Fronting in Reinsurance

The reinsurance industry has several complicated terminologies which are routinely used. This is because there are several concepts in the reinsurance industry that are different from the general insurance industry. The concept of fronting is one such concept. Fronting can be confusing to a layperson. This is because it is a complex arrangement. However, it has several benefits for companies who want to use their captive insurance companies to provide reinsurance.

In this article, we will have a closer look at what fronting is and what are the benefits of using fronting.

What is Fronting?

Fronting is an arrangement that defines the relationship between three entities.

1. The company or the individual getting insured is the first entity.

2. The insurer is the second entity, and

3. The reinsurer is the third entity.

Now, there are large corporate groups that have created their own captive insurance companies. However, such insurance companies may not be licensed to operate in all parts of the world.

For instance, an American conglomerate may have created a captive insurance company that is licensed to operate in all states of America. However, if they start operating in other countries such as Mexico or China, the insurance company may not have the required licenses. The management wants to insure their own risks. However, they cannot do so for legal issues.

In such cases, they use a third-party insurer for fronting. This means that they use a third-party commercial insurer who is licensed to provide insurance at that particular location. However, they do not want the commercial insurer to actually bear the risk. This is the reason that they immediately ask the commercial insurer to take out another reinsurance policy with their very own captive company.

This means that in essence, the captive reinsurance company is providing the insurance. The third-party commercial insurer has only been used as a front i.e. as a pass-through entity to transfer the risk to the captive reinsurance company in a legal manner.

How Does a Fronting Arrangement Work?

The first step in a fronting arrangement is for the insured company to contact the captive insurance company with its insurance needs. The captive insurance company then contacts the various insurance companies that are licensed to provide the policy. This is done to obtain an economical price. The insurance company immediately signs an indemnity contract which transfers the risk back to the reinsurance captive company.

However, it needs to be understood that since the commercial insurance company has underwritten the risk, they cannot completely transfer it to the captive reinsurance company.

In case, the captive reinsurance company goes bankrupt, the commercial company will still be obligated to pay out the claims. Third-party insurance companies are aware that they are undertaking this additional risk. Hence, they do charge a premium for this risk and also make provisions to be able to repay the loss if the situation for making a claim does eventually arise.

It also needs to be understood that if a commercial insurance company ends up going bankrupt, then the premiums paid by the insured are lost and, in some jurisdictions, they may also be liable to pay even more premiums.

Also, legally when a claim comes in, the fronting insurance company cannot simply pass on the liability to the captive reinsurer. As per the process, they have to pay the claim within the agreed-upon timelines. Later, they can get the same claim reimbursed by the reinsurance company. Many fronting companies design the contract in such a way that the cash flow received by them is earlier as compared to their obligation to pay the claim. This helps them ensure that their cash flow situation is not negatively impacted.

Types of Fronting

Companies which act as a front in such arrangements are aware of the fact they are just lending their balance sheets to another company and obtaining a fee for the same. However, in many parts of the world, it is mandatory for fronting insurance companies to participate in risk sharing. Based on this, the types of fronting agreements can be divided into two.

1. Pure-play fronting is when the risk is completely passed through from the balance sheet of the commercial insurance company. This means that they have an agreement wherein they are not liable to pay any claims regardless of adverse events which may be faced by the insured. Since there is no risk involved for the insurance company in such cases, they tend to take over pretty much any risk just for a nominal fee.

2. On the other hand, there is pro-rata fronting. In such cases, fronting insurance companies may be required to pay a certain percentage of the claim. However, the risk percentage is very minimal i.e. around 10% to 20%, and the majority of the risk is still carried on the books of the captive reinsurance company. Hence, in such cases, the fronting company is indeed undertaking a risk on its balance sheet. As a result, the commercial insurance company wants to make sure that the risk is compliant with its overall portfolio. In such cases, the commercial insurance companies view it as a retrocession agreement and conduct a thorough study before taking over the risk on their balance sheet.

The fact of the matter is that fronting is a widely used arrangement in the reinsurance industry. Even though the arrangement is complex and requires coordination by several parties, it is still preferred by many companies who have set up their own captive insurance companies and want to manage their own risk.