Introduction
This is an updated article on the subject of direct procurement insurance transactions. The original article appeared in Volume 10, Edition 2, Summer 1999 of the FORC Quarterly Journal of Insurance Regulation. Many state insurance-related laws have been added since 1999 and others have been amended. The specter of the new Nonadmitted and Reinsurance Reform Act (“NRRA”)1 due to become part of federal law on July 21, 2011, weighs upon many of the state insurance laws and state premium tax laws discussed in this article.
Statutes have changed the way insurance business is conducted inside (and outside) the United States. Many states have enacted laws permitting the formation and use of captive insurance companies, and several of those state laws permit organization and licensing of industrial insured captives and industrial insured group captives as permissible forms of alternative risk mechanisms.
The NRRA allows the surplus lines broker to place insurance on behalf of large, sophisticated commercial purchasers, as defined in the law, without having to satisfy a state’s diligent search requirement. These purchasers, known as “exempt commercial purchasers” must employ a “qualified risk manager” who has the education and training in insurance/risk management to properly represent the insured in this type of transaction. The insured must have had business in the previous year in excess of $100,000 in property and casualty insurance premiums on a nationwide basis. In addition, the insured must meet at least one additional criterion relating to:
- net worth ($20,000,000),
- annual revenue ($50,000,000),
- employees (500 full time employees or be an affiliate of a group that employees at least 1,000 employees),
- a municipality must have a population in excess of 50,000,
- a non-profit organization or public entity must have an annual budget of at least $30 million.
The concept of “exempt commercial purchasers” in the NRRA has a purpose and language similar to several state laws introducing and implementing the concept of “industrial insureds”. The congressional intent is that the NRRA pre-empt any state statute with provisions that are inconsistent with providing a unified structure to the regulation of surplus line insurance, reinsurance and direct procurement transactions.
Doing An Insurance Business Defined
New York Insurance Law §1101 defines the acts that constitute “doing an insurance business” in New York State. Section 1101 does not prohibit an insurer from soliciting, making or proposing to make, issuing or delivering a policy to a person outside of New York, even though the person is a New York resident, as long as those activities take place outside of the state. Section 1102 prohibits unauthorized insurers from doing an insurance business in New York State.2
A producer that acts for or aids an unauthorized insurer in soliciting, negotiating or effectuating any insurance policy by falsely claiming that the solicitation or other actions took place outside New York violates several sections of the New York Insurance Law: 1) Section 2117, prohibiting any person from aiding and abetting an insurer not authorized to do business inside New York; 2) Section 2122, prohibiting any insurance producer or other person from calling attention to any unauthorized insurer by advertisement or other public announcement, and 3) Section 2403 prohibiting any person from engaging in unfair and deceptive acts or practices.3
Federal Constitutional Protection of Direct Procurement Insurance Transactions
Notwithstanding these prohibitions on those who “aid and abet” the transaction of unauthorized business inside the state, the right of an insured to directly place coverage with an insurer of his choice is constitutionally protected, although a state may legitimately assess a tax on the transaction and require it to be reported. State Board of Insurance v. Todd Shipyards Corp., 370 U.S. 451 (1962); Connecticut General Life Insurance Co. v. Johnson, 303 U.S. 77 (1938); St. Louis Compress Co. v. Arkansas, 260 U.S. 346 (1922); Allgeyer v. Louisiana, 165 U.S. 578 (1897). This constitutional protection has been codified by nearly three-quarters of the states and the District of Columbia, in sections of the state insurance law or sections of the state tax code.4 One state, Delaware, which does not have a statute recognizing direct procurement, however, recognizes in case law that the right to independently procure insurance in the nonadmitted market exists.5
State Tax Laws
The basis for imposing premium taxes on independently procured insurance policies varies from state to state, with many states conditioning the effectiveness of a direct procurement transaction upon reporting of the transaction and the payment of premium tax by the insured. The rate of premium tax on independently procured insurance policies is generally the same as the surplus lines tax rate.
