Exploring Fronting: A Q&A
Simon Beynon answers important questions about fronting insurance program and why there is growing interest in the market.
For over 50 years, AIG companies have provided global fronting insurance program that combine varying amounts of risk transfer to insurance carriers and risk retention by the insured.
Until recently, our global fronting programs have largely focused on clients domiciled in North America and Europe. However that is changing and today, we are seeing a growing interest in fronting from clients in Latin America and the Asia Pacific region. These emerging market clients seek to better understand and explore the benefits of fronting to determine whether it should be added to their overall risk management strategy.
With this heightened interest in fronting program, it may be timely to review:
What is fronting?
In a fronting program, an insurance company (the fronting carrier) issues a policy and transfers some or all of the risk back to the insured. Most fronting programs utilize a reinsurance cession to the insured’s captive to secure the risk participation required by the insured. However, risk participation can also be secured through other means such as a rent-a-captive; a protected cell captive or even more simply, by an indemnity agreement where the insured commits to making the fronting insurance company whole for covered losses.
The fronting carrier is obliged to pay losses covered under the policy and then, seeks reimbursement from the insured through the reinsurance or indemnity agreement. In a fronting program, for that portion of the risk it seeks to retain, the underwriting risk resides with the insured. The fronting insurance company charges a fee to provide all of the services involved with the program and to assume the credit, operational, regulatory, tax and legal risk inherent in the issuance of a policy. Essentially, the fronting insurance company is replacing insurance risk for credit risk for that portion of the risk the insured retains.
Why do companies choose fronting?
Typically, as a company becomes more proactive in the management of insurance risks, it increasingly employs more sophisticated risk retention strategies. In these instances, a company chooses to retain its risk rather than pay premiums to an insurer to transfer it. However, counterparties (clients, banks, trading partners, etc.) or regulators or local laws often require a company to have locally admitted insurance protecting its risk and provide evidence of such cover. Since it is unlikely that a company or its captive reinsurer will have the necessary licenses or regulatory approval to directly insure its own risks for the specific coverages and in the specific countries where coverage is required, fronting provides an effective solution.
Fronting establishes the required evidence of insurance, enables the insured to retain its targeted amount of risk, and provides a formal structure for the insured to finance the risk over a period of time.
Therefore, the principal motivation behind a fronting program is to create a compliant insurance program that allows an insured to assume risk while accessing the regulatory licenses, policy administration, claims handling, and reporting services of a traditional insurance company.
Financial objectives may also motivate the decision to establish a fronting program. By participating in their own risk rather than procuring risk transfer through a more conventional insurance program structure, insureds may:
- Benefit from favorable loss experience
- Pay a lower premium than traditional insurance market pricing which would not consider any improvements in loss control that have yet to materialize in historic data
- Resolve a situation in which market conditions or underwriting capacity limit adequate risk transfer availability at acceptable premium levels
A company may opt for a blended program using a captive or indemnity program to assume high frequency losses and then to purchase an excess of loss policy from an insurance company. This strategy generally reduces a company’s insurance premium.
Alternatively, fronting programs may be driven by more strategic or operational objectives. Many companies are developing technologies or entering into areas that create new or unusual exposures that are either not addressed or addressed inefficiently by traditional insurance markets. Consequently, these companies work with an insurance company partner to develop a manuscript cover and assume much of the risk themselves in a thoughtful, methodical approach that allows them to finance their risk over a longer term horizon.
Some creative risk management strategies seek new ways to strengthen a product/service sales proposition with an insurance structure that benefits customers (e.g. an extended warranty program). Others prevent difficult risks from impeding a planned merger, acquisition or divestiture by covering the disputed or unacceptable liabilities with a fronted insurance policy where the ultimate insurance risk is retained by the buyer or seller. This strategy simplifies the sales process since the insurance policy covering the disputed or unacceptable risk eliminates the need for the buyer and seller to agree upon its value or the responsible party. A fronted insurance policy could also provide a strategic alternative to posting collateral or tying up cash when a counterparty does not truly understand the risk and seeks to mitigate its exposure by requiring collateral, a trust or reserves.
Why do insurers help clients retain risk?
Given underwriting risk for a premium is the core business of an insurance company, why would an insurer be willing to help a client assume their own underwriting risk? It seems counter intuitive. However, some insurers understand that being an effective and valued partner means providing the full range of risk management services that clients require. For some clients, fronting is often a necessary deliverable. For example, a client may have an unusual risk that its insurance company has no or limited appetite to cover on a risk transfer basis. The risk doesn’t disappear, so the insurer needs to be able to provide its client with creative alternatives for managing and financing the unusual, and consequently difficult to transfer risk.
In summary, fronting business is not new, but it is being embraced more in new markets. As clients in these regions deepen their understanding of fronting’s many benefits and efficiencies, they are adding this important tool to create a more sophisticated risk management strategy. Over time these companies are beginning to appreciate the range of benefits that risk retention strategies and the partnership with a fronting insurer can bring.