FRONTING - POST 2 of 2
09-04-2015, 09:42 AM
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FRONTING - POST 2 of 2
This is the article on Fronting continued. it was too long to go into one post 
IV. Fronting Statutes and Regulations
After intense and prolonged debate, he National Association of Insurance Commissioners (“NAIC”) adopted a Fronting Disclosure and Regulation Model Act in 1992. It provides that when a licensed insurer enters into a reinsurance transaction and delegates to the reinsurer claims handling and underwriting authority, prior regulatory approval is necessary if: (1) annual gross premium for the transaction is expected to exceed 5% of the insurer’s policyholder surplus; or (2) annual gross premium for all similar transactions is expected to exceed 15% of policyholder surplus. This Model has not been adopted in any state.
The Reinsurance Association of America markets a Compendium of Reinsurance Laws & Regulations which includes the topic of fronting. According to this Compendium, only 17 states and the Virgin Islands have any statutes, regulations, bulletins or attorneys’ general opinions (generically called “Regulation(s)”) on fronting. Those which exist are usually vague, piecemeal or overly broad. For instance, some fronting Regulations apply only to a narrow portion of the marketplace i.e. credit life and health, medical malpractice, home and service warranties or ambulance service agreements. [5]
In addition, some Regulations prohibit “fronting” without defining the term. [6] Other Regulations define it as “transfer of the risk of loss” or “transfer of a substantial portion of the risk of loss” or “transfer of substantially all of the risk of loss.” [7] The lack of a precise definition of fronting makes both compliance and enforcement difficult. Does “risk of loss” include timing risk i.e. can payment of the loss be put off until investment income plus the premium exceeds the loss? Is delegation of claims handing and underwriting authority irrelevant? What percentage of risk must be ceded to be substantial or substantially all risk? How is this measured in excess of loss or aggregate excess cessions? For instance, an insurer may cede only the first $500,000 of $1,000,000 limits but due to the underlying policy limits and/or the nature of the business, the reinsurer could actually pay virtually 100% of the losses.
Without better definitions, it is possible that garden variety quota share cessions will be regarded as fronting by regulators. For instance, the Florida fronting statute, § 624.404, defines fronting as a 50% cession to one unauthorized reinsurer or 75% to two such reinsurers. Perhaps the better approach is that taken by the NAIC and by Connecticut in defining fronting based on delegation of the insurer’s power, rather than any specific quantity of risk transferred. Connecticut Bulletin S-2 prohibits transactions in which:
[L]icensed insurance companies have entered into agreements with unlicenced insurance companies, which agreements enable the unlicenced insurance company in the name of the licenced company to do, among other things, (1) appoint agents; (2) collect premiums; (3) adjust losses; (4) process, approve and issue checks in payment of claims and expenses; and (5) maintain all records associated with such business.
V. Liability of Reinsurers to Insureds in Fronting Situations
Ordinarily, insureds have no right of action against a reinsurer due to lack of privity. [8] However, there are a number of cases which suggest that reinsurers subject themselves to direct actions by policyholders when they assume 100% of the risk and take over services to policyholders normally performed by the cedent.
An early example is O’Hare v. Pursell, 329 S.W.2d 614 (Mo.1959) in which the reinsurer assumed 100% of the risk, took charge of the pertinent books and records of the primary business, serviced the business, and adjusted and settled obligations directly with insureds. Under these circumstances, the court ruled that the reinsurer was directly liable to insureds:
By taking over the risk assumed by [the cedent, the] reinsurer put itself in the position of a contractor with the insureds. The law supplies the privity necessary for insureds to maintain a direct action upon the contract of reinsurance. [9]
For a case with similar facts and ruling, see Foremost Life Ins. Co. v. Department of Insurance, 395 N.E.2d 418 (Ct.App.Ind.1979).
