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Captives-Front and center By Michael J. Moody, MBA, ARM The growth of the captive movement has put pressure on a number of limited industry resources. Among those limited resources are such things as letters of credit (LOC), high limit property reinsurance, and fronting capacity. Unfortunately, most of these resources are badly needed to maintain the growth of the captive insurance industry. With regard to fronting, for example, many of today’s captives could not survive without adequate fronting insurers. While there are any number of definitions for fronting, most agree that it is a term that describes a relationship between an admitted insurance carrier and a captive and/or parent company. Traditionally, the process involves multiple transactions, the first being the execution of an insurance policy between the captive’s parent company and the fronting carrier, which is designed to provide the regulatory and/or contractually imposed compliance needed and, second, a reinsurance agreement between the fronting carrier and the captive. Thus, the fronting carrier transfers a selected retention and/or aggregate of the risk by use of a reinsurance agreement to the captive. In essence, many believe that it’s this fronting relationship that has led to much of the growth in the captive industry. CICA annual survey Annually for the past six years, the Captive Insurance Company Association (CICA) has surveyed its members with regard to their fronting practices. This year’s survey was a joint effort between CICA, Munich Re America and both the Arizona Captive Insurance Association and the Vermont Captive Insurance Association. The 2007 survey received 143 responses, compared to the prior year, which had 93 responses. The mix of types of captives was similar to the overall distribution of captives within the industry. The majority of responses (61%) came from single parent captives, while about 15% were from risk retention groups (RRGs). Additionally, cell captives accounted for 11% of the total, as did association captives, while agency captives rounded out the group with about 2%. Other important demographics were that 78% of the respondents were from U.S. domiciles and 22% were offshore. A majority of the captives (57%) were six years or older and 39% were listed as between one and five years old, with about 4% being less than one year old. Given the diverse but limited participation, it is somewhat challenging to determine which captive structures and other relevant questions are linked to the results. Much of the recent noise in the alternative risk arena is the claim that fronting costs are expensive and that these costs continue to be one of the most important issues for risk financing and alternative risk structures. Yet the survey revealed that 44% of the participants reported fronting fees of 5% or less of annual premiums. This is made all the more interesting when it is noted later in the study that pass-throughs—such as premium taxes, boards, bureaus and administration and other surcharges—have been lumped into fronting costs by survey participants. Additionally, 37% of respondents reported fees of 6% to 10% of annual premiums, and 9% indicated fronting costs of 11% to 15% of annual premiums. Ten percent reported “other” as their response. As would be expected, 41% of the participants indicated that the reason for fronting arrangements was access to admitted paper. Other reasons cited were: 29% for regulatory compliance and 9% for support services. About 8% stated that a global strategy was the reason they were fronting, while improved marketing was reported by 5% and an enhanced tax position was selected by 4% of the participants. So, in totality, around 70% of participants claimed that regulatory compliance and admitted paper are driving their need for fronting. The survey participants noted use of fronting carriers as follows: Key findings from the survey were that about 60% of the participants indicated no increase in cost over last year, and 16% reported a decrease in costs while 24% noted an increase in costs over the prior year. The survey also concluded in relation to price and value that the majority of those participants purchasing fronting considered their price/value relationship to be moderate to excellent, while less than 10% categorized the price/value relationship as “low.” Setting aside the price of fronting, the big news is an acknowledged shift in acceptable collateral form. Only 50% of the respondents indicated they were required to use a letter of credit (LOC) compared to over 70% just the year before. This change was reflected in the increased use of LOC/trust accounts, which accounted for 21% of all collateral methods. It is clear that the use of trust accounts is gaining favor with both fronting carriers and captive owners. Unfortunately, the survey does not offer any detailed data in terms of the size of the captives that were able to entertain trusts, or if the acceptance of trusts was for the full collateral amount or a portion thereof. Only part of the story CICA’s annual fronting survey is a good starting point in terms of market availability, pricing, collateral and the overall price/value relation-ship with respect to captives—however, the survey has its limitations in terms of overall market and specific program structure application, and we cannot correlate year-to-year results, given the shift in participation in both form and number. However, one thing is clear: Fronting fees and collateral requirements are only part of the picture. A number of other critical components should to be considered when choosing a fronting carrier. Carol A. Frey, vice president of business development & client retention for ACE Risk Management, says that the fronting carrier selection process should be much more robust and step well outside of fees and collateral