What Is a Fronting Arrangement and Why Do Captive Insurers Use Them?

An insurance pundit once observed that "fronting" is the same as "backing." That seemingly oxymoronic comment is not far off the mark in describing the relationship between a captive insurer and a fronting arrangement. Fronting companies provide financial backing and other forms of support that enable many captive insurers to meet their objectives. So it is not far off the mark to say that fronting is the same as backing.

What Is Fronting?

Fronting has been defined as the use of a licensed, admitted insurer to issue an insurance policy on behalf of a self-insured organization or captive insurer without the intention of transferring any risk. The risk of loss is retained by the self-insured or captive insurer through an indemnity or reinsurance agreement.

However, the fronting company (insurer) would be required to honor the obligations imposed by the policy if the self-insurer or captive failed to indemnify it. Therefore, the fronting company is subject to credit risk as a result of the arrangement, and fronting companies charge a fee for this service.

What Is a Captive Insurer?

A captive insurer is an insurance company that is wholly owned and controlled by its insureds; its primary purpose is to insure the risks of its owners, and its insureds benefit from the captive insurer's underwriting profits. Insureds in a captive choose to put their own capital at risk by working outside of the traditionally regulated commercial insurance marketplace.

The captive insurer is an unlicensed, nonadmitted insurer except in its own domicile. As a general rule, it is illegal for an unlicensed insurer to issue policies. So it is often necessary for the captive insurer to contract with a duly licensed insurer to issue a policy even if the captive desires to be the main risk-bearer.

Why Do Captive Insurers Use Fronting Arrangements?

Fronting arrangements allow captives to comply with financial responsibility laws imposed by many states that require evidence of coverage written by an admitted insurer, such as for auto liability and workers compensation insurance.

Fronting arrangements may also be used when business contracts with other organizations, such as leases, service contracts, and construction contracts, require evidence of coverage through an admitted insurer. The insured may face a contractual requirement that stipulates the use of insurers that meet a minimum financial rating to issue the insurance policy for a particular risk. By utilizing a fronting insurer, the certificates of insurance, as well as the policies, would be issued utilizing the name/paper of the fronting company, thereby meeting the contract's requirements.

An insured may also be required to have a licensed insurance company issue the policy for a particular risk. By utilizing the licensing of the fronting company, the captive insurer does not have to maintain licenses in each of the state(s) where business is written.

Another favorable reason for utilizing a fronting company is to potentially enhance the ability to achieve tax-deductibility. By using a fronting company, the insured may be in a better position to deduct its premium payments for the insurance placed through the fronting company and ultimately through the captive. Under self-insurance programs, tax deductions are allowed only for paid losses and not for loss reserves or for "incurred but not reported" (IBNR) amounts.

How Does a Fronting Arrangement Work?

Fronting is a specialized form of reinsurance. A commercial insurance company ("fronting company") is licensed in the state(s) where a risk from the captive is located. The insurance policy is issued on the paper from the fronting company, and then through contractual agreement ("fronting agreement") the risk is transferred to the captive. The insured receives a policy from the fronting company, but the risk covered by the program ultimately resides with the captive insurance company.

The cost of using a fronting company is based on a percentage of gross written premiums. For example, the percentage charged might be somewhere between 6 and 10 percent depending on the scope of services provided by the fronting company and prevailing interest rates at the time the arrangement is made. What this means for the captive is that for every $1.00 in premium, $.06 to $.10 of that will be sent to the fronting company. The balance can be maintained within the captive insurer to cover the costs of losses, loss adjustment expenses, and administrative expenses.

Since it faces a credit risk from the arrangement, the fronting company will also require that the captive secure its obligation by using some type of collateral. The amount of collateral needed is addressed in the fronting agreement. The typical types of collateral are captive funds withheld by the fronting company, a trust agreement funded by the captive's investment securities, or a letter of credit issued on behalf of the captive. A fronting company, through its own actuarial department, will often require anywhere from 125 percent to 150 percent of the projected loss fund as collateral. The captive's own actuarial study will address the projected loss fund amount as well and may be used to negotiate the required amount of collateral if necessary.

Due to the limited number of insurers offering fronting arrangements, it is imperative that captive owners maintain a solid business relationship with their front and strive for a long-term relationship. Moving from fronting company to fronting company on an annual basis is certainly not advisable.

The components of a typical fronting arrangement are as follows.

COMPONENTS OF CAPTIVE FRONTING ARRANGEMENTS

• The insurance policy
• A fronting agreement specifying, among other things, how much of the risk is retained by the front and how much passes through to the risk-bearer
• A reinsurance contract between the captive insurer and the front
• Collateral to provide assurance of the captive insurance company's ability to meet its claims payment obligations
• A charge for the fronting company's services that can include claims handling and loss control costs, premium taxes, commissions, costs of guarantee fund participation, and a fronting fee.

The primary purpose of fronting is compliance with insurance regulations. However, an important secondary purpose is to access services such as claims handling and risk control, as well as excess risk transfer capacity, from the fronting insurer in a cost-effective manner. The services typically provided by fronting companies go far beyond policy issuance and can include those indicated as follows.

TYPICAL FRONTING COMPANY SERVICES

• Claim services
• Engineering and risk control
• Issuance of certificates of insurance
• Performing premium audits
• Excess coverage placements
• Reinsurance placements
• Other required filings, such as Public Utility Commission, Interstate Commerce Commission, and evidence of auto liability coverage, that are needed by insureds

Fronting entails significant risks for the fronting insurer. When a licensed insurer issues a policy, it is assuming a primary legal responsibility to pay a covered claim. The risk is then allocated through the fronting/reinsurance transaction, but the primary liability to pay the claim stays with the front. Generally speaking, the insurer cannot escape this primary liability even if the reinsurer (such as a fronted captive) that is supposed to be sharing the risk cannot or does not perform. Conversely, if the front fails, the insured may not only lose coverage while forfeiting premiums paid to date but could also even remain liable for future premium obligations to the front.