A strong case can be made that the fronting space qualifies under this heading.
Here was a cohort of companies growing ~30% per year over the last seven to eight years, capable of delivering Ebitda margins in excess of 50%, and (at first glance) retaining relatively little risk. Insurance fee businesses that were also growth businesses.
Given these qualities, a would-be entrepreneur with a background in the underwriting or reinsurance broking world had a far better than even chance of being able to pull in money from a PE house to back their new front, or hybrid front.
The PE investor – with an almost permissible amount of self-deception – was able to see another home run insurance fee deal to sit alongside their retail broker and their MGA.
Under these circumstances, we saw a proliferation of fronting companies or hybrid fronts, with around 20 dedicated firms formed – and over 30 total if the insurers with fronting units are counted.
Back in March, many of these businesses looked like they were very well placed, having grown rapidly, and given the halo effect of their proximity to the booming MGA market.
A number were working towards exits or partial sell-downs that would have crystallized value. Incline P&C was working on its deal with Braemont, ultimately announced in June. Clear Blue was eyeing an H2 liquidity event, with Sutton National another likely candidate for a transaction. R&Q was prepping its fronting arm Accredited for a process with the help of a trifecta of banks.
The first cracks became evident in March when Trisura was obliged to delay its results before taking a C$81.5mn ($60.1mn) impairment related to a reinsurance recovery, underscoring the degree of latent risk in the model.
This was followed last month by the emergence of a collateral-forging scandal involving Vesttoo, a frequent trading partner of the fronting companies – which is believed to have introduced capital to upwards of half a dozen fronting carriers.
If Trisura’s impairment prompted difficult questions, the Vesttoo imbroglio halted all efforts to secure liquidity that were not absolutely essential. Clear Blue paused its process, as we revealed last month.
Accredited has plowed on – but that is more a comment on the exigencies of its parent company’s struggles than of the robustness of the M&A market.
All of the fronting companies thinking about an exit were arguing (or preparing to) that they should be valued at chunky price-to-Ebitda multiples.
The best insurance service businesses over the last couple of years have been able to secure 18x-20x a heavily adjusted Ebitda multiple, with some curbing of multiples evident over the last year as the increased cost of capital bites.
In essence, these businesses were being pitched as parallel businesses to MGAs or brokers. The Vesttoo crisis will likely prevent any of these from securing those kinds of valuations near term.
Partially, this will reflect the worse operating environment the fronts face in the aftermath. It is likely that their growth will be checked by MGAs choosing to make different choices around capacity, with the trade-offs that come with using fronts and collateralized reinsurance no longer ignorable. (Sources have said this is already a boardroom level preoccupation at MGAs, and some are known to have approached carrier-owned fronting units to explore moving business.)
In addition, fronts are likely to have to take on significant additional cost related to risk, compliance, and underwriting to demonstrate their bona fides to trading partners. The second part of this evolution will be a move towards even greater risk-taking as a means of demonstrating skin-in-the-game to persuade MGAs to work with them.
The consequences of Vesttoo will hurt the fronting companies, but the changes are less important than the role the crisis will play in uncovering what was already there.
Fronting companies: Insurers in brokers’ clothes
As I argued back in September last year after Mitsui Sumitomo’s Transverse acquisition, fronting companies are insurance companies, not insurance fee businesses. (For background see "Fronting companies: Insurers in brokers’ clothes”).
These are balance sheet businesses with significant downside risk to capital, volatility around earnings, and dependency on ratings to trade.
As such, they should be valued on a price-to-book basis, not a price-to-Ebitda basis.
Given that the fronts mostly operate in the US specialty market, the starting point for thinking about the valuations of these businesses should be where US specialty insurers are valued.
Removing some of the outliers gives you a valuation range of roughly 1.5x-2.5x book.
Translating the P/B into a price-to-Ebitda multiple will vary based on the businesses. But using public front Trisura’s financials suggests a 2x book valuation is equivalent to around 7.5x annualized Q2 operating earnings.
So, broadly speaking, suggesting that fronts should trade as specialty insurers not brokers implies a ballpark 50% haircut in their valuations.
If the premise is accepted that the fronts should be valued as specialty insurers, then where they should trade within that 1.5x-2.5x – or even down to the ~1x Argo trades at – depends on whether you consider them to be good or bad specialty insurers.
Obviously, this will differ by individual business, but taken as a class there are a number of factors that could be causes for concern.
First, fronting companies have more impairment and bankruptcy risk than traditional insurers because they run with high leverage.
Fronting carriers typically run with ~5:1 leverage on GWP, with reinsurance recoverables running at similar multiples of equity. (Premium leverage can be as high as 10:1.)
This leaves them running a huge amount of counterparty credit risk, which has scope to blow them up if it is not managed carefully.
The amount of leverage also leaves them exposed in the event of extreme tail risk which they have to re-assume from their reinsurers above loss ratio caps.
They are also major users of collateralized reinsurance capacity – not just via Vesttoo, but through names like Longtail Re, Topsail Re, Corinthian Re, and Fergus Re. Last year, this publication argued that collateralized reinsurance could prove the fault line in the MGA market that is exposed over time.
Second, rapid growth in insurance underwriting businesses is a red flag.
The fronting companies have grown incredibly rapidly in recent years. That growth profile has created a frisson of excitement for investors, but brings with it substantial risk.
If the fronts have allowed themselves to focus on originating new MGA relationships and bringing on new portfolios as the key gauge of success, then questions will have to be asked about the quality of their books.
Successfully managing rapid underwriting growth requires great dexterity, and normally that double-edged sword cuts the hand that wields it.
Third, the current elevated number of industry participants will create an era of heightened competitiveness, creating pressure around underwriting standards and, likely, fee compression.
Markets with excessive competition see returns compress, and the fronting space looks primed for this to happen. With the P&C market deep into the Long Firming cycle, this could also broadly align with an end to the period of rate hardening and cyclical flow of business into E&S.
Waiting for the watchdog’s verdict
The best valued insurance companies typically run with conservative leverage, a focus on building sustainably profitable underwriting books, and are underweight in the most over-saturated markets. None of which looks true about the fronts right now.
And standing in the background of all of this is AM Best. The industry watchdog has signed off on the proliferation of the fronting companies, including its heavy use of Cayman-based collateralized reinsurance capital.
Following the Vesttoo fiasco, AM Best announced that it was reviewing collateral arrangements at rated fronting companies and moved to put Clear Blue’s ratings under review with negative implications.
Given that the fronting companies whole model relies on being able to provide A- paper, AM Best is the ultimate gatekeeper for these businesses.
Until it concludes its review, there is a question mark hanging over the segment. Anyone that thinks that the ratings agency wouldn’t be bold enough to rock the boat should think back to its hawkish turn on total return reinsurers a few years ago, which threatened to upend the whole model.
This is another compelling reason to take a sober approach on the valuation of the fronting companies.
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