Think of surplus lines reform as a theatrical revival of the famous Broadway show “1776,” which tells how the Founding Fathers brought together 13 disparate colonies to form the United States—except this time each cast member is singing to his own music.
The Nonadmitted and Reinsurance Reform Act (NRRA), which takes effect July 21, will usher in a new era for all domestic surplus lines brokers, heralding an end to meaningless rules, arbitrary tax deadlines and voluminous paperwork. Yet even though the states have had a year to prepare for the new law, they remain mired in a schoolyard brawl about state sovereignty and how to divvy up tax revenue. They have devised two separate plans, neither of which seems to appeal to a majority of the states.
Meanwhile, big states like New York and California are opting to go their own way. Even wise old Ben Franklin would have a tough time with this production.
“It’s a mess,” says a director of compliance for a major surplus lines brokerage who asked to remain anonymous. “And we’ve squandered a year already.”
Surplus lines is the last, best resort for companies that can’t get enough coverage from their own licensed carriers to handle crises like hurricanes, tornadoes, oil rig fires and management meltdowns. In terms of the coverage it offers, the surplus market has traditionally been defined by its freedom of rate and form, which enables it to better provide for these disasters. But “freedom of rate and form” often sounds like an oxymoron to brokers in this market, who have to jump through hoops to offer coverage. For as long as anyone can remember, surplus lines brokering has been a bureaucratic nightmare, drowning brokers in red tape, tax headaches and ill-timed deadlines set by each state.
A Leader’s Edge story last June outlined some of what was wrong with the long-standing system. For example, a broker’s account for a company with exposure in 23 states might require 15 state-specific affidavits and signatures from five departments of insurance, three licensees, two retailers, two more from the insurer and several from all three. Don’t forget to add fluctuating tax payments and filing methods and fire marshal fees. And that’s not all.
Not only does each state have its own rules and tax rates, but some are contradictory. Marine insurance may be tax-exempt in one state but not in another. An insurer who is eligible for surplus lines placement in one state may not be licensed in another. Even a small item, like confusing a code, could lead to suspension of the broker’s license, warns A. M. Best in a recent report.
Then the client might buy or sell a piece of property during the year, which leads to a change in all the contracts. The result: a $100 premium tax payment divvied up 23 ways (to take the above example), with brokers paying pennies in premium tax to each state but spending dollars in administrative costs to do so.
“There are 2,800 software rules in our system to make sure our proprietary surplus lines tax system works,” says Roger Smith, who handles compliance for Marsh from Colorado to Hawaii. “For example, Arizona plus Utah equals X, but Arizona and Wisconsin is X plus Y minus 1.”
Start the Revolution
The Council set out in 2003 to end this bureaucratic and tax nightmare, undertaking an eight-year campaign that has lasted as long as the Revolutionary War. Efforts at the state level had gone nowhere, so The Council and other reformers took their case to Congress. There they found sympathetic supporters in House Finance Committee leaders Mike Oxley of Ohio and Richard Baker of Louisiana, both Republicans interested in simplifying government and helping business. But surplus lines reform had to pass the House four times before President Obama signed it into law in 2010.
By then the world had changed. Mortgage failures, the collapse of giant insurer American International Group and the worst recession since the 1930s led to calls for action. The Nonadmitted and Reinsurance Reform Act was tacked onto the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was pushed through by Democrats. Despite scant support from Republicans for the total package, the NRRA had strong backing from both sides of the aisle.
What the Act Does
The Nonadmitted and Reinsurance Reform Act is a simple measure. It puts the responsibility—and the rewards—for setting the rules and collecting the taxes on the home state, the one in which the client company (the insured) is based. So when Wal-Mart, for example, buys surplus lines coverage, Arkansas collects taxes on the transaction.
But Rep. Dennis Moore, D-Kan., one of the bill’s authors, had even higher hopes. “Each state should adopt nationwide uniform requirements, forms and procedures,” Moore said in a statement to Congress. In other words, 50 state rules were better than the thousands under which the industry was laboring, but one rule for all 50 states would be better still.
“Uniformity in the taxation of surplus lines will be of great benefit to insurance consumers, brokers and the states,” Moore predicted.
Brokers and The Council, of course, were thrilled by their legislative victory. “Now there’s only one tax filing per policy,” says Mike Johnston, executive vice president of CRC Insurance Services, a national wholesale brokerage with 30 offices nationwide.
