to refer to surplus lines intermediaries vary by state and include "agent," "broker," "producer," and "intermediary." Surplus lines intermediaries include retail producers, independent wholesale brokers, national wholesale brokers, managing general agents, underwriting managers, program managers, and Lloyd’s brokers.

These roles can overlap, so that one organization might function in several capacities. In most cases, a surplus lines intermediary acts as an intermediary between a surplus lines insurer and a retail producer to procure insurance for the retail producer's customer.

Retail agents or brokers (producers) : Retail producers deal directly with insurance buyers to obtain coverage in the standard market. A retail producer can be an insurance agent or an insurance broker. All retail producers must be licensed to place insurance with admitted insurers. Retail producers also may obtain a surplus lines license, which allows them to place business directly with surplus lines insurers. Retail producers who do not hold a surplus lines license can place surplus lines insurance through a licensed surplus lines intermediary.

Independent Wholesale Brokers : Independent wholesale brokers are generally, but not always, small to medium-size organizations that place business with a number of surplus lines insurers. They are often owner-operated. Independent wholesale brokers usually operate within their state of domicile or regionally, and the owners and principal producers are often active in their local communities. They develop strong relationships with local retail producers who come to depend on them for specific products and programs.

Independent wholesale brokers might practice niche marketing to gain a competitive advantage which is a type of marketing that focuses on specific types of buyers who are a subset of a larger market

National Wholesaler : A national wholesaler is a more complex organization than local or regional wholesale brokers because of its size and ownership. National wholesalers usually have several offices strategically located in various parts of the country. They offer many kinds of surplus lines coverage and special programs for certain classes of business.

National wholesalers can be independently owned, or they can be subsidiaries of larger organizations. Independent ownership gives wholesalers the freedom to deal with any retail producer or surplus lines insurer. However, it restricts their access to the exclusive products or programs available only to surplus lines intermediaries owned by larger organizations.

A variety of organizations might acquire or establish a national wholesaler as a subsidiary:

• An insurer
• A London brokerage
• A large retail brokerage
• An investor group

A national wholesaler that is a subsidiary of an insurer might operate independently, or it might rely on the insurer-owner to develop and offer exclusive surplus lines products or programs that are not available to other wholesalers. Exclusive products or programs create a competitive advantage for the wholesaler. However, a wholesaler owned by an insurer might be limited to placing business only with that insurer.

A strong surplus lines market exists in London, made up of both LLoyd's and other underwriters. When a London brokerage firm wants to diversify its operations in the United States or increase U.S. business placed in the London market, acquiring a national wholesaler can be an effective strategy. The wholesaler gains knowledge of the London marketplace and access to the London broker's programs.

A large retail brokerage that wants control over the placement of its customers’ business in the surplus lines market might acquire a subsidiary wholesaler to act exclusively for those customers. On the other hand, a retail brokerage might acquire a wholesaler simply as an investment, in which case it might not require its own surplus lines business to be placed through the subsidiary wholesaler.

Investor groups that own wholesalers usually allow them to operate independently without ties to any other type of insurance operation.

Managing General Agents : brokers for insurers using the independant agency and brokerage system

Employees of an MGA act on behalf of the insurer and often hold the title of underwriter. The role of MGAs varies by the classes of business they are authorized to bind and by the policy limits allowed under their binding authority. MGAs issue policies and endorsements for most of the insurers they represent and are responsible for marketing and loss reporting for the policies they issue.

Underwriting managers :  Act on behalf of a single insurer and assume the role of a branch office for that insurer. They might be a subsidiary or independently owned. Underwriting managers differ from MGAs because of the relationship with and the authority from the insurer they represent. Underwriting managers have broad authority to bind the insurer, place reinsurance on its behalf, and settle claims. An underwriting manager’s customers include retailers, wholesalers, or MGAs, while the customers of an MGA are primarily retail producers.

Program Managers : Some insurers seek to expand by developing program business. A Program Business is an insurrer's offering of a policy or a combination of policices with special coverages, prices, or both, to insureds with similar characteristics.

Surplus lines intermediaries with expertise in a particular area also might develop insurance programs. Insurers interested in program business might offer program manager contracts to these intermediaries. Program manager contracts are similar to MGA contracts, except they are usually limited to a specific program.

Program managers might be a division of another type of intermediary or an independent agency with one or more programs. The insurer might authorize the program manager to accept business from retail or wholesale producers.

A program nager is a surplus lines intermediary that has created a special, or niche program that fits a particular market.

LLOYD's Brokers : Lloyd’s (formerly called Lloyd’s of London) underwrites a significant proportion of the surplus lines coverage in the U.S. and has a reputation for underwriting specialized and unique risks. Unlike insurance companies, Lloyd’s is an insurance marketplace in which members' syndicates provide capital and accept surplus lines risks. Syndicates' day-to-day operations are administered by managing agents. 

A Lloyd's Broker is a specialist who has been carefully evaluated and accredited by Lloyd’s. He or she negotiates competitive terms and conditions with Lloyd’s underwriters on behalf of insurance applicants. At present, more than 180 firms are qualified as Lloyd’s brokers.

The managing agents of Lloyd’s syndicates also have the option of accepting business submitted by licensed surplus lines producers who are not accredited Lloyd's brokers. Lloyd’s stipulates the minimum requirements such intermediaries must meet, and the managing agent is responsible for ensuring the intermediary qualifies.

Niche marketing : A type of marketing that focuses on specific types of buyers who are a subset of a larger market.

• Subsidiary : A company owned or controlled by another company.
• Lloyd’s (Lloyd’s of London) : An association of investors, grouped in syndicates, who are represented by underwriters to write insurance and reinsurance.
• Managing general agents (MGAs) : Independent business organizations that function almost as branch offices for one or more insurers and that appoint and supervise independent agents and brokers for insurers using the independent agency and brokerage system.
• Underwriting guidelines (underwriting guide) : A written manual that communicates an insurer’s underwriting policy and that specifies the attributes of an account that an insurer is willing to insure.
• Binding authority : An insurance agent's authority to effect coverage on behalf of the insurer.
• Program business : An insurer's offering of a policy or combination of policies with special coverages, prices, or both to insureds with similar characteristics.
• Program manager : A surplus lines intermediary that has created a special, or niche, program that fits a particular market.
• Lloyd's broker : An insurance broker who procures coverage in the Lloyd's market on behalf of insureds.

Several general functions are performed by surplus lines intermediaries:

• Maintaining documentation
• Counseling
• Filing affidavits
• Collecting premium taxes
• Practicing sound management

Maintaining Documentation : Surplus lines intermediaries document each customer’s file to record each transaction. They make written records of all telephone calls and face-to-face discussions and file all correspondence. Lack of documentation is one of the leading causes of misunderstandings and Errors and Omissions claims. Without proper documentation, customers and insurers can allege that intermediaries are responsible for any mistakes.

In many states, the intermediary is responsible for maintaining copies of policies, which must be made available for review by state regulatory officials, if requested.

Counseling : Counseling is similar to the risk management process that all producers help their customers perform. However, surplus lines intermediaries should take their counseling responsibility even more seriously than other producers because of their unique role in surplus lines marketing. Professional surplus lines intermediaries help customers identify loss exposures and match them with appropriate coverage. It is not enough merely to understand the coverage being requested by the customer or proposed by the retail agent. The intermediary must review all submissions thoroughly and offer advice on appropriate existing coverage as well as unique or new coverage that becomes available.