Nearly three-quarters of the states require the payment of a direct procurement tax, calculated generally as a percentage of gross premiums, from a low of 1% of gross premiums written in Iowa, to as much as 6% of gross premiums written in Oklahoma.6 Utah (Ins. Code § 31A-3-301) exempts ocean marine insurance from the tax. Many states tax a reduced percentage for marine insurance and title insurance. In most states, written reports of direct placements are required to be filed with the Insurance Department within 30, 60 or 90 days from the placement, depending on the specific state law. The insured is generally responsible for making the filing and for remitting the tax, which is paid in addition to the premium. Even the owners of captive insurers7 are not exempt from the responsibility to file a return and pay tax on premiums paid for directly procured insurance covering risks that are located in New York.8
The direct procurement taxes tend to apply to property and casualty insurance more than life or health insurance because property and casualty insurance is more likely to be purchased out of state from an unauthorized insurer.9
Limits of the Direct Procurement Transaction
In direct procurement transactions a surplus lines broker (or retail producer) must avoid involvement and the insured typically deals directly with the market. The insured is, in most cases, required to leave the state's borders and to conduct the transaction outside the state's borders. See, e.g., People v. British & American Casualty Co., 133 Misc. 2d 352, 505 N.Y.S.2d 759 (Sup. Ct. N.Y. County 1986). The elements of the transaction, including negotiation, issuance and delivery of the policy, and payment of the premium, must occur principally outside the state of the insured and a broker (retail or wholesale) cannot be involved in the transaction.10
The direct procurement alternative is only available in limited situations and should only be used where there is evidentiary documentation that all the conditions of a direct procurement insurance transaction have been fulfilled. This includes proving that the foreign or alien insurer and its producers were not involved in soliciting or negotiating the business inside the state (although, as mentioned, there are certain states which require the transaction to be "principally negotiated" outside the state). There is some flexibility permitted by the New York Insurance Law, e.g., a proposed insured may learn about a particular insurer (such as at a trade association meeting or other gathering in the ordinary course of business) and may contact that insurer by telephone to request an application. It is nonetheless necessary for the insured, or the insured's representative, to conduct the bulk of the activity of the negotiation regarding coverage terms and pricing outside the state.
Please note, however, that a broker will not be able to place the insurance on behalf of the insured, as a retail broker is limited to dealing with the admitted market and is prohibited from placing business with an unlicensed insurer. [See, e.g., § 2117(a) of the N.Y. Ins. Law and NYID OGC Opinion No. 89-39 (8/17/1989).] A surplus line broker is permitted to deal with the nonadmitted market, but only where the insurer is eligible by virtue of approval of an application to the state insurance regulators, resulting in inclusion on a “white list” maintained by certain states or, in other states, where the surplus line broker verifies to the state insurance regulators that the insurer qualifies with the state’s financial and other requirements for surplus line insurers.
Similarly, in order to comply with the requirement that the policy be "issued and delivered outside the state in a jurisdiction in which the insurer is licensed,"11 it would be necessary for the insured, or the insured's representative, to accept delivery of the insurance policy outside New York. People v. British & American Casualty Co., 133 Misc. 2d 352, 505 N.Y.S.2d 759 (Sup. Ct. N.Y. County 1986).12
Section 1101(b) (2) (E) of the New York Insurance Law provides, in relevant part, as follows:
(2) Notwithstanding the foregoing, the following acts or transactions, if effected by mail from outside this state by an unauthorized foreign or alien insurer duly licensed to transact the business of insurance in and by the laws of its domicile, shall not constitute doing an insurance business in this state.
