In its most common form, a commercial insurance company (“fronting company”), licensed in the state where a risk to be insured is located, issues its policy to the insured. That risk is then fully transferred from the fronting company to a captive insurance company through a reinsurance agreement, known as a fronting agreement. Thus, the insured obtains a policy issued on the paper of the commercial insurance company. However, financially, the risk of that coverage resides with the captive insurance company.
There are several business reasons for this type of fronting arrangement:
-The need for a licensed carrier to issue the insurance policy for particular risk.
-The need for a carrier with a minimum AM Best rating and/or the ability to meet other financial strength measures to issue the insurance policy for a particular risk.
-The potential ability to achieve tax deductibility of premiums by the insured through successful risk-shifting.
An additional use of fronting exists where the captive, usually a single parent captive, serves as the fronting company and issues a policy directly to the insured parent company. When this happens, the risk is fully reinsured to one or more domestic or foreign reinsurers. Consequently, the fronting captive would not retain any of the risks and the parent company has gained access to the reinsurance market. The reinsurers would not have been legally able to write the risk directly.
The fronting company will require reimbursement by the captive insurance company of all costs related to the fronted policies it issues plus payment of a fee. Costs passed through typically include commissions, premium taxes, costs of guarantee fund participation and sometimes claims administration and underwriting costs. Costs and fees may be as low as 6% or as high as 30% of gross premiums paid by the insured. As the fronting carriers role varies, so too does the percentage of premium required for the fronting company by the participant.
The fronting company will almost always require collateral to secure the captive’s obligations to the fronting company under the fronting agreement. Collateral takes one of three forms: captive funds withheld by the fronting company, a trust agreement funded by investment securities of the captive or a letter of credit issued on behalf of the captive by a bank (usually secured by investment securities of the captive).
Dating back to the hard market days of 2001, captive insurance companies began to experience difficulties in implementing or retaining favorable fronting arrangements. Certain fronting carriers have exited the market, thus requiring existing captives to find new fronting relationships. This has decreased dramatically the number of fronting carriers available to captives. Remaining fronting carriers are more selective, thus making it more difficult for captive insurance companies to locate a fronting company. Finally, the fees charged by the remaining fronting carriers have increase by several points, reducing the margins of the captive insurance companies bearing the risk. The difficulties that captive insurance companies have experienced in finding suitable fronting carriers at cost effective rates is one of the greatest challenges facing the captive insurance industry today.