Filing Diligent Search Affidavits : The surplus lines intermediary is responsible for filing a dilligent search affidavit for each account confirming that it has been declined by admitted insurers. State regulators often review affidavits to ensure surplus lines intermediaries and retail agents have met diligent search requirements. Although the diligent search is the retail agent’s responsibility, surplus lines laws hold the surplus lines intermediary responsible for filing the affidavit. This division of responsibility can cause problems for the surplus lines intermediary when no system is in place to assure the intermediary that the retail agent has performed the diligent search. A diligent search affidavit confirms that coverage has been declined by admitted insurers.

Collecting Premium Taxes : Intermediaries apply the appropriate surplus lines premium tax, collect it from the policyholder, and remit it to the state(s) to which the tax is owed. The surplus lines tax varies by state, and the intermediary must know the tax rules of the state in which the loss exposures are located. Correctly collecting and remitting taxes is an important responsibility for surplus lines intermediaries.

Practicing Sound Management : To demonstrate professionalism to customers and insurers, a surplus lines intermediary follows management guidelines such as these:

• The operation of the office is organized and efficient.
• The intermediary honors his or her responsibilities as a fiduciary to insurers and the state by collecting premiums and taxes from policyholders and holding those funds in trust.
• All transactions adhere to applicable state statutes and regulations.
• The intermediary acts at the highest ethical level. An intermediary’s authority and responsibilities are extensive. Retail agents, surplus lines insurers, and regulators must be able to depend on intermediaries to execute those responsibilities in good faith.

The National Association of Professional Surplus Lines Offices (NAPSLO) provides a Code of Ethics for its members. This code provides intermediaries with guidelines for practicing sound management and for conducting their business ethically.

Wholesale brokers have additional responsibilities beyond the general functions involved in dealing with retail agents and surplus lines insurers. Wholesale brokers analyze loss exposures and prepare submissions that present all of the information underwriters need to evaluate and quote on a risk. The more complete the submission, the more likely the underwriter is to provide a favorable quote. Wholesale brokers identify insurers that might be interested in each submission and determine the best method for approaching them.

If a submission is large and complex, the wholesale broker might meet with the underwriter in person to review the submission. Some wholesale brokers involve the retail producer in this discussion. After receiving a quote, wholesale brokers prepare material the retail agent can use when making a presentation to the customer.

If the customer accepts the insurer’s quote and places an order, the insurer issues a binder. Verbal binders must be confirmed in writing. The wholesale broker is responsible for delivering the policy to the customer promptly and ensuring the coverage and limits it provides are those requested and quoted. This is important because E&O claims can arise from lack of attention to these details. Carefully checking the coverage and limits is a part of the transaction the wholesale broker should not delegate or neglect.

Service after the sale also is an important function. This includes communicating policy changes and claim notices from the retail agent to the surplus lines insurer and soliciting renewals as each policy expires. The ability to write additional new business and the opportunity to renew existing accounts often depend on the level of service wholesale brokers provide and the relationships they develop.

The functions of an MGA are similar to those of a wholesale broker. However, an MGA’s most important responsibility is to follow the underwriting guidelines and binding authority the insurer has specified. Insurers grant binding authority for specific types of business, coverage, limits, and territories. Because MGAs depend on their binding authority to be able to place business, they must exercise that authority with care. MGAs that underwrite poorly and cause excessive losses soon find that insurers are unwilling to grant them binding authority.

An MGA with a staff of well-trained, knowledgeable underwriters earns a reputation for serving customers and insurers well. The underwriters must be familiar with loss exposures, pricing, and coverage, and they must understand the extent of the binding authority granted by each insurer they represent. They also must know the types of loss exposures for which each insurer does not want to offer coverage.

After MGAs issue policies, they perform the same post-sale service functions that wholesale brokers perform. An MGA that offers a wide variety of coverage, high-quality products, and prompt service serves its customers well. A reputation for poor service results in lost business.

A program manager, whether independent or part of a large organization, usually performs a number of functions related to program business :

• Completes tasks usually assigned to an MGA, such as issuing policies on the insurer's behalf
• Markets the program to retail agents and sometimes to other wholesalers
• Handles claims with limited payment authority or passes claims directly to the insurer
• Places reinsurance on the insurer’s behalf
• Communicates with the insurer and sometimes with customers

In addition, the program manager usually owns the program and all rights to it. The program manager has binding authority from the insurer only for insureds that fit the program’s guidelines.

A LLOYD's Broker has marketing functions similar to those of wholesale brokers and MGAs. Lloyd’s brokers match the customer's needs with the expertise and reputation of Lloyd’s syndicates and underwriters. However, to do so, Lloyd’s brokers have additional capabilities:

• They need to know which syndicates and underwriters have expertise in the class of business for which they are seeking coverage.
• They need to be aware of which syndicates and underwriters have the best reputations.
• They need to choose the underwriter who provides the most favorable policy terms, conditions, and price.
• They need to know which underwriter others will respect and follow if more than one underwriter is needed to cover an account.
• They need to find other underwriters, after finding the leader, who are willing to take additional percentages of the limits until the account is completely covered.

Lloyd’s brokers that develop good working relationships with surplus lines intermediaries are best able to meet customers’ needs.

The Surplus Lines Intermediary Transaction Process : 

Placing a risk in the surplus lines market can be far more complex than placing a risk in the standard market. A retail producer initiates a surplus lines transaction by approaching one or more surplus lines intermediaries for assistance in meeting the needs of a customer or prospective customer. For the surplus lines intermediary, the transaction process consists of six steps.

Qualifying the submission : The first step in the process is qualifying the underwriting submission, which involves gathering information and evaluating the account. Because surplus lines intermediaries tend to specialize, they need to determine whether they have the expertise and contacts to meet that particular customer’s needs. 

Surplus lines intermediaries generally qualify a submission by answering questions such as these:

• Which retail producer is making the submission? Does that producer handle the account now? If so, why is the retailer involving a wholesaler? If not, what are the chances of displacing the current producer, often referred to as the “incumbent”?
• Who is the current insurer? Is it an admitted insurer? Is the current insurer offering renewal? Does the retailer have direct access to that insurer? If so, why use a surplus lines intermediary?
• When does the retail producer need the quote? Is that time frame reasonable?
• What coverage is the retail producer asking the surplus lines intermediary to provide?
• What type of insurer is needed? Does the surplus lines intermediary have access to such an insurer?
• What underwriting information is needed? What underwriting information is available, and is all of the underwriting information being shared with the surplus lines intermediary?

Surplus lines intermediaries may modify the qualification step based on the relationship they have with the retail producer submitting the account. If the retailer is a regular customer, the intermediary might expedite the qualification step. If the retail producer is a new customer, qualifying the submission usually will be more involved.

The qualification step is crucial. If the surplus lines intermediary does not fully understand the retail agent’s needs, the transaction cannot be successful regardless of what occurs in subsequent steps.

Preparing the submission : The second step is preparing the submission for the insurer. Preparing a quality submission is essential because of the characteristics that drive risks to the surplus lines market. Handling these risks requires both a high level of expertise and utmost good faith between the intermediary and the insurer. A professional underwriting submission describes the account and its loss exposures thoroughly, gives the underwriter all the information required to make an informed decision, and presents the information in a format that is clear and easy to understand. In general, high-quality submissions include five elements:

• Descriptive narrative
• Loss data
• Financial information
• Familiarity with rating techniques
• Lead time

The narrative includes a description of the customer’s business operations and associated loss exposures, all of the hazards associated with the account, and any risk control measures currently in place. The intermediary suggests how the account should be handled and provides the rationale for any recommended changes to the existing program.

