Commercial insurance risk and liability review, February 2016
Some Myths and Truths about Fronting Operations from the perspective of an International Surety Underwriter - Clementina Hiteshew
1. LMS and LMIC (Boston) Approved version of PASA article
March 17, 2006
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Original Article published on the Pan-American Surety Association’s online magazine.
Author: Clementina Bayot de Hiteshew
Senior Surety Underwriter
International Division / Latin America and Caribbean
Liberty Mutual Insurance Company
Liberty Mutual Surety
USA
Some Myths and Truths about Fronting Operations
from the perspective of an International Surety
Underwriter
Fronting is a term used to describe a specialized form of reinsurance involving various
factors resulting in a very dynamic model. Fronting transactions are complex and diverse
in nature due primarily to the following factors: commercial practices, applicable laws,
bond form differences, country requirements, different administrative procedures and
varying technology systems used by surety companies throughout the world. The sheer
number of parts involved in the transaction ranging from the client, ceding company,
fronting company, broker, currencies and languages has an impact on fronting requests
and makes them a very challenging and unique transaction to handle on a daily basis.
In order to demonstrate why fronting transactions are necessary and how they are
structured, it is best to walk through an example. Surety Company “A” (fronting
company) is licensed to operate in a certain territory and requested to issue a bond on
behalf of surety company “B” (ceding company). This is required because the risk is
2. LMS and LMIC (Boston) Approved version of PASA article
March 17, 2006
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located in a jurisdiction where Company B is not licensed to do business. Company “A”
has the license and ability to issue the bond and as a result, company “A”, the fronting
company, issues the bond on behalf of company “B’s” client. As a consequence of the
fronting transaction, the risk under the bond is completed transferred or ceded back to
company “B” (ceding company). This transfer is completed under a reinsurance
arrangement, or also well known as a “fronting agreement”.
The ceding company starts the fronting process by carefully selecting a foreign insurance
company licensed to operate in the territory where the bond is required. The ceding
company’s underwriter undertakes a detailed underwriting process which includes but is
not limited to the following: Analysis of legal regulations in the country, review of the
bond wording and the underlying contract, determination of rate and associated costs, and
the assessment of political and economical risks involved in the contract and the foreign
country. Furthermore, there are a number of administrative steps which need to be
performed in conjunction with the underwriting process not only to have the bond issued,
but also to ensure the premium can be collected. In order to make this work effectively it
is important to have complete and detailed documentation and supportive paperwork
from the very beginning of the transaction.
A fronting transaction has a certain level of complexity which has led to some confusion
in the surety market and as a result, has created some “Myth and Truths” as outlined in
the following paragraphs.
Truths
3. LMS and LMIC (Boston) Approved version of PASA article
March 17, 2006
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1) It is important to know who your partner is on a Fronting transaction:
From the moment that the fronting request reaches the desk of the International
Underwriter, the first and arguably most important decision is to pick the “right”
fronting company. The selection process is normally time consuming and should
involve careful due diligence. As part of this process, one should perform a credit
check and should review financial information on the fronting company to ensure the
fronting company maintains an acceptable credit rating and adequate financial
solvency. Furthermore, positive references should be obtained from other markets
that have done business with this fronting company.
2) The beginning of the process is the most important phase of the fronting
transaction:
In order to expedite the process, there sometimes is a natural tendency to ‘cut corners’
on the underwriting process, which normally leads to poor documentation and
inaccurate information. This will make it very difficult to understand and track the
bond information. This will affect all parties involved (fronting company, ceding
company and principal) and can turn the entire process into an administrative and
accounting nightmare. All parties should be fully aware of the importance of getting
it right from the very beginning in order to prevent this from happening. In the long
run, a correct and well documented transaction will save everyone time and money.
