Lead from the Front

Fronting is a term that may not be familiar to all risk managers. The practice can be beneficial to organizations that require evidence of locally licensed insurance, yet are looking to reduce the cost of risk by increasing self-insured retentions. In its simplest terms, a “fronting” arrangement involves an insured purchasing a policy from an insurer with the understanding that the insurer will transfer the risk to another party.

The fronting insurer is used to ensure the policy is issued by a locally licensed insurer with a good credit rating.

A key driver of increased interest in fronting today is the challenging economic environment. Companies are increasingly under pressure to improve efficiency and reduce spending. These companies are looking to align their insurance strategies with their corporate risk appetites, often by increasing retentions. They are also looking to their insurance programs to reduce spending on insurance premiums while maintaining comfort with this increased level of risk.

Often, companies can significantly reduce the cost of risk by increasing self-insured retentions. Companies that have experienced significant growth, either through organic means or by acquisition, can find that their insurance retentions have not grown in step. In other cases, contractual or regulatory constraints may have kept retentions low. Fronting allows companies to show evidence of insurance on that self-insured layer of risk, and therefore enables them to increase retentions and achieve the related savings.

COST REDUCTION

Knowledgeable risk and insurance advisors can help companies evaluate their ability to retain more risk, reduce insurance premium spend, and reduce total cost of risk. Strong internal risk management and good claims experience are the foundation for self-insuring. The decision to increase retentions is made through an evaluation of balance sheet strength, risk appetite, risk profile and prevailing insurance market conditions.

The self-insured layer is typically supported by traditional insurance above the fronted layer to provide balance sheet protection in catastrophic scenarios.

In other cases, the risk is ceded to another commercial insurance company.

For example, a large international organization may require licensed insurance in all of the regions in which it operates. Such an organization will try to partner with an insurance broker with a multinational platform so that it can place insurance in all of the relevant jurisdictions and ensure global consistency.

Similarly, it should work with a large international insurer that is licensed in the relevant locations. It is not uncommon for there to be some jurisdictions in which the primary insurer is not licensed. In these cases, the insurance broker will identify carriers that are licensed in the outstanding regions. That local insurer would front the policy and reinsure the risk back to the primary insurer on the global program.

Some fronting insurers have partner companies, which are not part of the same corporate family, in jurisdictions where they are not licensed to facilitate this process.

LOCAL REGULATIONS

Why is it important to have a policy from a locally licensed insurer?

There are a number of potential reasons it may make sense to enter into a fronting arrangement with a locally licensed insurer with a strong credit rating. For example, local regulation may require that the insured obtain locally licensed insurance for some or all risks. For example, in Canada, auto insurance must be provided by a provincially licensed insurer. In Argentina, non-admitted policies (those issued by insurers that are not licensed in the jurisdiction) are not allowed for any risk.

Another reason for fronting is in a situation where evidence of insurance is required by customers, suppliers or other business partners. Evidence of insurance could also be a requirement of debt covenants. If required, insurers will typically need to be licensed and may require minimum credit ratings.

A third driver of fronting with a locally licensed insurer is the cost advantage in jurisdictions with high taxes on premiums with unlicensed insurers. For example, in Alberta, unlicensed premium taxes can be as high as 50%. In Belize, non-admitted insurance placements are subject to a 25% withholding tax.

What can a client expect when setting up a fronted insurance program?

The property underwriter (for example) that a client or a broker has been dealing with for years may or may not have the experience or authority to structure a fronted program.

Some insurers (and risk advisors) have dedicated alternative risk or captive teams that specialize in fronted programs. The alternative risk underwriter will work closely with the client’s property underwriter to price and structure the fronted insurance program and associated indemnification contract.

Clients should expect the fronting insurer to charge a fronting fee. This fee is usually a percentage of gross premiums. The fee covers the administration costs of the fronting insurer, the cost of capital, profit margin and the cost of claims administration (if applicable). Large programs may have a lower charge on a percentage basis.

When retaining the risk, many companies will choose to manage claims through a third-party administrator (TPA). Alternatively, the fronting insurer can manage claims for a fee. Regardless, it is critical to ensure that all parties understand who will manage claims.

Premium taxes will apply to a fronted policy, just as they do to a traditional insurance policy.

Depending on the jurisdiction where the risk resides, additional taxes may also be incurred. For example, in the United States, risk ceded to an unlicensed reinsurer generates an additional 1% in U.S. federal excise tax (FET).

Similar to a policy with a large deductible, a fronted policy will require collateral to be posted. The collateral may be in the form of cash, a letter of credit, or a reinsurance security agreement. The collateral reduces the fronting insurer’s credit risk associated with the indemnity contract. The collateral is posted by the entity bearing the risk. Over time, collateral requirements may increase or decrease with program size and changes in unpaid claims reserves. When fronting several risks, a single facility can be used to cover the collateral for all risks with the same fronting insurer.

Certain countries or fronting carriers will also require that a minimum percentage of the risk be retained by the licensed fronting carrier.

DIFFERENT OPTIONS

There are two common forms of fronted insurance programs: fronted indemnified programs and fronted reinsured programs. In a fronted indemnified program, the policy is accompanied by an indemnity agreement such that the risk on the fronted layer is borne by the insured. The premium for this policy is the fronting fee and associated premium taxes. The insured posts the collateral with the insurer to cover claims costs. 

In a fronted reinsured program, the fronting insurer cedes the risk to a reinsurance company. The reinsurer could be another commercial insurer, as described above, or a captive insurance company established by the insured. Captives are licensed insurance companies in their domicile (e.g. British Columbia, Barbados, Bermuda or many U.S. states) but unlicensed elsewhere. In this structure the reinsurer posts the collateral.

In the current dynamic business environment, with companies facing economic constraints, and/or international growth through acquisition and mergers, the efficiency of the insurance program should be reviewed. Fronting is an option to consider that enables alignment with a company’s changing risk appetite while maintaining compliance with contractual and regulatory requirements.

There are two common forms of fronted insurance programs: fronted indemnified programs and fr
onted reinsured programs. In a fronted indemnified program, the policy is accompanied by an indemnity agreement such that the risk on the fronted layer is borne by the insured. The premium for this policy is the fronting fee and associated premium taxes. The insured posts the collateral with the insurer to cover claims costs.

In a fronted reinsured program, the fronting insurer cedes the risk to a reinsurance company. The reinsurer could be another commercial insurer, as described above, or a captive insurance company established by the insured. Captives are licensed insurance companies in their domicile (e.g. British Columbia, Barbados, Bermuda or many U.S. states) but unlicensed elsewhere. In this structure the reinsurer posts the collateral.

In the current dynamic business environment, with companies facing economic constraints, and/or international growth through acquisition and mergers, the efficiency of the insurance program should be reviewed. Fronting is an option to consider that enables alignment with a company’s changing risk appetite while maintaining compliance with contractual and regulatory requirements.