Out from behind the front: in the wake of a severe shortage of fronting insurers for captives a few years ago, more and more companies are trying to reduce their dependence on fronts--either by setting up risk retention groups or by writing business directly.

Sutter Health, a not-for-profit health-care system based in Sacramento, Calif., has two captives, and neither one of them uses a front.

Sutter's original captive, Sutter Insurance Services Corp., was formed in 1991, and it inherited its second captive in 1996 when it acquired a group of hospitals.

"We put these in place when fronting wasn't an option for us," says Michael Evans, the senior vice president and chief risk officer for Sutter Health and president of Sutter Insurance Services Corp.

"On the first captive, the fronting was not really available because it was so new in the industry, and the second time around it was too hard to find a front to do what we needed it to do," Evans says.

Because its captives operate in a single state, Sutter did not have to depend on a fronting insurer. As unlicensed entities, captives--especially those that operate in multiple states--have traditionally relied on fronting insurers to issue their "paper," the actual insurance policy and other forms required by regulators and lenders.

An increasing number of captives, however, have been looking for ways to reduce their dependence on fronting insurers after a number of big fronts--such as Kemper and Reliance--left the market a few years ago.

"Many captives are now exploring ways to not need a front," says Michael Mead, head of the Risk Sharing/Fronting Committee for the Captive Insurance Companies Association.

Although some industry sources say there has been an increase in the number of fronting insurers in the last year or two, it is still difficult for many parent companies to find a front willing to work with their captives.

"It's still a battle in many lines of coverage," says Mead, who is also president of Crusader Captive Services, a captive consulting firm. "It's still very difficult for the hard-to-place classes of business, no matter what their loss record is. (Fronting) companies, by and large, cherry pick opportunities," he says. No new players, he says, have come forward.

Stephen Cross, chief executive of Aon Captive Services Group, disagrees, in part. New players have come forward, he says, but they are taking a much more rigid approach than in the past.

"There's not a lack of insurers out there," Cross says. "There's a willingness to do it. They're doing it a lot more efficiently, however. I think you're seeing a more rigid approach to it. Collateral is certainly key," he says.

Many fronts these days are also charging higher fees, making it more costly all around to use a front.

"Fronting companies are taking full advantage of the situation, charging higher fees to act as fronts," says Henry Witmer, managing senior financial analyst at A.M. Best Co. Inc.

Collateral indeed has become a larger issue, as fronts are imposing much more stringent collateral requirements to protect themselves from some of the problems of the past.

For instance, one letter of credit would have been sufficient to cover all the members of a group captive, Cross says. Now, each member of the group has to provide its own letter of credit to the front.

Some captives also may have a difficult time getting a letter of credit and may have to support that letter of credit with cash, says Mark Bernfeld, a broker and consultant with Towers Perrin who spent more than 15 years at Liberty Mutual and at one point ran its captive-fronting operation.

Bernfeld says fronting capacity has loosened up selectively in the last few years, but notes that fronts have become niche players, focusing only on certain lines of business or certain types of captives. Some captives can easily find a front, while others cannot.

Group and association captives, for instance, are likely to have a much harder time finding a front than a single parent captive, he says. And there is usually much less capacity for a startup captive than for an existing captive.

"Despite the improving market, it can be very difficult for a new entrant to find a front," Bernfeld says. "Even superior performers in a higher hazard class may have difficulty as a startup," he says.

Many fronting companies are also not willing to do business with small captives, Bernfeld says. Fronting insurers have to put in the same amount of work to front for a small captive as they do for a large captive. But they get paid a lot more for doing the work for a large captive.

The captive market also is closely watching to see how it will be affected by New York Attorney General Eliot Spitzer's recent investigations into insurance brokers Marsh and Aon, and into American International Group. Marsh and Aon are two of the world's largest captive managers, and AIG is one of the largest fronting insurers.

"There's a lot of expectant observation," Mead says.

Mead says some captives are concerned about the appearance of longstanding relationships with some of the companies that have been targets of Spitzer's investigations.

Captives and fronting insurers are also more concerned, in this era of Sarbanes-Oxley, about the transparency of complicated fronting arrangements and any offshore arrangements, Evans says.

"It's a perception issue in the current environment that we're all in with transparency and all of that and regulatory agencies are looking at anything that has to do with something offshore," Evans says.

Because of the limited fronting capacity and new collateral requirements, companies have been trying to find ways to decrease their dependence on fronts.

Risk retention groups have become a popular option because they are able to write liability lines in multiple states without a front. The number of risk retention groups rose to 186 at year-end 2004, up from 86 at year-end 2001, according to the Risk Retention Reporter. Annual premiums rose to about $2.2 billion in 2004, up about $459 million from the previous year. Over the last three years, year-to-year percentage increases have been in the double digits, with RRG premiums increasing by 34 percent in 2002, 37.4 percent in 2003, and 26.4 percent in 2004.

"We are seeing, in the last couple of years, more and more risk retention groups," says Derick White, director of captive insurance for the Vermont Department of Banking, Insurance, Securities and Health Care Administration.

Some parent companies are also taking larger self-insured retentions, and they are working to obtain licenses so they can write their coverage directly.

"The ones (captives) that do have multistate operations are fairly aggressively trying to obtain licenses, at least in the major states in which they operate, so that a good chunk of the exposures that traditionally had gone through a front, they might now be able to write directly," Witmer says.

Although many captives are looking for ways to operate without a front, some captives will always need a front.

"I think there will always be a need for fronts," Witmer says. "Not every company is going to want to get a license in all 50 states--that is a chore in and of itself. The fronts are usually the larger companies, and they would have all of those licenses. There's a point of diminishing returns if a company starts to try to get a license in all the states it has operations in. It's just easier and cheaper to go through the front."

PATRICIA VOWINKEL, a former Reuters journalist, is a frequent contributor to Risk & Insurance[R]. She can be reached at riskletters @lrp.com.