To price coverage, the underwriter needs to review an account’s claim history. Most underwriters require a minimum of three to five years of loss data. In addition, the intermediary should provide details of any large losses that occurred prior to that period. In case the underwriter has questions about other losses occurring before that period, the intermediary should have access to records of all prior losses.

Complete and current financial information is an important element of a high-quality submission. The underwriter usually requires the customer’s most recent annual report, a Form-10K, and a financial statement, audited if possible. The surplus lines intermediary should review each of these documents thoroughly and be prepared to demonstrate an understanding of the customer’s financial position if the underwriter has questions.

Surplus lines intermediaries can improve their relationships with underwriters by being familiar with the rating techniques they use. Analyzing a loss exposure and understanding the rating process for that exposure gives surplus lines intermediaries insight into the submission from the underwriter’s perspective. Intermediaries who have analyzed submissions in this way are better able to work cooperatively with underwriters in meeting the customer’s needs.

Most underwriters prefer two to four weeks of lead time to quote a surplus lines account. If time is short, the surplus lines intermediary should provide the underwriter with additional information to expedite the process. For example, if the customer is willing to provide the current insurer’s inspection and risk control report, the surplus lines intermediary may find that the underwriter will be able to quote without new inspections. In the surplus lines market, many accounts are written within tight deadlines as a result of the trust between the surplus lines intermediary and the underwriter.

Submitting the Account : The third step is submitting the account to an underwriter. Marketing an account involves a number of important considerations, such as whether to approach a single insurer, several, or many. Restricted marketing is appropriate when the number of insurers willing to consider an account is small, or when an account is so complex that the time involved in working with the underwriter precludes multiple submissions. On the other hand, when a submission is highly unusual, the surplus lines intermediary may have no idea how insurers will respond. In this case, approaching many insurers might prove most successful. For most accounts, however, it is typical to obtain quotes from several insurers.

Laws, regulations, or agreements may stipulate that a customer must obtain insurance in the admitted market. This is referred to as the need for “admitted paper.” Surplus lines intermediaries must identify these customers before making a submission to an insurer on their behalf. If admitted paper is needed, the intermediary might suggest an alternative approach, such as finding an admitted insurer willing to issue a policy for which the surplus lines insurer would provide reinsurance.

A surplus lines insurer’s reinsurance arrangements can affect the surplus lines transaction. Intermediaries cannot expect to know everything about an insurer’s reinsurance program. However, knowing the limit of liability provided by treaty reinsurance, or whether the treaty contains certain exclusions, is helpful when deciding which insurer to approach with a submission or how best to handle an account. Underwriters are usually willing to share this information because it saves time for them and the surplus lines intermediary. When surplus lines intermediaries are aware of a source of facultative reinsurance that would assist in writing an account by providing reinsurance beyond the surplus lines insurer’s treaty, they should provide that information to the underwriter early in the process.

Intermediaries also must determine whether the surplus lines coverage is to be written as the primary layer or as excess coverage

It is crucial for the intermediary to have knowledge of the underwriting cycle, insurer loss experience, and any previous relationship between the customer and the insurer. During a hard market, insurers may limit the number of submissions an intermediary can make, and their interest in some classes of business may decrease. During a soft market, insurers will consider more types of business. Like the insurance cycle, loss experience can influence an insurer’s underwriting. An unfavorable loss history often results in a pricing increase and greater selectivity by underwriters. Finally, to avoid embarrassment and wasted effort, before submitting an account, the intermediary should check whether the customer has had a negative experience with that insurer.

The role of price in a customer’s choice of insurer is important. Some customers may be more interested in price than in policy terms, conditions, and limits. Other customers move from insurer to insurer annually, indicating that insurer relationships mean little to them. Surplus lines intermediaries should keep in mind that a customer “won” because of a low price will likely be “lost” when another intermediary presents an even lower price.

Some surplus lines intermediaries present only the quote they consider the best, while others present all the quotes they received. In this case, the proposal package may include a pricing comparison as well as financial ratings of the insurers, a comparison of policy terms and conditions, the commissions paid by each insurer, and the binding requirements for each insurer.

Because quotes can vary significantly when an account has been submitted to a number of insurers, it is important that the surplus lines intermediary explain to the customer the extent to which each quote responds to the loss exposures and why price should not be the only consideration.

If the surplus lines intermediary is a managing general agent (MGA) for the insurer, the intermediary has authority to bind the business for the insurer. Copies of the binder should go to the retail agent and the underwriter. After coverage is bound, the MGA issues a policy in accordance with the terms and conditions quoted.

• Properly remitting surplus lines taxes on the insured’s behalf
• Ensuring policies comply with applicable surplus lines regulations in the insured’s home state
• Maintaining or filing (as required by the state regulating the transaction) any affidavits needed

Policy maintenance services include these:

• Issuing (if an MGA) or requesting (if a broker) policy endorsements for additions, deletions, or other changes in insurable loss exposures
• Auditing insurable loss exposures (if an MGA) as dictated by the policy terms. The insurer usually handles this task if the placement is on a brokerage basis.
• Canceling a policy (if an MGA) or requesting cancellation (if a broker) at the insured’s request. The insurer also may request that an MGA send notice of cancellation if the insurer determines that it no longer wants to provide coverage for the loss exposures.
• Reporting claims to the insurer when notified by the retail agent or the insured. An MGA or a broker might not have any claim adjusting authority.

The states regulate surplus lines transactions through licensed surplus lines intermediaries. A surplus lines insurer, because it is not licensed in the state or states where it is insuring risks, is not subject to regulation by those states. Therefore, it is essential that surplus lines intermediaries understand their regulatory duties and perform them correctly.

Regulation of surplus lines insurance is accomplished through state control and monitoring of surplus lines termediaries. Regulators require that intermediaries obtain a surplus lines license and fulfill a number of duties with respect to each surplus lines transaction. Duties can vary by state, but these are typical activities:

• Verify that the producer has made a diligent search for coverage in the admitted market and file the required affidavit or documentation
• Determine whether the insurer is eligible to write surplus lines insurance in the state
• Maintain policy files for possible state regulatory audit
• Collect a surplus lines premium tax from policyholders and remit the tax to the state
• Disclose to the policyholder that the surplus lines insurer is a nonadmitted insurer and the policy has no, or limited, guaranty fund protection

State surplus lines stamping offices, often called surplus lines associations, exist in fourteen states. These organizations are established to facilitate and encourage licensees’ compliance with regulations.

Licensing : To obtain a surplus lines broker’s license in most states, the applicant must satisfy a number of requirements:

To place an account in the surplus lines market, a surplus lines intermediary must have what is commonly referred to as a surplus lines broker’s license in the insured’s home state.

Surplus lines intermediaries are licensed on a resident basis in their home state. Once they have a resident license, they can acquire a nonresident license in other states. Having a nonresident surplus lines license from another state allows a surplus lines intermediary to procure insurance for an insured whose home state is that other state.

• Be a licensed resident agent or broker for placing property-casualty insurance with admitted insurers
• Pass a written examination
• Pay an annual licensing fee
• Provide a license bond that protects the policyholder against loss of premiums paid to the broker and the state against loss of any unpaid surplus lines premium taxes

Surplus lines licensees also must fulfill continuing education requirements, which vary by state, to maintain a surplus lines license.

