As CPCU® students, we all studied foundations of the surplus lines market, also known as the excess and surplus lines, or E&S, market.
We learned that this segment of the industry accepts risks that insurers in the standard market have declined. We learned that surplus lines insurers can write insurance on a nonadmitted basis, subject to certain rules. And we learned that regulation of surplus lines transactions focuses on intermediaries, commonly called wholesale brokers, who are licensed to place business with surplus lines insurers on behalf of the retail agents and brokers who directly serve their insureds.
In this interview with Brady Kelley, of the National Association of Professional Surplus Lines Offices, Ltd. (NAPSLO), we will learn things about surplus lines that were not covered in our CPCU studies. Kelley is particularly knowledgeable on this topic, as he has served since September 2011 as executive director of NAPSLO. In this role, he is responsible for overall management of staff activities, services to members, and business operations. Kelley also previously worked for the National Association of Insurance Commissioners (NAIC), initially as director of financial services and later as chief financial and business strategy officer.
For Insights, Kelley explains how, over the past twenty years, the surplus lines market has experienced phenomenal growth, achieved an enviable solvency record, and become a significant segment of the overall property-casualty (P/C) insurance industry. In short, he shares what every insurance professional should know about the rising and dynamic surplus lines market.
Arthur Flitner (AF): Brady, how big is the surplus lines market, and how fast is it growing?
Brady Kelley (BK): Surplus lines direct premiums written in 2014 reached $40.2 billion, the highest point in the market’s history. This is a little over 7 percent of the total P/C industry, personal and commercial combined. But most of the business written in the surplus lines market is commercial lines. Surplus lines premiums equal almost 14 percent of the total of P/C commercial lines. In 1994, surplus lines was only 6 percent of total commercial lines—so surplus lines has more than doubled as a percentage of commercial lines over the past twenty years.
AF: Did surplus lines growth continue through 2015?
BK: The Surplus Lines Stamping Office of Texas issued a report in July showing that the fourteen states with stamping offices saw continued growth in surplus lines during the first half of 2015, up 9.5 percent from the same period in 2014.
[Editor’s note: At the time of print, the complete 2015 premium statistics were not yet available.]
AF: How does the underwriting cycle affect the surplus lines market?
BK: When the admitted market hardens, or its appetite for risk changes, such that placing insurance in that market becomes more difficult, some business naturally flows from the admitted market to the surplus lines market. The opposite is true when competition increases and the admitted market softens, as insurers seek to maintain market share by reducing rates and broadening coverage. These ebbs and flows in the underwriting cycle cause some business to fluctuate between the standard and surplus lines markets.
AF: Do some classes of business remain in surplus lines regardless of the underwriting cycle?
BK: Yes. For example, few insurers are willing to write broad cyber risk policies without freedom of rate and form, which is a key characteristic of the surplus lines market. Admitted insurers can avoid rate and form filing regulations to some degree in states that have exempt commercial policyholder laws. Retailers and insureds also look to the surplus lines industry for access to markets and coverage they cannot find anywhere else.
Surplus lines insurers offer expertise, experience and knowledge in placing specialty insurance, and they provide valuable knowledge about markets that retailers don’t work with every day—including those covering emerging and evolving risks, like cyber security.
AF: What do you mean by “freedom of rate and form,” and why are surplus lines insurers given this freedom?
BK: In a surplus lines transaction, the insurer can use whatever rates and policy provisions the insurer and the applicant agree upon. This is allowed because the insurer is not subject to the insured’s home state rate and form filing regulations. Without this freedom of rate and form, the surplus lines market could not accommodate the complexities of the risk or the unique policyholder needs that the admitted market is unable or unwilling to underwrite. For example, by increasing the policy deductible, adding a warranty that the insured will use certain loss control measures, and charging an adequate rate, surplus lines underwriters are able to provide customized insurance solutions for the most complex risks.
AF: In addition to having freedom of rate and form, are there other qualities of the surplus lines market that enable it to serve its purpose as an alternative market?
BK: Yes, definitely. The wholesale distribution system provides retail producers and their customers with access to coverages they cannot obtain in the standard market. But the real value of wholesalers is the customized solutions they help craft for the insured and the innovative insurance solutions they develop for emerging risks and uncertainties.
AF: What opportunities does the wholesale distribution system hold for retail agents and brokers?
