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The dark side of fronting.

No matter how you slice it, fronting is a fiction designed to circumvent the existing insurance regulatory framework.

Proponents argue that when fronting operates according to plan, policyholders save money, fronting companies receive their fees and reinsurers dutifully pay claims. When fronting fails, however, the victims are always the same-policyholders, claimants, creditors, stockholders and that huge collection of unwitting third parties who eventually pay more for coverages to offset security fund hemorrhaging.

Does this mean regulators should ban the practice? Not necessarily; some fronting is useful and arguably should remain. Front ing can, in limited and defined instances offer a means by which all parties can achieve their goals in a cost-effective manner. For example fronting may be appropriate when statutory prohibitions serve to undercut an insurer's longstanding relationship with its insured. This may occur when an insurer of a multistate firm lacks the requisite authority for writing particular lines in certain states or when an overseas insured opens a U.S. branch and seeks to retain its foreign-based insurer, especially when such insurer would qualify (and perhaps intends to apply) for licensure in the state in which the risks are resident.

Unfortunately, these are the exceptions. In too many instances fronting simply thumbs its nose at the regulatory process, creating its own set of rules and standards

Fronting can often lead primary carriers to abdicate their underwriting responsibilities, accepting risks and rates they normally would never consider. For example, Ideal Mutual Insurance Co., liquidated in 1985 by the New York Insurance Department, had entered into a fronting agreement with Illinois-based Kenilworth Insurance Co. in the early 1980s. Ideal agreed, for a 5 percent fee, to write New York City taxicabs and cede the business to Kenilworth. The necessary letters of credit were secured at the time, but proved grossly inadequate in 1982 when Kenilworth was liquidated by the Illinois Insurance Department. It is telling that Ideal's first action after re-acquiring the book of business was to re-rate the policies. Obviously, the rate for which Ideal was willing to front was far less than the rate for which it was willing to write.

The Dingell Report

The New York Insurance Department first became concerned with fronting in the late 1970s patterns of abuse began to emerge. Such patterns, but on a much grander scale, were documented in "Failed Promises," the recent report by the U.S. House Subcommittee on Oversight and Investigations, chaired by Rep. John Dingell, D-MI.. The report examines the road to insolvency traveled by three rather prominent U.S. insurance companies. Although the paths that led these companies to destruction varied, fronting provided a common point of origin.

The report is at odds with Jon Harkavy, vice president and general counsel of Vermont Insurance Management Inc., and other fronting advocates who look to the primary carriers as bastions of responsibility. Mr. Harkavy, in a recent letter to National underwriter, states, "Primary carriers are well aware of their obligations and do not issue coverage on their paper lightly." Although that is probably true for most primary carriers, "Failed Promises" reveals, in graphic detail, some costly exceptions. In reviewing the Integrity Insurance Co. debacle, the report concludes: "The intent of Integrity's management in using the company as a front was to profit from commission overrides received from the reinsurers. By retaining a minimal risk exposure, sometimes as little as 1 percent, the company's management believed they could profit even with loss ratios exceeding 200 percent."

I would ask Mr. Harkavy if Integrity was so concerned with their obligations, why did they give away the pen" to roughly 80 different managing general agents as reported by the subcommittee? Or why did Transit Casualty Co., in the words of the report, hand its pen and checkbook" to 17 managing general agents and 1,000 subagents in the early 1980s? Transit, the subcommittee maintains, "delegated its authority to underwrite, issue policies, place reinsurance, adjust and pay claims, collect reinsurance recoverables and handle cash and investments." Moreover, managing general agents were permitted to set the amounts of security required to be posted by reinsurers and to obtain the requisite letters of credit from them. So much for the diligent review of obligations.

Such problems are compounded when producers are permitted to direct business to companies in which they have an ownership interest. The Dingell report details how one Texas-based subagent, Carlos I. Miro, was able to establish his own captive, Lafayette Reinsurance Co., which ultimately bled millions of dollars from the primary carrier, Transit. Mr. Miro apparently established Lafayette for the sole purpose of gaining control of a significant portion of the premiums written under Transit's name.

Where Problems Lie

Some advocate that properly regulated fronting arrangements would eliminate the incidence of fraud. They claim that when reinsurance is placed with unlicensed but accredited companies or when appropriate letters of credit are in place, then fraud is impossible. Such sophistry is based on the assumptions that state regulators scrutinize accredited reinsurers as fully as licensed companies and that loss reserves, for which letters of credit have been secured, can be adequately evaluated.

Regulators cannot and should not be expected to hold accredited reinsurers to the same standards as licensed companies. If we did, then why would we continue to maintain the distinction? Moreover, much of the trouble with fronting emerges when reinsurers, managing general agents and/or policyholders are driving the primary carrier's business. They, not the primary carrier, are dictating underwriting guidelines, retention levels and loss reserves.

This last point is crucial in understanding why simply requiring unauthorized or unaccredited reinsurers to post letters of credit is not a suitable alternative to antifronting initiatives. Under New York state law, unauthorized reinsurers are required to post collateral in the form of letters of credit covering anticipated losses. Such letters must be in place when the business is ceded, but anticipated losses at that time may be a poor prediction of future reality. As the business matures, collateral is likely to grow far less rapidly than loss estimates, not to mention the potential for underreserving.

