Insurance and reinsurance programs take on many structures. Some are straightforward traditional reinsurance arrangements. For example, a ceding insurer produces a book of business through its agency force or through independent brokers and underwrites the business through its underwriting staff. Claims are then handled by the ceding insurer's claims department. A reinsurer or group of reinsurers contracts with the ceding insurer to provide quota share or excess-of-loss reinsurance protection.
Other structures involve business produced by third parties. These third parties are often non-risk-bearing organizations that contract with the ceding insurer to produce a certain class or line of business that is then subject to reinsurance protection. A different type of structure includes a ceding insurer that bears very little if any risk of loss and reinsures all or almost all of the risk to the reinsurer, which is the real party in interest and assumes the economic risk of loss for the business written. These are called fronting arrangements. Essentially, the ceding insurer agrees to write the business but then lays off all or most of the risk to the party that really wants to assume those risks.
Sometimes the structure of the deal combines the use of a third-party managing agent that produces and underwrites the business for a ceding insurer, which in turn acts as a fronting insurer for a reinsurer. These hybrid structures conflate the issues parties often confront when dealing with managing agency and fronting arrangements.
In our June 2001 and January 2004 reinsurance commentaries, we discussed some of the issues that may arise when contracting with a managing agent and the various rationales for creating a fronting arrangement. This commentary will discuss the interplay between the two.
Overview of Insurance Business Production
There are many ways insurance business is procured, produced, underwritten, and ultimately reinsured. Because there are many specialty lines of insurance, some of which are esoteric or highly specialized, very often they are underwritten by specialty brokers or other third parties that contract with insurance companies to provide the insurance policies necessary to insure that business risk. Sometimes the insurer is actively engaged in the business and participates both economically and with the underwriting and claims handling. Sometimes the insurer merely acts as a pass-through or fronting company for the business, which is ultimately reinsured to a specialty reinsurer created by the producer or an unaffiliated reinsurer that becomes the real party in interest.
The analogy is roughly similar to a market-maker in the securities world. Certain specialized stocks are traded between a few specialty securities brokers who create a marketplace for the securities for that industry. In insurance, certain business is sourced and underwritten only by specialist brokers. Because these brokers typically are not risk-bearing entities, they need to find an insurance company to supply the policy on which the business will be written and a reinsurer or a group of reinsurers willing to assume the risk associated with the policies being written. It is not uncommon for brokers to develop new coverages and insurance products for new risks and then reach out to the risk-bearing insurance market for insurers and reinsurers willing to participate in the new underwriting venture.
The Interplay between the Fronting Company and the Agent
The producer/agent of the business will typically contract with an insurance company as a managing agent to produce the insurance business on the fronting insurance company's policies. If an agent is producing and underwriting business on behalf of an insurance company, most states' insurance laws require that an agency agreement must be entered into between the agent and the insurer. The regulatory climate for agents changed in the 1980s because of perceived abuses by some unscrupulous agents. These agency agreements have provisions that purport to protect the insurer from abuses by an underwriter who that has no skin in the game.
If it is the producer/agent who is sourcing and underwriting the business (and owns the renewals as many managing agents do), it is likely then that the producer will look for an insurance company partner or for a fronting insurer that will allow the producing agent to write the business on that insurer's policies. Where the insurer is not a partner in the true sense (does not want to keep the business net), a fronting arrangement is generally created whereby the insurer is merely a pass-through for the business. The insurance policies produced are ultimately reinsured by the insurer that has the real interest in the business.
The insurer with the real interest in the business may be a true independent partner with the producing agent or may be a captive risk-bearing insurer created by the producing agent. Very often, the producer-owned reinsurers of these fronting arrangements are incorporated outside the United States, where the capital and regulatory requirements have lower barriers to entry.
In one scenario, the risk-bearing entity is a reinsurer ultimately owned by the producing agent. In this situation, it is in the producing agent's best interest to produce high-quality business in which the fronting insurer will receive its fronting fee and not have any real risk of being stuck with a book of poorly performing business with no live reinsurer.