The Council’s general counsel, Scott Sinder, agrees. “We are hoping that this will lead to a dramatic improvement in the surplus industry and give us space to grow,” Sinder says.
Drained, Not Dry
The surplus world could certainly use the help. “Surplus lines continue to face pressure…because of a soft market and a troubled U.S. economy,” says the most recent A. M. Best industry report, which describes it as “drained, but not dry.”
Lexington Insurance CEO Peter Eastwood does not disagree: “Last year was our fourth year in a row for negative growth.” A unit of American International Group, Lexington is the world’s largest surplus lines carrier. Eastwood and Lexington hope that the NRRA will give more companies easy access to the surplus market.
And that would help a recession-wounded nation. Brokers believe that simplifying tax laws would encourage them to create more products, which would put more businesses on the road to recovery. In California, 100,000 businesses employing 1.8 million workers use surplus lines coverage, accounting for about 15% of the national market, according to the California Surplus Lines Association. (A. M. Best put out a report late last year that said that $33 billion worth of surplus lines direct premiums were written nationwide in 2009.) Those California businesses produce $300 billion in annual revenue, pay workers more than $50 billion and pay $17 billion in state and federal taxes, according to the state surplus lines association. Surplus insurance is even more important to states such as Florida, where coastal businesses need it to survive, and Louisiana, where the recent BP oil spill has driven up rates throughout its oil-based economy.
War Between the States
Unfortunately, the same conditions that made it possible to pass Dodd-Frank and the NRRA also created a problem in enacting the law. As the current recession deepens, cutting into state tax revenues, the states are reluctant to part with any tax revenue generated from surplus lines transactions. “The upcoming fiscal year of 2012 is shaping up as one of the states’ most difficult budget years on record,” says a report released in March by the Center on Budget and Policy Priorities in Washington, D.C. “Forty-four states and the District of Columbia are projecting budget shortfalls totaling $112 billion.”
The NRRA also contains the means to snare the industry in a new web of complexity. Under the new law, premium tax revenue goes to the home state of the client company, so it no longer matters whether the tractor-trailers operated by a Chicago trucking company use Iowa roads to reach their destinations. Illinois still gets the money. And brokers say that’s probably the way it should be, since any claims against the policy come right to the company’s home office.
But the new regulations might also pit the so-called “have” states—where lots of companies that use surplus lines insurance are based—against the “have-nots,” states where surplus lines are bought but that don’t have major companies based in them.
Partly as a way to rectify this potential conflict of one state picking the pocket of the other, and partly to get rid of even more regulations, the NRRA allows individual states to enter into interstate compacts to share revenue and set one standard for governing surplus lines insurers and brokers. But in so doing, the new law could be creating the same quandary the Founding Fathers faced when they came to Philadelphia: Do we hang together or hang separately?
The National Association of Insurance Commissioners (NAIC) took the lead in trying to mold a multi-state compact called NIMA (Nonadmitted Insurance Multi-state Agreement), an admittedly “bare bones” approach focusing on tax sharing. But it doesn’t deal with the complex rules that govern the industry within each state. That wasn’t good enough for the National Conference of Insurance Legislators (NCOIL), which felt that any interstate compact should provide more efficiency and more uniformity as well as state oversight of the surplus lines industry. The result: NCOIL re-stitched the crazy quilt of initials with their own plan, which they called Slimpact (Surplus Lines Insurance Multi-state Compliance Compact).
Now, as the deadline arrives, the states have broken into four camps: NIMA, Slimpact, slow-coach states that haven’t yet changed their premium tax laws to conform to the NRRA and, finally, the states that want 100% of those premium taxes. Even worse, the landscape changes day by day as states join either NIMA or Slimpact, remain aloof, or make no decision at all.
A Good Idea Hijacked
Jerry Sullivan is chairman of the Sullivan Group, in Los Angeles, an outfit of wholesalers with an annual premium volume of $1.5 billion, all of which make use of the surplus lines marketplace. A former regulator and a proponent of state regulation, Sullivan has been around the brokerage industry for 35 years. He’s disgusted with the way the state regulators are acting.
“Congress made its intent clear: It wanted a process that is both simple and uniform,” Sullivan says. “But at this point it appears that what will be in place on July 21 will be neither simple nor uniform. Some states will be operating under NIMA, some under Slimpact, and some will have done nothing.”
