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Guidelines for selecting
fronting carriers
in an era of change
Carol Frey recommends an evaluation process for captive owners to consider in the area of fronting.
April 2006
Today’s risk managers unquestionably have a broad array of products and services at their disposal, including captives, which in combination ultimately creates a unique formula that can balance risk financing and insurance protection. When selecting an insurer to issue policies that will in turn be reinsured by a captive (referred to as a “fronting company”) in the alternative risk sector, there are multiple considerations. For many buyers of alternative risk products, it is a challenge to keep abreast of the appetite for participation on the part of the fronting companies. For example, fronting carriers may sporadically impose risk appetite shifts in relation to product offerings that may result in a more limited field of choice for some buyers. Furthermore, it may also come as no great surprise that as rating agencies evaluate and implement tighter capitalisation guidelines based on numerous portfolio evaluations, the selectivity of fronting markets may become even more elusive, and, going forward, may demand increased pricing requirements for the access to capital.
While both producers and their clients continue to pursue fronting companies for both traditional and more exotic purposes throughout 2006, it may also be an opportune time for buyers of alternative risk products to conduct more comprehensive fronting carrier evaluations. This would not be limited to just standard queries such as collateral positions and fronting costs, but would extend to an overall, holistic enterprise review of the fronting carrier. Instituting a more thorough, integrated evaluation process would typically occur during the infancy of the programme design and business planning process. Participating in this holistic process allows buyers to better identify their potential pool of alternative risk providers and to ensure that there is a shared management philosophy and strategic approach.
The publicly-held fronting carriers, as well as all publicly-held companies, are subject to Sarbanes-Oxley financial reporting requirements. As a result, the fronting carriers should be applying stricter corporate governance and continued adherence to regulatory compliance guidelines. For the buyer of alternative risk products, it would be worthwhile to identify the level to which each of these carriers is implementing comprehensive corporate governance and compliance practices within its organisation.
Aside from corporate governance practices, an even more interesting practice is learning how fronting carriers are applying effective risk management solutions to safeguard data and sensitive customer information, given the growing vulnerability of external threats to institutional data. Adding to that challenge is the ongoing complexity of keeping up with the demands of a constantly evolving technological platform.
Ultimately, those fronting carriers who anticipate these risks and challenges will differentiate themselves in the marketplace and serve as a stronger partner to a prospective buyer.
Generally, the availability of fronting carriers has been relatively constant since the hardening of the insurance market in late 2001. Annual captive owner surveys conducted by the Captive Insurance Companies Association (CICA) demonstrate that the fronting market for single parent captives has remained the same and that market share has simply shifted between these fronting carriers during the periods surveyed. The 2006 CICA Fronting Survey conducted by Johnson & Lambert indicates two predominant influences generate the continued need for fronting carriers: admitted paper and compliance. What is relatively more difficult to capture from a qualitative standpoint is the positioning of the fronting carriers in terms of specialisation, structures supported, capacity offered and whether or not risk transfer will be provided in addition to pure fronting (100 percent reinsurance) arrangements.
The consensus within the captive community is that the commercial fronting market has become even more restrictive when the purchaser is a group, association or other multiple owner structure. Furthermore, some fronting carriers will entertain new captive formations, while others may not. The continued divergence in appetite by the existing fronting carriers, particularly for groups and associations, has increased the use of The Liability Risk Retention Act, enacted in 1981 and extended in 1986.
As a result of lack of availability and/or the perceived prohibitive costs associated with a fronting carrier, these alternative risk buyers may pursue a Risk Retention Group (RRG) in order to direct-write liability exposures. The decision is generally determined based on a comparison of coverage availability, pricing, terms and conditions, capitalisation and collateral. The observed differences between an admitted fronting carrier and an RRG should not be compared only in relation to cost, since there are major differences in product and compliance. The added costs of admitted fronting carriers are a compilation of additional overhead associated with regulatory oversight, Sarbanes-Oxley financial reporting guidelines, overall compliance and ongoing rating agency monitoring and reporting. In anticipation of regulatory and rating agencies imposing greater scrutiny and increased capitalisation requirements on admitted fronting carriers, the commercial insurance companies could react by re-examining their interest in fronting arrangements and the associated profitability. While most RRGs do not currently have the same regulatory and rating agency requirements (unless they have pursued and received an A.M. Best rating), there has been a recent General Accountability Office (GAO) report that currently recommends increased standardisation in the regulation for RRG formations throughout the US. The GAO report also included recommendations for standardisation of accounting and improved disclosure and transparency. This disclosure would state that there is no backstop protection from State or Federal pools, should the RRG fail to fulfill its obligations.
