Thomas FX Hodson reviews the results of a recent survey showing that fronting is falling down the list of concerns for captive owners
For the last four years, the Captive Insurance Companies Association (CICA) has conducted an annual survey of fronting in the captive insurance market. The results of the surveys in the first three years have shown that the primary concern among captive owners has been, predictably, the cost and availability of fronting arrangements. In fact, the survey itself grew out of a concern among captive owners regarding just this issue.
But this year, the results were different, much to the surprise of the industry.
In this year's survey results, fronting fell to third place among the captive owners' primary concerns, behind reinsurance and security. So were this year's results such a surprise?
First, a brief overview of captives and fronting arrangements. Captive insurance companies are one form of alternative market tool that has experienced a dramatic increase in use in response to the hardening of the traditional insurance market. Captives are special purpose insurance companies formed for the objective of insuring or reinsuring the risks of its parent company or an associated corporation. A captive typically provides basic benefits to the parent company such as a special coverage form or a specific funding plan to finance losses the captive will pay. Captives can generally take one of the following forms:
- single parent, or pure captive, which insures only the risks of the parent company or owner;
- group captive, which is formed by an unrelated group or association of entities in order to insure the group against similar risks;
- rent-a-captive, which is formed by a third-party entity which 'rents' the use of the captive's capital to various other entities, each of which maintains an account within the captive;
- protected cell captive (similar to rent-a-captive), where legislation ctics, managing disputes in partnership with their clients, as opposed to merely taking clients' instructions and behaving in a reactive manner. Proactive dispute management lawyers are seizing the initiative by identifying at the outset of the case the best practical outcome for any given dispute and driving the case forward to achieve that outcome with the minimum cost and maximum effectiveness, using several sophisticated products to help clients identify the most cost-effective way to resolve a dispute.icy is issued. Most captives lack the required licenses to do business and, therefore, captives often must use a fronting arrangement in order to do business in a state in which its parent's risks are located.
A fronting insurer is a licensed carrier that issues the policies that a captive cannot issue. In other words, fronting is an arrangement whereby an insurer licensed in the jurisdiction, at the request of an unlicensed captive insurer, issues a policy on its own paper for a certain risk with the intention of passing all or most of the risk to the unlicensed captive insurer by way of reinsurance.
A typical fronting arrangement will operate as follows:
- the captive's parent pays a premium to the fronting insurer;
- the fronting insurer issues a policy to the parent;
- the fronting insurer cedes the balance of the remaining premiums back to the captive; and
- the captive may retrocede a portion of the risk to a reinsurer.
Pursuant to this type of transaction, the captive indemnifies the fronting insurer for all loss payments made under the policy issued by the fronting insurer, and the captive's obligation is collateralised by a letter of credit or some other security instrument. Further, the fronting carrier retains a percentage of the premium for its fronting services, typically ranging from 4% to 10%, and sometimes more.
The success of a fronting arrangement depends, in part, upon the economic soundness of both the fronting insurer and the captive. A prudent captive will require any fronting company that it partners with to have demonstrated financial strength and sound business strategy. As fronting companies have reacted to the hardened insurance market by charging higher insurance and reinsurance premiums and adopting restrictive policy and reinsurance contract conditions, the pool of acceptable fronting carriers available to the captive market has diminished.
Additionally, many companies that formerly acted as fronting companies have either gone out of business or chosen not to act as fronts any more.
For captives, this has meant a diminished pool of available fronting carriers that are offering less and charging more for their services. It is this state of affairs that lead to the first survey on fronting conducted by CICA four years ago.
Survey's primary concerns
The 2004 survey was, once again, conducted by CICA in conjunction with the Vermont Captive Insurance Association and the South Carolina Captive Insurance Association, and with the assistance of consultancy Johnson Lambert & Co.
Most striking of the 2004 survey results is that the cost and availability of fronting is no longer the number one concern among the captive owners surveyed. Concern about fronting had, in fact, fallen into third place.
The primary concern of captive owners as reflected in the 2004 survey is the availability and cost of reinsurance, followed by the form and amount of collateral captives are required to provide to support their underwriting.
This year, the response rate over prior years' surveys almost doubled.
Additionally, those captive owners that decided to forgo fronting arrangements this year grew as well. These results suggest that captives are moving away from fronting at a faster rate than in prior years.
While there may or may not be a shift away from the use of fronting, the reasons for using a fronting carrier have not changed. The 2004 survey results show that access to admitted paper (licensed insurers) and regulatory compliance are still the predominant reasons for captives to use fronting carriers.
Another trend reflected in the 2004 survey is the increased need for captives to provide collateral for their obligations to their fronting carriers. According to the 2004 survey, last year more fronting carriers required increased amounts of collateral for the risks ceded to the captives.
Additionally, while letters of credit remain the predominant form of collateral, the basis for the amount of collateral required has shifted.
In prior surveys, collateral amounts were predominantly based upon loss reserves and unearned premium reserves (UEPR). The 2004 survey saw a shift away from calculations based on loss reserves and UEPR, and towards other bases like the creditworthiness of the captive and its reinsurers, the underlying policy limits, and incurred but not reported (IBNR) reserves.
The 2004 survey results suggest other positive trends as well. First, that captive owners are not as unhappy with the state of the fronting market as they have been in the past. This result is reflected in the survey question regarding the price-to-value relationship. According to the survey, the price-to-value relationship increased, indicating that captive owners thought they were getting better value from their fronting carriers at a lower price than in prior years. The results of the 2004
survey also suggest tightening in the reinsurance market, where prices are increasing and terms becoming more restrictive for captives.
Alternatives to fronting
The results of the 2004 survey, however, may suggest a more ominous trend for the fronting market. While the response rate to the 2004 survey almost doubled over last year's survey, the number of companies indicating that they do not use fronting grew over years past. This, together with the fact that concerns over fronting fell to the number three spot, may suggest that companies are finding alternatives. Those alternatives may include high deductibles and deductible reimbursement programs, as well as the use of risk retention groups.
This apparent move away from fronting is a predictable trend after prior years' surveys indicated that captive owners were increasingly concerned with the cost and availability of fronting. Consequently, it appears, many of those captive owners took matters into their own hands and created alternatives to fronting arrangements.
We will have to wait for next year's survey results to see if this trend away from fronting and toward alternatives has the effect of creating more capacity among fronting carriers and lowering the cost. As they say, "Stay tuned..."
Attorney Thomas FX Hodson is a partner in the insurance and reinsurance department of Edwards & Angell LLP, a US law firm with over 300 attorneys focusing on financial services, private equity and technology. He may be reached at firstname.lastname@example.org.