Why Captive Insurers Often Put on a Front

Editor's Note:  Hylant Global Captive Solutions contributes this Thought Leadership article exploring fronting as a way to unlock opportunities in challenging insurance markets.

"Fronting" is the term used to describe a proven strategy that allows insurers, including captive insurers, to meet state regulatory requirements and provides the capability to participate in risks that they otherwise would be unable to assume. It is a long-used risk handling mechanism through which underwritten risk exposure is transferred within the insurance and reinsurance sector. For example, a captive insurance company may partner with a traditional insurer that will underwrite an insurance policy and pass most or all of the inherent underwriting risk to the captive. The insurer, in this example, is known as the fronting company and receives an agreed-upon percentage of the policy's premium as a fronting fee. Beyond the underwriting process, the fronting insurer's responsibilities will include quoting, binding coverage, and issuing policies. Their duties may extend to claims handling and management, but there is the opportunity for this service to be unbundled and contracted with a third-party administrator.

Insurers and captive insurers may also turn to fronting as a way to write controlled coverages, such as commercial auto, in states where they are not approved to do so. Fronting allows them to essentially "rent" the insurer's services to issue policies in those jurisdictions by paying a fronting fee to insurers that already have a legal presence and satisfy regulatory requirements. Fronting insurers embrace the strategy because it generates income without taking on commensurate levels of underwriting risk.

Captive owners often explore fronting as a way to facilitate their risk assumption goals. They turn to the fronting market to handle everything from underwriting to policy issuance to generating the documentation verifying they've satisfied regulatory and contractual requirements, where required. The insurer may also function as a reinsurer wrapping around the captive, ensuring that total coverage is afforded by the program.

Additionally, many organizations are under contractual obligations, such as commercial property owners and developers, for which a mortgage lender requires proof of insurance coverage from an insurer with an A.M. Best rating, such as A- or better. If a company wishes to establish a captive to provide property or general liability coverage associated with those properties—but is unable to evidence the required rating on its own—fronting allows it to meet the obligation.

An illustration of the combination of captive and fronting strategies might involve a property management company also engaged in building and owning facilities it manages. The property insurance marketplace may be hesitant to provide coverage for risks associated with this business sector so that the management company may face prohibitively expensive insurance premiums or a shortage of insurance capacity. By establishing a captive, the company, via its captive, assumes the first layer of risk, which reduces the premium costs paid to the insurer; this saving is utilized to fund the captive to pay losses, therefore satisfying the captive's obligations. The fronting insurer issues the policy and agrees to assume losses above that first layer. The captive will take care of losses related to their exposure and rely on the fronting insurer and its reinsurers to handle severe and catastrophic events. As previously mentioned, it's an arrangement that also satisfies lenders' contractual requirements.

The market for fronting has grown exponentially over the past decade from just a handful of insurers that were willing to serve this role. Entrepreneurially minded insurance executives recognized that fronting could allow them to offer policies without taking on underwriting risk (although they still faced credit risk and the remote possibility a reinsurer would be unable to perform as promised). As a result, there are a number of insurance companies that are happy to serve as fronting insurers for captives.

Exploring the use of captives and fronting is especially appealing in some of today's hardest insurance markets, particularly property coverage in regions that have experienced catastrophic climate-related incidents such as flooding and wildfires. As with any effort involving captives, talking with a knowledgeable consultant in the early stages will help organizations better understand whether it's a viable approach before they begin what might be a cumbersome process.