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NAVIGATING THE INSURANCE LANDSCAPE: DIRECT PROCUREMENT VS. SURPLUS LINES INSURANCE

By: Rafael Cestero Lopategui, Esq. | September 2024

Rafael Cestero is an Insurance Attorney and Capital Member at Cestero-Lopategui & Associates,

former Commissioner of Insurance for the Goverment of Puerto Rico, and a Board Member at the Puerto Rico International Insurers Association (PRIIA).



In the vast and intricate world of insurance, two terms often surface: surplus lines insurance and direct procurement. Both concepts represent alternative routes to obtaining coverage, particularly for risks that traditional insurers may shy away from. Understanding the differences, origins, legal aspects, and current market dynamics of these approaches is crucial for both insurance professionals and policyholders alike.


ORIGINS AND EVOLUTION


Surplus lines insurance traces its roots back to the 19th century, a time when traditional insurers were reluctant to cover certain risks deemed too high or unconventional. Enterprising individuals saw an opportunity to fill this gap by establishing non-admitted insurers, which operated outside the regulatory purview of the states where risks were located. These non-admitted insurers, often referred to as surplus lines insurers, provided coverage for risks that fell outside the scope of admitted insurers’ appetites.


Direct procurement, on the other hand, emerged originally by jurisprudence provided by the US Supreme Court back in the year 1897, with the case Allgeyer v. Louisiana, in which the court invalidated a Louisiana statute because it violated an individual’s constitutional right of “liberty of contract” granted by the Due Process Clause of the 14th Amendment. The validity, applicability and requirements of the direct procurement approach for covering particular risks, was subsequently confirmed and refined in the decades thereafter through a series of cases resolved by the US Supreme Court, and then ratified by Congress in the McCarran Ferguson Act of 1945. More recently, with the passage of the Nonadmitted and Reinsurance Reform Act (NRRA) in 2010.


This legislation aimed to streamline the process of purchasing surplus lines insurance by allowing insureds to bypass licensed surplus lines brokers and directly procure coverage from non-admitted insurers. The NRRA sought to enhance efficiency, promote competition, and provide insureds with more control over their insurance programs.


LEGAL FRAMEWORK


The legal landscape surrounding surplus lines insurance and direct procurement is multifaceted, governed by a combination of federal and state laws. Surplus lines insurance is primarily regulated at the state level, with each state enacting its own laws and regulations governing surplus lines transactions. These regulations typically require that surplus lines coverage be placed through licensed surplus lines brokers and that non-admitted insurers meet certain eligibility and financial stability requirements.


SURPLUS LINES INSURANCE AND DIRECT PROCUREMENT ARE ESSENTIAL IN TODAY’S INSURANCE MARKET, CATERING TO SPECIALIZED RISKS AND PROVIDING TAILORED SOLUTIONS.

Direct procurement, as facilitated by the NRRA, operates within a framework of federal and state laws. The NRRA grants insureds the right to directly procure surplus lines insurance from non-admitted insurers without the involvement of a licensed surplus lines broker. However, states retain authority over surplus lines transactions within their borders, and insureds must ensure compliance with state laws and regulations when utilizing direct procurement, for example the responsibility of the insured to pay state taxes for buying insurance outside of state borders.


PROS AND CONS


Surplus lines insurance and direct procurement each offer distinct advantages and drawbacks for insureds and insurers alike.


SURPLUS LINES INSURANCE:


Pros:


1. Flexibility: Surplus lines insurance provides coverage for unique or high-risk situations that traditional insurers may avoid.


2. Market Access: It offers access to coverage when admitted insurers are unwilling or unable to provide it.


3. Innovation: Surplus lines insurers often pioneer new insurance products and coverages in response to emerging risks and market demands.


Cons:


1. Lack of Regulation: Non-admitted insurers may not be subject to the same regulatory oversight as admitted insurers, potentially exposing policyholders to greater risk.


2. Limited Consumer Protection: In the event of insurer insolvency, policyholders may have fewer protections and avenues for recourse compared to coverage provided by admitted insurers.


DIRECT PROCUREMENT:


Pros:


1. Streamlined Process: Direct procurement eliminates the need for a surplus lines broker, reducing administrative burdens and potentially lowering costs.


2. Increased Control: Insureds have more direct involvement in selecting coverage, negotiating terms, and managing their insurance programs.


3. Efficiency: Direct procurement can expedite the insurance placement process, allowing insureds to quickly obtain coverage for their specific needs.


Cons:


1. Limited Expertise: Insureds may lack the specialized knowledge and guidance provided by surplus lines brokers, potentially leading to gaps in coverage or inadequate risk management strategies.


2. Compliance Challenges: Direct procurement requires insureds to navigate a complex regulatory landscape, ensuring compliance with state laws and regulations governing surplus lines transactions.


CURRENT MARKET DYNAMICS


In today’s insurance market, both surplus lines insurance and direct procurement play significant roles, catering to the needs of insureds across various industries and risk profiles. Surplus lines insurance remains a critical avenue for securing coverage for hard-to-place risks, specialized industries, and emerging exposures such as cyber liability and climate-related risks. Direct procurement is gaining traction, particularly among large commercial insureds seeking greater control over their insurance programs and costs. Insureds are increasingly leveraging direct procurement to streamline the insurance placement process, negotiate bespoke coverage terms, and access non-traditional markets and capacity.


LEGAL PRECEDENTS AND JURISPRUDENCE


Over the years, various legal cases have shaped the landscape of surplus lines insurance and direct procurement, addressing issues such as state regulatory authority, insured rights, and insurer obligations. Courts have generally upheld the rights of insureds to directly procure surplus lines insurance in accordance with the NRRA, affirming states’ authority to regulate surplus lines transactions within their borders. Despite its legal validation by the federal government since 1897, the right of an individual to directly pursue insurance remains still not-well understood, even for some state insurance regulators.


CONCLUSION


In today’s global business markets, in which technology provides both the insured and the carriers innovative solutions for better risk management, evermore surplus lines insurance and direct procurement represent alternative pathways for obtaining insurance coverage outside the traditional admitted market. While each approach offers its own set of advantages and challenges, both play integral roles in meeting the evolving needs of insureds in today’s dynamic insurance landscape.


By understanding the differences, navigating the legal framework, and leveraging the expertise of industry professionals, insureds can effectively manage their risks and secure tailored insurance solutions that meet their unique needs and objectives.


For more information about this article contact Rafael Cestero Lopategui, Esq. at

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