Mr Rob McCabe of AIG explores the key elements of fronting fees, and why “paying more pays off”.
Arisk manager recently told me his CFO questioned why their captive programme’s fronting fees were equivalent to the price of a new Ferrari. I responded that depending upon the nature and complexity of the underlying insurance placement, AIG’s fronting fees generally started around the cost of a mid-range BMW (in Hong Kong, not Singapore with its Certificate of Entitlement perhaps!) and could go as high as that of a new Rolls Royce – including the price of the real estate in which to park it.
In today’s environment, companies are seeking to minimise and better manage costs across their entire organisation, so how can initially perceived, “expensive” fronting fees be justified?
Historically, fronting insurance companies have been reluctant to divulge the “secret formula” behind their fronting fees, resulting in a perception that the pricing is “more art than science”. Many brokers and clients regard fronting fees as purely an “administrative servicing cost”, however administration is only part of the equation. There are a number of drivers that influence the fee in reality, including:
• The number of countries in which the policyholder has operations;
• The number of policies and certificates to be issued in each of those countries;
• The number of premium transactions;
• Anticipated claims volume and difficulty in handling such claims (often dependent on the nature of the underlying insurance policy(s);
• Volume of premiums;
• Credit risk assumed by the fronting insurer;
• Magnitude of policy limits to be issued; and
• Any other special servicing and reporting requirements that may be required to be tailored for the individual client.
These drivers seem relatively straightforward, but they do not fully explain the components that actually comprise the fronting fee, especially for global, multinational programmes. Let’s explore these components in more detail.
Central programme coordination
The risk manager and producing broker ordinarily want a single point of contact within the fronting insurer to agree upon the programme’s parameters. They may have little direct day-to-day contact with the local network delivering service at the individual country level (remembering that for multinational programmes, any number of locally admitted insurance policies may be required). Successful central programme coordination is vital for any controlled master programme.
The fronting insurer’s producing office is responsible for programme management and coordination, and therefore performs many key functions.
It has to agree on policy wordings and communicate underwriting instructions to its broader country network. It needs to verify and agree upon premium allocations between policies, and negotiate any special servicing and claims handling requirements that may be required. It will calculate and agree on the fronting fee, and have overall responsibility for account servicing on a day to day basis.
Additionally, that office is responsible for designing and implementing a compliant programme structure, as well as agreeing to, and executing, the required legal and collateral documents in a timely fashion. It must continuously track programme performance against mutually agreed key performance indicators (KPIs), respond to queries and resolve any other issues.
Ideally the team handling such programmes should have expertise in both captive and complex multinational programmes across all lines of the insurance business. This cannot be an occasional part-time or ‘side activity’ for traditional risk transfer underwriters. It should be recognised as a distinct discipline requiring specialist systems, human resources, and procedures to deliver excellent service, which of course comes with a monetary price.
Local service fees
In any global fronting programme, the local insurer will be issuing an admitted policy and providing local servicing such as certificate issuance, premium invoicing and collection, as well as payment of taxes.
There may also be local compulsory cessions and premium reserves withheld and local requirements governing premium and risk exportation. It is important that the local carrier ensures that the policy wording issued is compliant at the local level, and matches the client’s master policy wording to the greatest extent possible.
The local insurer should be adequately remunerated so that it is committed to servicing incoming business. Any locally deducted ceding commissions should be reasonable from a transfer pricing perspective. A multinational insurer with its own wholly-owned and managed network will most probably be in a stronger position to control such costs and manage its own network than one that is heavily reliant on “friendly local insurers” or non-group owned insurance companies.
Captive cash-flow management and reporting
Most fronting insurers centralise the global fronting programme’s reinsurance reporting and administration so that the captive also enjoys the benefits of a single point of contact.
The reinsurance administrator (or aggregator) is responsible for the tracking and onward payment of reinsurance premiums to the captive and other reinsurers, as well as reporting and billing losses.
