Fronting An arrangement whereby a local insurer cedes all or a substantial part of a risk to a foreign reinsurer in exchange for a fee. Hence, the local insurer “fronts” for a foreign insurer.
Reasons for fronting There are a number of reasons for fronting but two significant ones arise out of a combination of two situations, particularly in the past, which have led local insurers to front for foreign insurers. In the first place, historically, the low financial capacity of the Spanish market has made it necessary to disseminate the risks outside Spain, with the local insurer virtually limiting itself to broke the contract; and, secondly, the interest of foreign insurers in doing business in a tightly closed market subject to various barriers to entry.
Needs and Protection of the Spanish market The Spanish market was and is still protected to a large degree through several mechanisms:
A person may not conduct insurance activities in Spain unless authorised to do so;
For a long time vessels, aircraft and vehicles recorded or registered in Spain and assets of any type whatsoever located in Spain, with the single exception of goods in international transport, could not be insured outside Spain. Today those risks may be insured in Spain and in any country belonging to the European Economic Area. Spaniards with residence in Spain are not allowed either to take insurance with regard to themselves or their responsibilities in third countries other than EEA countries, except that they are travelling outside Spain and for the duration of the relevant trip. Nevertheless, the Ministry for the Economy and Finance may authorise exceptionally and for specific operations the insurance of Spanish assets, individuals and responsibilities outside the EEA countries.
Extraordinary risks as defined were insured until very recently exclusively by a State-owned insurance company (in practice they still are) precisely to tackle the low capacity of the Spanish market in the years following the civil war.
It is prohibited to stipulate in Spain direct insurance operations with insurance entities from third countries (other than EEA countries) which are not legally established in Spain (by having set up the appropriate branch office in Spain) or to do so through insurance intermediaries working for them. In the past that prohibition caught all insurance companies other than Spanish insurers or foreign insurers established in Spain.
The question arises: is fronting lawful? It is fair to say that fronting has been looked upon with suspicion. For many it has been a device to circumvent regulations, authorisations and controls for the exercise of direct insurance operations in the country. At first glance, one could say there is some truth in the argument. The writer once reviewed a fronting arrangement which recitals candidly set forth the intent to avoid the otherwise applicable insurance regulations which prevented the foreign insurer from covering local risks directly.
A deeper look into the fronting arrangement should tell otherwise. Even if we look at the cession of 100% of the risk, i.e., with a nil retention on the part of the local insurer, it seems clear that such cession would not be unlawful. The local insurer is liable to the insured who in turn has no relation, action or claim against the reinsurer (Article 78, Insurance Contract Act 1980). The reinsurer in turn is protecting the insurer’s financial position should the loss occur and the insurer have to pay the relevant claim. These contracts are independent of each other despite one being the premise of the other. It is common ground in Spanish legal doctrine that properly it cannot be said that the underlying risk itself is being assigned to the reinsurer or that there is no risk in which case the insurance contract would be invalid under Article 4 of the Insurance Contract Act 1980.
From the regulatory perspective, it is also clear that fronting is not prohibited. The Law for the control of private insurances of 2 August 1984 authorised the Government to prohibit insurance activities if insurers practically limited themselves to act as brokers. This could have been the case if an insurer ceded all its risks systematically to foreign reinsurers. To the extent of my knowledge, this authority was never used by the Government. This provision was repealed in subsequent regulatory and supervision laws, namely 1995 and 2004. The fairly recent reform to implement the EU Reinsurance Directive via Law 13/2007 of 2 July makes no reference to the issue.
Other legal antecedents, namely the rules on marine insurance, would also suggest that fronting is not unlawful. Indeed, Article 749 of the Commerce Code provides that all or part of the things insured may be reinsured with third parties.
Problematic issues Fronting is closely related to certain clauses that have been controversial in the Spanish market. Since the retention of the local insurer is not significant, it is understandable that the reinsurer will like to have a close look at any claims handling process. The control of the handling of claims by the reinsurer in particular and other clauses (simultaneous payment, cut-through, insolvency, etc.) led some legal writers to argue that the nature of the reinsurance contract was being altered, such that it could no longer be regarded as a proper reinsurance contract but as coinsurance and in some extreme cases as direct insurance.
This theory has been partially tested in the Spanish courts, I believe once, with no success.
Indeed, the facts of this case are in a nutshell the following: a local insurer Musini was sued by Real Sociedad, a football club, claiming the indemnity agreed under a policy which afforded protection to Real Sociedad in the events of death and/or invalidity of its players. The policy excluded any pre-existing health condition of the players under the terms described therein. The policy also gave the control of claims to the reinsurers. Musini retained 2% of the risk and ceded the remainder to Lloyd’s and London market reinsurers. One of the players was declared physically disabled for the practice of the game, and Real Sociedad claimed the agreed indemnity in the amount of 3.6 million Euros. Musini denied the claim availing itself of the exclusion.
