Welcome to the final article in our initial introduction to the insurance industry for Insurtechs. Before we pivot next month to focusing on some of the key corporate and financial issues facing Insurtechs, we get to delve into perhaps the biggest step an InsurTech can take – running their own insurance company. Maybe not as awesome as running, say, the L.A. Dodgers, but it really is the only way that an InsurTech can be fully in charge of all four key aspects (Distribution, Claims, Underwriting and Finance/Reinsurance) of an insurance carrier.
While operating as a managing general agent or third party administrator gives you substantial control of Distribution, Claims and Underwriting for a carrier, in most cases managing general agents (MGAs) and third-party administrators (TPAs) are not at ultimate risk for the losses under the insurance policies and therefore only receive a portion of the ultimate profit generated by their efforts on behalf of the carrier. And although it’s true that the proportion of those profits can increase if the MGA / TPA is willing to take on some of the downside risk in the form of contingent commissions based on underwriting results, ultimately InsurTech’s options for retaining “complete” control are limited to:
I find it useful to think of these as the insurance equivalent of renting a house, buying an existing home and building a new home.
Option 1: Fronting Carriers – Renting A House
Generally, insurance carriers need a license from every state in which they want to do business. Obtaining such licenses requires substantial time, effort and capital (as discussed below). In addition, insurance carriers are financially rated, and many of the major rating agencies are hesitant to rate a brand new carrier that is not affiliated with an existing insurer or major financial institution.
Because of these hurdles, many MGA / TPAs utilize what is called a fronting relationship with an existing broadly licensed insurance carrier. The first step in any fronting relationship is the MGA / TPAs forming what is known as a Producer Owned Reinsurance Company, or PORC. Once nearly exclusively located in the Turks & Caicos (there are worse places to have to travel for business), PORCs are insurance companies owned by MGA / TPAs in order to reinsure the business they produce for a fully licensed carrier. Once the PORC is formed, the fully licensed insurance carrier will transfer all of the premiums (and risk) to the PORC via something called a 100% quota share reinsurance agreement. And presto, you basically have yourself a fully licensed and rating insurance carrier, with none of the hassle of buying or forming one yourself.
However, just like renting a house, a PORC will need to pay the fronting carrier a monthly/quarterly fee (called a ceding commission) for the privilege of “renting” the fronting carrier’s licenses and financial strength ratings. In addition, because regulators shockingly logically, do not fully trust newly formed PORCs, in most cases the PORCs will need to post collateral (cash, letters of credit or trust account) to secure its obligations under the reinsurance agreement (think of this as putting up your first and last month’s rent). Finally, continuing our already tortured analogy, like that landlord who can decide to terminate or jack your rent up at end of your lease period, there is often no guarantee from one year to the next that the terms of the agreement won’t change.
Notwithstanding the above, given the cost and timing requirements related to buying or forming your own fully licensed and rated carrier, fronting provides a great way for InsurTechs to get their feet wet in this space.
Option 2: Buying a Shell – Buying An Existing Home
If using a fronting arrangement is like renting a house, buying a shell insurance company is definitely the equivalent of buying an existing home and hoping the home inspector did his job and you didn’t just buy a money pit.
In general, you cannot sell insurance company licenses as if they were assets. While this makes logical sense (given that they are issued to a specific company based on that company’s financials, management and business plan), oftentimes an insurance company’s licenses are by far what makes that company valuable. This often happens when the industry consolidates and an insurance holding company system ends up with more licensed companies than they need. This will lead the holding company to cause such extra insurance carriers to transfer all of their risk and administration to an affiliate through reinsurance and intercompany services agreements, and shutting down – leaving nothing but a “shell” of a company, with no ongoing operations, except its licenses intact.
Holding companies monetize these shells and their licenses by selling them to entities that want to hit the ground running when starting up their insurance carrier and are willing to pay for the privilege. Assuming the shells are fully cleaned out, and there are various mechanisms to do so, the purchase price can be as low as the minimum capital and surplus required by law to be held by the shell ($2M – $5M depending on state and lines of business) – think of this as land value – plus a fixed amount per state license (with more broadly licensed carriers and those licensed in populous states being the most expensive) – think of this as the value of improvements; a nice home is always going to cost more!
However, like any existing home, a shell is usually never clean. At some point in time, it likely once had active operations, including employees, risks that it was directly responsible for, and real estate. As such, the most important aspect of any shell deal is conducting appropriate diligence to ensure that the entity selling the shell company truly has stripped it of any legacy liabilities and if not (which is almost always the case) negotiating some level of parental guaranty or appropriate indemnity for any remaining liability. Think of this as getting a home warranty as part of your home purchase. You never hope to use it, but you are sure happy it’s there when your pipes burst during a Polar Vortex (or you find the corporate equivalent – such as unfunded employee benefit liabilities).
Also, because your purchase, and you as the purchaser, will be subject to an in depth regulatory approval process in the shell’s domestic state (called a Form A approval), including a possible public hearing, and there is the potential that other states may pull or limit the shell’s license authority due to the transaction, it is also key to ensure payment for the licenses is contingent on them being in good standing as fully transferred, just as you wouldn’t pay for a broken window you discovered during a final walk through. Finally, unlike fronting, as new owner of the shell, you will be directly subject to the full panoply of regulations impacting carriers including maintaining sufficient capital and surplus beyond the minimums (e.g., risk based capital), holding company filings, annual statutory financial reporting requirements, etc.
Option 3: Forming a New Insurance Carrier – Building A New Home
Take a long deep breath in … nothing beats that fresh new insurance company smell. Everything is how you designed it, from your choice of where to domicile it, to the type of licenses you obtained, and let’s not forget that great name and logo! Not only that, you don’t need to worry about whether this one has any hidden skeletons in the closet. As with a new house, a new, clean insurance company is often the best choice if you have sufficient time and resources.
But there are downsides. First, there are regulatory approvals to obtain. This often involves a relatively heavy level of vetting of not only your current financials, but also projected financial pro formas, business plan and management team. And obtaining such approval can take anywhere from three to six months, if not longer. And you thought getting a building permit was arduous! Next, once you obtain your license from your “domestic” state (called a “certificate of authority”), licenses must be obtained in all other states where you wish to conduct business. However, many other states may not issue you a license and allow you to write business in their state for a number of years, imposing what is colloquially known as “seasoning” requirements (think cast iron pan, not salt and pepper). While there are ways to address these requirements, for example utilizing a fronting relationship while your new carrier writes business in the domestic state for the required period of time, seasoning requirements are often the biggest deterrent to mass scaling from a newly formed insurer. Finally, as with buying a shell insurance company, you will need to be in charge of all the things that go into running a carrier (RBC, statutory financial filings, holding company filings, etc.) But, in the end, there is nothing like your first new insurance company, right?!
As indicated above, starting next week my partner Kathleen Swan is going to take the reins for a month and focus on the corporate and financial aspects related to growing InsurTech companies. But don’t worry – we’ll be back with more regulatory and industry-focused content in April and beyond!