Diligent Search and Filing of Affidavits : Generally, before marketing a prospective insured to surplus lines insurers, a good-faith diligent search of the admitted market is required. State laws and regulations often specify the number of admitted insurer declinations needed to satisfy the diligent search requirement. The surplus lines licensee conducting the transaction must document the details of these declinations and submit them to regulators, usually in the form of a diligent search affidavit. Each state specifies a time frame within which the affidavit or required documentation must be filed. Some states require only a summary of efforts to obtain coverage from admitted insurers. However, most states specify the information that must be shown on the affidavit, which usually includes these items:

• The names and addresses of the insured, surplus lines licensee, retail agent, and surplus lines insurer
• A description of the diligent search for coverage in the admitted market
• The reasons for using a surplus lines insurer for the coverage
• Confirmation that the policyholder has received written notification of the lack of guaranty fund protection and other limitations of using a surplus lines insurer

In some situations, the diligent search requirement may not apply. Some states have created an export list to simplify surplus lines transactions involving coverages generally unavailable from admitted insurers. The coverages or risks on export lists vary by state.

Determining Insurer Eligibility : A surplus lines intermediary can place business only with eligible surplus lines insurers. The intermediary must verify that a surplus lines insurer meets eligibility criteria before procuring insurance from that insurer.

States may use any one of three approaches to identify eligible surplus lines insurers. The majority of states publish a white list (eligibility list) of surplus lines insurers that meet the state’s eligibility standards. Other states use a broker responsibility approach, and a few states use a black list (ineligibility list). Black lists also might supplement a broker responsibility approach.

Record Keeping : Each surplus lines transaction must be reported to either state regulators or the appropriate state surplus lines stamping office, along with required documentation. Detailed recordkeeping is essential. Surplus lines intermediaries must keep sufficient information about each transaction conducted with a surplus lines insurer to clearly document their compliance with all applicable laws and regulations. Any state in which they are licensed and have done business may audit their records.

The details that surplus lines intermediaries must retain about each transaction generally include such items as information about the retail producer, name and address of the insured and insurer, a copy of the policy, a description of the exposure, amount of insurance and the perils insured against, effective date of coverage, policy premium, premium tax, and a copy of the diligent search affidavit.

Collecting Premium Tax : Government regulation of business is often directly linked to taxation. For example, all states impose a premium tax on admitted insurers, which pay this tax directly to the state. Surplus lines transactions are also subject to a premium tax in each state. However, because surplus lines insurers operate on a nonadmitted basis and are not subject to state jurisdiction, the surplus lines intermediary conducting the transaction is responsible for collecting the surplus lines premium tax from the insured and remitting it to the state.

Because of a federal law known as the Nonadmitted and Reinsurance Reform Act (NRRA), which took effect on July 21, 2011, only the insured’s “home state” has jurisdiction to regulate a surplus lines transaction, and the surplus lines intermediary is required to remit tax only to that state in accordance with its law. For a business, the NRRA defines “home state” as the state where its headquarters or “principal place of business” is located. For an individual, the NRRA defines “home state” as the state where the principal residence is located.

Under the NRRA, the states may, if they choose, establish premium tax-sharing compacts or agreements. To date, the states have not been able to agree on a consistent method for tax sharing. While some states do not wish to participate in any surplus lines tax-sharing arrangement, other states subscribe to one of two models:

• The Nonadmitted Insurance Multistate Agreement (NIMA) developed by the National Association of Insurance Commissioners
• The Surplus Lines Insurance Multistate Tax Compact (SLIMPACT) introduced by the National Council of Insurance Legislators

Although each stamping office operates differently, they share a number of common goals:

• To ensure an efficient, reputable, and financially stable surplus lines market
• To monitor the activities of people and entities involved in surplus lines insurance and to facilitate regulatory compliance by the state’s surplus lines licensees
• To protect the state’s tax revenues
• To protect consumers by ensuring that those seeking surplus lines coverage have access to financially sound and reputable surplus lines insurers
• To protect buyers of insurance by ensuring that surplus lines policies are issued with appropriate disclosures and any other required policy language

To accomplish these goals, surplus lines associations perform a number of activities:

• Offer newsletters, bulletins, reports, seminars, and Web sites containing information about surplus lines insurance.
• Distribute lists of eligible surplus lines insurers to surplus lines licensees.
• Evaluate the financial stability of eligible surplus lines insurers.
• Advocate regulatory and legislative changes to improve access to surplus lines insurance
• Distribute and explain changes in statutes, regulations, or rulings related to surplus lines insurance.
• Record premiums and tax liabilities for each surplus lines licensee.
• Compile premium data for statistical purposes and file periodic reports with regulators on the state’s surplus lines transactions. The stamping office facilitates accurate, timely remittance of the surplus lines premium tax to the states by its member brokers.

Surplus lines insurers are an essential component of the surplus lines market and have a number of attributes that enable them to perform their role effectively.

The attributes that allow surplus lines insurers to meet the needs of distressed, unique, new, and high-capacity risks include these:

• Their licensing status
• Their eligibility to operate as surplus lines insurers
• Their solvency record, compared with that of admitted insurers
• Their core insurance operations, which include marketing, underwriting, and claim handling

Licensing : Insurers can be categorized based on several characteristics, two of which are these:

• Place of domicile
• Status as licensed or unlicensed in a given state

The place of domicile for an insurer is the state (or other United States jurisdiction, such as the District of Columbia or Puerto Rico) or country under whose laws the insurer is formed and licensed. Depending on its place of domicile, an insurer can be classified as a domestic insurer, a foreign insurer, or an alien insurer in a given state. For example, if an insurer is domiciled in California, it is a domestic insurer from the perspective of California’s insurance regulators and a foreign insurer from the standpoint of insurance regulators of any other U.S. state. An insurer domiciled in Germany is an alien insurer from the perspective of insurance regulators in any U.S. state.

An insurer also can be classified as an admitted insurer or a non-admitted insurer. An insurer domiciled and licensed in California that is also licensed in Oregon and Nevada is a domestic admitted insurer in California and a foreign admitted insurer in Oregon and Nevada. That same insurer would be a foreign nonadmitted insurer in any other state. Every nonadmitted insurer is domiciled and licensed somewhere and is therefore an admitted insurer in that jurisdiction, which is responsible for regulating its operations and monitoring its solvency.

When a nonadmitted insurer meets the criteria imposed by a state’s surplus lines law, it becomes an eligible surplus lines insurer. It then is able to write business in that state through a surplus lines intermediary that has been licensed in accordance with that state’s law.

Admitted Specialty Insurers : Some admitted insurers specialize in niche markets, accepting some of the risks usually placed in the surplus lines market. They are not surplus lines insurers, but they provide some of the same coverages as surplus lines insurers. An admitted specialty insurer may be a subsidiary of a group of companies under common ownership that also includes one or more surplus lines insurers. As admitted insurers, these organizations are subject to rate and form filing regulations in each state in which they operate. Therefore, they do not have the same flexibility as surplus lines insurers to respond to new and unusual risks. However, they may have comparable specialty underwriting expertise.

Eligibility : Before July 21, 2011, each state established its own eligibility criteria for nonadmitted insurers wishing to write surplus lines business within its jurisdiction. Only nonadmitted insurers that met these criteria were recognized as authorized nonadmitted insurers, also referred to as eligible surplus lines insurers. This situation created challenges for surplus lines intermediaries, particularly when handling multistate accounts, because a nonadmitted insurer could be eligible to write surplus lines business in some states and ineligible in others.