Musini based its defence in court on three main arguments: firstly, the pre-existing health condition exclusion, secondly, that it had merely fronted for the foreign reinsurers and retained a very small portion of the risk, hence, it was not a contract of reinsurance but of coinsurance; and lastly that Real Sociedad had accepted a simultaneous payment clause whereby the insurer was bound to pay on or after it had been paid in turn by the reinsurers which in their view strengthened their argument that this was a coinsurance and not a reinsurance arrangement. In line with this strategy, Musini raised a procedural defence arguing that the case could only be adjudicated if reinsurers were joined to the proceedings.
The Court of first instance dismissed all three arguments and the procedural defence and ordered Musini to pay the agreed indemnity plus punitive interest and costs. Both the Court of Appeal and the Supreme Court dismissed the successive appeals lodged by Musini and confirmed the first instance judgment.1 Musini’s defence was dismissed on the following grounds:
It was found that the injury sustained by the player differed from the one suffered before he was incorporated into the policy taken out by Real Sociedad. Consequently, the pre-existing health condition exclusion was not applicable;
The contract entered into between Musini and the foreign reinsurers was not a coinsurance arrangement but a reinsurance contract proper. The courts reached that conclusion after a detailed analysis of both types of contracts;
The simultaneous payment clause was not valid since it was not singled out in the Particular Conditions of the policy and accepted explicitly by the insured as required by Article 3 of the Insurance Contract Act 1980. The explicit acceptance of any limitative terms was referred in Article 14 of the General Conditions solely to the Special Conditions of the policy but not to the Particular Conditions of the policy where the clause was inserted. Further, the court questioned the validity of the clause even if it was singled out and accepted explicitly by the insured. Further, even if the contract involved a large risk, in which case such clause may be valid since the parties are free to depart from the otherwise mandatory provisions of the Insurance Contract Act 1980, Musini did not prove that it was in fact a large risk as defined in the Insurance Contract Act 1980; and
The claims control clause inserted in the reinsurance contract only bound the reinsured and the reinsurers but not the insured. Further, even if such clause would have been inserted in the direct insurance contract, it would not be admissible to release the direct insurer from its obligations under the policy and the law pursuant to the mandatory provisions of the Insurance Contract Act 1980. Therefore, the insurer could not invoke this clause to release itself from the “rigorous” rules that required him to settle the claim adequately and swiftly.
CONCLUSIONS These judgments allow to reach explicitly and implicitly some interesting conclusions:
Fronting as such should not alter the nature and validity of a reinsurance contract.
A simultaneous payment clause even if singled out and accepted explicitly in the direct insurance contract by the insured may not be valid. The direct insurer cannot rely on this clause to oppose or delay payment of the claim. However, it may be valid if the insurance contract refers to a large risk provided the parties have specified this circumstance in the contract.
A claims control clause inserted in a reinsurance contract is valid. The insurer, however, cannot rely on it, even if accepted by the insured, to release itself from his obligations under the insurance contract to settle the claim fairly and quickly. It is unclear if it would be admissible in the event that the insurance involved a large risk.
Captives Although captives were known and used by a significant number of Spanish companies, the Spanish law ignored them until the implementation of the EU Reinsurance Directive via Law 13/2007 of 2 July which amended the Consolidated Text of the Law for the Regulation and Supervision of Private Insurances approved by the Royal Legislative Decree 6/2004 of 29 October.
A captive reinsurance entity is defined as a reinsurance entity owned by a non-financial entity or by a financial entity other than an insurance or reinsurance entity or that forms part of a group of insurance or reinsurance entities subject to consolidation, the object of which is to offer reinsurance protection exclusively to its owners or its owners’ group of companies (Article 1.3, j, of the Consolidated Text cited above as amended). The Spanish regulatory law has opted, therefore, for a so called pure captive as opposed to a broad captive.
Captives should keep a guarantee fund of 1.1 million Euros, down from the general threshold for reinsurance entities of 3.2 million Euros (Article 58bis, paragraph 3, of the Consolidated Text cited above, as amended).
L.C. RODRIGO ABOGADOS
1 Decisions of the Audiencia Provincial of Guipúzcoa of 15 November 2005 and of the Supreme Court of 8 April 2010 (JUR\2006\66548 and JUR\2010\123412, respectively). Please note that the remedy at the Supreme Court is not technically an appeal but a cassation recourse, but I have used “appeal” for ease of reference.