So what should a broker do? “Come July 21, we will comply with the requirements of NRRA, make filings and pay taxes with the home state of the risk,” Sullivan says. He adds ominously: “Should any state attempt to force brokers to comply with state requirements that might be in contrast to NRRA, the result will likely have to be settled in federal court.”
The Council’s Joel Wood, senior vice president of government affairs, who shepherded the NRRA through Congress, says The Council stands ready to defend its position. “If states try to claw premiums they are not due,” Wood says, “we will take action.”
In an NAIC State of Mind
Louisiana Insurance Commissioner Jim Donelon would rather avoid such a confrontation. “We are looking for a solution short of court,” he says. “I understand why brokers favor the home-state solution, but we public officials have a duty to protect our home states.”
Donelon has fielded calls from his fellow commissioners, romanced Florida and Texas to join the NIMA compact (enacted by 15 states but signed by just three by press time), interviewed potential clearinghouses and, all the while, kept an eye on the calendar as the July 21 deadline looms.
The soft-spoken Donelon is playing the John Adams character in “1776.” Though Adams was a fidgety New Englander whom nobody liked and Donelon is a likeable Southerner, their strategy for corralling states into a national union is equally hard-nosed. Does Donelon think the opposing Slimpact model has merit? Well, yes, but he believes it’s a non-starter with many states that don’t want to surrender their authority to the group. And politics is the art of the possible.
Florida, the nation’s third most populous state and one whose residents and businesses buy a lot of surplus insurance, has come on board. “We continue to work through NAIC to support NIMA,” says Jack McDermott, director of communications for Florida’s Office of Insurance Regulation. “And we are in the process of reaching out to other states.”
A bonus for Florida is that its “stamping office,” which now handles the receipt and distribution of surplus lines taxes for six states, is also one of the two candidates to run the NIMA clearinghouse. The other is the NAIC’s own OPTins program. Donelon says either one could be in business by July 21.
Others, including The Council, say that’s overly optimistic, believing instead that it will be late September before the NIMA clearinghouse will be up and running.
Louisiana, with its oil industry, is a huge consumer of surplus insurance, which is why Donelon is laboring so hard to put together a compact that shares the wealth. What about Texas, the second-largest state and the home to Exxon Mobil and other energy companies? The Lone Star State will get the tax revenue and not have to share it. So why join NIMA?
“We are hoping Texas will be a good neighbor,” Donelon says.
But other “have” states don’t look like they’re about to join with anyone. The state insurance departments of New York and California, which often have a lot to say about insurance, didn’t respond to calls for comment.
Others are more skeptical that the NAIC can get anything done (critics like to joke that the association’s initials stand for “No Action Is Contemplated”). They still remember how the NAIC flubbed the issue of broker licensing back in 1999. “Twelve years later, licensure problems are still a beast,” Wood says.
What keeps Donelon going? He thinks he’s gaining ground. He hopes to have 20 states take part in NIMA. His approach recalls how the founders persuaded colleagues to support the Declaration of Independence: Get enough momentum, and everyone will eventually have to join. Donelon has a few carrots and sticks to encourage cooperation. Only states that sign onto NIMA will be able to use its clearinghouse, and no non-participating state will be entitled to any portion of the tax that NIMA states collect.
“It will be one-stop shopping and on a quarterly basis,” he promises. “If we get 20 states in NIMA, it will eliminate 19 reports.”
Knee Socks and Powdered Wigs
Donelon is right: One single standard beats 50. But brokers watch all this politicking with equal parts elation and trepidation. They are elated because beginning July 21 they have an answer to at least some of their long-term issues. You pay the home state the tax.
But even that’s not simple. What about Kentucky, where you pay separate jurisdictions? Kentucky is part of Slimpact, which now includes nine states but probably won’t have its clearinghouse set up until 2012 to collect and distribute premium taxes. In the meantime, where do brokers send their taxes?
Not surprisingly, NCOIL, which could not be reached for comment, has sent an open letter to Congress urging that the effective date for the NRRA be extended another year, to July 21, 2012, to which The Council’s Wood responds: “Absolutely not going to happen!”
Brokers clearly want this melodrama to end. They are tired of knee socks, powdered wigs and taxation without representation. They are waiting for the cast to take center stage and sign the document that King George can read without his spectacles.
Just as in 1776, that may not happen without a fight.