A bill recently introduced in the U.S. House of Representatives attempts to address the frustration that brokers, insurers and their customers have with certain states’ regulation of surplus lines insurance and of reinsurance. House Bill 5637, the "Non- Admitted and Reinsurance Reform Act of 2006," would not give authority to any federal agency to regulate surplus lines or reinsurance. Instead, in a somewhat unusual approach, the bill would specifically prohibit the multi-state taxation and regulation of surplus lines insurance and multi-state regulation of reinsurance, and instead allow only one state to regulate those transactions. This bill in essence plays referee among state laws by, for example, permitting only the home state of an insured to tax and regulate a surplus lines transaction.

What is perhaps most interesting about the bill is not so much its technical provisions or its chance for passage in the near term, as the fact that the bill was introduced at all. The introduction of this bill, along with other federal legislative initiatives dealing with insurance, is a strong indication of the insurance industry’s frustration with the states’ inability to operate in a uniform fashion. The bill can be viewed as a rebuke of the current practices of some states, and is an attempt to force all states to do what they have not voluntarily been able to do—operate in a uniform fashion so as to facilitate the transaction of surplus lines insurance and reinsurance on an interstate basis.

An amended version of the original bill was approved by the House Financial Services Committee on July 26, 2006, based on a version of the bill approved by House Financial Services Committee’s Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises on July 19, 2006.

The bill consists of two titles, both of which take the same basic approach as that taken in provisions of a draft State Modernization and Regulatory Transparency Act ("SMART Act") that has been discussed in Washington. See Lord, Bissell & Brook LLP’s Client Alert: Proposals for Federal Regulation of Insurance (April 2004). The approach of the SMART Act (which has not yet been introduced) would not be to impose an optional or mandatory federal government regulatory scheme to be enforced by a federal regulatory body. Instead, the SMART Act would attempt to preserve regulation of insurance by the states, but require state regulation to follow certain federal standards. House Bill 5637 takes this same approach.

This approach is in contrast to the proposed National Insurance Act of 2006, also called the optional federal charter bill, introduced in the U.S. Senate earlier this year. The optional federal charter bill would give brokers and insurers the option of being chartered and regulated by a federal regulatory body to be created as part of the Treasury Department, which comprehensive federal regulatory scheme would preempt state regulation. See Lord, Bissell & Brook LLP’s Client Alert: Optional Federal Charter Bill - Proposed Alternative to State Insurance Regulation (May 2006).

The provisions of Title I, entitled "Non- Admitted Insurance," are in response to the problems that surplus lines brokers and surplus lines insurers, and their customers, have faced for many years as a result of multiple states attempting to tax and to regulate surplus lines transactions. Many states require, or at least take the position that they require, brokers to allocate surplus lines tax among the states on a multi-state risk. In addition to being complicated and burdensome, these allocation schemes are inconsistent and potentially impose multiple taxation on brokers. In addition, some states have taken the position that they require the surplus lines broker to be licensed in that state if any part of the risk is located in that state, even if neither the insured nor the broker have their principal places of business in that state and no part of the negotiations or communications regarding the insurance placement take place in that state. Brokers, insurers and their customers find these burdensome and inconsistent state rules frustrating, and their frustration has been exacerbated by repeated unsuccessful attempts to get the states, through the National Association of Insurance Commissioners ("NAIC"), to agree on a uniform tax allocation scheme and a uniform regulatory scheme.

Section 101(a) of the bill addresses these concerns by prohibiting any state other than the "home state" of an insured from taxing a surplus lines transaction. The "home state" of an insured is defined as its principal place of business (or the state of residency if the insured is an individual). The bill defines "premium tax" as including any tax imposed on an insured who independently procures insurance, and thereby also prohibits any state other than the home state of the insured from attempting to tax a direct placement of insurance with an unauthorized insurer.

The bill, in Section 101(b), also permits states to enter into an interstate compact to allocate among the states the premium taxes paid to an insured’s home state. The bill does not specify an allocation formula, and specifically does not adopt the rather complicated and cumbersome allocation schedule that is contained in an NAIC’s model regulation on allocation of surplus lines tax (which allocation schedule has been adopted by only three states). Presumably, if the states cannot agree on such an allocation scheme, then the home state of the insured would keep all of the premium tax. Given the inability of states in the past to agree on a specific tax allocation formula, which is part of the frustration giving rise to House Bill 5637, it remains to be seen if such a compact could be effectively implemented. Large commercial states that serve as the home state of many commercial insurance buyers may have very little incentive to agree to any kind of allocation scheme. Nevertheless, Section 101(b)(4) states that Congress "intends that each state adopt a nationwide or uniform procedure, such as an interstate compact, that provides for the reporting, payment, collection, and allocation of premium taxes for nonadmitted insurance consistent with this section." (emphasis added). This statement of Congressional intent (which, based on applicable Constitutional principles, cannot command the states to adopt an allocation scheme) assumes that allocation of premium tax on multi-state risks is appropriate and can be readily done.

