Challenges of Reinsurance and Fronting in Captive Insurance Programs

Reinsurance and fronting arrangements are key elements in all captive insurance programs.

Essentially, a fronting arrangement is when a licensed, admitted insurer issues an insurance policy on behalf of a self-insured organization or captive, with the risk being retained by that particular entity through an indemnity or reinsurance agreement.

Fronting enables 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.

An insured may also be required to have a licensed insurer issue the policy for a particular risk; therefore, by using the licensing of the fronting company, captives don't have to maintain licenses in each state where the business is written.

While fronting's primary purpose is compliance with insurance regulations, it can also be used 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.

From a tax perspective, by using a fronting company, the insured may also be in a better position to deduct its premium payments for the insurance placed through the fronting company and, ultimately, through the captive.

Since it faces a credit risk from the arrangement, the fronting insurer requires the captive to secure its obligation by using some form of collateral, such as funds withheld by the insurer, a trust agreement financed by the captive's investment securities, or a letter of credit issued on the captive's behalf.

Reinsurance Challenges

While reinsurance and fronting may be effective solutions and present a host of benefits for a captive, they also come with their unique set of challenges.

In terms of reinsurance, the biggest problem is securing it in the current hard market, said Michael Woodroffe, president of Kirkway International. This is particularly true of small captives that don't have the necessary scale, he said.

"If you are a Fortune 500 company with a single-parent captive that has been around for 40 years there's no problem at all," said Mr. Woodroffe. "It's the smaller companies at the bottom of the pyramid who use group association, agency type captives where it's an issue.

"They tend to have smaller limits and amounts of capital, without a large balance sheet behind them. Therefore, they are more reinsurance dependent.

"But with rates hardening, it's getting trickier to secure reinsurance, with prices going up in most casualty lines. It's also getting harder to find reinsurers prepared to provide cover for the captive."

Additionally, Mr. Woodroffe said that there are fewer reinsurers available to provide coverage, driven by consolidation and mergers. They are also demanding higher attachment points and are wary of the impact of inflation on longer-tail business such as medical malpractice, commercial auto, and workers compensation, he said.

"So, if you upset someone or you have a unique risk that doesn't fit anything, you have a limited choice," said Mr. Woodroffe. "InsurTechs, for example, are tricky business that are hard to price and quantify, so it's a long sell for reinsurers."

Similarly, there's a lack of fronting insurers available, which has been exacerbated by the hard market, resulting in higher premiums and less coverage, according to Martin Ellis, senior vice president and manager at Comerica Bank. As a result, fronting insurers have the leverage in terms of pricing and structure, he said.

"An example of this that we see on the banking side is that many of our captives try to get excess collateral they have provided to their fronting [insurer] released, only to find out that the fronting [insurers] are inflexible and have little incentive to act in a timely manner," said Mr. Ellis. "The collateral provided is usually in the form of letters of credit or reinsurance trusts, and the fronting [insurer] can be slow at releasing or decreasing letters of credit or allowing the captive to withdraw excess funds out of reinsurance trusts."

Mr. Woodroffe said that despite many fronting insurers appearing to be open to new captive clients, the reality is two-thirds of their business comes from their main managing general agents (MGAs). It's especially tough for trucking and professional liability lines, he said.

"It's a challenge for captives to find fronts," said Mr. Woodroffe. "It both takes a long time—as much as 4 or 5 months—and pricing is difficult to achieve."

Available Solutions

Dan Teclaw, director at A.M. Best, agreed that fronting pricing and capacity may be challenges in certain lines. That may cause organizations to look into setting up a single-parent captive or cell, join a group captive, or become a member of a risk retention group to access reinsurance more efficiently or to manage their own unique risks, he said.

"These types of decisions emanate from strong risk management policies, procedures, and processes driving risk identification, risk appetites, and risk tolerance," said Mr. Teclaw. "Sound enterprise risk management (ERM) processes in financial and operational controls are fundamental to ERM frameworks to reduce omnipresent but less common non-underwriting risks such as fraud and cyber ransomware."

Steve Bauman, head of global programs and captive practice, North America, at AXA XL, put the shortage in captive experts and bandwidth for fronting and reinsurance down to the exponential growth in captives over the last 5 years. He said this was particularly acute in new lines of business for captives, such as directors and officers and construction.

"It's therefore vital for captive owners to take the time to build strong partnerships with industry experts," said Mr. Bauman. "So, when it becomes an issue of scarcity, it's easier to get things done."

Captives are also having to compete with a surge in MGAs looking for fronting insurance for their programs. That is being driven by a need for them to have rated paper.

Another major problem, said Mr. Ellis, is the bundled approach of a fronting insurer providing reinsurance for the captive as a way for it to transfer excess risk on large claims may be more expensive than if these services were unbundled. Thus, he advised shopping around.

"Check to see if it's better for the captive to purchase reinsurance and other services such as claims handling separately instead of having it provided by the fronting [insurer] in a bundled package," said Mr. Ellis. "As the captive grows its surplus capital, it may be in a position to take higher deductions and thus reduce the amount it is paying its fronting [insurer]."

He added the following: "Make sure the captive isn't overpaying for various coverages and that there are appropriate stop loss limits to protect the captive from catastrophic claims."

Mike Ramsey, senior vice president, client development, insurance collateral solutions at Wilmington Trust, recommended working with a trusted adviser such as an insurance broker or trustee to navigate through the design, structure, and collateral requirements of a captive. He added that it was key to carry out a cost-benefit analysis on whether to retain risk within a captive and then reinsure it or to access the traditional insurance market.

"There are various collateral solutions that exist, so understanding the best solution that fits a captive owner's needs is important," said Mr. Ramsey. "Also, it's important to note that even if a captive is retaining risk on a direct basis (e.g., without the need for a front), there could be certain deductible obligations with an [insurer] that might need to be collateralized."