The federal Nonadmitted and Reinsurance Reform Act (NRRA), which took effect on July 21, 2011, simplified the situation by imposing national eligibility standards for surplus lines insurers domiciled in any U.S. jurisdiction. The states must incorporate the national eligibility standards into their surplus lines laws. These standards are set out in Sections 5A(2) and 5C(2)(a) of the Nonadmitted Insurance Model Act developed and published by the National Association of Insurance commisioners (NAIC).

To be an eligible surplus lines insurer in a given state, a nonadmitted insurer domiciled in the U.S. must be licensed in its home state and must have capital and surplus equal to the greater of $15 million or the capitalization requirement specified by the state in which it wants to write surplus lines business. A state’s insurance commissioner has the authority to make an exception and authorize a nonadmitted insurer with less capitalization to write surplus lines business in that state, provided the insurer has at least $4.5 million in capital and surplus.

Alien insurers wishing to write surplus lines business in the U.S. must maintain a trust fund or other collateral in the U.S. They also must submit financial statements and other documentation to the states in which they write business and to the NAIC. The International Insurers Department (IID) of the NAIC monitors the performance and financial strength of these alien insurers and publishes a Quarterly Listing of Alien Insurers. Licensed surplus lines intermediaries are permitted to place business with any alien insurer on that list.

Surplus lines intermediaries may place business with any alien insurer that appears on the Quarterly Listing of Alien Insurers published by the NAIC.

Solvency : State guaranty funds generally do not cover the policyholders of surplus lines insurers. As a result, determining the solvency of these insurers is essential.

A.M. Best Company, Inc. is an international credit rating organization that focuses on the insurance industry. Analysts at A.M. Best evaluate the financial strength of individual companies and assign a Best’s Rating, which can range from A++ for companies with superior financial strength to E for companies under regulatory supervision because of poor financial performance and F for companies in liquidation.

The sources of information for assigning Best's Ratings are the NAIC Annual Statement and quarterly statements filed by individual insurers. These may be supplemented by audit reports, U.S. Securities and Exchange Commission reports, records of insurance department examinations, and internal insurer documents. The ratings are reviewed quarterly, although mergers, catastrophic losses, reinsurer insolvencies, or other unusual events might necessitate additional reviews.

A.M. Best considers an insurer to be a Financially Impaired Company (FIC) when a state insurance department takes regulatory action because of concerns about the insurer's financial condition, the adequacy of its capital and surplus, or its ability to conduct normal insurance operations. The rating agency tracks the frequency of financial impairment among both admitted insurers and surplus lines insurers. Between 1977 and 2010, the Financial Impairment Frequency (FIF) for surplus lines insurers was slightly higher than that of admitted insurers, 1.01 compared to 0.89.

In recent years, however, surplus lines insurers have performed well. Between 2004 and 2010, there were no financial impairments among surplus lines insurers operating in the U.S. Over the past ten years, surplus lines insurers consistently earned a higher proportion of Excellent (A–, A) or Superior (A+, A++) ratings than the total property-casualty industry.

Operations : The core operations of all property-casualty insurers, including surplus lines insurers, are marketing, underwriting, and claim handling. Because of the nature of the risks insured in the surplus lines market, these functions can be more challenging for surplus lines insurers. The insurance professionals involved in surplus lines transactions require specialized skills to operate successfully in this market.

By their nature, surplus lines insurers pursue a focused differentiation strategy by directing their efforts to insureds whose needs are not met by admitted insurers. Surplus lines insurers concentrate on serving segments of the property-casualty insurance market that are inadequately served by admitted insurers and in which they have specialized expertise. By focusing, an organization limits not only its market, but also the number of competitors. In that way, an insurer can reduce costs or provide products and services that differentiate it from this limited number of competitors. Succeeding in this approach, however, requires detailed knowledge and complete understanding of the target market niche.

To be successfull the marketing Approach of surplus lines insurers must have detailed knowledge and complete understanding of its target market niche. 

The expertise of the surplus lines insurer’s underwriters may influence which classes of business the insurer writes. For example, underwriting kidnap and ransom coverage for corporate executives stationed overseas requires detailed knowledge of the socio-political climate in the foreign country, local law enforcement, and appropriate risk control measures.

Claim representatives working in surplus lines also require specialized expertise. For example, some insurers and independent adjusting firms maintain pollution liability teams that are prepared to go anywhere a major loss has occurred. These teams coordinate the mitigation of damages, prevent further damages, and handle claims. Because of the specialty nature of the business written in the surplus lines market, claims can be complex and require personnel with specialized skills and knowledge.

Surplus lines insurers’ relationships with surplus lines intermediaries are essential to their success. When insurers work with intermediaries operating on a brokerage basis, the insurer’s underwriters make the decision to accept or reject submissions. Other intermediaries have binding authority and complete the underwriting process for submissions that fall within the parameters established in their contracts with surplus lines insurers.

Licensed surplus lines intermediaries are permitted to place business with any alien insurers  that appears on the Quarterly Listing of Alien Insurers published by the NAIC.

A fundamental marketing decision that a surplus lines insurer must make is what types of products it will offer.

The classes of business that a surplus lines insurer will offer depend on management's willingness to accept Underwriting Risk.

When determining what types of products to sell, surplus lines insurers consider these factors:

• Financial resources
• Regulation
• Underwriting expertise
• Reinsurance
• Operating states
• Processing requirements
• Taxation
• The insurance underwriting cycle

The insurer's financial rating also determines the types of products to sell. For certain classes of business, customers typically require a minimum financial rating, which an insurer must meet or exceed to compete successfully in those classes. These financial ratings are assigned by A.M. Best Company, which rates almost all insurers licensed and operating within the United States.

Surplus lines insurers also consider residual markets operating in a given state when determining what products to offer. Business that can be written in residual markets, such as automobile insurance plans or FAIR ACCESS TO ISNURANCE REQUIREMENTS PLANS(FAIR), might create adverse selection problems if the surplus lines insurer can write the business only after the residual market declines it. In addition, admitted insurers moving in and out of these markets in response to changes in the insurance underwriting cycle can create a difficult competitive environment.

One advantage for surplus lines insurers operating in states with residual market plans is that these plans are funded by assessing admitted insurers; nonadmitted insurers are generally not subject to residual market assessments.

Management's willingness to accept underwriting risk also influences the classes of business to be offered. Risk-averse managers might insure different classes of business than managers who are more comfortable with risk.

A surplus lines insurer also should consider a state’s volume of surplus lines business. High premium volume might indicate great opportunity or a favorable regulatory environment.

Taxation : Taxation of admitted and nonadmitted business can affect the choice of products offered. An admitted insurer pays state premium taxes, calculated as a percentage of the insurer’s written premiums. Admitted insurers file these taxes directly with the states in which they are licensed and include taxes in their ratemaking formulas.

Taxes on nonadmitted business are shown as a separate, additional item on the invoice presented to the policyholder by either the insurer or the surplus lines intermediary. The surplus lines intermediary collects these taxes and remits them with a tax return to the insurance department in the insured’s home state. These taxes are often higher than those paid by admitted insurers, which increases the total premiums that policyholders pay. Although surplus lines insurers do not pay the taxes directly, they consider the tax rate as one marketing factor when determining which products to offer in certain states.

A hard market begins when insurers tighten underwriting standards and sharply raise premiums. During this phase, insurers pare their business to only the more profitable risks. Because of changes in underwriting standards during hard markets, admitted insurers decline more submissions, which are then offered to surplus lines insurers. For this reason, there is usually an influx of insureds from the admitted market into the surplus lines market during the hard market phase.

