Putting up a good front: insurers, captives and buyers must fulfill specific responsibilities if fronting arrangements are to survive.
A significant change in the nature of the alternative risk transfer market needs to occur in order to maintain the viability of captive fronting.
The Fronting Community
Each captive fronting deal is executed by a fronting community, that consists of the carrier: the captive, which acts as the reinsurer; and the buyer, which is often the parent of the captive. In this arrangement, a buyer seeks coverage on either a single or multistate basis. The carrier acts as the fronting company, issuing the policy on its paper for the coverage in the particular state where the risk is located. The carrier then transfers at least a substantial majority of that risk through a reinsurance agreement to the captive insurance company, or reinsurer. Captive reinsurance fronting, as a product, is unique in nature. It is not a traditional risk transfer arrangement where greater dollars are paid for a presumably more identifiable risk. Nevertheless, fronting carriers reinsuring with a captive can assume substantial credit risk because the captives reinsuring the risk may not be sufficiently capitalized.
The recent downfall of several large, long-standing carriers, along with the effective withdrawal of other competitors, has left a void in the alternative sector .A.M. Best Co. estimates that just six fronting companies account for 75% of the market. This reality--augmented by an increase in time number of insurer failures in 2002 despite an improved combined ratio--confirms that buyers of these fronting services have been stripped of choice as well as long-term value. (See "P/C Insurers' insolvencies vs. Combined Ratio," on this page) The market is in need of quality insurance front companies that offer a solid financial rating combined with a desire to understand and support the alternative market.
To sustain a viable captive market in the future, a very different paradigm must emerge. The solution cannot be left solely to the serf-correcting market influences of the laws of supply and demand. If the buying and selling behaviors of all members of the fronting community do not demonstrate a higher value proposition, the health of the fronting market will diminish further.
An even greater threat looms: Efforts to revive failed regulatory proposals could imperil the captive fronting market as we know it. While there's been little interest in anti-fronting regulations over the past five years, more insolvencies may reinvigorate past efforts. In the wake of recent insolvencies and the potential for increased regulation, the number of carriers willing to provide fronting services for captives may plummet.
A Question of Value
A survey by the Captive Insurance Companies Association and the Vermont Captive Insurance Association illustrates captive owners' perception of the value provided by insurance front companies, as part of the captive community. In the 2003 survey, 26.1% of the respondents reported excellent value from their fronting carriers. This score is down from the 37% of respondents reporting excellent value in the 2002 survey and 58% in 2001.
It's important to evaluate the value question from the perspective of the insurance fronting company, too. It is crucial for the front company insurer to provide value to both its customers (brokers and captive owners) and its owners or shareholders. A study by the Geneva Association and the Insurance Information Institute states that the property/casualty industry in the United States has consistently underperformed when comparing the return on equity to the cost of capital. Given the results of this study, one could argue that the shareholders of insurance companies have seen little value from their investment. (See "P/C Insurers' Return on Equity vs. Cost of Capital," on this page.)
Does this mean that members of the captive fronting community must save each other from themselves? Does it mean that a fronting carrier must be guaranteed a profit without taking any fronting risk?
The answer to both questions is obviously no. However, a change in attitude, behavior and practices across all sectors of market participation must occur in order to achieve a reasonable and responsible balance
The following two scenarios illustrate the issues in the alternative marketplace:
A West Coast broker attempted to renew its client's casualty program, and like many companies today, the client wanted to move its property coverage to the captive, too. The broker asked the incumbent carrier for the casualty program to front the property exposure with reinsurance provided by the insured's captive. But the captive, which had been paying an inadequate $30,000 fee to the carrier, refused to allow more fee income to cover the property reinsurance front. The carrier responded by walking away from the entire risk.
Clearly, there was no winner in this situation. In the end, no one, including the buyer of the product, achieved ally long-term value.
The second example is one of unintended coverage involving allocated loss adjustment expense. A carrier negligently issued and signed a reinsurance contract with a captive owned by a major manufacturer where the language was unintentionally vague on allocated loss adjustment expenses. The intent of the reinsurance provided by the captive was to reinsure nearly 100% of all indemnity and allocated loss adjustment expense for the parent's risk, yet the captive contested the contract on the basis of ambiguous language. In the end, the carrier did not pay indemnity dollars, but it did end up paying millions in legal expenses. No party in this arrangement could have intended this result when the program was originally crafted.
A New Covenant
What is the lesson from this? A new covenant needs to emerge in the fronting captive arena. The fronting captive community, in this case a "trinity" of the carrier, reinsurer and buyer, should embrace cooperative ways to manage its risk. With such a covenant, all parties--including brokers-will support the future viability of the alternative marketplace. This must be done through sound independent decisions that are less oriented to the cheapest price and minimal carrier involvement and more toward sustaining an important product.
Each party would have responsibilities under this new covenant. (See "Keys to Survival" on this page.) The call for a covenant should not imply that fronting carriers that deal with captive reinsurers need to be protected from themselves. The captive fronting community, however, does share the responsibility to prevent a fronting company carrier from becoming a "potted plant." The fronting carrier should not--and cannot--ignore the immense risk that exists well beyond the policy period in most third-party contracts. No one in the industry should ever again fall prey to the following thought process: "Carriers are not entitled to a substantial fronting fee since they have little unreinsured risk." Too many underwriters over the years have succumbed to this terribly false notion.