RRGs, as well as other group/programme formations, require considerable commitment from their members and even more from their boards of directors to ensure that the product meets its established and ongoing business objectives and maintains continual buy-in from its members each year. Education is critical to the successful implementation of these alternative risk formations. An essential fundamental step is the coordination and support of a professional captive formation specialist who is experienced in leading a potential buyer through the extensive cost-benefit analysis of various risk-sharing alternatives. It is not uncommon for this process to take up to a year or more, and will in some cases test the patience and interest level of the buyer. However, this process is necessary to constructing a programme that is designed to meet its outlined business objectives.
Risk financing programmes are generally adopted by buyers who wish to share in their own risk, want greater control of their claims process and, in the case of a captive, are willing to put their own capital at risk. When prospecting for fronting carriers, the buyer should consider the following criteria:
If so, is the carrier willing to share risk on your programme in an excess of loss, aggregate or other risk sharing/transfer arrangement? Generally, those markets that share risk are underwriting, and therefore evaluating, your exposure, based not only on your unique loss experience, but also in terms of the carrier’s portfolio experience and expertise and industry rating. Is the carrier prepared to explain its underwriting process and how that parlays into the product offered to you as the buyer?
This is a key question for a risk-sharing partner. Many carriers take a fully unbundled and hands-off approach when it comes to claim management, related services, loss control/safety and engineering evaluation. Other carriers may offer a purely bundled approach. Interestingly, this position is in direct conflict for most alternative risk buyers who wish to consider a risk-financing structure. In these fully unbundled or totally bundled scenarios, the buyer needs to clearly understand the claims process and under what circumstances the client can participate in claims, legal recourse and possible recovery initiatives.
Thankfully, there is a handful of fronting carriers that offer both a fully-bundled or cafeteria-style unbundled risk management services platform. Basically, the client can access any risk management service, including claims management, recovery services, billing review, benchmarking, loss prevention and safety engineering services, without the forced hand of buying paper and insurance. The unbundled and cafeteria-style options generally offer the buyer increased product integrity, a greater potential for checks and balances, and stronger auditing controls. Is the carrier providing consultative services for the captive owner or prospective alternative risk buyer?
Is this firm conducting the feasibility study and initial pro-forma financial plan? A fronting carrier that offers these integrated consulting services on a fee basis or otherwise may unknowingly or indirectly influence the client during the scenario analysis. Fronting carriers who do not offer these services would be indifferent to the structure being requested. Furthermore, these fronting carriers may offer supplemental programme designs not initially requested, or perhaps question the suitability of a specific structure being pursued on any number of underwriting, exposure, overall premium or financial review characteristics.
Under what circumstances are they provided? The bundling or unbundling of captive management services offers yet another reason for inquiry. With the pressures of transparency, disclosure, financial reporting and regulatory compliance and the fact that there is a plethora of brokerage, banking and independent specialty providers solely dedicated to captive management activities—it would seem that the buyer should have a choice in the selection of captive management services.
This function is a regulatory and accounting procedure for the captive insurance company and the related parent company (if applicable), not the insurer. Some fronting carriers offer these services on an unbundled basis, while others only provide these services on the programmes for which they are fronting. Others, in fact, do not supply captive management services at all, with the exception of conducting reporting for their own sponsored or rent-a-captive facilities, where it is the insurer’s capital and regulation at risk.
The real ‘trifecta’ is when a fronting carrier is bundling its fronting, along with claims-handling services, in conjunction with captive management services. In this totally bundled product, the buyer would certainly need to have a clear understanding of internal auditing procedures and to assure that one function does not in any way have influence over the other. The buyer should be confident that the claims-handling practices and reserving practices are regularly reviewed prior to the close of captive management reporting.
