A risk manager recently told me his CFO questioned why their captive program’s fronting fees were equivalent to the price of a new Ferrari. Continuing the automotive analogy, I responded that our fronting fees generally started around the cost of a mid-range BMW and could go as high as the cost of a new Rolls - Royce, including the price of the real estate on which to park it.
Nowadays, all companies are seeking to minimize and manage costs across their entire organization, so how can these fronting fees be justified?
Historically, fronting companies have been reluctant to divulge the secret formula behind their fronting fees resulting in a perception that the pricing has been more art than science. Indeed, many brokers and clients often regard fronting fees as purely an administrative servicing cost, and they evaluate fees against the perceived workload of a given risk management program. In reality, administration is only part of the equation, and there are a number of drivers that influence the fee, including the:
- Number of countries
- Number of policies and certificates to be issued
- Number of premium transactions
- Anticipated claims volume
- Volume of premiums
- Magnitude of policy limits to be issued, and
- Any special servicing and reporting requirements
These drivers are straightforward, but they do not fully explain the components that actually make up fronting fees, especially for global programs. Let us explore the seven main components of fronting fees.
Central Program Coordination
The risk manager and producing broker will normally want a single point of contact within the fronting insurer to agree upon the parameters of the program, and, in reality, they may have little direct day-to-day contact with the local network delivering service at the country level. Successful central program coordination is vital for any controlled master program.
The fronting insurer’s producing office responsible for program management and coordination performs a number of key functions. It has to agree on policy wordings and communicate underwriting instructions to the network. It needs to verify and agree upon premium allocations and negotiate any special servicing and claims handling requirements. It will calculate and agree upon the fronting fee and have overall responsibility for account servicing. That office is responsible for designing and implementing a compliant program structure that meets the client’s needs, and agreeing to and executing the required legal and collateral documents in a timely fashion. On an ongoing basis, it must track program performance against key performance indicators (KPIs), respond to queries and resolve any issues that may arise. Ideally ,the team that handles such programs should have expertise in the areas of both captive programs and complex multinational programs across all lines of business. This cannot be an occasional part-time or side activity for traditional risk transfer underwriters. It should be recognized as a discipline in its own right, requiring specialist systems, people, and procedures to deliver excellent service. As with all things, such expertise comes at a price.
Local Service Fees
In any global fronting program, the local insurer will be issuing an admitted policy and providing local servicing such as issuance of certificates, premium invoicing, premium collection, and payment of taxes. There may also be local compulsory cessions and premium reserves withheld and local requirements governing the exportation of premium and risk. It is important that the local carrier ensures that the policy wording issued is compliant at the local level, and at the same time, matches the client’s master policy wording to the greatest extent possible. The local insurer should be adequately remunerated for this work so that it is committed to servicing incoming business. Any locally deducted ceding commissions should be reasonable from a transfer pricing point of view. A multinational insurer with its own wholly-owned and managed network may be in a stronger position to control such costs and manage its network than one that is heavily reliant on friendly local insurers.
Captive Cash flow Management and Reporting
Most fronting insurers centralize the reinsurance reporting and administration of global fronting programs so that the captive also enjoys the benefits of a single point of contact. The reinsurance administrator or aggregator is responsible for the tracking and onward payment of reinsurance premiums to the captive and other re-insurers, as well as the reporting and billing of losses. Partnering with a fronting insurer with a good track record of expeditious cash flow is valuable, as it will help maximize the captive’s investment income and help minimize its foreign exchange risk. Some fronting insurers may demonstrate their confidence in their cash flow performance by offering a cash flow guarantee with an interest penalty under which they commit to move funds to the captive from key countries within an agreed time frame.
Management of claims handling and adjusting across a global program is not without its challenges but affords the client numerous benefits. A standardized approach with consistent claims handling across the globe should assist with the client’s risk financing strategy. A global program will also provide consistent management information on losses on a paid, incurred, and outstanding basis, something that is impossible to achieve if you have multiple fronting partners instead of a single global fronting partner. The need for a fronting partner with real global claims handling capabilities in country was evident in recent years with the Thai floods and Japanese earthquake, where a rapid response helped minimize costs.
Credit and Cost of Capital
A fronting insurer may seek to protect its own credit position by seeking acceptable collateral such as letters of credit or trusts. Depending on the market involved, bank and parent guarantees, a protocol d’accord or a lettre d’engagement have also been used. Apart from the credit position, qualifying collateral also provides capital relief for the cedant or fronting company. Some clients struggle to see how the fronting insurer’s capital position is impacted by providing fronting services. The simple truth is that any risk written and ceded still attracts capital. For a captive program, the risk is from the reserves: unearned premium reserves, outstanding loss reserves, and incurred but not reported claims. In calculating fronting fees, the fronting company must be certain to cover its own cost of capital and the residual credit risk after allowing for any qualifying collateral. This is a key component of the fee, especially as fronting companies have become more aware of the capital implications of ceding to unrated re-insurers. The advent of Solvency II and the financial crisis have focused minds in the area of capital management. This may result in the fronting fees for certain accounts increasing to reflect the capital consumption.
Regulatory and Operational Risk
Insurance is a highly regulated business that is getting even more regulated. The risk that a policy might be out of compliance due to a change in law or regulation can lead to losses for the fronting insurer. Also, a program with a complex structure and coverage spanning many countries has an increased probability of an operational or documentation problem which similarly causes the fronting insurer to incur unforeseen costs. While these are not underwriting risks, they are risks nonetheless, and the insurer needs to be compensated for them.
In implementing and managing a captive program, the fronting insurer should not simply seek to cover its own administrative costs and cost of capital but to deliver an adequate return and profit for its shareholders. In some markets, inexperienced fronting insurers may only wish to charge a nominal fee for captive fronting, but this fails to recognize the valuable resources that handling such programs can consume. That being said, the fronting company will normally write a significant amount of net premium on the program and will recognize this when determining its fee.
In negotiating its fronting fee, the commercial realities of the marketplace come into play, and there are ways that the risk manager can work with it's existing fronting company to control the fronting costs. On the administrative side, having a single policy per country with an annual, non-adjustable premium payment can be cheaper than multiple premiums and multiple policies. Reducing policy limits can also provide some relief, but it is important that they are still fit for purpose. There are two other tools available to help manage the cost of fronting fees.
The captive can offer additional qualifying collateral to mitigate the capital costs of the program. A Regulation 114 Trust or Security Interest Agreement may compare very favorably with the cost of a letter of credit, and may not encumber the captive’s or sponsor’s credit line, and both instruments afford the fronting company capital relief.
Consider getting the captive rated by a U.S. NAIC approved NRSRO such as A.M. Best, Fitch, Moody’s, S&P, or one of the other recognized rating organizations. This rating will also provide capital relief for the fronting company as balances ceded to a non-NRSRO rated reinsurer are treated harshly from a rating agency perspective.
In recent years, fronting insurers have been fine-tuning their pricing models and moving toward a more scientific approach to determining appropriate fronting fees. If your captive is still paying a fronting fee that would not even buy a used Soviet-era Trabant, you can continue to enjoy the ride, but you might want to ask yourself if your fronter is providing you with the Cadillac service that you deserve, and if this is sustainable over the long term. What looks like a good deal today can become a costly headache if it’s always in the shop being repaired.