Another example of liability by conduct is Venetsanos v. Zucker, Farcher & Zucker, 638 A.2d 1333 (Sup.Ct.N.J.1994). As part of a fronting relationship, Homestead Insurance Company (“Homestead”) assumed 100% of the insurance risk under a boat policy issued on the paper of Mutual Fire and Inland Marine Insurance Company (“Mutual Fire”). Homestead, its officers, employees and affiliates, produced the business, underwrote it, adjusted and settled claims and, generally, acted as if Homestead was the policy issuing company. When Mutual Fire was placed in receivership, the assignee of the policyholder filed an action against Homestead not for reinsurance recoverables, but for failure to: (a) negotiate a settlement of the underlying claim in good faith and within the policy limits; and (b) advise the policyholder of the existence of risk in excess of policy limits
The Venetsanos court recognized the usual direct action rule that reinsurance proceeds are payable to the receiver of the cedent rather than the policyholders of the cedent. However, the complete fronting nature of the transaction caused the court to uphold summary judgment in favor of the policyholder’s assignee, imposing the obligation of a primary insurer on Homestead:
Here, Mutual, the local admitted insurer, merely provided the use of its policy for a consideration in order to enable a non-admitted carrier and its affiliates to solicit and evaluate risks, sell policies, wholly insure, and wholly control payments of claims on risks in this state. We will not consign a New Jersey insured or its uncompensated victim-assignee exclusively to uncertain and probably inadequate recourse against an insolvent insurer in a foreign rehabilitation proceeding in such circumstances, particularly where the reinsuring agreement is unavailable. [10]
The court did not indicate how it would have ruled had the assignee been seeking reinsurance recoverables.
A similar case is Keightley v. Republic Ins. Co., 946 S.W.2d 124 (Ct.App.Tex.1997). In this case Republic Insurance Company (“Republic”) reinsured 100% [11] of the risk of National County Mutual Fire Insurance Company (“National”) on the policy in question. Due to National’s financial difficulties, Republic took over National’s claims handling functions by assigning a claims manager for National’s insureds, adjusting and settling claims, hiring defense counsel and establishing and funding a bank account in National’s name for payment of claims.
The assignee of the policyholder did not seek reinsurance recoverables from Republic. It brought various statutory and common law claims against Republic for refusal to settle within the limits of the policy. Republic moved for summary judgment based on the policyholder’s lack of privity with Republic. Noting that the plaintiff sought damages based on Republic’s wrongful conduct rather than under the reinsurance contract, the court rejected Republic’s motion for summary judgment on one statutory deceptive trade practices count and one common law negligence count that did not require privity between Republic and the insured.
A more recent case on point is Edens v. United Benefit Life Ins. Co., 2001 WL 11431140 (N.D.Tex.). United Benefit Life (“UBL”) was the fronting company and its parent Central Reserve Life (“CRL”) was the reinsurer. CRL agreed to perform all the administration of UBL policies “including but not limited to, all actuarial, underwriting, compliance, legal, issuance, accounting, administration, data processing, systems and claims processing services” [12] with respect to the UBL policies. The policyholder sought to recover from the reinsurer and CRL moved for summary judgment on the basis that it had no liability to the policyholder. The court declined to so rule stating:
The court’s concern is that for all intents and purposes CRL was the insurer. A reasonable conclusion that might be drawn from the administrative services agreement is the UBL was simply fronting for CRL in the provision of health and accident insurance by CRL to the public. That agreement suggests that, realistically, UBL was doing no more than to provide an insurance policy and certificate forms bearing its name and address and, perhaps, a sales organization, and that all other aspects of the insurance undertaken in the name of UBL, which, pursuant to the agreement between the two, was entitled to all profits derived from policies issued in the name of UBL. [13]
The conclusion which might be drawn from these cases is that a fronting reinsurer which, by contract or conduct, creates a direct relationship with an insured will be liable to the insured for the its misconduct.
VI. Conclusion
From a business standpoint, fronting has two benefits: (1) it allows reinsurers to run primary insurance programs without being licensed as such or establishing the mechanisms to service insureds; and (2) its gives primary insurers the opportunity to profit from fronting fees without incurring significant insurance risk. While the first benefit may be real, the second is often illusory given the highly leveraged nature of the transaction, the adverse interests inherent in the relationship and the particular vulnerability of the front when something goes wrong. Many insurers have learned through sad experience the pitfalls of fronting.
From a regulatory standpoint, the first business benefit noted above is not a benefit at all. Regulators observe that reinsurers which lack the proper licenses or mechanisms to service policyholders should not be doing so. Since these reinsurers may be beyond regulatory jurisdiction, regulators lack the authority to protect consumers from any improprieties committed by these reinsurers. Should the transaction fall apart, the front company may be damaged financially in an irretrievable fashion, forcing the insurance department to take over the company and for guaranty funds to adjust and pay losses. Notwithstanding these dangers, fronting statutes and regulations are so piecemeal and vague as to be almost wholly ineffective in achieving the goals of regulators.