When this scenario is not initially contemplated in the programme selection process, the burden then falls on the auditors, regulators or buyer to manage. One possible strategy for purchasing a fully-bundled programme would be for the buyer to designate a third-party claims audit on a regular basis. Typically, fully-bundled arrangements are better suited for smaller and growing companies moving away from traditional insurance purchasing.
It is now more important than ever that the enterprise interview be conducted by the alternative risk buyer. Not only must the buyer be confident of the carrier’s underwriting capabilities, but also in terms of claims-handling practices, communication channels, auditing routines and overall-instituted best practices.
Is the fronting carrier prepared to acknowledge your business as premium and/or deposit accounting? Is the fronting carrier’s accounting clear and notable in your quotation?
What processes does the fronting carrier have in place to review transactions, how does this process work and at what point does the buyer become aware of any changes in recording philosophy? Asking these questions will allow the buyer of alternative risk business to gain a better understanding of the fronting carrier’s organisation and how that organisation is applying risk transfer tests to its overall methodology for financial recording. Additionally, the buyer may want to explore the number of policies that will be needed to complete the programme structure and how each policy does or does not constitute risk transfer.
Although there is no tried and true industry guideline in terms of where these benchmarks are set (or will be set), it is still a forum for discussion and an opportunity to discern the thoroughness of a fronting carrier with respect to structural review and overall accounting procedures. A healthy conversation on the process of structural review with a fronting carrier will offer the buyer potential future considerations in relation to the type of product it requires to meet specific business needs. In addition, it is important for the captive to obtain its own independent tax and accounting analysis.
What best business practices has the carrier instituted? And how do these practices improve the product for the buyer? For example, is the fronting carrier aware of processing statistics and if so, are they willing to provide the buyer and producer servicing metrics? Documentation in all forms, such as proposals, policies, agreements, and invoices should be clear in content and accurate in relation to the deal offered and bound. A fronting carrier that can demonstrate measurability and comparison to established best practices will certainly differentiate itself in an industry that is still suffering in the wake of Mr. Spitzer’s actions.
As with traditional insurance companies, fronting markets are sensitive to underwriting cycles. Fronting appetite is relatively easy to observe and producers are likely to know the markets that are consistently fronting markets, versus those that are not. For buyers, it becomes a decision as to how sensitive they are to more significant swings in market conditions. In an example of heightened purchasing sensitivity, a buyer may elect to front an exposure given an extreme market condition and select a fronting carrier whose appetite does not include any element of risk transfer. However, in a subsequent softer market, the same buyer may then want to combine fronting with risk transfer. This buyer should be aware of the fronting carrier’s appetite and attempt to partner with a fronting carrier that has demonstrated those varying degrees of underwriting platform. Selecting a “fronting only” scenario would result in the buyer having to switch carriers when his or her insurance buying appetite changes.
The underwriting platform for the buyer of risk financing structures should consider strategic growth and specialisation versus generalisation of the fronting carrier. A select few fronting carriers are global in reach and are capable of extending to the buyer more product that can support and share risk as the client’s operations expand internationally. Captives are a natural fit for international, controlled master programmes, and as such, having a fronting carrier that can offer global coverage and service will build consistency in underwriting platform. Other fronting carriers are positioned as domestic or international-only providers. Similarly, some fronting carriers are strictly commercial markets, whereas other carriers are broader in product offering in terms of consumer products, employee benefits, healthcare, life and pension.
The risk manager needs to have a general idea of the scope of risk sharing in terms of design and the products that are to be considered in a long-term strategic risk financing programme. In recent years, captives have been seeking to diversify and expand their risk appetite to include employee benefits (ERISA and non-ERISA) and other third party coverages and products. Consequently, the buyer may want to consider these varying degrees of product offering while in the evaluation of fronting carriers.
Who are the members of the leadership team of the fronting carriers you are considering? For how many years have they managed the organisation and how successful has the organisation been under this management team? A buyer should always learn about fronting markets in terms of overall leadership and instituted underwriting guidelines. A risk manager using a captive will value underwriting discipline and execution. The buyer should have the opportunity to learn who is currently managing the organisation, and its achievements under their direction, and to understand the company’s commitment to fronting and risk management programmes. Accessibility to the management team, including a chief underwriter, should be possible—depending on the level of the buyer’s special business needs. Fronting carriers whose business leaders can somehow manage to balance the underwriting platform with the business needs of the buyer will clearly have positioned themselves and their company for a long-term partnership and mutually beneficial enterprise.
