Surplus Lines Market in the Shifting Regulatory Sands

1. Surplus Lines Marketin the Shifting Regulatory Sands Steve Stephan Napslo Dan Brown SONNENSCHEIN NATH & ROSENTHAL LLP

2. SURPLUS LINES OVERVIEW • Market for hard to place risks • Operates as a supplemental/secondary market to the admitted market • **REGULATED – IN EVERY STATE**

3. ROADMAP FOR TODAY’S DISCUSSION • Brief History of Surplus Lines • Certain Definitions • Insurance Company Eligibility • Eligible Risks • Size and Nature of the Market • Broker Issues • Insurer Reporting and Recordkeeping • Premium Taxation • Limits to Regulation • Applicable Federal and State Laws • Stamping Offices • Snapshot of the Market • Future of the Market

4. HISTORY OF SURPLUS LINES REGULATION • 1752 Philadelphia Contributorship 1st P&C Company • protects houses from liability due to fire • 1890’s Lloyds of London a player in U.S. commercial property risks • 1890 N.Y. enacts America’s 1st Surplus Lines Law • designed to control not eliminate the market • similar to law today with producer regulated • few states follow N.Y. lead (notable exceptions IL & MA) • 1897 NAIC appoints Unauthorized Insurance Committee • charge: to study the “problem of underground insurance”

5. HISTORY OF SURPLUS LINES REGULATION (cont.) • 1900-1960 Misunderstood market and unresolved debate among Regulators • NAIC Proceedings about “undesirable” “lawless” “illegitimate” • 1960 U.S. Senate’s Antitrust and Monopoly Subcommittee Hearings • inquiry into alien surplus lines prompts NAIC to act • 1962 NAIC adopts Non-Admitted Insurers Information Office • reviews financial condition, trust funds and deposits • 1970’s-mid-80’s availability/affordability concerns in product and professional liability lines • 1982 NAIC adopted the Surplus Lines Model Act • some form of the Act in all states

6. SURPLUS LINES DEFINED • Insurance that the admitted companies (the market) will not write • Ebbs and flows with the market • Nonadmitted means not licensed aka unauthorized • Not transacting business in the state where the risk is located/resides • Current dispute in California on this point • Critical Supplemental/Secondary Market

7. INSURER ELIGIBILITY • Must be admitted in at least one state • Exception: Illinois • Financial and statutory requirements vary by state • Specialized knowledge and expertise • “White lists”

8. ELIGIBLE RISKS • Mostly commercial • Capacity driven • Distressed risk driven • Focus is on unique, exotic, novel, or unusual risks • Diligent search required (to maintain the focus) • Broker affidavits required (to confirm the focus) • Export lists - export without diligent search permitted (but still subject to remaining surplus lines laws)

9. SURPLUS LINES MARKET • Nature of surplus lines business makes it difficult to get an accurate count • There is no agreement on what makes up surplus lines premium • What we do know • Surplus Lines business goes by many different names • Domestic, Foreign, Alien, Offshore, Onshore, Independent Procurement, Direct Procurement • Lloyd’s of London is unique (70 Lloyd’s syndicates per NAIC Quarterly Listing of Alien Insurers) • A.M. Best reported top 25 Surplus Lines Carriers represented 80% of the market with a premium volume of $30 billion

10. ROLE OF THE BROKER • Client eligibility • Insurer selection • Record maintenance • Affidavits • Surplus lines placements filings • Collect and remit taxes and fees • Policyholder disclosure

11. BROKER LICENSING REQUIREMENTS • Surplus lines licenses - required for brokers to place business • “Courtesy filings” – less common • Independent procurement – the [i] insureds place business [ii] directly with Surplus Lines carrier [iii] from outside the state [iv] without broker involvement

12. INSURER REPORTING REQUIREMENTS • 21 states require reports from insurers • Report format and deadlines vary by state • Data calls – do they apply to surplus lines (nonadmitted) insurers? • NAIC Medical Malpractice Data Reporting • 2007 CA Wildfire Data Call

13. STATE REPORTING DUE DATES AS OF 12/31/07

14. SUGGESTED BEST PRACTICES FOR INSURERS • Provide policyholder disclosure noticeswith all policies • Track info on surplus lines placements for all states • Request at time of binding • Update continuously • Create reporting database