The courts, however, are recognizing heightened liability to insureds when reinsurers take over the functions of their cedents. If effect, reinsurers are being held to the same standards as insurers when they act as insurers rather than reinsurers. [/I][/I
IV. Fronting Statutes and Regulations
After intense and prolonged debate, he National Association of Insurance Commissioners (“NAIC”) adopted a Fronting Disclosure and Regulation Model Act in 1992. It provides that when a licensed insurer enters into a reinsurance transaction and delegates to the reinsurer claims handling and underwriting authority, prior regulatory approval is necessary if: (1) annual gross premium for the transaction is expected to exceed 5% of the insurer’s policyholder surplus; or (2) annual gross premium for all similar transactions is expected to exceed 15% of policyholder surplus. This Model has not been adopted in any state.
The Reinsurance Association of America markets a Compendium of Reinsurance Laws & Regulations which includes the topic of fronting. According to this Compendium, only 17 states and the Virgin Islands have any statutes, regulations, bulletins or attorneys’ general opinions (generically called “Regulation(s)”) on fronting. Those which exist are usually vague, piecemeal or overly broad. For instance, some fronting Regulations apply only to a narrow portion of the marketplace i.e. credit life and health, medical malpractice, home and service warranties or ambulance service agreements. [5]
In addition, some Regulations prohibit “fronting” without defining the term. [6] Other Regulations define it as “transfer of the risk of loss” or “transfer of a substantial portion of the risk of loss” or “transfer of substantially all of the risk of loss.” [7] The lack of a precise definition of fronting makes both compliance and enforcement difficult. Does “risk of loss” include timing risk i.e. can payment of the loss be put off until investment income plus the premium exceeds the loss? Is delegation of claims handing and underwriting authority irrelevant? What percentage of risk must be ceded to be substantial or substantially all risk? How is this measured in excess of loss or aggregate excess cessions? For instance, an insurer may cede only the first $500,000 of $1,000,000 limits but due to the underlying policy limits and/or the nature of the business, the reinsurer could actually pay virtually 100% of the losses.
Without better definitions, it is possible that garden variety quota share cessions will be regarded as fronting by regulators. For instance, the Florida fronting statute, § 624.404, defines fronting as a 50% cession to one unauthorized reinsurer or 75% to two such reinsurers. Perhaps the better approach is that taken by the NAIC and by Connecticut in defining fronting based on delegation of the insurer’s power, rather than any specific quantity of risk transferred. Connecticut Bulletin S-2 prohibits transactions in which:
[L]icensed insurance companies have entered into agreements with unlicenced insurance companies, which agreements enable the unlicenced insurance company in the name of the licenced company to do, among other things, (1) appoint agents; (2) collect premiums; (3) adjust losses; (4) process, approve and issue checks in payment of claims and expenses; and (5) maintain all records associated with such business.
V. Liability of Reinsurers to Insureds in Fronting Situations
Ordinarily, insureds have no right of action against a reinsurer due to lack of privity. [8] However, there are a number of cases which suggest that reinsurers subject themselves to direct actions by policyholders when they assume 100% of the risk and take over services to policyholders normally performed by the cedent.
An early example is O’Hare v. Pursell, 329 S.W.2d 614 (Mo.1959) in which the reinsurer assumed 100% of the risk, took charge of the pertinent books and records of the primary business, serviced the business, and adjusted and settled obligations directly with insureds. Under these circumstances, the court ruled that the reinsurer was directly liable to insureds:
By taking over the risk assumed by [the cedent, the] reinsurer put itself in the position of a contractor with the insureds. The law supplies the privity necessary for insureds to maintain a direct action upon the contract of reinsurance. [9]
For a case with similar facts and ruling, see Foremost Life Ins. Co. v. Department of Insurance, 395 N.E.2d 418 (Ct.App.Ind.1979).
