Whether you are negotiating a fronting fee with an insurance company for the first time, as you have a “start up” captive insurance company, or you are looking to renegotiate a “renewal” captive company fronting fee, you are going to be in for the insurance education of a lifetime.
The cost of “fronting” goes up on the very basis that there is a shortage of insurance companies willing to “front.” The insurance market losses companies like Quanta Capital, Alea, etc. and thus reduces the options available. Where are the new fronting insurance companies going to come from? Hurricanes Katrina, Rita, and Wilma have brought havoc to the property captives, where we see fronting fees rising to 15%. The new Bermuda companies will acquire U.S. insurance company platforms and will be the “fronting” insurers of the future.
Owners of captive insurance companies must realize that “fronting” insurance companies need to be approached on various levels of management, with preferably senior management getting into the decision making process early on in the negotiations.
Underwriting Departments are playing a greater role in captive fronting, with the financial departments looking closely at the credit risk of the parent transaction. For instance, several years ago, construction companies would capitalize captive insurance companies just to insure the self-insurance deductible under their Owner Contractor Insurance programs. Now “fronting” insurance companies are examining the financial statements of these same construction companies to make sure they can sustain the ownership of the captive insurance companies. Interestingly enough, captive owners need to continue to monitor the financial statement of their fronting insurer, and to be on top of any potential rating downgrades by the rating organizations. Insurance company management historically has had a tendency of “failure to disclose” negative results.
Fronting insurance companies are playing a greater role in the selection of the domicile for the captive insurance company. Domestic versus offshore domicile continues to be debated. Even on shore domiciles like New York State, with its 35 captive insurance companies, are trying to expand the captive concept by reducing the threshold, $100 million parent net worth to $25 million parent net worth captives. More advertising needs to be injected into the New York captive initiative.
Most of the experienced, fronting insurance companies, have shown the ability and expertise to “front” captives from Vermont domiciles to Hawaiian domiciles, and from Barbados to Bermuda. The focus has been to continually drive down overhead expenses and those domiciles doing this are attracting all the new captive formations.
Interestingly enough, domestic captive domiciles did not lead in 2005 formations, with Bermuda and the Cayman Islands accounting for 134 captive formations. Vermont with 37 captive formations led the United States.
Fronting insurance company pricing for the risks going into captives are getting a closer look by the actuarial profession. Captive owners have come to recognize they need their own actuarial support when disagreeing with the fronting insurance company’s assessments of what is the correct price for the risk. Whether you are a residential contractor in California or a nursery home in Florida, your captive requires adequate pricing executed by the fronting insurer. We are going to see more litigation in the future between captive owners and their front insurance companies, as the disagreements over pricing continue to persist on each renewal.
Captive owners want their front insurance companies to come up with independent prices for each risk, and that concept continues to be a problem with the front company. When it is admitted, and has to use their filed rates. Insurance company market conduct reports are going to expose front carriers that they are violating their rate filings when writing primary insurance products which are reinsured back to the captive insurance company.
The more mature captive insurance company, with over five years of financial history, needs to have a committee of its Board of Directors look closely into the entire costing structure of the fronting fee. This would be a great excuse for members of the captive board to understand this important transactional cost.
What are the detailed components of the fronting fee? How are they monitored by the captive owner? When was the last time a new fronting company was asked to quote on the captive? Once the captive board gets this training, the Boards will not be “rubber stamps” and exercise more judgment at insurance decision making.
More and more mature captives are looking to write their Directors and Officers Liability Insurance into their captive. The front insurance company writes the traditional D and O form, and that risk in then ceded back to the captive, acting as reinsurer. The exclusions in the traditional D and O policy are then covered by a direct procurement policy from the captive, eliminating the need for the front. The pricing for the direct procurement policy should be controlled by the owner of the captive. In some aspects, a captive writing direct insurance policies in the United States should apply for an A.M. Best’s rating. If we remember captives are a long time investment and by getting an “A” rating from Best’s, the captive becomes a substantial asset.
Reciprocity among captive owners can be another way of eliminating the “fronting” fee. Each owner uses the “A” rated captive for each other’s risks, and purchases a sophisticated reinsurance program behind both captive insurance companies. When fronting fees approach double digits, it is necessary for captive owners to seek alternatives to “fronts.” Creative solutions need to be implemented, and captive company budgets need to have the financial resources to explore alternatives.
Finding “fronts” for Contractors Pollution Liability Insurance is another area that is getting significant attention. General contractors, residential or commercial, trade contractors, carpentry and plumbing, specialty contractors, foundation and pipeline, and remediation contractors, are all candidates for captives, and in the early years require “fronts.” Captives can substantially reduce the insurance costs of traditional pollution coverage for contractors, especially when layering of policy limits is introduced above the captive retention. Customary pricing above the captive retention follows the simplistic approach that the lower liability layers are priced higher than the upper layers, again giving the captive owner a “pricing” discount.
The identification of the “fronting” carriers has not changed dramatically in the last few years:
3. Old Republic
5. Liberty Mutual
6. Discover Re
The negotiating process with each of these carriers has always been a challenge for captive owners. Insurance company “fronts” are a dynamic group, and with people constantly changing positions, requires that you pay significant attention to your fronting carrier to continually provide favorable relationships and eliminate misunderstandings. When was the last time you asked your fronting carrier, how is my program going rather than react to their letter saying they are going to cancel your “fronting” relationship because they are returning from that particular insurance product line.
There have been a number of studies on what the “fronting fee” includes, or should include. The amount of these fees keep changing but the overall concept remains the same. Focus and concentrated efforts are required to keep this “fee” economically effective.
Among the recent “fronting fees” the following is included:
1. State Premium Taxes (not negotiable);
2. Federal Excise Taxes (not negotiable);
3. Government schemes (not negotiable, but try and get how they are arrived at);
4. TRIA charges (usually not negotiable);
5. Aggregate protection (negotiable, look at the concept of purchasing this yourself from outside the structure); and
6. Profit margin for carrier/fronter (negotiable).
If loss ratios are attractively low for your captive insurance company, make every effort to obtain a lower “fronting fee.” Insurance carriers are always seeking low loss ratio business even as a “front.” If you can, try to influence the decision maker. Many “fronting fees” get renewed as is when they are comparatively high in mature, and it is in the carrier’s interest to renew as is because there is little additional costs in doing renewals. It is the “lifeblood” of the insurance company.
On the basis of regulatory and rating agency fear, “fronting” carriers have made a conscious effort to require and substantially increase the collateral requirements they are asking for from captive owners. This is an area of negotiation and as many Agent Owned Captive Insurance Company Owners have found out, too late, over collateralized programs lead to the inability of the agent to fund the letter of credit and therefore the “front” cancels the program.
Captive Owners need to know that over-funded collateral is another way a “front” company can access additional capital for growth. You need to understand the true components of the collateral required:
1. Loss Reserves (Schedule F – loss reserves plus unearned premium reserves and Incurred But Not Reported losses) … IBNR deserves the most attention since these are estimates, and does the Captive Owner want to pay for an independent actuarial study for the loss payout pattern, and full development.
2. Many “front” companies want funding that would include funding the letter of credit equal to high loss ratios, this is despite the fact they had set the pricing on the “fronted” policy. Owners need to have the expertise to challenge the methodology of the pricing.
In conclusion, “fronting” insurance companies provide “licensed paper,” which is asset value; they provide regulatory compliance and finally support services. Remember if fronting fees are greater than 5%, and mostly in the 6-10% range. When going over 10%, it is imperative that you look for another option.
By Andrew Adamson