Captive Resource Center

Businesses and Associations

Research & Information

Hugh's Views Issue 3: March 11, 2002
Guarantees and Captives · Part 2

Fronting companies are fewer, and their fronting fees are going up. Fronting fees are only one cost of operating a reinsurance captive. The other is the guarantees being demanded by the fronting companies. These are amounts that the captive is required to pledge, either by tying up their own assets in a lower-returning reinsurance trust (the so-called §112 trusts after the code section in New York insurance law) or a letter of credit from a bank, costing 1-2% or more of the amount. (The need for fronting for unlicensed captives seeking to underwite only the risks of their shareholders, a service more often than not unappreciated if not unwanted by captive owners, steeped in insurance history, is grudgingly accepted as unavoidable).

In this article I am only addressing guarantees demanded above and beyond loss reserve (plus premium reserve) collateral, for which fronting companies have statutory obligations. In this article I am calling "guarantees" amounts of collateral or security above and beyond offsetting statutory reserves.

Some stories I have heard about guarantees being demanded by fronting companies surprise me: from 200-300% of expected losses all the way up to 120% of full limits exposed. I think the fronting companies are exaggerating and propose some ways for them to compromise in ways that could make it possible to write more fronted business.

Two purposes: Guarantees sought by fronting companies serve two purposes. The first is to compensate them for the capital they claim they have to tie up by ceding unearned premiums and loss reserves (including IBNR) to unlicensed captives. The theory, and I stress the word theory, is that state regulations do not permit them to take credit for the unlicensed reinsurance, so they must take a "hit to capital" by showing these amounts as uncovered liabilities. If the reinsurance was to, say, Lloyds rather than the unlicensed captive, there would be no such requirement. That's the theory. In practice, some fronting companies, when presented with a big enough or good enough fronting business account have been known not to require these compensating guarantees. I won't go into the details of what constitutes "big enough/good enough"; readers can use their own imagination scale.

The other purpose of the guarantees sought by fronting companies is to cover the credit risk arising from the obligations of the fronting policy in case the captive didn't' respond. This would be the case if and only if

The aggregate amount of the claims increased to unexpected or unforeseen levels in excess of the captive's assets and resources (which include recapitalization by the owners)

The captive's assets, even though adequate, were blocked, illiquid, or undervalued.

What are they for? As far as I can tell, the reasons most cited for demanding guarantees (keeping in mind my limited definition of "guarantees")in excess of the first kind fall into two types, closely related to the two causes just mentioned.

1. Business risks: The evaluation of the underlying risks makes the underwriter uneasy. This includes lack of confidence in the loss projections presented, but can also include dislike for classes of business, such as the recent avoidance of long-term care nursing homes business.
2. Credit risks: The credibility of the captive's owners, or their creditworthiness, makes the underwriter uneasy. This includes "guidelines" laid down by the investment and legal departments of fronting companies that are inspired more by bank lending rules than by commercial risk-taking practice. It also includes concern about the real commitment and persistence of the members of group or association captives (including risk retention groups) when faced with heavy losses requiring higher premiums or more capital.

I find it exasperating that the promoters and consultants presenting captive business plans to potential fronting companies don't seem to be able to minimize the business risk by presenting the right kind of feasibility study. This is probably because of the absence of an agreed-upon language of risk, which, in turn, gives rise to different opinions about the ultimate financial outcome of loss scenarios and the effect of risk management. But I think it is also due in part to the belief that simplifying or holding back some risk information while elaborating on and emphasizing others, instead of laying out all the details and scenarios will somehow be acceptable to fronting company underwriters.

What to do? To encourage more licensed insurers to front for reinsurance captives, and to make fronting more financially acceptable to financial officers of captive owners, I think the time has come to take a fresh look at guarantees. This starts with a suggestion for fresh steps to reconcile the differences between fronting companies' credit concerns and the urgent need for fronting "paper" of captive owners. My thoughts on what these steps might be were inspired by reading summaries of the Basel 2 banking regulations for banks' risks. To simplify, they are built on three "pillars".

Pillar one is the quantitative part, what I called " business risks", above.

Pillar two is continuous review of risk management, and the appreciation of exposures that cannot be assessed in merely quantitative terms.

Pillar three is more public disclosure.

Hugh's views: Taking the three pillar approach, the new fronting relationships ought to follow these lines:

1. The underlying risks ought to be systematically analyzed and presented with ranges and probabilities, according to acceptable analytical techniques (This is ought to be the rule in any case).
2. Quarterly, if not monthly updates on the underlying risks, risk management, as well as the financials of the insured/shareholders as well as the quality of the captive's assets ought to be agreed on between fronting companies and captive owners. The information technology available today should not make this an onerous requirement. I would add to this rather ordinary call for more frequent information from the buyers a requirement for parallel more frequent updates from the fronting companies towards their captive customers - their changes in business, reserving practices, reinsurance placements, aggregate exposures, and investments. Part and parcel with this increased information flow would be rate or guarantee adjustments. At first they would be "horse traded", but soon a set of guidelines would emerge, no doubt named after the ones who publish the most credible one earliest - "The Kemper Guidelines" or "The Aon guidelines". Once AIG adopts them they would become universal.
3. Contingent capital instruments provided by the fronters to captive owners, sometimes called "backing for fronting." The idea is neither new nor untested. The captive owners, or the captive itself if it has the resources, "invests" in unsecured subordinated debt instruments of the insurers, their holding companies, or even their main shareholders. This provides the capital guarantee the fronter needs. Instead of costing the captive owner something, it would actually produce a return. The securities themselves would serve as the capital replacement for collateral and letters of credit, whether or not they were rated securities. And It seems to me that both the business risk and credit risk concerns of the fronting companies could be addressed in the variable terms of the subordinated debt instruments.

At the recent CICA conference I learned that at least one fronting company, CNA, has developed their own contingent capital structure that works so successfully that it solves the fronting problem on the one hand, and works in programs without captives - another kind of "virtual captive."

But subordinated debt instruments would be better for captive owners, who might be able to further monetize them. As The Economist magazine concluded in their opinion piece about subordinated debt issued by banks (as compared to insurance companies). "It's worth a try."

Can't get enough of Hugh's oft-irreverent views? You're in luck! Follow this link to all of Hugh's pearls of wisdom:

To Hugh's Views Menu

Hugh Rosenbaum, one of captive.com's friends and valued contributors, is a freelance consultant. Hugh can be reached by telephone at +4420 8883 6729 or by e-mail at hughro2@yahoo.com. Learn how you can spend a day with Hugh!

Visit Hugh's Captive Consulting and Music Websites at
http://www.hughro.com/