Fronting in Insurance: Building Strong Partnerships for Success

In the complex world of insurance, a term often discussed, yet not widely understood, is "fronting." This article aims to provide an accurate definition of this practice, while exploring the nuances of fronting in insurance, shedding light on its mechanisms, advantages, potential pitfalls, and the role it plays in the ever-evolving insurance landscape.

What is fronting?

Fronting involves one insurance company, known as the  "fronting insurer,"  who agrees to issue an insurance policy on behalf of another insurance company which takes the insurance risk via instrument reinsurance. It basically refers to accessing risk capacity through partnerships with other insurers. This can be for example a captive insurer or reinsurer.

A captive insurer or reinsurer is a specialized type of insurance company that primarily underwrites and assumes the insurance risks of its parent company or a group of related companies.

Essentially, the fronting insurer acts as an intermediary, enabling the second insurer to engage in insurance activities while navigating regulatory complexities. However, this arrangement is not without its complexities and responsibilities. The fronting insurer assumes both legal and financial obligations, including the crucial task of claims payment, and may impose service fees for its role. These fronting agreements operate under strict regulatory scrutiny to ensure adherence to local insurance laws and regulations.

Insurance regulators closely monitor fronting arrangements to prevent abuse and ensure that the policies issued through such arrangements provide genuine coverage and protection to policyholders. If not properly managed, fronting arrangements can pose financial and regulatory risks to both the fronting insurer and the captive insurer.

In Germany, which happens to be the largest market for ELEMENT, public opinion on fronting is characterized by a dual perspective:

1. In General, It Is Possible: Fronting arrangements are generally considered a viable practice within the insurance industry. They offer opportunities for insurers to expand their reach and for businesses to secure coverage that aligns with their specific needs.
   
   
2. The 'Skin in the Game' Requirement: From a regulatory standpoint, it is crucial for the fronting insurer to demonstrate a tangible commitment to the insurance technical risk. This often translates to carrying approximately 10% of the risk. While legally, it is possible to have 100% reinsurance quotas, the regulatory requirement of that 10% acts as a safeguard to ensure that insurers have a vested interest in the policies they underwrite.

Why “Skin in the Game”?

One might ask the justified question, why taking risks as a fronting carrier is important – also given the fact that the former BaFin did not even consider fronting as insurance business until 1980.

However, there have been several bankruptcies and crises of carriers with established fronting models in recent years, as those carriers did not control the business they wrote. As written above, the fronting carrier is liable towards the end-customer and then has to try to get the money back via reinsurance. Hence, that mechanism relies on trustworthy reinsurers and stable cash management in case of bad business. As that did not work too many times, fronting carriers are perceived to have to carry risk in order to have the incentive to monitor and manage the underwritten business.

Reasons for Fronting

Some of the common motivation to use fronting are:

• Cost minimization: Use an existing carrier to place risk (and take back risk via a cheaper reinsurance solution) by saving operational setup costs
• Speed: Founding an insurance carrier takes time (and we all know time is money).
  That goes for the general carrier setup and for the entrance into additional markets.
• Regulation: Regulation is complex and difficult. Being compliant creates a lot of effort, and that can be outsourced to a fronting carrier.

Main risks of fronting – the unlucky man in the middle

Looking at recent years and market examples, we have identified three core risks:

1. Underwriting and sales risk

• • Weak selection of partners leading to high loss ratios.
  • Companies carrying risk on own P&L have limited financing available, almost no fronting carrier has rating
  • Too aggressive underwriting; when technical result becomes negative, fronting carriers tend to be stuck with risks and go out of business.

2. Business Risk

• • Only 120% SCR in some countries traditionally needed for starting a new carrier. (ii) Additionally, the local regulation is perceived as loose.
  • Companies do not properly control MGAs and TPAs and operate highly inefficient (diverse market requires TPA handling)

3. Counterparty Risk

• • Fronting to small reinsurance companies to save on costs.
  • When reinsurance companies fail, counterparty default risk is too high and not sufficiently covered.
  • Since underwriting is too progressive, no reserves to cover up losses in case of a default.

What does it then take to play the fronting business model successfully, to access additional risk capacity?

1.   Careful partner selection:

Selecting the right partner is required to ensure that the partner aligns with the fronting insurer's strategic objectives, has a solid reputation, and possesses the necessary financial stability and regulatory compliance. A thorough due diligence process should be in place to assess the partner's credentials, financial strength, and commitment to mutual success.

2.   Controlling the underwriting via technology and/or smart business rules:

Leveraging technology and implementing smart business rules can streamline underwriting, enhance risk assessment, and improve overall operational efficiency. Automated systems can help in evaluating risk exposure, setting appropriate premium levels, and expediting policy issuance. By embracing these tools, fronting insurers can reduce the margin for error and enhance their competitive advantage in the market.

3.   Only work with strong reinsurers:

These reinsurers should have the capacity to bear the ultimate risk associated with the policies issued through fronting arrangements. This ensures that, in the event of significant claims, the reinsurer can fulfill its obligations, safeguarding both the fronting insurer and policyholders.

4.   Establish a strong balance sheet to cover potential losses and/or liquidity gaps caused by the delay of losses/claims: 
Building and maintaining a robust balance sheet is a critical aspect of the fronting business model. This serves as a financial safety net to cover potential losses or liquidity gaps caused by delays in claims payments or unforeseen contingencies.

In conclusion, playing the "fronting business model" successfully involves meticulous partner selection, the adoption of efficient underwriting practices, partnering with strong reinsurers, and maintaining a solid financial foundation. By adhering to these four principles, fronting insurers can navigate the complexities of the insurance landscape while providing valuable services to their partners and policyholders, while ensuring long-term stability and sustainability.

ELEMENT has built more than 30 different insurance products – pretty much across the whole range in P&C. As a digital insurance company, we are able to always offer our business partners innovative insurance solutions quickly, flexibly, reliably and efficiently along the entire B2B2X value chain. The combination of insurance and technology expertise makes us a pioneer in the insurance industry.

With that, ELEMENT brings quality and speed – and yes, we are able to, and want to have skin in the game.

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