Greg Lang of RAIN
6 February 2024Analysis

The veritas about fronting

If you are serious about captives, fronted paper helps maximise a captive’s value as a reinsurer. Fronted paper is required for regulated lines of insurance like workers’ compensation and auto liability. Often, rated paper is demanded by lenders with credit and liquidity concerns, and this demand is increasing.

Traditional insurers continue to run from difficult and emerging exposures, so fronting property deductible policies has become a cottage industry as traditional property markets reduce capacity and increase rates. There is also a growing focus on enterprise risk captives to cover policy exclusions and provide funding for uninsurable operational, financial, and strategic risk. Fortunately, there are more fronting options now than ever. I count 28 insurers offering fronting in the US right now.

Why fronting?

Fronting carriers are insurers who issue admitted or non-admitted policies on behalf of an insured or group for a fee. The term “fronting” comes from the banking industry: it’s a fee payable by a borrower to a fronting bank for the credit risk the bank assumes for issuing a letter of credit (LOC), bond, or other type of contractual guarantee. Essentially, the fronting fee covers the capital charge for the risk assumed. The same is true for fronting insurers.

Insurers front fees are paid as a percent of premium subject to a minimum, with percentages ranging from 3% to 10% or more. The minimum fee for a single policy has grown to around $250,000. Why so expensive? That is a fair question. What is unfair is suggesting fronts do not take any risk. When people tell me this, it gives me pause. Many captive owners develop their own policies and manage their own claims, and these actions create significant exposures for fronting companies.

Veritas means “truth” or “reality” in Latin. If there were no risk in fronting, why would so many transactions require it? One hundred per cent of the fronting deals I work on have risk. The biggest risk may not be underwriting risk. Instead, it could be a regulatory, credit, or reputational risk – all exposures fronters must contend with. As the demand for fronting increases, so do the risks.

ECO/XPL

When a bank engages in a fronted transaction, they know exactly how much risk they will assume as the loan amount does not change after the documents are signed. Insurance policies are different. Insurance is the only product I know of where the “cost of goods sold” is not known at the time a policy is issued. Even policies with well-defined terms and clear aggregate limits can be challenged and changed by a court. These exposures are real and getting worse.

Extra-contractual obligations (ECO) are expenses imposed on an insurer by a regulatory, judicial, or governmental organization. ECO losses fall outside the insurance policy. ECO is a form of punitive damage as its intention is to punish. Additionally, excess policy limits (XPL) losses result from the mishandling of an insurance claim, which results in liability for loss above the stated policy limit.

ECO results from negligence, bad faith, or deceptive practices. An insurer may be found to have engaged in deceptive sales practices and may be sued for misrepresenting what perils are covered by a policy. The state where the policy was issued does not care who mishandled the claim or used deceptive marketing, they hold the fronting company responsible. If a captive owner created the policy or managed the claims, isn’t it fair they should cover this cost?

Some fronting contracts specifically transfer ECO and XPL to their reinsurer or captive while it’s implied in others. Commercial reinsurers have begun pushing back to mitigate their ECO/ XPL obligations, but few captives have the leverage to do so.

Credit/Liquidity Risk

While banks typically have real property or other assets such as cars or boats as collateral for their loans, fronting carriers require liquid assets such as cash or LOCs Unlike banks, insurance companies are subject to Statutory Accounting Principles (SAP) Statutory accounting requires a liability to be recognised on the insurer’s balance sheet for unauthorised reinsurance that exceeds collateral held from that reinsurer. Captive reinsurers typically meet the definition of unauthorised reinsurance, and unauthorised reinsurance cannot be recognised on the insurer’s balance sheet as an asset. Instead, an acceptable asset is required – for example cash, LOC, or a trust if it meets the state’s asset liquidity requirements. The most common form of trust is a Reg 114 trust, which is modeled after a NY state statute that includes a specific list of acceptable assets. Admittingly, the assets held by a bank and the insurance company does offset most of the credit risk assumed while fronting. ECO and XPL are good examples of why insurers charge so much for their service.