BK: Mainly the opportunity to find quick, workable solutions for their customers when problem exposures arise. Retail producers who don’t already know wholesale brokers to call when they are needed should cultivate those relationships in advance. When the need actually arises—for example, your customer calls you on a Friday afternoon for an insurance solution that your regular carriers can’t provide—you may keep or lose that customer depending on whether you can find a solution and bind the coverage that day. The foundation of the wholesale distribution system is the experts who can provide the right solution for a complex risk when everyone else says no.
AF: How do surplus lines insurers acquire the underwriting expertise needed to write unique and difficult risks?
BK: Surplus lines insurers can, and often do, hire or train underwriters to handle the classes of business they wish to write. In many cases, insurers give underwriting authority for certain classes of business to managing general agents, program managers, or wholesale brokers who already possess the needed underwriting skills and experience. This approach enables an insurer to enter into new classes of business quickly without having to acquire additional employees. Here again, we are talking about the immense value added to surplus lines transactions by the wholesale distribution system.
AF: In a 2015 Best’s Special Report, A.M. Best notes that domestic professional surplus lines insurers posted lower combined ratios than the total P/C industry in nine out of the last ten years. It seems paradoxical that the market for hard-to-place risks would have better underwriting results than the standard market. Why is this so?
BK: It’s largely a result of the surplus lines market’s underwriting and pricing discipline. Because admitted insurers must generally adhere to their filed class rates and standardized forms, they are often unable to modify provisions and rates optimally for business that they want or need to write in order to reach their goals and the goals of their insureds.
AF: Traditionally, there has been a perception among many in the industry that surplus lines insurers are more likely than admitted insurers to become insolvent. Is there any truth to this?
BK: No. That perception is not based on data. In 1994, the Derek Hughes/NAPSLO Educational Foundation commissioned a solvency study by the A.M. Best Company. The data showed that the surplus lines market’s financial stability and solvency were at least on par with the overall P/C industry.
This study, published every year since 1994, was expanded over time to cover not just financial stability and solvency but also the state of the surplus lines market, regulation and legislation developments, and current distribution trends. In fact, based on the data since 1994, the surplus lines market’s solvency record has outpaced that of the admitted market for more than a decade now.
AF: Has anything about the financial stability and solvency of surplus lines changed over the past twenty years?
BK: It has actually improved relative to the overall P/C industry. Over the past eleven years, not a single surplus lines insurer became financially impaired, while 207 admitted insurers did. But, to be fair, there are many more admitted companies than surplus lines companies, so A.M. Best uses financial impairment frequencies, or FIFs,to compare these two groups. The FIF for one year is the number of companies that become impaired that year, divided by the number of companies operating in the insurance market that year. When you compare the FIFs of admitted insurers and surplus lines insurers from 1977 through 2014, the FIF for surplus lines insurers is 0.79—lower than the 0.88 for admitted insurers.
An additional indicator is that 99 percent of domestic professional surplus lines insurers have A.M. Best ratings of A- or higher, while 78 percent of the total P/C industry are rated A- or higher . And there are no domestic professional surplus lines insurers with ratings less than B++, compared with 99 such ratings for the total P/C industry.
AF: What would you say is the main reason that surplus lines insurers have lower FIFs than admitted insurers?
BK: I will defer to the experts and quote from the 2015 Best’s Special Report: “The expectation of surplus lines carriers and their long-term success remains grounded in key factors: freedom of rate and form, ability to maintain price integrity, a focus on bottom line stability, balanced risk/reward tolerance levels, strong investment returns, and enterprise risk management capability exceeding risk profiles” (p. 13).
AF: You have been NAPSLO’s executive director since 2011. Would you briefly describe NAPSLO and the roles it performs?
BK: Incorporated in 1975, NAPSLO is a professional trade association representing the surplus lines industry and the wholesale insurance distribution system. It provides networking opportunities, education and career development programs, and regulatory and legislative advocacy on behalf of its members—which include approximately 400 brokerage firms, 100 insurers, and 200 associate firms.
We serve as the voice of the surplus lines industry, advocating for the industry’s vital role in the insurance marketplace and in providing innovative solutions for complex insurance risks. With the leadership of our board of directors, and the support of the NAPSLO team of 11 professionals and nearly 220 volunteers serving NAPSLO’s 10 working committees, we are focused on providing advocacy, services, and programs for members.
AF: What would you say is NAPSLO’s most important achievement in its regulatory and legislative advocacy role?