Collateralization for the fronting company is required for two primary reasons: 1) to protect the fronting company from credit risk; and 2) to address the balance sheet impact of captive reinsurance on the primary insurer trader statutory accounting principles.
Credit risk is the most significant exposure for the fronting company, occurring when the reinsurer is unwilling or unable to honor its financial obligations. This is a significant concern because fronting companies are generally much more highly leveraged than are primary carriers. In a fronting arrangement, the fronting carrier will cede its premium, forgo the concomitant investment income and will still be required to maintain adequate reserves. At the same time, the fronting carrier is ultimately responsible for paying losses and retains 100% of the credit risk. It is the nature of the beast that a fronting carrier is essentially required to advance funds or, in other words, extend credit to its customer. Commercial banks and the derivative capital markets charge considerably more for this type of service than fronting carriers generally do. Further, a commercial bank's credit exposure is generally fully collateralized and represents in all cases finite limits of exposure.
Regarding the issue of balance sheet impact, as an insurance company a fronting company assumes a liability when it issues a policy. Under statutory accounting principles, an insurance company that acquires reinsurance from an authorized reinsurer is allowed to record an offsetting credit corresponding to the reinsurance receivable. In contrast, an insurance company that acquires reinsurance from an unauthorized reinsurer is not allowed to record an offsetting credit. This substantially reduces the amount of capital available for writing other insurance, unless the reinsurance obligation is secured by a letter of credit or statutory trust arrangement. In a typical fronted arrangement, the captive is not an authorized reinsurer in the state where the policy is issued. Therefore, the front's reinsurance contract with the captive is not all approved asset. This reality creates the need for proper collateral to address the regulatory issue. Without proper collateral, the state will deem the transaction to be an unauthorized reinsurance placement and the fronting company will need to use its own surplus to offset the liability created by the policy. Clearly, this cost of capital is not contemplated in the fee charged by the fronting company.
The fronting carrier must require collateral commensurate with the risk and pricing. The collateralization should be for an amount equal to the captive insurance company's ultimate expected losses plus unearned premium reserves. In some instances, collateral may be required for the captive's overall aggregate exposure.
The collateral can be in the form of a trust agreement funded by the captive's investment securities, a letter of credit issued on behalf of the captive by a bank, or captive funds withheld by the fronting company.
According to the 2003 CICA/VCIA survey, 84.8% of respondents state that they provide collateral as part of the fronting arrangement. When asked on what the amount of collateral is based, an alarming 37.8% said that the collateral was based on actual loss reserves only. This can be rationalized in one of two ways: 1) either the respondents/captive owners did not understand the question: or 2) the fronting companies involved in these arrangements are not properly collateralized for their assumed credit risk. Either way, each respondent's "trinity" needs to be re-evaluated to ensure the ongoing viability, of its success.
Threat of Regulatory Intervention
The threat of regulatory intervention leading to greater restrictions on the captive market is a very real one. The regulatory intervention attempted in the past had the potential to severely hamper the alternative market. In 1993, time National Association of Insurance Commissioners adopted a model bill addressing fronting activities after urging by state insurance regulators. Its purpose was to define fronting and to protect buyers from abuses that can occur, particularly in light of concerns regarding insolvency. Ten years later, the bill has not been made part of the NAIC accreditation requirements nor has it been adopted by any state, largely due to its stringent wording. Unless the industry is able to better address its own irresponsible behavior, however, it is more than possible that regulators will renew their efforts.
An additional important issue is time need for insureds owning captives to be cognizant of applicable tax laws and rulings, and to obtain independent legal and financial advice concerning the tax treatment of captive programs. The broker and the ceding insurer are not in a position to advise the insured concerning tax issues.
The captive fronting arena represents a time-honored tradition of creative, alternative risk solutions. It must remain vibrant and available to all those who seek to purchase these products. Insurers' unwavering commitment to this important marketplace, however, must be supported by an equivalent dedication by all parties involved. This will be the only way to preserve the undeniable benefits and value over time of captive fronting products. Support for the alternative marketplace through informed and sound business decisions will facilitate insurers' ability, to afford these products well into the future, in spite of the toughest challenges the industry may face.
Keys to Survival
To support the future viability of the alternative risk transfer market, all members of the captive fronting community need to do their part.
Carrier responsibilities would include the following:
* Underwriters must set an adequate yet reasonable price for their product.
* Underwriters must take meticulous care to avoid unintended risks from the fronting arrangement.
* Carriers must swiftly pay all covered claims.
* Carriers should possess an adequate infrastructure to provide vital services to the captive buyer.
* Underwriters should not attempt to hide behind ambiguous contract language when legitimate claims are intended to be covered under the policy or reinsurance contract.
The following responsibilities would apply to buyers, captives mad brokers:
* Buyers will choose fronting carrier insurers that demonstrate responsible claims, underwriting and pricing behaviors.
* Buyers will choose fronting carriers with the necessary financial strength, expertise and ability to provide quality service.
* Buyers must maintain the financial stability and strength of its captive insurance company.
* Buyers must support the need for the fronting carrier's collateralization.
* Buyers, captive managers and brokers must avoid parsing words when it is clear that coverage was never intended
William N. Curcio is president of Ace Risk Management.
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|Title Annotation:||Alternative Market|
|Author:||Curcio, William N.|
|Date:||Oct 1, 2003|
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