Stricter underwriting and higher premiums in a hard market result in increased profits, which attract more capital to the insurance industry and increase underwriting capacity. This, in turn, leads to a soft market, in which insurers relax underwriting standards and lower premiums to attract more business. Most insureds can secure coverage from admitted insurers, and fewer insureds must seek coverage in the surplus lines market. Eventually, the relaxed underwriting standards generate more losses and decreased profits, and the cycle begins again with hard market conditions.

Surplus lines premiums typically expand during a hard market and contract during a soft market. Moreover, a surplus lines insurer may adjust product offerings in a hard market to add coverages that were available from admitted insurers during the preceding soft market but are no longer available in the hard market. In a soft market, a surplus lines insurer may stop writing coverages that are available from admitted insurers and focus on marketing coverages that remain unavailable in the admitted market.

Premium-to-surplus ratio, or capacity ratio : A capacity ratio that indicates an insurer's financial strength by relating net written premiums to policyholders' surplus.

Guaranty fund : A state-established fund that provides a system for the payment of some of the unpaid claims of insolvent insurers licensed in that state, generally funded by assessments collected from all insurers licensed in the state.

Diligent search : A surplus lines regulatory requirement establishing that coverage for the risk is unavailable from admitted insurers.

Residual market : The term referring collectively to insurers and other organizations that make insurance available through a shared risk mechanism to those who cannot obtain coverage in the admitted market.

Automobile insurance plan : Plan for insuring high-risk drivers in which all auto insurers doing business in the state are assigned their proportionate share of such drivers based on the total volume of auto insurance written in the state.

Fair Access to Insurance Requirements (FAIR) plans : An insurance pool through which private insurers collectively address an unmet need for property insurance on urban properties, especially those susceptible to loss by riot or civil commotion.

Adverse selection : The decision to reinsure those loss exposures that have an increased probability of loss because the retention of those loss exposures is undesirable.

Underwriting cycle : A cyclical pattern of insurance pricing in which a soft market (low rates, relaxed underwriting, and underwriting losses) is eventually followed by a hard market (high rates, restrictive underwriting, and underwriting gains) before the pattern again repeats itself.

Managing general agent (MGA) : An authorized agent of the primary insurer that manages all or part of the primary insurer's insurance activities, usually in a specific geographic area.

Reinsurance : The transfer of insurance risk from one insurer to another through a contractual agreement under which one insurer (the reinsurer) agrees, in return for a reinsurance premium, to indemnify another insurer (the primary insurer) for some or all of the financial consequences of certain loss exposures covered by the primary's insurance policies.

Treaty reinsurance : A reinsurance agreement that covers an entire class or portfolio of loss exposures and provides that the primary insurer's individual loss exposures that fall within the treaty are automatically reinsured.

Facultative reinsurance : Reinsurance of individual loss exposures in which the primary insurer chooses which loss exposures to submit to the reinsurer, and the reinsurer can accept or reject any loss exposures submitted. Facultative reinsurance can cover exposures excluded under a surplus lines insurer's reinsurance treaty.

Hard market : Market conditions in which insurer competition diminishes, buyers have difficulty finding coverage, premiums increase, and insurer profitability rises.

Soft market : Market conditions in which insurer competition is intense and is indicated by widely available coverage, lower premiums, and decreased insurer profitability.

Capacity : The amount of business an insurer is able to write, usually based on a comparison of the insurer's written premiums to its policyholders' surplus.

Surplus Lines Underwriting : Surplus lines underwriters have more flexibility than underwriters in the admitted market. This flexibility allows surplus lines underwriters to make an otherwise unacceptable risk acceptable and meet the customer’s insurance needs.

Although surplus lines insurers and admitted insurers use essentially the same underwriting process, their underwriting practices differ in important ways. One difference is the more significant role that bindng authority plays in the surplus lines market. When an insurer provides binding authority to an intermediary, the intermediary performs the underwriting process for the insurer, but the insurer must perform additional underwriting tasks related to delegating binding authority. Another difference is that surplus lines underwriters have greater flexibility to modify policy premiums, policy provisions, insureds’ loss exposures, and the insurer’s retention. This enables surplus lines insurers to provide a supplemental market for insureds unable to obtain coverage in the admitted market.

Underwriting Process :

The basic underwriting process is the same in the admitted market and the surplus lines market. Whether underwriters are employees of a surplus lines insurer or surplus lines intermediaries with binding authority, they use a process that includes these steps:

1. Gather the necessary information
2. Make the underwriting decision
3. Implement the underwriting decision
4. Monitor the underwriting decision

To make an underwriting decision on new accounts, renewals, or policy changes, underwriters need adequate information. The insurance application or endorsement request is an essential source of underwriting data. Underwriters also can obtain important information from other sources, including producers; risk control reports ; government records such as motor vehicle reports (MVRs); financial rating services such as Dun & Bradstreet and Standard & Poor’s; claim files; and the applicant’s or insured’s own records, such as annual reports or financial statements.

Once underwriters have gathered all pertinent information about an account, they need to determine its risk level, available underwriting options, and appropriate pricing. One way to determine risk level is by analyzing hazards associated with the account. To make an underwriting decision, an underwriter must consider whether these hazards make the overall level of risk desirable or undesirable. Based on their evaluation of an application, renewal, or policy change, underwriters have three options:

• Accept it
• Reject it
• Accept it with modification

After making an underwriting decision, the underwriter implements the decision. If the decision is consistent with underwriting guidelines and within the underwriter’s authority, he or she can approve the application, renewal, or policy change and request that appropriate documents be issued. If some aspect of the account exceeds the underwriter’s authority, it will require a supervisor’s approval. Whether the application is accepted, rejected, or accepted with modification, the decision is clearly communicated to the producer and to other insurer personnel.

The underwriting process does not end when a policy is issued. The underwriter assesses the quality of initial underwriting decisions by monitoring claim activity on policies, policy changes that may indicate increased hazards, and overall profitability of the book of business for which he or she is responsible. Despite variations in the hazards or loss experience of individual accounts, the entire group of accounts an underwriter handles is expected to meet profitability goals established for the book of business. Careful monitoring of each account helps the underwriter meet these goals.

Finally, as the policy expiration date approaches, the underwriter might need to repeat the underwriting process before agreeing to renew the policy. Renewal underwriting generally can be accomplished more quickly than new business underwriting because the insured is known to the underwriter and more information might be available because claim reports or risk control reports have been added to the file. However, the underwriter must determine whether any changes in the account have occurred and, if so, repeat the underwriting process.

Role of Binding Authority in the Surplus Lines Market :

Intermediaries with binding authority are an important part of the surplus lines market. Insurers grant binding authority to intermediaries who have the expertise to successfully underwrite the classes of business the insurer wishes to pursue. The degree of binding authority depends on the insurer’s philosophy, the intermediary’s experience and profitability, and the type of insurance involved. The conditions, terms, and scope of the binding authority may vary by state to comply with regulations.

Surplus lines insurers extend binding authority to qualified intermediaries for several reasons.  Intermediaries understand the particular classes of business and types of specialized coverage handled within the binding authority. Moreover, intermediaries are familiar with the local territory in which the business is written and have relationships with the retail producers submitting the business. Extending binding authority to qualified intermediaries also saves insurers the cost of hiring and training additional employees.

