Fronting and Insurance "Paper"

When considering retaining risk via a Captive, a key consideration is the "paper" on which the policy is written. This isn’t the actual paper, but something referred to as Insurance Paper.

In the insurance industry, the term Paper is often used to describe both the insurance policy itself and the carrier underwriting that policy. This concept becomes particularly interesting when we delve into how an insurance company’s paper can be used, as well as the structure and operations of insurance companies that support such usage. 

The Structure of Insurance Companies

Many insurance companies own multiple subsidiary insurance carriers, which function much like shell corporations. Each of these carriers is essentially an entity with a license to underwrite insurance business.

Companies may apply for licensure for different carriers to serve various lines of business or other purposes, but all these entities operate under the same overarching umbrella or parent company. As a result, these carrier shells can sometimes be bought and sold quite frequently.

For example, Travelers, a prominent insurance company, operates several carriers such as: 

• Travelers Casualty & Surety
• Standard Fire Insurance Company,
• Travelers Excess & Surplus Lines Company, and
• U.S. Fidelity & Guaranty Company, among others 

This means that even though an insurance policy might be issued through Travelers, the name of the insurance carrier on the policy may not necessarily be "Travelers." The carrier that is named on the actual policy is whose paper it is.

The use of multiple carriers provides insurance companies with the flexibility to operate in different states and write different lines of business. 

For instance, Standard Fire Insurance Co. is often utilized by Travelers for personal lines business, while Travelers Casualty & Surety typically focuses on Admitted Commercial Lines. 

Insurance Requirements & Considerations 

This separation allows for different rate filings, policy forms, and other requirements for each carrier, enhancing the company's ability to tailor its offerings to specific market segments.

Oftentimes insureds have specific requirements that dictate a variety of considerations, such as: 

• What type of insurance they need to carry
• The limits of that insurance
• What type of insurer is providing the coverage 

Our focus in this article is centers on the "type of insurer” portion.

Types of Insurers and Related Requirements

The “type of insurer” can vary:

• Admitted as opposed to Non-Admitted, or Excess & Surplus (E&S)
• Rated vs. Non-Rated

Whether it be by contract covenant or statutory requirement, many insureds are required to carry coverage specifically by an insurer that is Rated (typically A- AM Best of equivalent) or on Admitted Paper.

• Insurance Ratings are stamps of approval from independent Rating Agencies that attempt to give transparency into the Financial Stability of the insurer. Regulators and insureds want to be sure that if a claim were to arise, that the insurer is able to pay that claim. The main rating agency for Insurance Carriers is AM Best. Demotech is another, but is often considered of lower reliability and many times is not accepted by banks or other contracted parties with insureds.

• Admitted Insurers are insurers that file and comply with rate and form filings from the state in which they are authorized to write business. These restrict the carrier to certain rates based on their actuarial and projected filings submitted to the state, and require them to use approved policy forms (typically industry-standard forms with slight deviations). 

By complying with the state regulations, an admitted insurer garners the benefit of being partially backstopped by the State Insurance Fund. If an admitted insurer were to fail, a portion of their liabilities would be paid out by the state fund. 

• E&S Carriers on the other hand, do not comply with Rate & Form and as a result don’t have State Fund backing. As a result, E&S insurers are seen as “less stable”. E&S carriers typically work through Excess & Surplus Lines Agents (wholesalers) and focus on more complex commercial risks that admitted carriers might find unprofitable due to rate limitations. While E&S carriers are not regulated in the same way as Admitted carriers, each state has a Surplus Lines Authority that does still oversee them, to a certain extent.

How Captives Can Meet Insurance Coverage Requirements

There are different situations in which an insured would be required to be covered by admitted paper. For example, NY Auto Liability or Workers Compensation. 

If an insured is required to have Rated and/or Admitted paper, how is it even possible for a captive (which almost certainly does not carry such designations at its onset) to support the coverage it needs? 

There are different ways around the issues presented.

If the issue is purely one of rating, it is possible to have the Captive Cell/Facility rated by AM Best or Demotech. AM Best requirements tend to be very steep and as such, typically only very well capitalized insureds, like Fortune 500 companies, are able to achieve that success. Demotech ratings, however, are more plausible and can present a solution to the issue.

But, in a situation where rating the Captive is not possible, a Demotech rating won’t be accepted by the contracted party, and/or admitted paper is required, “Fronting” is the common solution. 

How Fronting Insurance Works

On a basic level, Fronting Arrangements function by allowing an Insurance Carrier (whether they be rated, non-rated, admitted, or E&S) to charge a fee for “lending” their paper to a group, which can then present it to their contracted parties. On paper, it appears as if this carrier is insuring them, however, behind the scenes really it’s the insured's (in our situation, the captives) own capital backing this policy.

At first blush, this arrangement might seem to be, at best, a willful misrepresentation. 

In fact, the practice is perfectly legal, universally accepted, and a very common structure within the insurance space. It’s quite possible that you were issued a policy that used a front of some sort. MGA’s, MGU’s, Programs, and even true Carriers use fronts for different purposes. Whether that be to access admitted paper, access a different state, or be a pass through for risk retention, Fronting Arrangements are a fundamental aspect of the Insurance Ecosystem.