Another example of liability by conduct is Venetsanos v. Zucker, Farcher & Zucker, 638 A.2d 1333 (Sup.Ct.N.J.1994). As part of a fronting relationship, Homestead Insurance Company (“Homestead”) assumed 100% of the insurance risk under a boat policy issued on the paper of Mutual Fire and Inland Marine Insurance Company (“Mutual Fire”). Homestead, its officers, employees and affiliates, produced the business, underwrote it, adjusted and settled claims and, generally, acted as if Homestead was the policy issuing company. When Mutual Fire was placed in receivership, the assignee of the policyholder filed an action against Homestead not for reinsurance recoverables, but for failure to: (a) negotiate a settlement of the underlying claim in good faith and within the policy limits; and (b) advise the policyholder of the existence of risk in excess of policy limits
The Venetsanos court recognized the usual direct action rule that reinsurance proceeds are payable to the receiver of the cedent rather than the policyholders of the cedent. However, the complete fronting nature of the transaction caused the court to uphold summary judgment in favor of the policyholder’s assignee, imposing the obligation of a primary insurer on Homestead:
Here, Mutual, the local admitted insurer, merely provided the use of its policy for a consideration in order to enable a non-admitted carrier and its affiliates to solicit and evaluate risks, sell policies, wholly insure, and wholly control payments of claims on risks in this state. We will not consign a New Jersey insured or its uncompensated victim-assignee exclusively to uncertain and probably inadequate recourse against an insolvent insurer in a foreign rehabilitation proceeding in such circumstances, particularly where the reinsuring agreement is unavailable. [10]
The court did not indicate how it would have ruled had the assignee been seeking reinsurance recoverables.
A similar case is Keightley v. Republic Ins. Co., 946 S.W.2d 124 (Ct.App.Tex.1997). In this case Republic Insurance Company (“Republic”) reinsured 100% [11] of the risk of National County Mutual Fire Insurance Company (“National”) on the policy in question. Due to National’s financial difficulties, Republic took over National’s claims handling functions by assigning a claims manager for National’s insureds, adjusting and settling claims, hiring defense counsel and establishing and funding a bank account in National’s name for payment of claims.
The assignee of the policyholder did not seek reinsurance recoverables from Republic. It brought various statutory and common law claims against Republic for refusal to settle within the limits of the policy. Republic moved for summary judgment based on the policyholder’s lack of privity with Republic. Noting that the plaintiff sought damages based on Republic’s wrongful conduct rather than under the reinsurance contract, the court rejected Republic’s motion for summary judgment on one statutory deceptive trade practices count and one common law negligence count that did not require privity between Republic and the insured.
A more recent case on point is Edens v. United Benefit Life Ins. Co., 2001 WL 11431140 (N.D.Tex.). United Benefit Life (“UBL”) was the fronting company and its parent Central Reserve Life (“CRL”) was the reinsurer. CRL agreed to perform all the administration of UBL policies “including but not limited to, all actuarial, underwriting, compliance, legal, issuance, accounting, administration, data processing, systems and claims processing services” [12] with respect to the UBL policies. The policyholder sought to recover from the reinsurer and CRL moved for summary judgment on the basis that it had no liability to the policyholder. The court declined to so rule stating:
The court’s concern is that for all intents and purposes CRL was the insurer. A reasonable conclusion that might be drawn from the administrative services agreement is the UBL was simply fronting for CRL in the provision of health and accident insurance by CRL to the public. That agreement suggests that, realistically, UBL was doing no more than to provide an insurance policy and certificate forms bearing its name and address and, perhaps, a sales organization, and that all other aspects of the insurance undertaken in the name of UBL, which, pursuant to the agreement between the two, was entitled to all profits derived from policies issued in the name of UBL. [13]
The conclusion which might be drawn from these cases is that a fronting reinsurer which, by contract or conduct, creates a direct relationship with an insured will be liable to the insured for the its misconduct.
VI. Conclusion
From a business standpoint, fronting has two benefits: (1) it allows reinsurers to run primary insurance programs without being licensed as such or establishing the mechanisms to service insureds; and (2) its gives primary insurers the opportunity to profit from fronting fees without incurring significant insurance risk. While the first benefit may be real, the second is often illusory given the highly leveraged nature of the transaction, the adverse interests inherent in the relationship and the particular vulnerability of the front when something goes wrong. Many insurers have learned through sad experience the pitfalls of fronting.
From a regulatory standpoint, the first business benefit noted above is not a benefit at all. Regulators observe that reinsurers which lack the proper licenses or mechanisms to service policyholders should not be doing so. Since these reinsurers may be beyond regulatory jurisdiction, regulators lack the authority to protect consumers from any improprieties committed by these reinsurers. Should the transaction fall apart, the front company may be damaged financially in an irretrievable fashion, forcing the insurance department to take over the company and for guaranty funds to adjust and pay losses. Notwithstanding these dangers, fronting statutes and regulations are so piecemeal and vague as to be almost wholly ineffective in achieving the goals of regulators.
The courts, however, are recognizing heightened liability to insureds when reinsurers take over the functions of their cedents. If effect, reinsurers are being held to the same standards as insurers when they act as insurers rather than reinsurers. [/I][/I
