The "Fronting" Wars Continue
April 2003
There is currently a fronting shortage in
the captive insurance arena. Captives that are thoroughly researched and competently
formed, regulated, and managed can avoid the problem. If the security is appropriate
and the management is closely monitored, most threats to solvency can be eliminated
or mitigated.
by Michael
R. Mead
M.R. Mead &
Company, LLC
As the insurance year unfolds revealing personnel changes and strategy shifts,
as expected, the market for risk sharing partners to provide fronting services
is noticeably smaller and a bit more tentative. This issue has been raised before,
but has become a front-burner topic.
Life goes on, and captives are being considered and formed at a record pace,
but both the number of insurers offering fronting, and the appetite of those
who do so, has diminished. The forthcoming CICA/VCIA Fronting Survey * will show that the trends recognized in the past
2 years continue.
Certainly a part of the situation is driven by the fact that there are fewer
insurers today, and fewer yet who have the financial and underwriting resources
to offer what I call certification and regulatory services, "fronting." The
loss of Kemper, all other considerable issues aside, was a big blow. It spread
files, accounts, and work throughout the system, which did not retain the same
number of people who did the work before the fall. It delayed some "new, new"
deals.
The reduction in the sheer numbers of insurers manifests itself throughout
the system, from increased premiums to lack of available coverage or limits
in all lines, not just "fronting." While the equity markets remain uninterested
in commercial property/casualty business, the capital needed by the system must
come from elsewhere. Some has come from Bermuda and Europe. More is needed,
and I am aware that several people and investment institutions are seeking ways
to construct a profitable model. I believe that fronting, properly handled,
can be that model.
Is Fronting the Culprit?
Some insurer executives have taken the position that fronting is undesirable
in and of itself, that it caused the notorious demise of other insurers, such
as Frontier and Legion, and so should be avoided at all costs.
My view is that while some lessons can be drawn from the Frontier and Legion
dramas, fronting per se did not cause their problems, and should not cause any
other insurer problems. The essence of fronting is underwriting, in the sense
of knowing the character, capacity, and capital of your client. If proper underwriting
is in place, and maintained throughout the company, fronting should be a profitable
venture.
One cannot overlook the selfish view of insurance company executives, namely
that their shareholders have invested considerable capital in building claims
and loss control and underwriting facilities. These facilities cannot be supported
in a model where the risk is transferred to a captive, and the captive selects
its own service providers, which may or may not be those of the "front." This
model only works if you didn't build up the internal service providers to begin
with.
So, the better model may be to construct a company that is almost "virtual,"
and acquires services from others, including the reinsurer captive. I believe
that such a model is coming. The model must address other failure modes for
captives.
Common Causes of Fronting Failure
What are the most common causes of fronting failures or losses? In my experience
they are poor or inadequate security and inattention to the finer details of
the reinsurance agreements.
Security must be provided in order for the fronting company to comply with
NAIC and rating agency requirements. While this appears as immutable, in fact,
there is a wide range of definition of "compliance." It can begin with whether
or not collateral is required for the 75th or 90th percentile confidence level,
or more (or less). This decision cannot be driven by an argument between dueling
actuaries. The nature of the risk, and the character, capacity, and capital
of the captive owner must be carefully considered.
Then the nature of the collateral must be closely considered, and perhaps
rejected. Dirt is not collateral, nor bricks and mortar. Some will argue that
"hard" assets are allowed elsewhere, and I am not arguing for total disallowance
of noncash assets. But I am stating that cash and cash equivalents are a necessary
obligation in order to insure the success of the captive. Insurance, including
captives, is still a business in which "stuff" happens. We have seen the 100-year
flood followed by the first flood of the next hundred years the next day.
Some will argue that heavy cash requirements put a captive solution out of
reach for many owners. So be it. Many have said captives are not for everyone.
You must be able to finance your losses if you are going to engage in risk finance.
For many insureds, the best answer is still to muscle up and pay the outrageous
renewal premiums of the traditional market.
To promote a new captive without truly understanding the motives of the owner,
and the nature and amount of his/her resources, is not serving the client or
the industry professionally. This seems basic, but often the true motives for
forming the captive are not clear to either the owner or the manager. By that
I mean that some owners believe that as the money put in came from them, they
can do with it as they please. They may have formed a captive to have one, and
don't really need it. They do not understand that impairing the financial posture
of their captive can mean regulatory action, and even harsh measures to regain
clear approvals. Even writing bigger checks.
Situations have developed in which the owner has changed the capital, or
impaired the capital, or spent the capital elsewhere, and thereby caused the
captive to lose the ability to respond to claims.
When the captive, as reinsurer, is unable to respond to claims presented
by the fronting insurer, the fronting company must then adjust the claim, pay
the claim, and then seek recourse from a questionable reinsurer. This raises
many, many legitimate problems for the "front." Regulators are questioning;
investors are shying away; other reinsurers are putting in restrictions. I can
understand why a beleaguered executive would reconsider getting involved with
captives in the first place. Perhaps a more thorough underwriting would have
prevented or avoided this peril.
Avoiding the Threat to Solvency
Some will say that fronting is not a good line of business. I argue that
such a circumstance was not caused by fronting, but rather by losing control
or contemporaneous contact with the state of the captive's finances and management.
If the manager has the checkbook, with appropriate controls in place, then
the owner cannot endanger his/her own captive. This sounds obvious, but as more
and more captives are formed by owners who are not truly knowledgeable in insurance
and risk finance, we see these situations arise.
Twenty years ago when risk managers ran captives as an adjunct of an overall
risk finance program of a large and resourceful organization, managers were
accountants (generally) who kept the books, paid the bills, and bought the lift
tickets. Today with more and more insureds seeking an alternative approach,
which I favor enthusiastically, managers are entrepreneurial and promoters.
This is a good thing. But it is incumbent on managers and regulators and insurers
to know their clients even better than they have previously.
Of course, most captives are thoroughly researched and competently formed,
regulated, and managed. It is always the dramatic blow-ups that get the headlines
(or the quiet death of the desk drawer). But it is often from these "poster
children" that insurers leap up and point to them as a reason to do no "fronting."
If the security is appropriate and the management is closely monitored, most
threats to solvency can be eliminated or mitigated. It may take a new model
to accomplish the mission.
*The author is the CICA Chair of the Committee which
prepares the report.
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