(E) transactions with respect to policies of insurance on risks located or resident within or without this state . . . which policies are principally negotiated, issued, and delivered without this state in a jurisdiction in which the insurer is authorized to do an insurance business; (emphasis added)
Section 2117(a) of the New York Insurance Law provides, in relevant part, as follows:
(a) No person, firm, association or corporation shall in this state act as agent for any insurer or health maintenance organization which is not licensed or authorized to do an insurance or health maintenance organization business in this state, in the doing of any insurance or health maintenance organization business in this state or in soliciting, negotiating or effectuating any insurance, health maintenance organization or annuity contract or shall in this state act as insurance broker in soliciting, negotiating or in any way effectuating any insurance, health maintenance organization or annuity contract of, or in placing risks with, any such insurer or health maintenance organization, or shall in this state in any way or manner aid any such insurer or health maintenance organization in effecting any insurance, health maintenance organization or annuity contract. (Emphasis added)
New York case law, as set forth in People v. British & American Casualty, and interpretations of the New York Insurance Department with regard to Sections 2117 and 1101, appear to indicate that the role of a broker in a direct procurement situation is limited to that which the insured, himself, is entitled to do. For example, if a New York insured calls a Lloyd's broker and discusses the insured's coverage requirements and the Lloyd's broker sends the insured information about the rates of an alien insurer and/or a binder from the alien insurer, this would likely be considered illegal solicitation by the alien insurer and, quite possibly, the Lloyd's broker, if he is deemed to be soliciting business inside New York. If, on the other hand, the insured calls the Lloyd's broker and indicates that he will be in London and wishes to meet the broker and/or the alien insurer to discuss coverages, and the Lloyd's broker sets up the meeting which, in fact, occurs in London, resulting in a binder mailed from the alien insurer or by the broker on a subsequent date to the insured in New York, this would appear to meet the requirement that the placement be principally solicited and negotiated outside New York. The Lloyd's broker is not violating section 2117 since he is doing no act inside New York. The alien insurer is violating no law since it falls within the exception as well and is not soliciting or negotiating coverage inside New York.
As another example, if the insured asks its broker in New York to travel to London as its representative to sit down with a Lloyd's broker (or with the alien insurer at its U.K. head office) and negotiate a policy, and the broker returns with a binder, once again, it would appear that this placement is principally solicited and negotiated outside New York and that the New York broker is not violating New York law, provided there were no substantive telephone discussions of or correspondence regarding coverage terms or pricing involving the insured or its New York broker and the alien insurer or the Lloyd's broker prior to the New York broker's departure for London. If there were, the broker would be subject to possible fines and loss of its license. Hammond v. Hunkele, 170 A.D.2d 484, 566 N.Y.S.2d 69 (2d Dept. 1991); People by Abrams v. American Motor Club, Inc., 133 A.D.2d 593, 520 N.Y.S.2d 383 (1st Dept. 1987). However, variations in state laws do exist.13
Although the New York Insurance Law also requires reporting and payment of appropriate taxes, it is clear that there are differences between state direct procurement statutes. Most state statutes are similar to the Colorado Insurance Law14 which allows direct procurement transactions only if all elements (including the negotiation, issuance, delivery of the policy and the payment of premium) occur wholly outside the insured's state. Negotiations by mail or telephone from within the state are not exempted and insurance agents or brokers licensed in the insured's domicile may not generally be involved as such.
Protection of Independently Procured Insurance Transactions Based in U.S. Supreme Court Case law and the McCarran-Ferguson Act; Erosion of the Protection in Some States
Allgeyer, St. Louis Cotton Compress and Connecticut General Life Insurance were decided before the enactment of the McCarran-Ferguson Act, 15 U.S.C.S. §§1011-1015, in 1945 which reserves to the states the exclusive power to regulate and tax insurance.
Citing these decisions as precedent, the U.S. Supreme Court in State Board of Insurance v. Todd Shipyards Corp., 370 U.S. 451; 82 S. Ct. 1380; 8 L. Ed. 2d 620 (1962) invalidated a Texas premium tax levied on a wholly out-of-state transaction where the only contact with Texas was the location in the state of the insured property. The insurance transaction at issue was a multi-state policy issued by unlicensed alien insurers that insured the Texas property of a New York corporation that owned property in Texas. In finding that due process, as well the McCarran-Ferguson Act, limited the state's power to tax this transaction, the Court gave great weight to the following facts:
- The policy was negotiated and issued outside of Texas;
- The premium was paid outside the state;
- All losses were adjusted and paid outside of Texas;
- The insurers were not licensed in Texas;
- They had no offices or agents in Texas;
- They did not solicit business in Texas; and
- They did not investigate risks or claims in Texas.