A fronting provider with a good track record of expeditious cash flow management will help maximise the captive’s investment income and minimise its foreign exchange risk. Some fronting insurers demonstrate confidence in their cash flow performance by offering a “cash flow guarantee” with an interest penalty under which they commit to move funds to the captive from key countries within an agreed timeframe.
Claims handling
Managing claims across a global programme is not without its challenges but affords clients numerous benefits.
A standardised, consistent, global claims handling approach should assist with the client’s risk financing strategy. A global programme will also provide consistent loss management information on a paid, incurred and outstanding basis, something that is impossible to achieve if one has multiple fronting partners.
The need for a fronting partner with real global claims handling capabilities “in country” was no more evident than in Asia Pacific, following the Thai floods and Japanese earthquakes, where an immediate response helped minimise overall insurance losses and associated costs.
Credit and cost of capital
A fronting insurer may seek to protect its own credit position by seeking acceptable collateral such as letters of credit (LOCs) or cash trusts.
Depending on the market, bank and parental guarantees, a protocol d’accord or a lettre d’engagement, have also been used. Apart from the credit position, qualifying collateral also provides capital relief for the cedant or fronting company.
Some clients struggle to see how the insurer’s capital position is impacted through the provision of fronting services. The reality is that any risk written and ceded attracts a capital charge. For a captive programme, the risk is from the reserves: unearned premium reserves, outstanding loss reserves, and incurred but not reported (IBNR) claims.
In calculating fees, the fronting insurer must cover its own cost of capital and the residual credit risk, after allowing for any qualifying collateral. This has become critical as fronting insurers are more aware of the capital implications of ceding to unrated reinsurers. Financial reform and increased regulation brought about in response to the global financial crisis has focused minds on capital management, which may result in fronting fee increases for certain accounts to reflect capital consumption and additional regulatory change.
Regulatory and operational risk
As insurance continues to become increasingly regulated, the risk that a policy might be uncompliant due to changes in law can lead to losses for the fronting insurer.
Complex multinational programme structures are at greater risk of having operational or documentation problems, similarly causing fronting insurers to incur unforeseen costs. Whilst these are not pure underwriting risks, they are operational risks nonetheless, and consequently compensation is required.
Profit
A fronting insurer should deliver an adequate return and profit to its shareholders. In some markets, inexperienced fronting insurers may only charge a nominal fee for captive fronting and by doing so fail to recognise (let alone expense for) the valuable resources that handling such programmes can consume.
There are ways that risk managers can work with their existing fronting insurer to control costs however. On the administrative side, having a single policy per country with an annual non-adjustable premium payment can be cheaper than multiple premiums and policies. Reducing policy limits can also provide some relief but these should still be fit for purpose and exposure. There are two other tools to manage fronting fee costs:
• Captives can offer additional qualifying collateral to mitigate a programme’s capital costs. A Regulation 114 Trust or security interest agreement may compare favourably with LOC costs and may not encumber the captive’s or sponsor’s credit line while affording fronting companies capital relief; and
• Captives rated by a US NAIC approved Nationally Recognized Statistical Rating Organizations (NRSROs) such as A.M. Best, Fitch, Moody’s or Standard & Poor’s or another recognised rating organisation may also provide capital relief for fronting companies, as balances ceded to a NRSRO rated reinsurer are treated more favourably from a rating agency perspective.
In recent times, fronting insurers have been reviewing their pricing models for fronting services offered, and typically taking a more informed approach to determining appropriate fees, based on the true costs of the fronted insurance programme.
If your captive still pays fronting fees that would not even buy a used Mini Moke, you can continue to enjoy the ride, but you may wish to question if your fronting insurer is providing the Ferrari-like service you deserve, and whether the current level of service is sustainable over the longer term, in an increasingly changing regulatory and evolving global risk environment. What looks like a good deal today can quickly become a costly headache if it is always in the repair shop!
Mr Rob McCabe is the head of AIG Global Risk Solutions (GRS) in Asia Pacific.