requirements. She says it “should extend to an overall, holistic enterprise review of the fronting carriers under consideration.” And she says that ideally this process should take place prior to the formation of the captive or any other risk financing program structure under consideration. Alternative risk financing programs are unique to each captive and customer and, therefore, require a strong understanding of underwriting and finance, in conjunction with an ability to service the business with confidence and commitment. “These programs have many moving parts and require an infrastructure that is well established and proven,” notes Frey. While fronting carriers are considered as limited resources within the captive industry, Frey states that for the most part, “the availability of fronting carriers has been relatively constant since late 2001.” Generally, she says that the number of carriers has remained relatively flat; it is just that the market share changes from year to year depending on a market’s underwriting appetite, overall service capabilities and relationship management. While the CICA survey can shed significant light on market availability and general tendencies based on the survey participation, what it does not do is provide information as to how the individual fronting carriers position themselves on any number of critical elements essential to a well-managed risk financing program. Frey says that there are more markets willing to entertain single parent captives than groups, associations or other industry-specific or agency-structured captives as well as those that prefer only established captives as opposed to start-ups. Frey also says that a market’s appetite can change from year to year putting the burden on the buyer, broker and captive manager to manage the preferred palates of each and every potential fronting carrier. Notably, those markets that maintain a consistent appetite and underwriting philosophy would be categorized as “go to” carriers of choice. Obviously, one of the most important issues when selecting a fronting carrier is financial strength. Frey points out that insurers are rated by either A.M. Best and/or Standard & Poor’s, among other rating agencies. But it is important that the captive owner and related parent company continually monitor the financial strength of its fronting carrier. As new capital modeling requirements and related rating agency reserve requirements become adopted, it will be more essential than ever to monitor the various fronting companies in terms of their financial rating—recognizing that these models and corresponding financial ratings are conceived to demonstrate both the short- and long-term ability of an admitted company to deliver on its obligations. One point of differentiation between fronting carriers is how they approach the issue of additional services over and above the policy issuance and related regulatory and rating agency requirements. Frey reports that this is one area that will need to be reviewed in detail. For example, she says, “What is the fronter’s position with regard to claims management and loss control? Will they allow the captive to have the ability to purchase claims management services from another service provider, or must the captive use the fronting carrier’s claims services exclusively?” Yet another important bundling issue relates to the purchasing of risk transfer insurance. “How much of the risk transfer (or reinsurance, if any) does the fronting carrier want or require to consider underwriting the program?” Every carrier has its own philosophy with regards to the bundling and unbundling of services and risk transfer options (x/s of occurrence, aggregate protection, quota share, or any combination thereof). Frey suggests that these options and appetites be identified early in the marketing and captive feasibility process. Much of the growth in the captive movement has come about due to the increasing interest by captive owners in maximizing the strategic value of their captives. One of the ways that they are doing this is by organically expanding the captive’s utilization in innovative ways. As a result, it is important to determine in advance how the fronting carrier can or cannot support new risks. Frey notes that many captives have been formed to provide workers compensation, only to expand the captive’s coverage to liability or property coverage in later years. “Will the fronting carrier under consideration be interested in providing admitted paper for these additional exposures and under what conditions?” she asks. Summary CICA (www.CICAWORLD.com) provides a wealth of information in its annual fronting survey. And with the 2007 survey, the scope of the survey was expanded even further by including valuable information on reinsurance and employee benefits in captives, thereby increasing the value of the survey. However, as ACE’s Frey points out, the analysis should not end with just information regarding the fronting fees and collateral requirements. A more holistic review should be taken to assure the best fit between the fronting carrier, the captive and the parent company. Captives, generally speaking, are long-term strategic vehicles, and, therefore, the selection of a fronting partner should be as extensive as any other selection process that the captive owner is undertaking. This kind of in-depth analysis can help in building a stronger business relationship and partnership. After all, fronting carriers and captives share a common objective in terms of optimizing captive retentions within an acceptable tolerance for risk and risk transfer for those risks that neither the captive nor the parent company can or are willing to self-insure. Finding the right fronting partner may result in a well-balanced program and contribute to overall program continuity. * The Author |
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