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Captive - fronting arrangement

A

alch84

Member
Hello,

It would be great if someone could help me out with a particular part in the SA3 Core Reading I can't quite get my head around.

"If a captive is to insure some of the risks itself, it will either have to be authorised as an insurer in the ordinary way, or it will incur the expense of using an authorised insurer to front its operation. Under a fronting arrangement, the insurer will write the risk but will then "reinsurer" 100% of it to the captive. The risk the insurer runs is that, if the captive defaults, the insurer will be responsible for the liabilities, and because the insurer will charge for taking that risk, it is more expensive for a captive to get a risk funded than to insure it directly."

Since this particular para relates to pros and cons of setting up captives, what does this actually mean?

Cheers
 
If a company sets up a captive, it has a couple of choices in how it does this:

1) the captive can be set up as a direct insurer. A disadvantage of this is that it will have to go through all the authorisation that's needed to become an insurer. This can be time-consuming and costly.

2) the company can find an established insurer that is already authorised to write insurance. The captive can then just be used as a reinsurer, reinsuring 100% of the risks. So, any claims the company has will effectively pass straight through the insurer to the captive. The captive therefore pays 100% of the cost of all the claims and the insurer pays nothing.
But, as with any reinsurance, you always have to consider the risk of reinsurer default. In this case, that means the risk of the captive defaulting, or not having enough money to pay the claims. If that happened then the insurer would suddenly become liable for all the claims. Therefore the insurer will charge a premium to cover itself against this eventuality, making this option more expensive.
The insurer will probably also charge for expenses incurred in setting up and maintaining this arrangement.

So broadly, in terms of advantages and disadvantages, option 2) is more expensive but option 1) involves more hassle.

Does that help?
 
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