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Inside in Full: Fronting companies: Insurers in brokers’ clothes

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Topics: MGAs Topical Trends

We have reached a new peak of frothiness in the fronting market...

Having retired three years ago following close to five decades running runaway market leader State National, Terry Ledbetter indicated he was returning as executive chairman of Kestrel, a new fronting player led by son Luke, based on an alliance with AmTrust.

This came after Mitsui Sumitomo agreed to pay the most absurd price for a P&C asset since it bought Amlin in 2015 by signing a deal to takeover Transverse for $400mn. (No matter how kindly you interpret the numbers, the upfront consideration is at least ~20x run-rate revenues and what looks like an Ebitda multiple in the 30s, for a franchise that last year drew half of its premiums from a single cat MGA. And then there is substantial an earn-out on top.)

These developments come on top of a succession of other launches over the last couple of years that takes the number of fronting operations – including units of insurers – above 25.

It is easy to see why capital is extremely interested in the fronting space. Growth has been absolutely meteoric.

Fronted premiums in 2021 were up 50% on 2020 at $7.5bn, according to Aon figures, and have increased more than 300% over the last seven years. Major growth has continued again this year, according to sources.

This growth reflects a) the structural growth of the now $60bn-premium MGA space in recent years, and b) an increased propensity from MGAs to use a fronting structure to access capacity. Both of these sources of growth are being juiced right now by the P&C pricing cycle.

Fronting companies are also the class of company in the sector with the highest potential margins, with sources suggesting that they can comfortably run at 50% margins, and up to 75% if run lean (or with limited capabilities, depending on your perspective).

State National is the posterchild for the sector. The Ledbetters sure-footedly built a multi-decade franchise with an utterly dominant market position under family ownership before a two-stage exit, ultimately to Markel. Since then the business has broadly doubled in size, even as it has lost market share and transitioned to Matthew Freeman’s leadership.

The high degree of private equity interest in the space also represents spill-over interest from other insurance fee businesses, like brokers and MGAs, which have been overwhelmingly successful investments.

And if you squint hard, a fronting company might just look like the next great insurance fee business opportunity, with the fixed fee it charges to provide paper to MGAs seeking backing from reinsurance capacity.

But with eyes wide open, it becomes very clear that fronting firms are insurance companies in brokers’ clothes.

And indeed, it is worse than that. They are highly leveraged balance sheet businesses that present as capital-lite fee businesses, which can write business at leverage of 4:1 in an AM Best framework, or more like 10:1 using collateralized reinsurance structures.

And despite these businesses being highly leveraged balance sheet plays taking increasing amounts of risk, they are in some cases run by executives with backgrounds in distribution, with business production seemingly the core value-creating activity.

This doesn’t mean that there aren’t great returns to be made in the fronting space for those that get it right. Structural growth plus high leverage and low variable costs is a dream formula. What it means, though, is that the pursuit of those returns comes with real – and probably under-appreciated – risk.

Exuberance from new capital in a space with too many market participants, some management teams with ill-suited skill sets and latent risk creates the pre-conditions for business failures. If realized, that scenario will create a broader correction that will hurt the whole fronting space, even the well-run names.

There are two central risks to the health of a fronting company.

First, fronting carriers are increasingly ‘hybrid’ writers and run substantial amounts of underwriting risk including in the tail where it could prove fatal.

The current boom of fronting companies are broadly looking to emulate State National. But in seeking to break State National’s monopoly they are in the process of competing away the advantages that have been central to that franchise’s success.

Increasingly, fronting companies are taking 10-20% quota-share participations on programs they write, rather than passing through all of the premiums less a 5% fee. Although small in absolute terms, these shares can be sizable relative to the amount of surplus fronting carriers operate with.

But more worrying is the tail risk that the fronts are taking on. Many of the reinsurance contracts that the fronting companies buy include loss ratio caps, above which the tail falls back to the fronting company.

This leaves fronting companies with uncapped exposures to extreme tail risk events in areas like cyber that have systemic risk, and cat where caps can be set as low as 1-in-100-year events, sources said. If you get a big enough severity event, fronting companies will fail.