Surplus lines insurers provide specific guidelines to their intermediaries when extending binding authority. These guidelines specify acceptable territories, classes of business, maximum premiums and policy limits, mandatory endorsements, and other factors. The underwriting guidelines also indicate which submissions the intermediary must refer to a higher underwriting authority within the insurer.

Binding authority relationships carry a different responsibility for underwriting profitability than brokerage relationships. In a brokerage relationship, the insurer makes the final decision to bind and issue the policy. In a binding authority relationship, the intermediary makes that decision based on the contract and guidelines the insurer provided. The selection of acceptable submissions is the intermediary’s responsibility, and the insurer holds the intermediary accountable for underwriting results.

Underwriting guidelines may require the intermediary to share a submission with the insurer before providing a quote. Generally, however, the insurer does not see an application until several weeks after the intermediary has bound coverage and the policy is in effect. The insurer then reviews the submission to confirm that the intermediary adhered to the underwriting guidelines. Insurers monitor binding authority business for profitability through post-underwriting reviews, risk control inspections, premium audits, and financial reviews.

An insurer that grants binding authority to intermediaries must perform two additional tasks within its underwriting division:

1. Select the intermediaries that will receive binding authority
2. Select the classes of business to be included in the binding authority

The process of selecting intermediaries for binding authority contracts generally begins with a specific marketing need on the part of either the insurer or the intermediary. The initial contact can be made by either party, depending on where the need originates. When deciding whether to grant binding authority, a surplus lines insurer evaluates a number of factors, including these:

• The intermediary’s financial condition
• The intermediary’s marketing needs
• The intermediary’s underwriting expertise
• The intermediary’s marketing area
• The intermediary’s reputation
• The intermediary’s other insurers
• The insurer’s need for other intermediaries with binding authority in the marketing area

In addition to selecting intermediaries for binding authority contracts, surplus lines insurers also must decide which classes of business to include in the contracts. Insurers may consider any number of factors in making this decision. An insurer’s plans to write new classes of business and the capabilities of its existing underwriters to handle those classes of business would be primary considerations.

Ability of Surplus Lines Marktet to make Underwriters modifications : 

The decision to accept or reject an application, policy change, or renewal is relatively simple. However, modifying an unacceptable or borderline account to make it acceptable requires greater underwriting expertise. While it is possible to make underwriting modifications in the admitted market, it is generally easier to make such modifications in the surplus lines market.

Admitted insurers, relying on the law of large numbers, typically limit their underwriting to loss exposures with a sufficiently large number of exposure units. This enables the insurer to use filed forms and rates and apply predetermined underwriting guidelines. The types of risks submitted to surplus lines insurers do not lend themselves to this approach, and surplus lines underwriters must be able to apply specialized underwriting knowledge and judgment, based on their experience in handling unusual risks.

Surplus lines underwriters, whether they are insurer employees or intermediaries with binding authority, can exercise any of these options when attempting to make an otherwise unacceptable risk acceptable:

• Modify the loss exposure through risk control
• Modify the policy premium
• Modify policy provisions, deductibles, or limits
• Modify the insurer’s retention through facultative reinsurance

Modify the loss exposure through Risk Control : 

One approach to modifying an unacceptable submission is requiring the applicant to implement risk control measures to reduce hazards. For example, installing an automatic sprinkler system, adding a guard service or security system, and improving housekeeping and maintenance can reduce physical hazards. Some risk control measures are relatively inexpensive and simple to implement, while others require considerable capital investment.

Generally, a surplus lines insurer’s risk control representatives are proficient in the specialty classes of business the insurer writes. As a result, they can make sound risk control recommendations accompanied by well-reasoned, convincing explanations that help the intermediary “sell” the recommendations.

Modify the Poliy Premium :

Another way to make an unacceptable submission acceptable is to modify the policy premium. A surplus lines underwriter has greater flexibility in pricing coverage than an admitted underwriter because surplus lines insurers are not constrained by rate filing regulations. Experience, expertise, and good judgment all play important roles in selecting a rate that earns a reasonable profit yet is competitive enough to obtain the account.

Modify Policy Provisions, Deductibles or Limits : 

Surplus lines underwriters can modify policy provisions because of their freedom from form filing regulations. For example, a policy can be modified to exclude a cause of loss that has resulted in frequent losses, omit an exclusion to provide a coverage the insured needs, or impose a condition, such as requiring a working burglar alarm system.

An underwriter also can modify the policy deductible. For example, if an account has had a large number of small claims, increasing the deductible might make the submission acceptable.

Changing policy limits is another approach to modifying an unacceptable submission. An insurer’s underwriting guide usually specifies the maximum policy limits an underwriter can approve. The limits usually reflect reinsurance constraints or availability and possible catastrophic loss from a single loss exposure. If high policy limits are requested, the underwriter might suggest lower limits that are within the underwriter’s authority.

For property insurance, the underwriter must be alert for overinsurance that could indicate a moral hazard and might lead to a fraudulent loss. Underinsurance, however, is a more common problem. Adequate policy limits are essential to collect a premium commensurate with the loss exposure. From the insured’s standpoint, adequate policy limits also meet coinsurance requirements and ensure an adequate loss recovery.

Modify the Insurer's Retention through Faculative Reinsurance : 

If an applicant is in a class of business not covered by the underwriter’s treaty reinsurance, or if the amount of insurance needed exceeds net treaty capacity, the underwriter might be able to transfer a portion of the loss liability to a facultative reinsurer. Faculatative Reinsurance transactions are negotiated individually. A surplus lines underwriter usually has established relationships with reinsurers or reinsurance intermediaries that can provide the types of facultative reinsurance needed for special risks.

Case Study :

Dale is a licensed surplus lines intermediary who has been granted binding authority by Millstone Insurance. He has been approached by a retail producer looking for property and premises liability coverage for a vacant, forty-year-old, fire-resistive factory building. The company that occupied the building has gone into receivership, and the bank holding the mortgage has taken possession. The building has been vacant for three months, and the bank anticipates it will take between six and nine months to sell. The retail producer is looking for $3 million property coverage on the building, replacement cost coverage, $2 million premises liability coverage, and a $500 property loss deductible.

Dale knows this type of risk has historically been very profitable and the standard market rarely writes this class of business. The fact that the premises are in possession of the bank, rather than a failing business, makes it a more attractive risk.

He begins by evaluating the risk control measures in place. The building is securely locked, the property is posted “no trespassing,” and the bank has contracted with a security company to patrol the premises on a regular basis. However, the automatic sprinkler system has been disconnected, and the heat in the building has been turned off. Dale stipulates that the sprinkler system must be reconnected and, because it is winter, sufficient heat maintained in the building to prevent the water system from freezing.

Dale is aware that copper theft is a significant exposure in vacant buildings, and the factory’s extensive copper plumbing system is an attractive target for thieves. He decides to modify the policy to exclude coverage for the copper piping. In addition, because of the building's age, he elects to provide the property coverage on an actual cash value basis rather than at replacement cost. Finally, he increases the deductible to $5,000.

Dale knows this risk will fall within Millstone’s reinsurance treaty, so facultative reinsurance will not be required. Based on his evaluation of the risk, Dale feels it is attractive, and he selects a rate high enough to make the account profitable but low enough to be attractive to the bank. He presents his proposal to the retail broker and a bank representative, who accept the coverage as offered. Dale completes the application, binds coverage, issues a binder, and submits the application and supporting documentation to Millstone Insurance.