Fraud

Another good example is fraud. One of the biggest insurance stories of 2023 was the creation of billions of dollars in fake LOCs to support reinsurance transactions. As seen through this story, criminal deception is another example of the credit risk fronting carriers face. Over $3 billion dollars of fraudulent LOCs were created, allegedly by former employees of Vesttoo, an insurtech firm. The LOCs were then used as collateral in reinsurance transactions. Fronting carriers Clear Blue and Trisura had significant exposure to this scandal. Fronts need to conduct appropriate due diligence on counterparties as well as conduct collateral reviews.

Compliance/Regulatory Risk

Purging clothes and cleaning out garages are common new year activities. It looks like some regulators and carriers are also doing some house cleaning to begin 2024. I have had two calls to find homes for existing captives. Programs that once passed legal scrutiny no longer qualify. Both are financial guarantee captives – nothing illegal about financial guarantee. It is just that traditional Property and Casualty (P&C) insurers are not licensed to front them. In most states, financial guarantee insurance requires its own license and capital. The only exception is if the P&C insurer uses a surety bond, but bonds have restrictions too. Structuring a financial guarantee program is often the easy part. Distinguishing financial guarantee from Insurance can be tricky and can even result in litigation.

I sometimes see policy language that breaks insurance rules. One example is the rule of indemnity, which states that an insurance contract should not compensate for damages beyond the extent of the loss incurred. Insureds should not profit from a covered loss. I agree with that.

I have also written about indemnity rule breakers such as parametric insurance and life insurance. I agree with them too. Some states’ captive laws now specifically include language for parametrics, but this does not make them acceptable in all circumstances.

Fortunately, many of these issues can be caught and corrected before any damage is done. Alternatively, programs can be shut down before penalties are levied. I always tell my clients: we do not want to wind up on the front page of the Wall Street Journal or in Captive International for the wrong reason.

Reputational Risk

Reputational risk is a growing exposure for public and private companies trying to meet board and stockholder demand for Environmental, Social and Governance (ESG) compliance. ESG impacts traditional insurers, fronts, and service providers such as brokers, actuaries, and claims administrators who support fronted business. Shifting ideologies has made placing and servicing certain types of business more challenging.

In early 2022, several major European insurers adopted restrictions on writing new oil and gas business. Later the same year, some of these insurers re-entered that market to support their country’s energy crisis caused by the war in Ukraine and the sabotage of two natural gas pipelines.

I had a fronted deal rejected by several carriers because my client is in the gun industry. The insurance coverage we were looking to front is currently being written by two traditional carriers – one on an admitted basis and the other non-admitted. The premium is north of $100 million dollars between the two programs. I guess mom was right in saying “everyone is doing it” was not enough as it was not good enough for the fronts either. I found other markets will entertain this exposure, but for how long?

Guns, fossil fuels, cannabis, gambling, diesel trucks, and real estate in environmentally sensitive areas have all become problematic for select insurers. I support their right to choose. I am also glad we have options.

Conclusion

The truth or veritas is insurance is a highly regulated business. Fronting is no exception. For a person who has been doing captives and fronting for a while, it sometimes feels like we make everything more complicated than it needs to be. That is fair. Some fronting carriers have been at this business for a long time too. They make good money and make fronting look easy. It is just not fair to say they do not take risk.

Greg Lang is the founder of the Reinsurance and Insurance Network (RAIN). He can be contacted at: glang@rainllc.com


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More on this story

Asset management analysis
23 November 2022   Products and services that can be legally bought and profitably sold will be, no matter how much someone disapproves of them, says Greg Lang of the Reinsurance and Insurance Network.
Analysis
4 August 2023   Greg Lang of RAIN provides a guide to some turns of phrase and their links to the captive insurance industry.
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14 November 2023   Greg Lang of RAIN flags up some warning signs that people need to be aware of when considering forming a captive.