In addition, sources said that there is an increasing prevalence of terms in which reinsurers cap their exposure to bad faith awards where limits are lifted. These caps – which can be set at, say, $5mn for a $1mn-limit policy – can leave fronting companies with unreinsured shock losses. In an era of nuclear verdicts, taking this kind of risk net on a small balance sheet is a dangerous game.

Other sources of underwriting risk include commission corridor structures, sources said.

Second, fronting carriers run huge reinsurance recoverables relative to their surpluses, leaving them exposed to significant counterparty credit risk.

One of the foundation stones of State National’s success has been its legendarily tight reinsurance contracts. It has demonstrated over many years that it has the ability to manage the counterparty credit risk it runs.

There are multiples ways in which fronting companies could end up facing distress as a result of their reliance on reinsurance, as was seen historically with players like Legion and Reliance.

They may have weak contract wording that is not truly back-to-back with the underlying program, leading to the rejection of claims from reinsurers.

Otherwise, they could face issues if one of their reinsurers gets into financial distress. An increasing amount of capacity in the MGA world is being provided by collateralized or soft-rated reinsurers. Typically these reinsurers will have to post collateral to support a program, but sources suggested that they will often be required to collateralize to a level far below a loss cap.

Sources suggested you can see reinsurance deals with loss caps of 250% collateralized only up to 100% or 150%. If these reinsurers fail, the fronting companies will be on the hook for sizeable net losses.

Fronting companies could also face issues if they get into a legal dispute with their reinsurers as major losses emerge from badly underwritten programs. In the past fronting companies have failed, sources said, because claims were slow-walked by reinsurers leaving the fronts with substantial unfunded liabilities.

Industry structure change from monopoly to highly competed market

The risks in the system are becoming exacerbated by the number of players in the market. When Clear Blue was launched in 2015, it was the first real challenge to State National’s near-monopoly.

Since that point we have seen a fundamental shift in market structure, as monopoly gave way to a highly competitive market, with many mouths to feed.

    

Competition has already encouraged fronts to take on more balance sheet risk, as a way of winning programs. And over time, as it intensifies there will be a further slackening of underwriting and contract standards, elevating the risk of blow-ups.

An additional risk is that pressure around fees will pick up. Fronting carriers typically charge a 5% fee. This can be as high as 6-7% on a small, labor-intensive deal. Or it can be as low as 2-2.5% on larger, simpler deals.

For the most part, however, deals still cluster around the 5% mark.

Multiple sources argued that to date competition has focused on the amount of underwriting risk that is shared. But over time, in a marketplace with 25+ participants and limited product differentiation, fees seem likely to come under pressure as well.

With margins of well over 50%, there is also a huge amount of excess margin to compete away. Some fronts struggling for top line will inevitably be willing to accept the trade-off.

A lot of young, sub-scale businesses in their ramp up phase targeting similar business will also ultimately collide with the soft market, which could be doubly painful given lower rates and reduced flows to E&S where MGAs are overweight.

More constrained growth opportunities will lead to more intense competition, likely further undermining underwriting standards. Soft market conditions will also cause profitability issues to emerge with more programs – which will further hurt performance.

The final risk for the capital coming in to back fronting carriers is exit risk. State National through its IPO initially, and then through the sale to Markel, again demonstrated that there was a path to crystallizing value. And Transverse’s deal suggests that blowout valuations – well beyond what State National achieved - could be available for some players.

 But it is far from clear that there is a Markel or a Mitsui for every fronting carrier. As well as a limited pool of strategic acquirers given the amount of goodwill, most of these firms even at maturity would be sub-scale for an IPO – which might suggest they need to be recycled through private equity ownership.

Clear Blue and at least one other fronting carrier have attempted this over the last couple of years and come away without inking a deal, demonstrating execution challenges around sales that include contested valuation methodologies and revenue concentration risk.

And these deals did not get done against a backdrop of favorable peer group performance. The risk that private equity will get trapped in these businesses intensifies if we get even a single blow-up in the group.

If that happens – and all the conditions are there for this to happen over the next few years - there will be contagion from the poorly risk managed business to those that have stayed much closer to the State National template.

 

Inside P&C provides unparalleled market intelligence on the entire US P&C market – from small commercial and personal lines right through to reinsurance and Bermuda. Redeem your complimentary 14-day trial for more premium content from Inside P&C.

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