A key differentiator for fronting companies is their ratings. Industry rating agencies, such as A.M. Best and Standard & Poor’s, are responsible for monitoring financial strength and longevity. Stronger ratings generally substantiate preferred consideration and in some cases justify pricing differentials. Ratings are critical to a fronting market’s reputation and reflect the degree of business and portfolio management.
An easy way to research your prospective markets is to identify if any of them are currently, or were, on Credit Watch, or to see if your potential fronting carrier has experienced upgrades or downgrades in various agency ratings. According to A.M. Best, over the last five years downgrades have well outpaced upgrades. So the question is: which fronting markets have fallen into what category? Since the use of fronting is valued-based on admitted coverage and compliance—how can you make sure you are selecting a healthy and financially responsible fronting carrier?
In today’s terms, as well as in the future, the importance of ratings will translate into how the fronting carriers are modeling in terms of catastrophic events—both natural and man-made–—and how their aggregation of exposure is monitored. Not only should a risk manager have a general understanding of the fronting markets’ catastrophic modelling techniques, but the buyer should also know “how they fit in” to the overall portfolio of exposures and how the fronting carrier knows if the aggregation is close to penetration or exhaustion. Does that mean that the carrier seeks supplemental treaty or reinsurance support? Or, does it mean the door is closed? Does the carrier evaluate portfolio aggregation across multiple lines of business, such as property, business interruption and workers’ compensation for a single catastrophic event?
With the Terrorism Risk Insurance Extension Act of 2005 (TRIA) renewed under a limited scope and higher incident thresholds for quota share protection—how does you fronting carrier price and collect for TRIA? If your carrier is deferring TRIA premiums until an incident—how do you know what premium will be due and will the carrier disclose that now or after the event? How is the carrier anticipating changing rating agency requirements for capitalisation and how is it expected to impact catastrophe and related TRIA pricing or availability? For a risk manager, these questions will provide insight into the fronting carriers’ foresight and could reveal the carriers’ preparedness, and possibly, their survivability.
A final signal for alternative risk buyers is to monitor how various fronting markets have reacted during and after catastrophic events. How quickly were financial results shared? What were the results and how often are the results changed or restated?Are the results shared in terms of gross, net of reinsurance and net of taxes? What percentage impact did the net loss have to the fronting carrier’s overall capital and surplus? The timeliness of reporting along with balance sheet impact will certainly assist a risk manager to gauge the systems in place for measurability—and can be a critical discussion point with the chief financial officer when decisions of fronting selection are being made. This is particularly important when fronting for long-tail and/or catastrophic exposures are being considered.
While this article is by no means a fully comprehensive checklist, it is intended to provide buyers of alternative risk business with food for thought. Being able to conduct and evaluate fronting carriers on a deeper level in relation to profile, bundling vs. unbundling, underwriting platform, leadership and experience, capitalisation, and catastrophic and aggregation modelling can result in a decision that is mindful of the current and increasingly changing business environment. Buyers will always be sensitive to pricing and collateral. The challenge after a thorough market evaluation is to be able to apply an enterprise evaluation factor that accounts for the overall assessment of the fronting carrier(s) in addition to the obvious pricing costs associated with an alternative risk financing relationship. This factor and the end result should validate the buyer’s overall confidence in the decision-making process.
A secondary, yet more selfish outcome of this enterprise evaluation may offer a prospective or existing captive owner the opportunity to apply this same exercise upon the captive itself and its related supporting services. Captives, while not directly subject to Sarbanes-Oxley financial reporting requirements, will nonetheless by compared to these standards, whether they are recommended or imposed by the captive owner or board of directors. By applying the same due diligence process as discussed above for the selection of fronting carriers, the captive owner may discover areas for improvement. A heavier emphasis on compliance, data integrity, and actuarial analysis that includes a catastrophic component may expose areas of vulnerability for the captive.
Whether a captive intends to take on higher retentions or limits, or broader coverages, or decides to maintain its current underwriting position, this enterprise evaluation could certainly guide the risk manager or alternative risk buyer through an intensive testing protocol that will result in a healthier and financially stronger risk financing structure.
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