Components of Surplus Lines Insurance Products

The Surplus Lines Insurance product that an insurer markets to consumers in competition with other insurers consists of several components:

• The insurance policy
• Underwriting and pricing
• Risk control services
• Claim services
• Services provided by the intermediary

The Insurance Policy : 

When consumers buy insurance, they obtain an insurer’s promise to pay for certain types of losses. The promise itself is intangible but is usually evidenced by a tangible written contract, called an insurance policy. The insurance policy contains all the policy-provisions that specify the agreement between the insurer and the insured. Policy provisions establish a number of important coverage elements:

• Who is insured by the policy
• The premium payable by the insured
• When coverage begins and ends
• What types of losses the insurer covers
• What types of losses are excluded from coverage
• How much the insurer will pay for a covered loss
• The territory in which losses must occur in order to be covered
• What the insured must do after a loss

Writing the wording of an insurance policy is called drafting. Insurance policies used in the surplus lines market are usually drafted by insurance advisory organizations such as Insurance Services Office, Inc. (ISO) and the American Association of Insurance Services (AAIS), by insurers, or by brokers. Forms and endorsements drafted by advisory organizations are generally referred to as “standard” forms and endorsements.

Surplus lines insurers often use standard forms and endorsements, although they typically modify them to either broaden or restrict coverage as appropriate for a particular policyholder. This process involves the claim and underwriting personnel of a surplus lines insurer. Often, an exclusion in an admitted insurer's policy can be turned into a grant of coverage by the surplus lines insurer. Losses can be analyzed to add either a coverage restriction or a coverage grant. For example, many surplus lines insurers have tailored additional insured extensions for the construction class of business to respond to state laws or claim experience.

Surplus lines insurers can differentiate their products from those of admitted insurers in this way, because they are not subject to form filing regulations. Despite this freedom, surplus lines insurers seldom draft original policies “from scratch” because the process is a time-consuming, complex task that requires a team of experts, including legal counsel. More typically, when confronted with the need for a new policy form, an intermediary or underwriter will extract suitable provisions from existing policies and draft any additional provisions needed for the new form.

In many cases, surplus lines brokers develop insurance programs in cooperation with surplus lines insurers. A significant part of developing the insurance program is selecting appropriate policy forms and endorsements. If no existing forms and endorsements meet the needs of the program, the broker may develop new forms and endorsements, either by drafting them from scratch or, more likely, by using a combination of existing and newly drafted policy provisions.

Brokers’ forms exist in another context as well. Numerous businesses, typically larger ones, hire retail insurance brokerages to procure insurance for them. Some brokerages maintain policy forms and endorsements designed to provide the best possible coverage for their clients. Brokers may present these forms to admitted or nonadmitted insurers when applying for insurance on behalf of their clients. In some cases, the brokers’ forms are so favorable to the insured that the insurer will not accept them without modification. For example, a broker’s form may omit certain policy exclusions that an insurer is unwilling to omit.

Underwriting Pricing

Underwriting is the process by which an insurer screens applicants for insurance and decides which applicants to accept, what policy provisions to use, and what price to charge for the insurance. Although pricing insurance coverage is actually a component of underwriting, it is such an important aspect of insurance products that it is often discussed separately.

In the simplest case, a policy premium is calculated by multiplying the applicable insurance rate by the number of expousre units. For example, the rate for a particular property insurance policy is $0.50 and the exposure unit is each $100 of insured value. If the limit of insurance (insured value) is $100,000, the policy premium is calculated as $0.50 times 1,000 exposure units equals $500. The policy premium is also affected by the coverage provided by the policy. For example, a high deductible affects both risk selection and pricing.

To develop appropriate insurance rates, an insurer begins with loss costs developed by an advisory organization, loss costs based on the insurer’s own loss experience, or a combination. To convert loss costs to rates, the insurer increases the loss costs by adding charges that reflect the insurer’s expenses, contingencies, and profits.

An example can illustrate how underwriting, including pricing, can differentiate two insurers’ products. Insurer A and Insurer B both use the same standard policy provisions for insuring commercial general liability (CGL) loss exposures. However, the two insurers have different risk selection standards. An applicant who is accepted by Insurer A for CGL insurance is rejected by Insurer B, because the applicant’s loss history and financial condition do not meet Insurer B’s underwriting standards.

Moreover, the two insurers price their CGL insurance differently. In the case of an applicant that is acceptable to both insurers, Insurer A charges more premium than Insurer B to insure the same applicant. Thus, even though both insurers use the same policy forms, they offer different products as a result of their different approaches to risk selection and pricing.

Risk Control Services

Insurers frequently provide risk control services to their insureds as part of the insurance product. An insurer may use its own employees or a risk control subsidiary, or it may purchase risk control services from an unaffiliated vendor on a fee basis.

The extent of risk control services provided by insurers depends on several factors, including the size of the policy premium, type of operations in which the insured is engaged, type of coverage being offered, quantity and quality of risk control personnel available to the insurer, and insurer’s outlook on providing risk control services. Examples of insureds that can benefit from risk control services are manufacturers, building contractors, and high-value properties. Surplus lines insurers also can use risk control services on smaller risks, through third-party inspection services that evaluate an applicant’s loss exposures during the application process.

Risk control services are a common component of certain types of surplus lines insurance, such as these:

• Kidnap and ransom insurance, which usually includes expert assistance in providing pre-loss security advice and, in the event of a kidnapping, negotiating the payment of ransom
• Employment practices liability insurance, which may include training to help insureds maintain a workplace environment that will avoid employment practices violations

Claims Services

In every property or liability insurance policy, the insurer has a duty to investigate losses and pay covered claims in accordance with policy provisions. This involves the use of the insurer’s own claim personnel, outside claim personnel the insurer has hired as independent contractors, or a combination of the two.

The quality of the insurer’s claim handling is an essential element of the insurance product. When an insured suffers a loss, favorable handling of the claim can leave the insured satisfied with the overall insurance product, while poor claim handling causes dissatisfaction. Some policyholders believe the quality of an insurer’s claim handling is so important that they select an insurer on the basis of its reputation for handling claims promptly and fairly. One bad claim experience can cause an insured to cancel the policy and never do business with that insurer again.

After a surplus lines policy is issued but before any losses occur, the insurer may send an experienced claim representative to meet with the intermediary and the insurance buyer to gain a thorough understanding of the loss exposure and familiarize the insured with the claim process. In many cases, large insurance buyers and insurers want to understand what is expected from both sides. In particular, if the buyer is using a large deductible, the insurer’s claim representatives will tailor a claim process for that individual account. Because of the special types of risks insured by surplus lines insurers, claim handling is a critical component of the relationship between the surplus lines insurer and the policyholder.

Services provided by Intermediaries

When insurance transactions involve intermediaries, the services they provide are also components of the insurance product. In addition to finding a suitable insurer for the customer, an intermediary may provide certificates of insurance, make policy changes such as adding insureds or increasing limits, and report claims to the insurer. In some cases, intermediaries may be responsible for underwriting and pricing through delegated binding authority,so the services they perform can be as integral to an insurance product as those performed by the insurer.

In other words; when intermediaries are responsible for underwriting and pricing through delegated binding authority, the services they perform or as integral to the insurance product as those performed by the insurer.

This discussion examines four examples of insurance products that could be written profitably in the surplus lines market even though admitted insurers were unwilling to accept the risks:

• General liability insurance for a distressed risk
• Single event liability and event cancellation insurance for a unique risk
• Commercial property insurance for a high-capacity risk
• A package of coverages for a new risk