Addressing the letter of credit problem, the Dingell report states: "This letter of credit requirement has failed abysmally to protect primary companies, policyholders and the public from the consequences of bad reinsurance in cases observed by the subcommittee. Available letters of credit to pay claims have been woefully inadequate because they have been based upon greatly understated loss projections."

A further drawback to letters of credit, according to the subcommittee, is that some of the instruments appear to be less irrevocable than others. The Mission Insurance Co.'s California liquidator, for example, had reported difficulties with banks resisting payment. Like empty fire extinguishers, the report states, letters of credit often look good until they are needed.

Ideal, Mission, Integrity and Transit represent examples of fronting at its worst. These are the horror stories that demonstrate the dark side of fronting. But even when fronting works, I am still amazed at the number of insurers so willing to act as accomplices to the destruction of their own markets. Insurers that fail to underwrite or view fronting as a risk-free means of increasing cash flow contribute to the long-term diminution of the industry's importance and influence.

There are a few other points worth mentioning:

Responsibility. When companies cannot qualify or do not wish to enter a state's market, why should regulators countenance the backdoor approach that fronting offers? Certain responsibilities are assumed by insurers conducting business in a state. In exchange for being granted access to potentially lucrative markets, they are expected to contribute to residual market mechanisms, finance security funds, provide markets in times of need, submit to periodic financial examinations, work with regulators to ensure that policyholders are treated fairly and equitably and abide by prevailing rules and regulations. Unlicensed carriers acting behind the cloak of authorized companies appear to be gaining all the privileges associated with licensure with none of the attendant responsibilities.

Policyholder Choice. Mr. Harkavy and RIMS Governmental Affairs Director Howard Greene believe that because some policyholders seek fronting arrangements, regulators should step aside and allow them their choice. Policyholders should, of course, be permitted to select their own insurance companies. But for policyholder safety and the overall good of the insurance mechanism, sound regulatory policy encourages participation within the authorized market. In fronting arrangements, a policyholder accepts few of the risks associated with its decision to buy low-cost insurance products through a fronting insurer. Should the fronting company fail, security funds will be tapped, assessments may be necessary and insurance costs are likely to rise for all of us. The savings and loan crisis has reminded us that sound economic judgments suffer when risk is shifted from the decision-makers. If a policyholder's decision to use a fronting carrier meant the insured could be held responsible for lapsed workers' compensation payments or unpaid automobile claims, I suspect fronting would rapidly lose its allure.

Alternative Markets. Mr. Harkavy has claimed that the solvency concern expressed by regulators is a red herring, designed to divert attention from regulators' real concern-the loss of commercial business to alternative markets.

Regulators have no objections to properly run alternative markets. New York enjoys an active and dynamic excess lines market. In addition, many major New York firms and municipalities, including New York City, choose to self-insure certain lines. New York has also established rules that strengthened the usefulness and attractiveness of purchasing groups operating in the state. If private carriers cannot adequately fulfill the needs of the insurance marketplace, alternative markets are the only reasonable choice for insurance consumers. However, each state takes seriously its responsibility to allow insurers to conduct business within its borders. When insurers rent that authority to entities beyond the state's control, regulators become concerned about the ultimate protection afforded policyholders and the public.

Threat to Competition. When primary carriers enter a market and write business at inadequate rates, as Ideal did in the New York cab market in the early 1980s, other insurers feel the pinch to reduce rates to reflect new market realities. Companies in such situations attempt to navigate between the Scylla of inadequate rates and the Charybdis of eroding market share. Not surprisingly, few complete the voyage unscathed.

A Suitable Definition. Some would argue that fronting, like pornography, is impossible to define. Certainly there are definitional problems. We should, however, be able to distinguish those situations and circumstances under which fronting can be useful and safe from those under which fronting is unnecessary or dangerous. Should a retention level be specified? To what extent should retention levels vary based on factors such as the primary carrier's degree of control or historical retention levels? How can so-called legitimate uses of fronting be carved out? I am confident that, if we can agree that the ends are worthwhile, we can overcome such definitional stickiness.

In the 1976 film "The Front," Woody Allen plays a good-natured nebbish who fulfills a real need: putting his names to scripts and screenplays authored by television writers who had been blacklisted during the McCarthy era. Unfortunately, the tenor of the times required honorable individuals to participate in such charades. Currently, licensure for those that meet a state's capital and ethical requirements is not a demanding procedure. However, most commercial insurance coverages are abundantly available through each state's admitted market, abetted by excess lines carriers and self-insurance mechanisms. Thus, most fronting arrangements in existence today are at best unnecessary, at worst a serious threat to the health and stability of a dynamic commercial market.
COPYRIGHT 1991 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
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Article Details
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Title Annotation:reinsurance fronting
Author:Curiale, Salvatore R.
Publication:Risk Management
Date:Jan 1, 1991
Previous Article:Fronting is a consumer right.
Next Article:Opportunities lie ahead.

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