BK: Well, while it took a number of years, and passed the U.S. House of Representatives on four prior occasions, full passage of the Nonadmitted and Reinsurance Reform Act of 2010 (NRRA) has been NAPSLO’s greatest legislative accomplishment. Having surplus lines defined and codified in federal law, with a national framework for its more uniform regulation with the state-based regulatory system, continues to enhance the consistency and effectiveness by which the states both regulate and tax surplus lines insurers and brokers.
This national framework has provided NAPSLO with an opportunity to develop guiding principles for uniformity in a number of state surplus lines regulatory requirements, and the NRRA has facilitated important regulatory reform and efficiency in our market’s history.
AF: How has the NRRA affected the surplus lines industry?
BK: Since its passage, the NRRA has produced significant benefits for the surplus lines industry. The greatest benefit of the NRRA is the efficiency brought about by home state regulation and taxation. A goal of the NRRA was to achieve a simpler and more efficient system for regulation and taxation of surplus lines by establishing the insured’s home state as the one and only jurisdiction to regulate and tax transactions.
Before the NRRA was enacted, surplus lines brokers and insurers often dealt with inconsistent regulatory requirements, depending on the state where the risk was located or the state where the transaction occurred. A multistate risk was even more complex, because each state with any portion of the underlying risk had regulatory jurisdiction over the transaction. The NRRA’s home state approach has corrected this problem and brought uniformity to transactions.
Another key reform intended by the NRRA relates to national standards for eligibility of surplus lines insurers. Before the NRRA, states imposed inconsistent standards to determine whether a surplus lines insurer would be included as an “eligible,” or “listed,” insurer. As a result, brokers and clients were often frustrated and confused when confronted with the fact that, for multistate risks, companies would meet the eligibility and listing requirements in one state but not others. To solve this problem, in Section 524 of the NRRA, Congress set forth uniform national criteria for determining the eligibility of U.S.-based companies to write surplus lines insurance.
AF: Industry meetings and publications are dominated by discussion of emerging risks such as cyber, autonomous vehicles, drones, the sharing economy, the Internet of Things, and legalized marijuana. By and large, the admitted market is not equipped to insure new and emerging risks. Can the surplus lines market satisfy the demand for insurance on these risks?
BK: It can, and it will. By its nature, the surplus lines market is uniquely able to adapt to these emerging risks, and surplus lines professionals are truly experts at developing solutions for them. They are also innovators, which is a critical trait for thinking outside the box to solve complex insurance issues.
AF: Looking to the future, what is NAPSLO doing to attract the best and brightest into the surplus lines industry?
BK: The need to recruit new talent into the surplus lines industry is a challenge that is likely to grow if not addressed proactively. NAPSLO’s Career Development and Next Generation Committee leads the charge in reaching out to prospective students around the country about careers in surplus lines and recruiting them to NAPSLO summer internships, where they can learn about different career paths within the industry. Our member volunteers have visited nearly 40 college campuses in the past 18 months and talked to almost 3,000 students about careers in the surplus lines industry.
NAPSLO also hosts a nine-week summer internship program for college students interested in working in surplus lines. This year, sixteen NAPSLO interns each spent five weeks with a NAPSLO member surplus lines insurance company and four weeks with a NAPSLO member wholesale brokerage firm learning about all aspects of the business. This program is also beneficial for NAPSLO member hosts, because it brings an opportunity to introduce prospective employees to their firms.
NAPSLO’s Next Generation, which is a dynamic group of insurance professionals under the age of forty who are currently employed by NAPSLO member firms, plays a key role in attracting new college graduates and young professionals to the surplus lines insurance industry. It also provides an avenue for young insurance professionals to become more involved in the surplus lines community, which is critically important in developing the next generation of leaders for the industry.
Further, the Derek Hughes/NAPSLO Educational Foundation’s scholarship program selected fourteen students to receive $5,000 scholarships for the 2015–16 school year. And the foundation participates in two symposiums annually: the Excess & Surplus Lines Symposium, hosted by Troy University, and the Extreme Risk Takers Symposium, presented by Illinois State University, where students can learn more about careers in surplus lines and employers can connect with those students. It also sponsors the Gamma Iota Sigma International Conference each year, reaching nearly 500 of the best and brightest risk and insurance management students.
Taken together, these initiatives help grow and strengthen a truly important segment of the insurance industry—surplus lines.
Many thanks to the Excess/Surplus/Specialty Lines Interest Group for its contributions to this article.
This article was featured in the Spring 2016 issue of Insights, the professional journal of the CPCU Society.