The last sentence of the majority opinion in Todd Shipyards states:
... Congress tailored the new regulations for the insurance business with specific reference to our prior decisions. Since these earlier decisions are part of the arch on which the new structure rests, we refrain from disturbing them lest we change the design that Congress fashioned.
Todd Shipyards, 370 U.S. 451, 458.
A number of state supreme courts have, in recent years, recognized the Todd Shipyards analysis as the prevailing approach to determine whether a state has the power to regulate and tax an insurance transaction. In these cases Todd Shipyards was distinguished on the basis that activities relating to the insurance process were conducted in the state.
In Ministers Life & Casualty Union v. Hasse, 30 Wis. 2d 339, 141 N.W. 2d 287 (Sup. Ct. Wis. 1966), the Supreme Court of Wisconsin held that the state could tax a mail order life and health insurer that was not licensed in the state if there was a systematic and continuous solicitation of Wisconsin citizens by mail and the use of Wisconsin investigatory services and physicians for claims settling and underwriting purposes.
Judicial decisions prior to United States v. South-Eastern Underwriters Ass'n, 322 U.S. 533, 64 S. Ct. 1162, 88 L. Ed. 1440 (1944), tended to view insurance contracts as something other than articles of commerce. Hence those contracts were not considered interstate transactions within the commerce clause. Accordingly the State's power to deal with the subject involved only the due process provision. When South-Eastern Underwriters Ass’n held that insurance policies were articles of commerce, Congress promptly enacted the McCarran-Ferguson Act to ensure the State's continuing authority to regulate and tax those transactions.15
Ministers claimed that by virtue of the McCarran-Ferguson Act as construed in Todd Shipyards, the states were granted only a limited power to regulate and tax insurance companies, or that at least the constitutional standard of due process as applied to a state's jurisdiction to regulate insurance, as established in the pre-Southeastern Underwriters Association decisions of the Supreme Court, was “frozen,” thus substituting for a flexible and developing constitutional standard of due process a more fixed and rigid statutory standard.
Thus, Ministers claimed, because Wis. Stats. § 201.42, in effect, prohibited the doing of a mail-order insurance business with Wisconsin residents, that it exceeded this limited grant of power, not because it violated the due-process clause but because it violated the commerce and supremacy clauses of the U.S. Constitution.
However, the court reasoned that the McCarran-Ferguson Act did not specifically grant the states any power, but left them with the power they already possessed, unaffected by reason of the commerce clause, except to the extent provided in the Act.16
Similarly, in Howell v. Rosecliff Realty Co., 52 N.J. 313, 245 A. 2d 318 (Sup. Ct. N.J. 1968) in which premium was paid to an unlicensed insurer outside the state of New Jersey with regard to a public liability policy, the court recognized that the nature of a public liability policy required the insurer to investigate, settle and pay claims within New Jersey. As such, the policy may be taxed by the State of New Jersey.
In Haisten, v. Grass Valley Med. Reimb. Fund, 784 F. 2nd 1392 (9th Cir. 1986), the United States Court of Appeals for the Ninth Circuit explains that the Todd Shipyard case applies only to cases where the insurer has no contact with the forum state. This explanation misinterprets the Todd Shipyard case and misconstrues the distinctions between the facts of the two cases. The Haisten case involved a medical malpractice insurance fund (“Fund”) based in the Cayman Islands that covered California insureds. The manner in which the Fund was established, appearing to be doing business only in the Cayman Islands, amounted to a conspiracy to evade California law. The Fund was incorporated in the Cayman Islands, where it maintained its sole office. Its directors meetings were held there. All transactions and communications (e.g. the issuance and delivery of the policy, the payment of premiums and claims) were conducted in the Cayman Islands. The insureds worked through an attorney-in-fact or agent in the Cayman Islands. The Fund contended that it does not solicit business or advertise in California. By this elaborate structure, deliberately crafted to evade California state law, the Fund deliberately intended to avoid California insurance regulations, while at the same time, providing physicians at one hospital with malpractice insurance. The Fund was analogous to the offshore captive insurer of the physicians. Further, the contract of insurance stipulated that only California malpractice liability would trigger the reimbursement mechanism.