Section 102(b) prohibits any state other than the home state of the insured from requiring licensing of the surplus lines broker in respect of surplus lines insurance for that insured. The bill would specifically pre-empt the laws of all states other than the home state of the insured from applying to a surplus lines insurance transaction. However, Section 102(d) saves from preemption any state law that restricts the placement of either workers compensation insurance or excess insurance for self-funded workers compensation plans with a nonadmitted insurer.

The bill would restrict even the home state of an insured from regulating surplus lines insurance in certain respects. Section 104 of the bill would prevent any state from imposing any qualification standard on a U.S. domiciled surplus lines insurer other than a $15 million minimum capital and surplus, and therefore would remove from states any discretion to deny surplus lines eligibility to an insurer on the basis of the state’s analysis of the safety and soundness or of the management of a surplus lines insurer. This section provides that no state may (i) impose eligibility requirements for U.S. domiciled surplus lines insurers except in conformance with certain sections of the NAIC’s Non-Admitted Insurance Model Act, or (ii) prohibit a broker from placing surplus lines insurance with an alien insurer that has been qualified to be listed on the Quarterly Listing of Alien Insurers maintained by the NAIC’s International Insurance Division.

Section 103 of the bill would prohibit any state, beginning two years after enactment, from collecting any fees for licensing a nonresident broker unless that state participates in the NAIC national insurance producer database for the licensing of surplus lines brokers (or an equivalent uniform national database). By threatening state fee revenues, Section 103 is intended to push states to participate in the National Insurance Producer Registry ("NIPR") implemented by the NAIC, thereby facilitating the multi-state licensing of producers.

Finally, Section 105 of the bill prohibits states (including the home state of the insured) from requiring that a broker representing an "exempt commercial purchaser" make a diligent search to obtain desired insurance from licensed insurers before seeking that insurance from a surplus lines company, as long as appropriate disclosure has been provided to and acknowledged in writing by the insured. The definition of an exempt commercial purchaser roughly follows the definitions in many existing state laws of "industrial insureds." The definition of exempt commercial purchaser requires that the insured employ or retain a qualified risk at least $100,000, and that the insured meet certain minimum net worth or revenue thresholds. The amended version of the bill approved by the Committee contains a list of alternatives for what educational, certification or experience qualifications are needed to qualify as a "qualified risk manager."

The provisions of Title II, entitled "Credit for Reinsurance," are in response to attempts by a few states to regulate reinsurance transactions—even where neither the ceding company nor the reinsurer is domiciled in that state—by (i) imposing requirements and conditions for recognizing financial statement credit for reinsurance, (ii) requiring or prohibiting certain contract provisions, or (iii) requiring additional reporting by and financial information from reinsurers. These states are not following the traditional rule that most states have followed of deferring to the state of domicile of the ceding company on such questions.

Title II prohibits any state, other than the state of a domicile of a ceding company, from determining whether or not the ceding company may take financial statement credit for ceded reinsurance. The amended version of Section 201(a) as adopted by the Committee provides that if a reinsurance transaction qualifies for credit for reinsurance under the rules of the state of domicile of the ceding company, and that state is an NAIC accredited state, then no other state may deny a ceding company credit for reinsurance. This approach is in line with the traditional rule followed by most, but not all, state regulators of deferring to the credit for reinsurance rules of the state of domicile of the ceding company. In addition, Section 201(b) prevents any state other than the state of domicile of the ceding company from restricting or eliminating the ability to contractually require arbitration of disputes, or from dictating what choice of law provisions the contract should contain.

Section 202(a) of Title II provides that if a reinsurer is domiciled in a NAIC accredited state, or is domiciled in a state that "has financial solvency requirements substantially similar to the requirements necessary for NAIC accreditation," then that state of domicile is solely responsible for regulating the financial solvency of the reinsurer. Section 202(b) provides that no state other than the state of domicile of a reinsurer may require the reinsurer to provide any financial information other than that which it files with its domiciliary state. This provision appears to prohibit the state of domicile of the ceding company from requiring such additional financial information if the reinsurer is domiciled in an accredited state (or a state that qualifies for accreditation), but would permit any state to request such information from, for example, alien reinsurers. For purposes of these sections, the term "reinsurer" is defined in Section 203(4) a an insurer that (i) is principally engaged in the business of reinsurance, (ii) does not "conduct significant amounts of direct insurance as a percentage of its net premiums," and (iii) is not engaged on "an ongoing basis in the business of soliciting direct insurance."

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