15. SAMPLE COMPANY DATABASE • Policy number • Name/address of Insured • Premium – Commission paid • Policy Eff. Date / Exp. Date – Limits • Account producer and contact info • Surplus lines licensee, contact info, license number

16. PREMIUM TAX ISSUES • Broker collects taxes – remits to states • Amount of tax varies by state • Multi state exposures present complex tax allocation issues • Various parties seeking to resolve (to be discussed)

17. LIMITS TO REGULATION • U.S. Constitution requires due process • Todd v Shipyards (U.S. Supreme Court - 1962) • tax case • transacting business within vs. outside the state where the risk is located • Numerous state cases have followed • taxation and regulation • Notable: N.J. established a guarantee fund • Evanston Ins. Co. v Merin (N.J. 1984) challenge failed

18. APPLICABLE LAWS • Federal Liability Risk Retention Act of 1986 specifically allows surplus lines availability to purchase groups • State Laws or Regulations - Do they Apply? • Solvency • Claims Handling • Unfair Trade Practices • Fraud Reporting • Cancellation Laws • Special Assessments • Rate and Form Filings • Essex Insurance Co. v Zota (Florida)

19. STAMPING OFFICES • Stamping Offices - 15 states (MN added 1/09) • Surplus Lines Brokers become members of Surplus Lines Association • Quasi-regulatory agencies • Financial security review and market conduct of surplus lines brokers • Collectors of surplus lines taxes

20. STATES WITH STAMPING OFFICES AS OF 6/15/08 *Source: U.S. Stamping Office Directory Courtesy of the Surplus Lines Stamping Office of Texas and the Excess Lines Association of New York (ELANY)

21. COMPOSITION OF THE SURPLUS LINES MARKET TODAY • Alternative Market or Market of Choice* • U.S. Surplus Lines Share of Commercial Lines in 2006 was 14.4% vs 85.6% for Admitted Carriers • Surplus Lines grew 173% among U.S. domestic carriers over the past 5 years • Far outpacing the total U.S. Property & Casualty Industry • 2001 and 2002 saw a dramatic increase in surplus lines writings up 35.7% and 61.7% respectively • 2007 had a drop of -3.5% • Backbone of Surplus Lines business is experienced underwriting • Nimble and innovative with forms • Nimble and flexible with rates *Source A.M. Best Research 2008 Special Report

22. SURPLUS LINES OF THE FUTURE THE MARKET Surplus Lines Business Self Insured Risk Retention Groups Captives “Wall Street Insurance” Standard Carriers • Surplus Lines IndustryWill Remain StrongIFIt Remains Nimble

23. SUMMARY • Surplus lines is regulated – brokers and insurers have specific responsibilities • Designed to be a supplemental/secondary market • Maintain complete and accurate records • Update records and monitor reporting requirements continuously • Communicate with brokers • Complex interplay of state and federal laws

24. Surplus Lines Regulatory ReformPresented at AICP New England Chapter May 15, 2009Norwood, Massachusetts Steve Stephan NAPSLO Steve Stephan Director of Government Relations NAPSLO 200 NE 54th St. #200Kansas City, MO 64118816-741-3910 (direct)steve@NAPSLO.org

25. WHY ARE NRRA REFORMS SOUGHT? • State Surplus Lines laws never modernized • GLBA had unintended consequences for nonresident Surplus Lines producer • Surplus Lines tax system is dysfunctional • Surplus Lines placement laws could have unintended consequences • NRRA– “act of congress” means instant nationwide reform • Other reform efforts failed 1

26. Multi-state risks equal mission impossible • Single state risk is clear • Multi-state Mono-line property – based upon property values - manageable except for 10 gross premium states • Typical statute – “allocate taxes based upon risk exposures in state” – at state tax rate • Package, excess, umbrella, casualty, E&O, D&O result in best guess • Allocation methodologies could include revenue, payroll, loss history, number of employees, man hours, and other criteria

