What Does Fronting Mean in Insurance?

Fronting is an arrangement between a licensed insurance company and a self-insured organization or captive insurer. It allows the self-insured or captive to issue policies while avoiding certain regulations and requirements.

What is Fronting?

Fronting refers to when a licensed, admitted insurance company issues policies on behalf of an unlicensed insurer. The fronting company provides its licenses and services but does not intend to take on any of the actual risk.

Instead, the risk is passed to the self-insured or captive through an indemnity or reinsurance agreement. So the front takes on the legal obligations of the policy, while the risk bearer handles the coverage and claims payments.

How Fronting Works

Here is a breakdown of how a basic fronting arrangement functions:

• The self-insured or captive seeks to issue insurance policies in a state where it is not licensed.

• It partners with a fronting company that is licensed in that state.

• The fronting company formally issues the insurance policies.

• Through a reinsurance agreement, the risk is passed to the self-insured/captive.

• The fronting company charges a fee for its services, usually 4-10% of premiums.

• The self-insured or captive provides collateral to cover potential claims.

So the fronting company puts its name on the policy and provides services, while the captive bears the risk and handles claims.

Why Insurers Use Fronting Agreements

There are several key reasons self-insureds and captives utilize fronting:

Access to Licenses

Fronting allows unlicensed insurers to issue policies in states where they lack a license. The fronting company provides its licenses so policies can be sold.

Meet Financial Responsibility Laws

Many states require automobile and workers compensation policies to be issued by an admitted, licensed insurer. Fronting satisfies this requirement.

Business Contracts

Leases, construction contracts, and other agreements often mandate coverage through an admitted carrier. Fronting complies with this necessity.

Enhanced Tax Deductibility

Premiums paid to a fronting company may qualify for better tax treatment than self-insured premium equivalents.

Excess Coverage Access

Fronting companies can efficiently provide access to reinsurance and excess coverage placements.

Regulatory Compliance

Fronting allows self-insureds and captives to comply with regulations they’d otherwise violate by directly issuing policies.

Claims Handling

The fronting company can provide professional claims handling services as part of the arrangement.

The Fronting Company’s Role

The fronting insurer provides a range of services in addition to formally issuing policies:

• Licensing – Allows policies to be issued in states where the captive isn’t admitted.

• Claims Administration – Handles first notice of loss, adjusting, settlement, and payments.

• Risk Control – Loss control engineers conduct risk assessments and recommend improvements.

• Certificates of Insurance – Issues certificates showing admitted coverage exists.

• Premium Audits – Audits policyholders’ records to determine final premium amount.

• Excess Coverage Access – Facilitates securing reinsurance and excess placements.

• Regulatory Filings – Completes necessary filings with state agencies.

So fronting provides compliance, services, and efficiency to the captive.

The Captive Insurer’s Role

While the fronting company offers services and regulatory compliance, the captive insurer retains the key insurance functions:

• Risk Bearing – Ultimately responsible for covering claims payments.

• Collateral – Posts collateral (125-150% of projected losses) to guarantee ability to pay claims.

• Reinsurance Contract – Formally passes risk from front to captive through a reinsurance agreement.

• Premiums – Receives the “net” premiums after fronting fees are deducted.

• Policy Administration – Handles core policy administrative duties like endorsements, cancellations, renewals.

• Actuarial – Develops rates and projections for the fronting company and state regulators.

The captive bears the risk and handles many administrative duties of the policies issued.

Fronting Company Risks

Fronting arrangements expose the fronting company to certain risks:

• Credit Risk – Front is liable for claims if captive fails to reimburse them. This is why collateral is required.

• Reputational Risk – Regulatory issues or policyholder complaints with the captive could damage the front’s reputation.

• Excess Risk – Unexpected losses above projections could hit the front’s bottom line. They may lack adequate reinsurance themselves.

• Administrative Risk – Any functions handled by the captive could be handled inadequately, increasing the front’s burden.

The fronting company takes on meaningful risks by allowing an unlicensed insurer to operate under their paper. The fronting fee aims to compensate for these risks.

Captive Risks of Fronting

Fronting also exposes the captive to certain risks, including:

• Excessive Fees – Fronting fees paid to the fronting company could become excessive, eating into the captive’s underwriting profit.

• Lack of Control – The captive may lack control over policy administration, underwriting, and claims handling since the front provides these services.

• Collateral Obligation – Posting collateral ties up assets that could otherwise be invested to earn interest income.

• Lack of Transparency – The captive may receive limited information on policyholders and claims activity under the fronting arrangement.

• Fronting Company Failure – Regulatory action against or insolvency of the fronting company could be very problematic.

While fronting provides benefits, the captive also assumes risks by ceding control over key functions.

The Fronting Agreement

The terms and structure of a fronting arrangement are detailed in a fronting or reinsurance agreement between the two parties. This contract will address:

• Division of Risk – How much risk is retained by front vs. passed to captive.

• Fronting Fees – Amount or percentage charged by fronting company.

• Collateral – How much and which assets the captive must post with the front.

• Claims Handling – Procedures for administering and paying claims.

• Policy Administration – Responsibilities for endorsing, canceling, non-renewing policies.

• Premium Flow – How premiums are directed from insured to front to captive.

• Indemnification – Indemnity terms for each party.

• Termination – Ability to exit the arrangement and resulting processes.

The fronting agreement essentially governs the entire relationship and defines the structure of the program.

Collateral Requirements

Since the fronting company retains credit risk under the arrangement, the captive is required to post collateral assets. These assets can be used to reimburse the front for claims payments if the captive fails to honor its obligations.

Typical collateral options include:

• Withheld Funds – The front simply withholds a portion of the captive’s funds to serve as collateral.

• Letter of Credit – The captive has its bank issue a Letter of Credit payable to the fronting company.

• Trust Fund – Assets are put into a trust account controlled by the fronting company.

Collateral usually amounts to 125% – 150% of the captive’s projected claims obligations. The fronting agreement outlines the specific collateral requirements.

Challenges of Fronting Arrangements

While fronting arrangements facilitate captive insurance programs, some key challenges include:

• Availability – There are a limited number of fronting companies, so securing an arrangement can be difficult.

• Corporate Governance – Captives lose control over key functions, complicating governance.

• Excess Risk – Unforeseen losses could exceed collateral assets and hit the fronting company’s bottom line.

• Regulatory Action – Many states are increasing oversight of fronting arrangements. Tighter regulations make fronts less willing to partner with captives.

• Reputational Risk – Damage to the captive’s reputation could tarnish the fronting company by association.

Fronting enables captives to navigate certain obstacles, but it does entail meaningful complications for both parties.

The Bottom Line

While complex, fronting arrangements allow captives and self-insureds to comply with regulations and gain operational efficiency. By leveraging a licensed carrier’s services, the captive can issue policies nationwide, outsource functions, and ultimately retain control of risk.

So fronting provides a licensed “front” to enable an unlicensed captive “backing” to operate an insurance program. The fronting company and captive insurer carefully delineate duties through a detailed fronting agreement.

If structured properly, fronting offers benefits like licensing, claims services, and risk transfer capacity. But it also exposes both parties to credit risk, lack of control, and regulatory uncertainty. Parties must weigh these pros and cons when considering a fronting arrangement.