Previous articles in this captive column have examined the role of fronting, and the costs associated with fronting, from a big picture perspective, using general numbers for things like taxes, boards, bureaus, profit, and other items. It behooves the cost-conscious captive owner/operator to drill down further into these costs. While improvement may only come in single percentage points, accumulated from several line entries over time, these can be material. As it is your money, it should be looked at more closely.
The location, identification, and successful execution of fronting, or risk sharing, for captives continues to be problematic, but some progress is being made. Many captive owner/operators have successfully negotiated the acceptance of certificates from their captives, with no rating or admission by a state other than their domicile. Some insurers remain solidly in the marketplace, and offer terms to all comers.
For those captives that must use the services of a risk sharing partner for certification of credit and regulatory risk, there are several factors which deserve a closer look. A tip of the hat goes to my friend Andy Barile for recently reminding me of some of these aspects of fronting costs.
The typical breakdown of costs for a captive program will show line items such as:
| Taxes, boards, and bureaus | 2%-4% |
| Fronting fee | 5%-15% |
| Claims administration | 2% |
| Loss control | 2% |
These may appear to be small, even benign in the overall scheme of things. Often, it is heard from the underwriter, "Well, they are what they are." Well, usually they are not.
Taxes, Boards, and Bureaus
The logic in lumping taxes, boards, and bureaus together is that they are assessed by states on the insurers overall book of business as state income tax, support of guarantee funds, fire marshal taxes, second injury funds, and the like. I agree that these are nettlesome, small matters when you are putting together a large program to save your business. The temptation to let them pass without further examination is the norm.
But the facts are that these numbers are known. If you are dealing with a publicly held, admitted, rated insurer, which is usually the case, then the exact numbers are in their public financial filings for all to see. Further, the states clearly reveal such charges, usually on their websites.
So, if your underwriter says that the state charges are 4 percent, and you research or ask your consultant/broker to research (which a good one would have done already) and learn that they are actually 2.8 percent, and that captives are exempt from state taxes and that risk retention groups are excepted from guarantee funds, either you or your underwriter have picked up $12,000 on a $1 million premium. Whose money is it? Who will get to keep it?
Some may wonder if an underwriter or insurance company representative would purposely misstate the numbers to improve his/her own position. I think not, but if, in the interests of their shareholders, they can successfully negotiate a higher return through dealings with an uninformed party across the table, why would they not do so?
Fronting Fees
Costs may also include an item known as residual market loadings. These are basically legacy charges for the insurer having been successfully in business in a particular state for some time, and accumulated charges to reimburse claims for insurers who were not so successful. Your risk sharing partner may well attempt to include some of these charges in your fronting charges. There is some logic to this, particularly in programs that are essentially large deductible programs disguised as captives.
I would assert that if an insurer is fronting for a captive—which captive is taking licensed, actuarially sound, adequately financed risk—then there should be no reason to include charges for risks to which the captive will never be asked to contribute by regulators. But should a good negotiator for the fronter be able to lay off costs? As a shareholder, I would applaud the effort.
Claims Administration
Charges for claims administration should likewise be subject to scrutiny. The risk sharing partner may take the position that only its in-house claims staff is qualified to represent them, which is a reasonable position to defend. Adjusting claims is a difficult endeavor, usually handled by trained, skilled individuals, and the stakes in event of an error are huge.
If, however, the captive determines that it is best able to handle the claims that it will be financing, then, after it has proven that to the satisfaction of all parties, it should not be charged by others merely to oversee. Certainly not at rates that are charged to those who are merely accepting risk as a part of an overall risk strategy in which they are not licensed, and not securing IBNR to actuarial levels.
These are complex issues to confront, but, again, it is your money if you are the captive owner. So, it is worth it in the end.
Loss Control
Similar issues arise with charges for risk control. No party has more at interest in controlling risk than the owner/operator of a captive. Measuring and evaluating that risk, and managing it, requires skill and knowledge, not just the desire to spend less on insurance.
The risk sharing partner, fronter, is also invested in the successful execution of informed risk management. If the captive is not able to demonstrate the clear ability to do what is necessary to manage risk, few observers would criticize the risk sharing partner for protecting not only its position, but that of its less capable partner. Ultimately, the paper put forth is that of the fronter, and the consequences for mistakes are huge.
Therefore, a charge for risk control must be analyzed to determine who is doing what, and what chance of success exists, and who will secure the risk. A standard charge of 2 to 4 percent, with no discussion of details, costs, and measures of success requires a closer look. I would argue that if all losses are already secured, then why add a charge for risk control? But insurers must answer to shareholders, regulators, and reinsurers, in addition to policyholders. Captive owners must answer to themselves. It all makes for great conversation—with your money.
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