4. LMS and LMIC (Boston) Approved version of PASA article
March 17, 2006
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3) International Fronting companies are not required to have a specialized
staff:
Most insurance companies do not have the luxury or the ability to hire separate staff
to exclusively handle and service fronting transactions. In most cases, fronting
transactions are not profit centers as the fees collected for handling fronting requests
are nominal and make very little, if any, contribution to the overall profitability of the
surety operation. Fronting operations are primarily viewed as a complementary
service that indirectly add value through networking, partnering, and exchange of
market information and intelligence. As a result, it is sometimes difficult for an
insurance company to justify hiring additional staff to handle this very valuable, but
complementary service. The same people that handle reinsurance, finance and
accounting, and underwriting, are normally the same ones involved in servicing
international fronting transactions.
4) International Fronting transactions are time-consuming:
Unfortunately, fronting transactions rarely involve standard processes as each one has
its own characteristics. As a consequence, the process requires a deeper analysis and
effective communication skills in order to guarantee a successful outcome. For the
International Underwriter, the biggest challenge is to maintain good communications
with all the parties involved in the process. Due to the fact that several elements of
the fronting transactions are truly “foreign’ to the domestic underwriter and are very
different than the process for local bond requests in the country in which they operate,
it is very important for there to be clear expectations between the various parties to
5. LMS and LMIC (Boston) Approved version of PASA article
March 17, 2006
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make the process as transparent and efficient as possible. Of course, the other
complication is the language barrier; usually, Spanish and English not to mention
those cases in Brazil, where a third language, Portuguese, is thrown into the equation.
Now let’s look at some of the Myths:
Myths
1) Fronting company should not be underwriting the transaction:
This is one of the most often debated matters in the surety market. The fronting
company provides valuable assistance to the ceding company by analyzing the legal
aspects of the contract and the bond wording which in turn, could protect not only the
ceding company but just as importantly, the client. For example, the fronting company
may advise the ceding company that the bond wording is not acceptable in the foreign
market. The fronting company’s advice and input is very important because the
ceding company does not have the knowledge and the expertise in the foreign market.
The fronting company and the ceding company should be considered a team and
should work together. The ceding company should look forward toward commercial
and proactive input from the fronting company to add value and to negotiate a well
structured fronting transaction that is beneficial to all parties.
6. LMS and LMIC (Boston) Approved version of PASA article
March 17, 2006
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2) The company requesting the bond always dictates the rules:
If a ceding company wants the issuance of a bond in another country, then they need to
understand the legal requirements and customs in that country. The ceding company’s
requirements are subject to modification due to legal regulations, local market
underwriting conditions and practices, the actual bond wording required by the obligee,
and contract conditions. For instance, in the case of on demand bonds, there may be a
need for additional indemnity protection. This will not only protect the ceding company,
but also the fronting company.
3) Fronting transactions are not profitable:
On the surface, this could be considered a truth; however, this needs to be explored from
a different angle. The ability of the ceding company to provide service to its good
standing client in foreign countries while showing a deep knowledge and awareness of
the local market conditions is clearly a strategic and competitive advantage. This is a
distinctive asset between sureties in the same market and puts the company in a strategic
position in the eyes of the client. This valuable asset does not directly show up in the
income statement, however this can lead to additional business opportunities. In fact, if
marketed correctly this could have a postive impact on the ceding company’s financial
results.
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March 17, 2006
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4) Asking is not necessary:
There are so many differences in fronting procedures and regulations from country to
country that it is impossible not to ask questions as part of the learning process. To
further complicate matters, there are very few academic publications in the market
related to fronting transactions. As a consequence, the best school for learning
fronting is daily on the job training. The knowledge level is continually increased not
just by underwriting the bond but understanding the entire fronting transaction. With
the simple variation of just one element the entire process may have a completely
different result compared to a very similar case without that element. This makes each
fronting transaction a lesson in itself. If questions are not asked during the process,
then an effective learning experience is not guaranteed.
As you have now come to learn, fronting is a complicated yet valuable service that can
only be successful through an effective exchange of knowledge, expertise and
communication by all partied involved in the transaction. In conclusion, we hope this
article gives you a better appreciation and understanding of the concept of fronting and
the truths and myths associated with this subject matter.
Marzo 17, 2006.