What is the difference between fronting and reinsurance?

Fronting and reinsurance are two common arrangements in the insurance industry. While they share some similarities, there are important differences between these structures. Understanding fronting vs. reinsurance helps explain the purpose and mechanics of each.

What is Fronting?

Fronting refers to when one insurance company (the fronting company) issues an insurance policy, then transfers all or most of the risk to a reinsurer via a reinsurance agreement. The fronting company receives a fee or commission for allowing its paper to be used, despite not retaining much or any of the risk.

There are two main scenarios where fronting is used:

1. Captive insurers

Many large corporations and organizations self-insure risks through a captive insurer they own. However, captives are often not licensed to write policies directly in some jurisdictions.

Captives use a fronting arrangement to work with a commercial insurer who can issue complaint policies on the captive’s behalf. The front then cedes the risk back to the captive reinsurer.

2. Access to reinsurance

Some insurers have limited ability to access reinsurance markets directly. Fronting provides a way for them to still transfer risk. An insurer fronts the policy, then retrocedes the risk to reinsurers.

In both cases, the front bears little or none of the ultimate insurance risk. It provides administrative policy services and access to its paper and ratings.

What is Reinsurance?

Reinsurance is risk transfer between insurance companies. An insurer transfers, or cedes, a portion of its policies’ risks to a reinsurer in exchange for coverage.

There are two main types of reinsurance arrangements:

• Proportional reinsurance – The reinsurer takes on an agreed percentage of each policy the insurer writes. Losses and premiums are shared proportionally.

• Excess of loss reinsurance – The reinsurer covers losses above a defined retention level on policies. The insurer pays up to the retention and the reinsurer covers the excess.

Unlike fronting, the insurer continues to bear part of the risk. It uses reinsurance to limit large exposures and stabilize profits.

Key Differences Between Fronting and Reinsurance

While fronting involves an element of reinsurance, there are important distinctions:

Let’s look at some of these key differences in more detail:

Risk Transfer

The fronting company transfers nearly all or 100% of the underlying risk to a reinsurer. It acts as a pass-through entity.

With traditional reinsurance, the ceding insurer retains a substantial portion of the risks on its books. It purchases reinsurance for volatility reduction, not complete risk transfer.

Risk Retention

Fronting carriers aim to retain little or no actual insurance risk. Their main exposure is counterparty credit risk if the reinsurer defaults.

Reinsurance only covers a pre-set portion of risk, leaving the insurer with the remainder. Net retention averages around 60% in the property/casualty market.

Purpose

Fronting facilitates policy issuance and compliance. It lets captives and small insurers write business they couldn’t do alone.

Reinsurers help larger insurers stabilize results, mitigate losses, reduce their capital needs, and expand underwriting capacity.

Pricing

Fronting carriers earn a fee or commission for their services, not a risk premium. Fees range from 1-5% of policy premiums.

Reinsurance pricing is risk-based. The reinsurer earns premiums tied to the amount of risk assumed from the insurer.

Counterparties

Fronting arrangements in captive insurance often involve captive reinsurers or captives fronting for each other.

Commercial reinsurers are the counterparties to traditional reinsurance agreements.

Real-World Examples

Here are some examples to illustrate fronting vs. reinsurance:

Fronting

• A Bermuda captive wants to insure risks for its parent company in New York where it is unlicensed. It enters a fronting arrangement with a NY domestic insurer.

• A regional insurer needs to access Lloyd’s syndicates for cyber risk. It fronts policies then retrocedes 100% to syndicates.

Reinsurance

• An auto insurer cedes 30% of each policy’s premium and losses to a reinsurer to reduce loss volatility. The insurer retains 70%.

• A Florida domestic insurer buys catastrophe reinsurance to cover hurricane losses over a $10 million retention per event.

The Takeaway

While fronting and reinsurance both involve risk transfer between insurers, fronting represents complete transfer to facilitate policy issuance rather than risk management.

By understanding these structural differences, insurers can implement the right approach to meet their business needs for policy compliance, risk mitigation, or accessing underwriting capacity.