27. SURPLUS LINES REFORM HISTORY • MULTI-STATE RISKS CAUSE PROBLEMS • NRRA Pending in the Senate as S 929 since 2007 • Passed the House as HR 5637 in 2006 (no Senate action); Congress adjourned without action • Passed the House as HR 1065 in 2007 • Senate held hearings summer 2008 – with a favorable review of surplus lines reforms • NAIC testifies in support of NRRA with changes • No Commissioners are openly opposing NRRA at this time 2

28. Gross Premium Statutes Make Compliance Literally Impossible • Ten States have statutes that tax gross premium, but very few follow the statutes – but there are exceptions • If Gross premium paid to the home state, there is nothing left to allocate to the other states • Should surplus lines broker pay gross premium or allocate the taxes – not clear • State insurance departments audit insurers expecting the annual statement to reconcile with broker filings • The two sets of records never reconcile for multi-state risks, but a lot of time is expended by all parties in the reconciliation effort

29. Reform efforts at NAIC • 1995 SL multi-state tax working (MSTWG) group formed • 1995 NITCH non-admitted tax clearinghouse –abandoned • 1995 NAIC model regulation for allocation of multi-state tax adopted by NAIC but never gets state support • 2000 MSTWG reconstituted – asks all stated to adopt allocation laws instead of gross premium laws– abandoned in 2002 • 2005 NAIC MSTWG reconstituted again and surplus lines task force asks industry/regulatory representatives to investigate a multi-state compact to allocate taxes • 2008 industry representatives complete draft compact, but NAIC SL task force personnel have changed and opt to reconstitute the MSTWG yet again and explore options other than a compact. They subsequently indicated they could investigate a “light” version of a compact. • MSTWG Group Leader does not want to seek legislative changes.

30. NRRA REFORMS • Single-State Tax Remittance • Single-State Placement Compliance • Uniform Nationwide Definition of Exempt Commercial Purchaser • Uniform Nationwide Definition of Insured’s “Home State” • One Surplus Lines Broker’s License from the “home state” needed for multi-state placement 3

31. NRRA OTHER PROVISIONS • States encouraged to join a compact “or other procedure” to divide taxes • Uniform insurer eligibility • Participate in NIPR within 2 yr • GAO study of surplus lines market required • Applies to independently procured insurance 4

32. NRRA STATUS • NAIC reportedly supports core provisions of Surplus Lines portions of the bill • NAIC seeks change to definition of home state, insurer eligibility, other provisions • Some regulators want reinsurance title severed – but negotiations continue • Some want uniform Co. eligibility revised • Some want stronger provisions to encourage states to divide taxes 5

33. SLIMPACT • CREATED BY GROUP OF 60 VOLUNTEERS • MANY REFORMS SIMILAR TO NRRA • Single-state placement compliance • One producer license for a multi-state risk • Differs from NRRA in that taxes remitted to all states by broker based upon uniform formula adopted by compact • States must select from four optional uniform payment dates • States can opt out of placement compliance rules – not tax allocation rules • Optional uniform placement compliance rules 7

34. SLIMPACT REFORMS • Formation of a compact commission • Centralized data clearinghouse • Slimpact does not impact company licensing • Definition of home state differs • 4 optional tax payment dates • Mandatory rules for tax formula, data • Surplus Lines policy in home state is deemed Surplus Lines in all compacting states 8

35. SLIMPACT OPTIONAL RULES • COMMISSION CAN ADOPT OPTIONAL RULES (SUBJECT TO OPT-OUT) FOR: • Diligent search • Banking, bond, record keeping • Policyholder notice • Transaction documentation • One tax rate for all non-admitted insurance • Preempts inconsistent state laws 9

36. CHANCES OF SUCCESS • My view – NRRA good chance • If NRRA joined with other bills such as NARAB, OII, NICPA, Systemic Regulator? • SLIMPACT – better chance if NRRA encourages states to join • SLIMPACT stand-alone – more difficult • SLIMPACT would need largest Surplus Lines states to take initiative 10

37. QUESTIONS Steve Stephan Director of Government Relations NAPSLO 200 NE 54th St. #200Kansas City, MO 64118816-741-3910 (direct)steve@NAPSLO.org

38. This concludes our presentation. Thank you! Dan Brown SONNENSCHEIN NATH & ROSENTHAL LLP Steve Stephan Napslo