by John Prescott and Deborah Lambert, Johnson Lambert & Co.
Fronting is a term that describes a specialized form of reinsurance frequently employed in the captive insurance marketplace.
In its most common form, a commercial insurance company ("fronting company"), licensed in the state where a risk to be insured is located, issues its policy to the insured. That risk is then fully transferred from the fronting company to a captive insurance company through a reinsurance agreement, known as a fronting agreement. Thus, the insured obtains a policy issued on the paper of the commercial insurance company. However, economically, the risk of that coverage resides with the captive insurance company.
There are several business reasons for this type of fronting arrangement--
- The need for a licensed carrier to issue the insurance policy for particular risk.
- The need for a carrier with a minimum AM Best rating and/or the ability to meet other financial strength measures to issue the insurance policy for a particular risk.
- The potential ability to achieve tax deductibility of premiums by the insured through successful risk-shifting.
An additional use of fronting exists where the captive, usually a single parent captive, serves as the fronting company and issues a policy directly to the insured parent company. Then that risk is fully reinsured to one or more domestic or foreign reinsurers. Consequently, the fronting captive would not retain any of the risks and the parent company has gained access to the reinsurance market. The reinsurers would not have been legally able to write the risk directly.
When serving as the risk bearing entity, the captive will face several challenges in the implementation of a workable fronting arrangement: the magnitude of fronting fees, potentially onerous collateral requirements and the risk of financial failure of the fronting company.
The fronting company will require reimbursement by the captive insurance company of all costs related to the fronted policies it issues plus payment of a fee. Costs passed through typically include commissions, premium taxes, costs of guarantee fund participation and sometimes claims administration and underwriting costs. Costs and fees may total as high as 25 to 30% of gross premiums paid by the insured. A fronting fee of 30%, translates to only $0.70 of each $1.00 of premiums being available to the captive to cover the costs of losses and loss adjustment expenses and administrative expenses of the captive. The magnitude of these fronting fees can make it difficult for the captive to net adequate premium revenue commensurate with the underlying risk while remaining cost-effective for the insured.
The fronting company will almost always require collateral to secure the captive's obligations to the fronting company under the fronting agreement. Collateral takes one of three forms: captive funds withheld by the fronting company, a trust agreement funded by investment securities of the captive or a letter of credit issued on behalf of the captive by a bank, usually secured by investment securities of the captive. With limited financial resources and resulting limited financial flexibility, the captive may find meeting collateral requirements to be difficult. Additionally, the front will have the right to make subsequent collateral "calls" which again may prove onerous to the captive. A captive parent company's provision or guaranty of the captive's collateral requirement may result in adverse tax consequences with respect to the parent's ability to deduct premiums related to the insured risk.
Should the fronting company fail financially, the captive may find that the collateral it provided to the fronting company is tied up for a long period of time. Further, the captive may find it very difficult to retrieve any excess collateral. The captive also will likely find itself in the position of needing to find an alternate front on short notice, likely at an increased cost to the captive.
In the scenario where the captive serves as the fronting company, the most significant risk is that the reinsurer will fail financially or fail to honor its financial obligations. To the extent that the captive does not require collateral or if collateral turns out to be insufficient then the captive may be unable to ultimately collect such amounts from the reinsurer.
With the beginning of the current hard market in early 2001, captive insurance companies began to experience difficulties in implementing or retaining favorable fronting arrangements. Certain fronting carriers have exited the market thus requiring existing captives to find new fronting relationships. This has decreased dramatically the number of fronting carriers available to captives. Remaining fronting carriers are more selective, thus making it more difficult for captive insurance companies to locate a fronting company. Finally, the fees charged by the remaining fronting carriers have increase by several points reducing the margins of the captive insurance companies bearing the risk. The difficulties that captive insurance companies have experienced in finding suitable fronting carriers at cost effective rates is one of the greatest challenges facing the captive insurance industry today.
This article is reprinted with permission of the Self Insurer Publishing Corp. and the Palmetto Insurance Journal