In another scenario, the risk-bearing entity is an independent insurer acting as a reinsurer. In this situation, it is often the case that the producing agent's only form of compensation is the fee earned from producing and underwriting the business plus any profit sharing on the profitability of the entire book of business. Here, the independent reinsurer must be vigilant to ensure that the producing agent is producing quality business and not just ramping up the volume to earn a large commission and then disappear.
The reinsurer cannot rely on a fronting insurer to monitor the managing agent where the fronting insurer is not retaining any risk. The fronting insurer is merely collecting a fronting fee as the business is all being reinsured to the reinsurer. If the fronting insurer was brought into the deal by the managing agent, there is even more reason to monitor the business carefully.
What Can Go Wrong?
At the outset, it is important to be clear that most managing or producing agents do an excellent job in their specialty areas and do their very best to produce high-quality and profitable risks. Nevertheless, where insurance companies allow others to do the producing, underwriting, and claims handling, things can go very wrong.
In a recent case, an insurance company acting as a reinsurer became the real party in interest to a fronting deal created and produced by a managing agency and its affiliates. Essentially, the agent allegedly diverted millions of dollars of funds from the reinsurance arrangement to its affiliates and then to its principals. See Lincoln Gen. Ins. Co. v. U.S. Auto Ins. Servs., Inc., 2015 U.S. App. 8172 (5th Cir. 2015).
In this case, the managing agency produced and underwrote auto insurance policies for a third-party fronting company. The reinsurer reinsured 100 percent of the business written. The agency agreement was between the fronting company and the managing agent. The managing agent issued the policies, collected and handled the premiums paid, and handled the claims. Although there was a premium trust account, the managing agent had the power to manage the money and to retain its commission before depositing any funds into the trust account. The managing agency engaged an affiliate to handle the claims.
The deal was structured based on a target loss ratio. After paying a small fronting fee from the premiums collected, the managing agent received 20.6 percent of the remaining premium as its compensation. The reinsurer received 10 percent of the premiums assuming the loss ratio target was not exceeded. The balance would pay losses, and if the loss ratio was lower than the target, the managing agent would receive additional commission.
We can stop the narrative here because it is pretty clear what can go wrong. If the loss ratio were somehow manipulated, the reinsurer would not get its 10 percent, but the managing agent would get its 20.6 percent off the top. Also, if the funds meant to be put aside to cover the target loss ratio were siphoned off, there would not be enough money to pay the losses.
In this case, the managing agent allegedly entered into contracts with other affiliates and paid those affiliates $50 million, which was never put aside for the anticipated losses. Additionally, the managing agent allegedly unilaterally changed the formula used to calculate its commissions and artificially depressed the loss ratio to inflate its own commissions. When the losses finally came in, the trust fund was depleted and the reinsurer had to fund all the claims.
Managing and monitoring a managing agent is absolutely critical to avoiding an unintended loss. If the real party in interest is a reinsurer behind a fronting arrangement, the reinsurer must audit and monitor the managing agent to make sure that the premiums are being allocated and deposited correctly and that the target loss ratio is being met. The right to audit must be carefully crafted into the reinsurance agreement where the managing agency agreement is solely between the fronting ceding insurer and the managing agent.
Although modern managing agency agreements provide statutory and contractual protections against managing agency abuses, there is no substitute for boots on the ground (or at least virtual boots accessing premiums and claims systems in real time). It is important for the real party in interest to examine any third-party service contracts entered into (or better, proposed to be entered into) by the managing agent to avoid self-serving contracts with affiliated companies that merely increase the fees paid to the managing agent.
Frequent reporting, auditing, and spot-checking are critical to maintaining a healthy managing agency arrangement that works for all parties. Where there is a fronting insurer involved, it is critical to make sure that the reinsurer―the real party in interest―has all the rights to receive reports and monitor and audit the entirety of the fronting and managing agency arrangement.
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