On a deeper level, Fronting is actually a Reinsurance structure. Technically speaking, the fronting insurer is on-risk, meaning they are responsible for the risk written into the policy they front, but cedes the entirety of the risk to the reinsurer (the Captive, in our case). This is what actually allows the Front to occur. In exchange for a fee, the Fronting carrier is allowing the risk to “pass-through” from their balance sheet to the Captives balance sheet.

As it is truly a Reinsurance agreement, there are some complexities that come along with such arrangements.

Behind Fronting Insurance: Risk, Capital, and Collateral 

When booking the business, since the Fronting Carrier is technically on-risk, they have to enter a liability on their balance sheet to account for that risk. Then, the risk can be transferred off their balance sheet as "Reinsurance Ceded".

Even though the risk transfer passes through and the Fronting Arrangement contemplates that the Fronting Carrier is wholly indemnified by the Captive for any losses, when push comes to shove, if the insured/captive were to go bankrupt there is precedent for the Fronting Carrier to be liable for any losses.

This leads to two main challenges: 

• Credit Risk
• Statutory Risk

In an effort to mitigate Credit Risk, that is the risk that the insured/captive defaults and leaves the Fronting Carrier on the hook, Fronting carriers will require collateral from the Captive/insured to protect against this outcome. Collateral provides a safety net for the Fronting Carrier. In a worst case scenario, the Fronting Carrier can draw from the collateral to minimize their exposure.

Many times this collateral is calculated as what’s called “gap” collateral. The fronting carrier will make a calculation of the gap between the Aggregate Attachment Point (the captive's ultimate exposure) and the capitalization of the captive itself. Whatever the difference is between the two, will typically be the required collateral size. This however can vary from carrier to carrier and Coverage type to Coverage type.

From a Statutory Risk perspective, the Fronting Carrier has true risk transfer flowing through their balance sheet. Insurers are required to file Annual Statutory Filings to their state regulator. Part of the Statutory Filings is the Schedule F, Reinsurance Assumed & Reinsurance Ceded. This Schedule breaks-down reinsurance premiums by:

• The Reinsurer and the Reinsured
• Reinsurance recoverables from authorized and unauthorized reinsurers, and
• A restatement of the balance sheet gross of reinsurance ceded 

Those last two points are of note because of their implications. That is: 

• Reinsurance ceded impacts the carrier’s surplus
• Reinsurers must be designated as “authorized”

An insurance entity has to be licensed and approved to write reinsurance business, which a captive is likely not. Since Reinsurance ceded impacts surplus, regulators require that reinsurance be ceded to authorized reinsurers. 

As we discussed that with a fronting arrangement the Fronting Carrier is ceding reinsurance to an unauthorized reinsurer (the captive), there is a statutory accounting adjustment that prevents insurers from taking credit for this type of ceded reinsurance. This adjustment ends with a net reduction to statutory surplus, called the Schedule F Penalty. 

Nobody likes to be penalized and so there’s a way around it.

Insurers can take credit for ceded reinsurance to an unauthorized reinsurer if the reinsurer provides collateral in an approved manner, in an amount equal to or greater than those reinsurance reserves.

In cases of both Credit & Statutory Risk, collateral helps mitigate issues and provide the needed buffer layers to get deals done. 

So, while collateral needs to mitigate credit risk are at the discretion of the fronting carrier, in order to avoid incurring a surplus penalty, the statutory collateral required will be driven by regulators.

Types of Collateral

Now that we know what the collateral is for, how can we do it?

Collateral is typically approved by Fronting Carriers in the following forms:

Cash is king. No fronting carrier will decline an upfront cash payment.

However, as Cash is not often the most feasible way to collateralize, a Letter of Credit (a letter issued by the insureds bank with an evergreen clause) can be used to fulfill collateral needs. There are costs to having an LoC issued and related interest rates typically vary. In higher interest rate environments, this option can be expensive. 

Additionally, some groups opt to either send money to the fronting carrier to a separate Funds Withheld account, which, depending on the situation, can potentially sit in an interest bearing account to offset the opportunity cost of those dollars.

Last is a Regulation 114 Trust, also known as Reinsurance Trust, or a NY Trust. These are Trust structures where the bank acts as the trustee, the captive deposits cash or approved securities into the trust, and the fronting carrier serves as the beneficiary of the trust. These trusts have the ability to earn interest, and be posted in allowable securities, not just straight cash. 

Funds Held and 114 Trusts have become a popular choice for their ability to generate interest income, and their relative ease of use for the fronting party for the purposes of reinsurance collateral. In cases of need, the fronting carrier can easily call/transfer the securities/cash to meet the captives obligations for capitalization and collateralization as per the fronting/reinsurance agreement. Additionally, in cases where there are losses and there is a need to top off a loss fund, this can mitigate having to pull and transfer funds from elsewhere.

Fronting Arrangements and their related collateral requirements play a significant role in many Captives, depending on the type of coverage involved, contracted insurance requirements, and the regulatory environment in which the captive is domiciled. But suffice it to say, without the ability to Front, many captives simply wouldn’t be able to include the types of risk in their policies that make captives attractive options in the first place. 

The XN Captive Team can guide you through your needs and specific risk situation during a free consultation. For more information on XN Services related to Fronting Arrangements, visit our Services page.