In the previous article, we have already learned about how fronting works in reinsurance. We now know how different entities have to collaborate in this complex arrangement called fronting. The concept of fronting is fairly recent and has been growing quite rapidly. However, before deciding whether or not fronting is right for a particular reinsurance company, we need to consider its benefits and drawbacks in detail.
Benefits of Fronting
Captive reinsurance companies prefer to use the fronting arrangement. This is because of several benefits that this arrangement provides. Some of the important benefits of fronting arrangement have been mentioned below:
- Compliance with Regulations: The first and foremost benefit of a fronting arrangement is that it allows the captive reinsurance company to cover the risks in a manner that they want while being compliant with the law.
In many parts of the world, obtaining an insurance license can be an expensive as well as a difficult task. In such countries, captive reinsurance companies are not able to operate. The fronting arrangement provides a viable workaround that can be used by captive reinsurance companies without making any significant changes to their own operating models.
- Claims Handling: The claims handling process can be quite complex and time-consuming. It requires the collection, storage, verification, and archiving of several business documents. As a result, this can be quite expensive and time-consuming for the captive reinsurance company.
Commercial insurance companies already have processes in place which allow them to manage these claims in a more cost-efficient manner while simultaneously having a faster turnaround time. The outsourced claim handling process is a major selling point for captive reinsurance companies since it reduces their administrative tasks as well as administrative costs.
- Tax Benefits: Several companies use captive reinsurance and fronting arrangements as a more cost-effective mechanism that helps them manage their own risk. This is because it is possible to set up a captive reinsurance company in a tax haven. Now, if the insured company pays the premium directly to a related party, it has to be treated differently for tax purposes. However, if the same insured company pays the premium to a third-party commercial insurance company, it becomes an expense and hence can be deducted from their profits. The reinsurance premium is received by them in a tax haven where the tax rules are more favorable. The end result is that the company ends up saving taxes as a result of using the fronting arrangement.
- Excess Risk Transfer: Captive reinsurance companies may not want to hold on to all the risk generated by their group companies.
For instance, it is possible that they may want to provide insurance only up to a certain monetary amount. However, it is likely that the business activities of the group companies may generate even more risk. In such cases, captive reinsurance companies might want to use retrocession in order to get rid of their risk. In this case, since the captive insurance company already has an arrangement with a commercial insurer, they can utilize it to get rid of the excess risk that they have on their books at a reasonable price.
Drawbacks of Fronting
Fronting is generally perceived to be a convenient arrangement in which the needs of all the relevant parties are met. However, there are certain drawbacks to this arrangement as well. The most important drawbacks have been listed below:
- Expensive: Firstly, it is important to understand that fronting is an expensive process. This is because there is a third-party commercial insurance company involved. The actual premium for risk issuance will be taken by the group captive company. This excess premium which is paid to the third-party company is what makes fronting an expensive affair.
- Frauds: Regulators around the world are skeptical that fronting arrangements can be used to embezzle money from one group company to another.
Lets assume a group has two companies, company A and company B. Both these companies use company C as their captive reinsurance company. Now, A and B contribute money to C which can be accessed via an insurance claim. It is possible that company A may submit a false claim which will be processed by the insurers because captive reinsurance company C will be willing to pay the claim. In the process, it is likely that shareholders of group company B have been marginalized in order to benefit the shareholders of company A.
- May be Illegal: In many parts of the world, pure-play fronting is illegal. This is because it is assumed that the entire arrangement is created only to divert the attention of the regulators. Hence, in such cases, commercial insurance companies are required by law to share at least a small percentage of the risk. The fact of the matter is that fronting arrangements are viewed with suspicion by regulators all over the world. Hence, insurance companies need to be extra cautious to ensure that they are not acting against the law.
The fact of the matter is that fronting is a complicated activity that has both pros and cons. In some situations, the pros outweigh the cons which is the reason why fronting is being increasingly used in the reinsurance industry.
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