Is Fronting a Win-Win for Insurers?

Fronting can be defined as an alternative way of entering markets and growing premium, a valid tool to be used for the benefit of both an insurer who needs the front and an insurer willing to be the front for the right compensation.

Fronting is a reinsurance arrangement. The fronting carrier is the insurance company on whose paper the insurance policy is issued. The reinsurer assumes from the fronting carrier all or substantially all of the underwritten risk in exchange for a fee to the front.

Benefits to the fronting insurer. For the insurer providing the paper as the front, fronting can be a revenue generator. It gives the company an opportunity to profit from fronting fees without taking on substantial risk but lending its paper and, to a certain extent, its capital.

Risks to the fronting insurer. The key to any successful business relationship is a good and healthy partner. When an insurer lends its paper, it is on the hook, or responsible for fulfilling policyholder obligations. Despite the fact that risk has been transferred under a resinsurance arrangement, should the reinsurer fail to perform, it will be the responsibility of the fronting insurer to make good on those policyholder obligations.

In order to mitigate this risk, the fronting insurer should evaluate the financial health of its reinsurer/partner. Fronting arrangements always require collateral to secure the reinsurer’s obligations under the fronting agreement. The most common types of collateral are:

1. funds withheld by the fronting company
2. a trust account funded by investment securities
3. letters of credit

Benefits to the fronted insurer. The insurer looking for the front is typically driven to enter into fronting arrangements because it lacks access to the market through a direct policyholder relationship. Most commonly insurers are looking for this type of arrangement because they are not authorized in a particular market or because the insurer lacks the financial credibility in the form of a rating, such as A.M. Best.

Risks to the fronted insurer. Similar to the fronting insurer, a healthy business partner is essential. The reinsurer is tying their product to the fronting insurer such that there is a concentration of risk and there may not be alternative fronting insurers. Leverage granted to the fronting insurer or the failing health of a fronting insurer can negatively impact the business. The risk from failing health may be obvious but less obvious is that leverage allows a fronting insurer to increase the cost of the arrangement and to modify collateral requirements, tying up assets of the reinsurer.

Regulatory considerations. With every decision made, insurers who choose fronting as a business model should consider the regulations of their state of domicile. There’s not room in this article to discuss the numerous state regulations, but be aware that some regulators will be more favorable to these types of arrangements while others may make such arrangements prohibitive. For example, the State of California, California Code of Regulations (CCR para 2303.15), imposes a limitation on a fronting carrier to retain 10% of the risk.

Accounting. For statutory reporting, transactions recorded under fronting arrangements are governed by SSAP No. 62R – Property and Casualty Reinsurance. Under US generally accepted accounting principles, the guidance of ASC 944 – Financial Services – Insurance is applicable.