Fronting Arrangements – A Necessary Headache

Just about any captive involved with controlled lines will end up dealing with fronting arrangements. Controlled lines are lines of insurance that are regulated by the state. The most common examples include workers compensation, healthcare benefits, and automobile insurance. The necessity of the fronting arrangement arises out of the need to provide sufficient evidence of financial strength or solvency for regulatory purposes.

Although fronting is necessary, neither the captive owners nor the fronting companies generally seek out these relationships. Insurers typically make more money selling insurance instead of fronting. Captives have to pay a portion of premiums to the fronting company. Fronting arrangements can tie up as much as 12 percent of the captive’s gross written premiums. In addition, collateral from the captive is generally mandated to be used in order for the fronting company to agree to the contract.

Of all the issues with fronting arrangements, collateral is the most hotly debated. Fronting carriers lose underwriting capacity when engaging in fronting arrangements. In effect, captive insurance companies lease surplus capital from fronting carriers in exchange for collateral (letters of credit). The amount of fronted liabilities that are not collateralized impair the fronting carrier to write additional premium. This impairment is generally known as a Schedule F penalty, named after Schedule F of the fronting carrier’s annual statement which details authorized and unauthorized reinsurance arrangements. However, most captive insurance companies are not going to materially impact the underwriting capacity of large carriers, such as The Hartford. The larger issue is that the captive is a non-recognized insurer and its premiums are non-admitted assets.

In short, the fronting carriers have an incentive to place a higher value on potential losses (incurred but not reported losses) and mandate a higher collateral from the captive. This creates a natural conflict of interest between the fronting carrier and the captive. The captive would prefer less collateral as it is cheaper for the captive, but Schedule F penalties create the opposite incentive for the carrier.

This complex issue compounds in the event the captive switches fronting carriers. The captive now has to handle two fronting companies: 1) the former company with no incentive to set collateral low; and 2) a new fronting company with little direct experience with the captive. Since the standards for setting collateral are generally a matter of professional judgment, there may be considerable issues to discuss between all parties.

Another frequent point of contention with fronting arrangements is whether the captive may retain control over claims management. One of the key values offered with captive insurance is that the owner gains maximum control over systemic risks. This includes claims management and selection of defense counsel. However, many fronting carriers require the captive to use the fronting carrier’s claims management program as the fronting carrier is taking on liability by fronting for the captive. This arrangement may preclude the owners from being able to deny claims or litigate cases to trial if the fronting carrier deems the case a good candidate for settlement.

Given these pitfalls, captives should consider whether there are any options out of the collateral issues. One way of avoiding collateral demands is through the use of pre-paid premium financing. Most captives pay their premiums in monthly installments. However, if a captive pays all of its annual premiums up front, then the fronting company can hold the total premium and release the premium as the captive earns it. This has the effect of funding the fronting carrier’s unearned premium reserve. Many captives lack the liquidity to fund their whole year’s premium in a single installment. Premium finance companies frequently front annual premiums by lending the amount of the annual premium to the captive.

In the event that premium financing is either unavailable or is otherwise disfavored, captive managers should focus on negotiating around the following points when drafting fronting arrangements.

  • Captive managers should push for claims cooperation so that any settlement requires the captive’s permission;
  • Captive managers should consider whether the loss adjusters handling claims are appointed by the fronting carrier or the captive;
  • Dispute resolution choice of law should be discussed (whether on fronting carrier’s home turf or the captive’s home state);
  • Captive managers should consider the relative merits and pitfalls of arbitration and mediation clauses in the event of a dispute between the fronting carrier and the captive.

As with all aspects of captive insurance, competent captive managers should be at the front lines of these negotiations. The complex regulations governing the legal relationships between fronting companies, captives, and reinsurance companies are a minefield of legal issues demanding the expert coordination of a number of different parties.