There are plenty of mixed messages coming from the captive fronting market Is it beginning to settle down or are the number of insurers willing to offer fronting decreasing? asks Phil Zinkewicz.

Each year for the past seven years, the Captive Insurance Companies Association (CICA) has offered its "Captive insurance company fronting survey" in which issues such as captive fronting fees, security and primary reasons for using a fronting carrier are addressed. At this year's CICA meeting in Orlando, Michael Mead of MR Mead & Co said that the survey showed that reinsurance and security are as big or bigger issues for captive insurance companies than finding fronting companies.

"Captive fronting is not as big an issue as it was six or seven years ago," said Mead. "The shift to concerns about reinsurance security is related to the fact that there are not a lot of reinsurance companies left that have 'A' ratings. This is partly due to September 11, but the fact of the matter is that reinsurers were showing signs of having difficulties before that. September 11 only served to exacerbate reinsurers' financial difficulties. So the fear is that a captive could purchase reinsurance and then find that the reinsurer is not around to pay claims later on."

Peace in the kingdom

Mead said that 2004 was the first year that reinsurers, as an industry, had shown a profit since 1978. He added that one of the reasons reinsurers have been losing money is that natural catastrophes have been on the increase and there is every reason to believe this will continue. The 2004 hurricane season was bad enough with four storms, one after another, hitting Florida. But last year's Hurricane Katrina caused the insurance industry its largest losses ever for a natural catastrophe and recovery was so badly handled that it resulted in political finger pointing at the state and federal level.

Captives, understandably, have to be very careful when purchasing reinsurance. The situation becomes even more perilous when captives that do not have fronting companies have to go into the reinsurance market to buy excess coverage. However, regarding captive insurance company fronting, Mead said there is "peace in the kingdom". He said the captive fronting market has "settled down", and that there are still insurance companies willing to front captives.

Nevertheless, Andrew Barile, an insurance industry captive consultant based in California, sees things a bit differently. "The number of companies that are out there willing to entertain fronting for a captive has dramatically decreased," says Barile. Moreover, he said that the fronting companies that remain in the marketplace are "calling the shots" because there have been no new players to come into the market to replace the ones that have been lost. Fronting companies are becoming stricter, he explains. "Some fronting companies won't do an association captive, others won't front for agency captives," Barile explains. "Moreover, those fronting companies that are remaining in the market are demanding to control the accounts and saying that they want to control the reinsurance contracts or the management of the captive itself."

Barile says also that fronting companies want more control when considering fronting for a new captive. "They're tired of watching new captives go belly up. They want to know where the captive will be domiciled, what kind of security they have and how their boards of directors will be constructed. Especially in the litigation area, many captives have lost cases because they have had weak boards."

Some offshore captive insurance arenas have been notorious for being frugal with their financial information. Many fronting companies believe that, if more captive insurance company transparency is not coming about through regulatory efforts, they must take it upon themselves to demand full disclosure. Many of the fronting insurance companies today have financial analysts reviewing the statements of the offshore insurer. "Since the chartered accounting firms might not be one of the big four, particular reports are closely scrutinised - balance sheets, income statements, cash flow statements and notes to financial statements," says Barile.

He adds that the cost of letters of credit and the "stacking" of letters of credit for each underwriting year to the captive in business have all led to the introduction of the insurance trust for captives. "The Regulation 114 Trust formulated by the New York State Insurance Department has given the captive another option to secure the fronting carrier," he says. "Banks like trusts because the captive owner usually deposits funds in the trust, which the banks like to manage. The amount of the fund, once again, requires professional negotiating, particularly on start-up captives. Fronting carriers like the trust because they can draw upon it should the captive be a slow payer."

Shopping around

But all of the demands do not necessarily have to be on the side of the fronting company, says Barile. "Captive companies are beginning to learn, and those that are not should learn, to shop around for fronting companies on an annual basis to find out whether they are paying too much for their current fronting company and whether they can renegotiate fronting arrangements."

The ability to seek out the culturally correct fronting carrier requires an in depth knowledge of the insurance industry explains Barile. "Access to senior management of fronts also helps to eliminate the usual disconnects going on in the large bureaucratic insurers. It should be remembered that the cost for a front - 5%, 7.5% or 12% - is totally negotiable. There is no manual, nor are there guidelines to follow. It requires knowledge, options, and the ability to access many carriers to find the ideal fronting insurance company."

Catherine Duffin, division executive vice president of Gallagher Captive Services in Illinois, attempts to put the CICA captive fronting survey into perspective. "You have to remember that the CICA survey is done on an annual basis," she says. "And, from the year 2004 to 2005, the industry lost one fronting company carrier. So, from that perspective, things are looking pretty good." But she admits that it is also true that in the last five years there has been a dramatic decrease in fronting carriers. A decrease that has nothing to do with Legion, a specialty carrier that fronted. "Some carriers just pulled out of the market for other reasons," she explains. "There is still a powerful list of carriers out there for fronting purposes - Liberty Mutual, AIG, the Hartford. So, the captive industry is by no means in dire straights."

Duffin also agrees with Barile in that fronting companies are taking a tougher look at captives to determine whether they are financially secure. "I have seen them want more control in the claims area," she says. "And, they're reluctant to front for start-up operations capitalised at half a million dollars. They want start-up operations capitalised at three to five million dollars."

Moreover, Duffin says that very few captives have "gone under". "There have been large parent companies that have had three or four captives and have decided to close one down. But that's not the same as going under."

Therefore, the fronting issue remains problematic for offshore captive insurance companies. Many believe that the issue won't be resolved until offshore captives open up their financials freely to insurers. On the positive side, there are signs they might do so in the not-too-distant future. For example, last year representatives American Association of Managing General Agents (AAMGA) in the US made a trip to Bermuda in order to "network" with insurance executives in that market.

According to Seth Johnson, vice president of Atlantic Specialty, Richmond, Virginia, who is a member of the AAMGA, the team met with executives to discuss catastrophic reinsurance developments. "Bermuda is an interesting marketplace," says Johnson. "Bermuda insurers and reinsurers are in the process of making themselves more accessible to the US MGA marketplace." And that can only be a good thing for captive fronting.

- Phil Zinkewicz is a freelance journalist.