Because the sum and substance of the Fund's transactions to insure California doctors against loss from medical malpractice exclusively in California indicate that the Fund purposely directed its activities toward California residents, we conclude that the Fund purposely availed itself of the benefit and privilege of conducting activities in California. In light of its substantive connection with California, the Fund should have reasonably anticipated being haled into court there.
Haisten, 784 F. 2d 1392, 1400.
In any event, California does not couch its direct procurement provision as an exemption from, or exception to, the doing-business laws. Instead, the California statute clearly states that "[a]ny person may negotiate and effect insurance to protect himself, herself, or itself against loss, damage or liability with any nonadmitted insurer." Calif.. Ins. Code § 1760. As is the case with most other states, California imposes a tax and reporting requirement on insurance procured in reliance on this provision. Cal. Rev. & Tax Code §13210
Thus, the Ninth Circuit U.S. Court of Appeals cannot restrict the applicability of the Todd Shipyards ruling to cases where the insurer has no contact with the forum state. Any attempt to do so misinterprets the Todd Shipyards ruling as well as the preceding U.S. Supreme Court rulings in Allgeyer, St. Louis Cotton Compress Co., and Connecticut Gen. Life Ins. Co. and their [incorporation] in the McCarran-Ferguson Act.
In Associated Electric & Gas Insurance Services, Ltd. v. R. Gary Clark, 676 A. 2d 1357 (Sup. Ct. R.I. 1996), the Rhode Island Supreme Court affirmed a District Court decision holding that the insurer, which was neither a licensed insurer nor an authorized surplus lines insurer in the state, was liable for premium tax on direct procurement coverage provided to several Rhode Island insureds. The taxpayer's defense was based principally on the Todd Shipyards case. The parties stipulated that no representatives from the company came into Rhode Island and no agent fees were paid by the company to Rhode Island residents. The Rhode Island Court found that the tax was due.
- First, the court referred to a series of cases, each of which had distinguished the Todd Shipyards line of cases, and each of which had its appeal to the U.S. Supreme Court dismissed for lack of a federal question. The Rhode Island Supreme Court found that such a dismissal was a determination on the merits.
- The Rhode Island Supreme Court also found that the Todd Shipyards doctrine was superseded by Quill Corporation v. North Dakota, 500 N.W. 2d 196 (Sup. Ct. N.D. 1993) in which the U.S. Supreme Court held that Quill Corporation, a mail order business incorporated in Delaware with no sales force and insignificant tangible property in North Dakota, was not required to collect a use tax levied by North Dakota from its North Dakota customers. The court ruled that the imposition of a duty to collect taxes did not violate the due process clause of the Fourteenth Amendment as Quill annually mailed 24 tons of catalogs and flyers into North Dakota and made annual sales approaching $1,000,000 to North Dakota customers. Notwithstanding its holding that the due process clause did not bar the imposition of the tax, the Supreme Court held that the “physical presence” test of National Bellas Hess, Inc. vs. Department of Revenue of the State of Illinois, 386 U.S. 753; 87 S. Ct. 1389; 18 L. Ed. 2d 505 (1967) should be followed on the basis of the Commerce Clause. Associated Electric & Gas Insurance Services, Ltd., 676 A. 2d 1357, 1360-1361.
In any case, the right to independently procure insurance is codified in Rhode Island Law as R.I. Ins. Code § 27-3-38.1. If the theory of the Rhode Island Supreme Court decision in the Quill decision were to be widely adopted, if not expanded, the ability of unlicensed and unauthorized insurers to provide coverage for risks located within a state, with which they have no other contact without being subject to tax, could be largely diminished. Similarly, if the trend of decisions regarding state tax jurisdiction were followed with reference to taxes on insurance premiums without regard to Todd Shipyards or to the principles of Connecticut General Life and the other cases discussed above, the ability of a state to tax insurance transactions would be greatly expanded.
