In rating State National, A.M. Best notes third-party capital dependency

Fronting and the provision of program services, to providers of third-party reinsurance or ILS capital, is one of the hot trends that has emerged in insurance and reinsurance over the last year, largely due to State National’s work.

The agreement that State National has with the world’s largest manager of insurance-linked securities (ILS) and catastrophe risk investments Nephila Capital, seems to have piqued the interest of ILS investors and the capital markets.

A way to access the returns of catastrophe risk insurance business more directly, the fronting or program business model sees capital providers offering up reinsurance capacity to back the fronted insurance business that companies such as State National can provide.

As a provider of program services and fronting facilities for insurance, reinsurance and ILS or alterntaive capital, State National has been working with Nephila since the second half of 2014. Essentially the arrangement enables the ILS manager to deploy reinsurance capacity through State National’s admitted carriers which have ‘A’ ratings across 50 U.S. states.

That access to insurance risk cannot be beaten. It also means that the reinsurance capacity is being provided outside of the typical renewal cycle, which enables the business to be underwritten efficiently and also removes the need to compete for renewal signings.

State National recently announced that $1.9m of ceding fees were earned from the relationship with Nephila Capital in the first-quarter, with an expectation that fee income from that one program business relationship could reach $13m for the year.

An attractive amount of fee income for putting other people’s capital to work. It’s no wonder the business model of ILS capacity backing fronting or program business providers is attracting great interest.

In rating State National, rating agency A.M. Best discusses the growth of program business services and fronting at the firm, saying; “This business produces significant fee income for the organization. Part of State National’s success in program business is its ability to avoid channel conflicts and mitigate exposure through collateral posted by participating companies.”

The posting of collateral means that State National takes on new business incrementally, as the range of capacity providers it works with either grow their participation or new ones come on board. So that means steady and sustainable growth, with collateral provided to back the underwriting.

A.M. Best also notes that positive rating factors are; “Partially tempered by the elevated ceded leverage from the extensive use of reinsurance. This is somewhat mitigated by the collateral held by State National.”

State National also controls risk within its program business relationships using indemnification clauses contained within the reinsurance contracts that are used.

In the case of the relationship with Nephila, working with ILS capital which will be collateralized in some form, provides security, although it is of course vital to have robust contracts underlying the agreements.

A.M. Best notes the growth of State National’s business being driven by ILS capital, saying; “The program business has grown significantly, and this portfolio has a dependency on third-party capital.”

Noting the dependency is perhaps A.M. Best’s way of saying that it views the capital as maybe being less permanent than if State National was underwriting for a traditional insurance or reinsurance capital provider.

It is perhaps one of the risks that goes hand in hand with being a program service provider, or for any business that aims for its core revenue stream to be generated by fronting purely for other people’s capital. We’ve seen business plans for start-ups aiming to provide these services and continuity of capital will be key for them.

But it is not the permanence of the capital that companies like State National need to worry about. If they are providing a good service, with access to business that is unique and which adds value to an ILS managers portfolio, then getting capacity from the ILS market should never be an issue.

However, let that service level slip and permanence of capital could be the last thing they need to worry about. Fronting and program business providers who want to work with ILS need to realise that as this area of the market expands, more companies launch looking to offer these services, ILS capital suddenly has more choice of who to work with.

That puts pressure on companies like State National to maintain their service levels, continue to find new high-quality business to put their partners capital to work in, and to ensure that it can produce enough of that business to keep them happy.

So yes, some of State National’s income is dependent on third-party reinsurance capital. But that’s a good thing, it’s efficient and there’s a lot of it available, as long as State National can continue to provide the service that the capital provider wants.

So start-ups looking to the fronting for ILS space should take note. As a pure service provider, without your own balance-sheet capital keeping your skin in the game, the quality of your service is what really matters to the capacity providers you will work with.