The fronting relationship can cause confusion. This article explains the basics of fronting and why it may be necessary for licensing, rating, pooling, or regulatory reasons.

by Larry P. Schiffer
LeBoeuf, Lamb, Greene & MacRae, L.L.P.

Reinsurance plays a variety of essential roles in the insurance industry. It is used to expand underwriting capabilities, provide capital, and boost the credit rating of the ceding company. While not true partners in a legal sense, in a traditional reinsurance transaction, the ceding insurer and the reinsurer have much in common. Both have an interest in restricting insured losses to only those covered by the underlying insurance policy and the reinsurance agreement. Both also have an interest in pricing the business in such a way that both the ceding insurer and the reinsurer earn a profit. Key to the traditional reinsurance relationship is the trust between the ceding insurer and the reinsurer.

Reinsurance is also used to structure an insurance relationship so that the real party in interest ends up with the risk it wishes to assume. In this kind of transaction, the ceding insurer generally has little relationship with the underlying risk and, in essence, is standing in for the reinsurer. When a risk is underwritten by an insurer which cedes all or nearly all of the risk to another insurer, the relationship is called "fronting."

Introduction to Fronting

Fronting occurs for a number of reasons, a few of which are discussed below. Fronting is used where the insurer is not licensed to write business or a specific line of business in a particular state. Fronting also is used where the insurer’s rating is below the program or insured’s requirements. Finally, fronting is used in situations where risks are assumed by a pool of insurers or reinsurers.

In each of these fronting relationships, the ceding insurer has entered into the relationship for a fee only, and generally does not intend to assume any risk of loss. The fronting insurer has no interest in whether the underlying business is profitable or loss making. It also has little interest in restricting losses because the losses are being covered in full by the reinsurer.

The traditional duty of utmost good faith, which requires the ceding insurer to disclose to the reinsurer all relevant information about the risk being reinsured, is much less of an issue in a fronting situation. Here, it is generally the reinsurer that knows all about the risk and needs a fronting company for reasons having nothing to do with risk evaluation and selection.

Fronting for Licensing Reasons

Where an insurance program is negotiated with an insurer that is not licensed in certain states or is not licensed for a particular line of business, a fronting insurer is needed for the unlicensed states. This circumstance may arise when structuring an insurance program for an individual risk that has multiple state and multiple line insurance needs, or when structuring a large program for an industry or coverage class. A licensed insurer is used to write the policies in the necessary states, and those risks are ceded at or near 100 percent to the program insurer which technically acts as a reinsurer.

A fronting relationship is often typical of an insurance program led by overseas or offshore insurers or reinsurers. Difficult risks often are insured only by certain markets outside the United States. In these circumstances, the overseas markets will engage a licensed insurer in the United States to issue the policy on the form designated by the overseas markets. The overseas markets will create the underwriting guidelines, engage the claims administrator, and establish the reinsurance structure. The reinsurer merely uses the paper of the licensed insurer to issue the policies the overseas market wishes to write.

Insureds with captive insurance programs also may use fronting insurers for their offshore captives. As most offshore captives are not licensed in the United States, a fronting insurer is often necessary to structure the captive program in the United States.

The fronting insurer and the program insurer will, however, enter into a formal reinsurance agreement reflecting the fronting arrangement. In spite of the fronting aspect of the relationship, the fronting insurer remains legally liable to the insured. And, if the reinsurer fails to perform, it is no excuse to the insured that the issuing insurer merely fronted for the reinsurer. Assessment by the fronting insurer of the credit risk of the reinsurer when entering into a fronting arrangement is essential.

Fronting for Rating Reasons

Where a program or an insured requires an insurer to be rated A or better, a lower-rated insurer or one that suffers a downgrade before renewal will need to use a fronting insurer if it wishes to remain a part of the program. As above, a licensed insurer with the required rating level will front for the program insurer and will cede at or near 100 percent to the program insurer. The reinsurance relationship also is the same as above, with the fronting insurer assuming the credit risk of the program insurer.

Fronting for rating reasons may take place on the direct insurance or the reinsurance level. Where a reinsurer with a long-standing relationship with a ceding insurer has its rating cut, it may look for a fronting reinsurer to assume the business. The reinsurer will then cede all or most of it to the original reinsurer, now acting as a retrocessionaire.

These types of fronting relationships develop when the reinsurer is either the traditional market for a particular program or there has been a long-standing relationship with the insured that the parties wish to continue. A fronting relationship for rating reasons also occurs where a program administrator or managing general agent has its own insurer that assumes the risk. Often, these insurers are smaller and do not have the ratings necessary to qualify for many program insurer rating requirements. In those circumstances, a fronting insurer is necessary to complete the transaction.

Fronting in a Pooling Situation

A fairly typical fronting situation arises in the case of an insurance or reinsurance pool. Generally, the pool manager assigns one of the pool members as the policy issuing company for the pool. The risk is then ceded through a reinsurance contract between the fronting company and the remaining pool members. Usually, in this type of relationship, the reinsurance contract is on a quota share basis, with the fronting ceding company retaining its pool percentage.

In other pooling situations, a separate fronting carrier issues its policy and reinsures the risk under a reinsurance contract directly with the pool. The fronting insurer in this situation remains legally liable to the insured and, depending on the pool’s structure, may assume the credit risk of each of the pool members.

Regulatory Issues

In certain states, fronting is not looked at very favorably by insurance regulators. In the 1970s, fronting took a large share of the blame for the insolvencies of that era. Many of the companies that went insolvent fronted programs supported by large and complicated reinsurance structures often filled with small, thinly capitalized reinsurers. When the inevitable losses came in, those reinsurers, which also reinsured many other long-tail programs, either failed or went into runoff. Congress, and the regulators, harshly criticized these fronted reinsurance programs as one of the causes of these insolvencies.

The result of this criticism was a regulatory crackdown on fronting relationships in certain states. In some states, a reinsurance fronting deal will be disallowed unless the fronting insurer retains at least 10 percent of the risk. Regulatory issues must be considered when reviewing a fronting transaction.

Conclusion

Fronting is a device used to structure an insurance program where the real insurer in interest is either not licensed in a particular state or does not have the rating to satisfy the program or the insured. While the fronting insurer many not assume any risk and merely takes a fee for the use of its paper, its relationship with the real insurer in interest is technically a reinsurance relationship. Because of that relationship, the fronting carrier is legally obligated to the insured and assumes the credit risk of the reinsurer. Thus, fronting is not risk-free, and careful attention to the transaction is needed by all parties.

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