Industrial Insured Exemption
Another form of direct procurement transaction is the industrial insured exemption. Broadly drafted industrial insured exemption statutes exist in less than one-third of the states (not including such key industrial states as Massachusetts, Michigan, Texas and Washington, among others).17 These exemptions are generally designed to permit sophisticated commercial insureds to procure insurance from a non-admitted insurer without the need to involve a surplus lines broker in seeking declinations from admitted carriers prior to placing the business. The exemption is predicted on the alien (or other non-admitted) insurer refraining from doing business where it is not authorized to do so. Alien insurers seeking to write business in states which have enacted the industrial insured exemption must otherwise abide by the rules restricting their activities. In essence, the limitations imposed on non-admitted insurers by the direct procurement requirements also apply to industrial insured placements. Industrial insured placements typically require that the insured:
- Procure insurance by utilizing the services of either a full-time employee18 acting as an insurance manager or buyer or a regularly and continuously retained, qualified insurance consultant or risk manager;
- Have an aggregate annual premium on all of its insurance totaling at least $25,000; and
- Have at least 25 full-time employees.19
The rules prohibiting negotiation and delivery of a policy inside the state are less strict for industrial insured placements than they are for direct procurement placements.
Approximately 13 states allow the formation of industrial insured captives or industrial insured group captives or otherwise apply an industrial insured exemption to captives only.20
Finally, it is worthwhile noting that there is no prohibition on an eligible surplus lines insurer transacting business on a direct procurement (or industrial insured) basis as well, provided the strict rules as respects direct procurement business and/or industrial insured business are observed.
Enforceability of the Rules of Direct Procurement Outside the Insured’s Home State
As a practical matter, there would appear to be more of a risk for the New York broker in involving itself in direct procurement transactions (which generally presuppose the absence of a broker) than there is for the alien insurer which is not transacting U.S. surplus lines business. A New York broker’s license could be jeopardized if it were found to be violating New York law. With regard to an alien insurer which is not transacting U.S. surplus lines business, it would be difficult for insurance regulators to enforce the statute as against such a company, even if it is found to be violating New York law.21
Conclusion: Questions Arising From Nonadmitted and Reinsurance Reform Act
As the NRRA takes center stage and marches toward its July 21, 2011 deadline for implementation by the fifty states, numerous questions surround the Act and perplex state legislators and insurance regulators. Among those questions are the following:
- Will the concept of an “exempt commercial purchaser” exception to the due diligence rule for placing business with non-admitted insurers pre-empt the “industrial insured exemptions” in states that have enacted them?
- Will a state that did not adopt the “industrial insured exemption” now be obliged to abide by the “exempt commercial purchaser” exception to the due diligence rules for multistate surplus lines risks as set forth in the NRRA where that state is the “home state”?
- Will the approximately 14 states that have not (thus far) assessed a tax on independently procured insurance now be obliged to do so by reason of the NRRA’s pre-emption of regulation of non-admitted insurance? Will all those states now codify the right of direct procurement?
Failure by the states to conform their insurance laws and regulations, in a uniform manner, to the mandates of the NRRA will likely result in legal challenges by private parties, state insurance regulators and insurance trade organizations. The most vexing problems may arise as various states enact different iterations of statutes, certain of which adopt some, or none, of the NRRA’s mandatory uniformity requirements in the areas of 1) taxation and allocation of taxes on premiums paid for policies covering multistate risks placed through surplus line producers or through direct procurement transactions, 2) declinations in advance of placements of risk by sophisticated commercial insureds based in states that have enacted an industrial insured exemption, and 3) broker licensing requirements. In that case, some of the state laws will wind up being pre-empted by the NRRA and made totally irrelevant or subject to legal challenge. In many states, brokers and/or insureds (the latter in direct procurement transactions) will have no clarity as to how to report and/or pay the taxes and may inadvertently end up in violation of state laws.