CHAPTER § 5.14 Alternative Risk Transfers or Sources of Indemnification

• Jurisdiction: United States

§ 5.14 Alternative Risk Transfers or Sources of Indemnification

[1] Fronting Policies

One step removed from self-insurance, "'[f]ronting' refers to the issuance of an insurance policy under which the insured is left to administer all claims and agrees to reimburse the insurer for all settlements or judgments paid."³²¹ "Thus, the insurer essentially functions as a surety relative to the insured's ability to pay covered third-party claims." This allows policyholders to "retain the risk associated with lower-level coverage"—and incur less expensive premiums—"while complying with financial responsibility laws and transferring claims handling responsibility to the insurer issuing the fronting policy."³²² There is some disagreement among commentators and courts over whether front policies are truly insurance, i.e., whether there is any actual transfer of risk.³²³ However, if the insurer remains on the hook in the event that the insured becomes insolvent, courts generally find that fronting policies do in fact entail a transfer of risk.³²⁴

[2] Captive Insurers

Captive insurers are "insurance companies owned by another organization whose exclusive purpose is to insure risks of the parent organization and affiliated companies."³²⁵ In these arrangements,

[t]he parent corporation pays premiums to the captive insurer rather than an outside firm to insure some business risk. The captive insurer reinvests the premiums it receives and then pays claims by drawing on the principal and return on its investment. Captive insurers can lower costs and facilitate coverage for certain hard-to-insure risks that traditional carriers may not underwrite.³²⁶

[3] Self-Insurance

Self-insurance can be broadly described as any risk not otherwise insured. However, the term also operates as a term of art in the insurance industry. Under this more specific conceptual definition, self-insurers usually "engage in the same sorts of underwriting procedures that insurance companies employ," including "(1) estimating likely losses during the period; (2) setting up a mechanism to create sufficient reserves to meet those losses as they occur; and (3) arranging for commercial insurance for losses that are beyond a preset amount."³²⁷ This preset amount is often referred to as a "retained limit," and many self-insureds will purchase insurance to cover losses in excess of a retained limit as stated in the policy. In some states, self-insurers are regulated similarly to other insurers.³²⁸ Realistically, however, few companies have the resources to set aside reserves to cover unforeseen risks to their businesses. Because there is no risk-spreading, many do not consider self-insurance to actually be insurance.³²⁹

[4] Reinsurance

Reinsurance is insurance for insurance companies. "A reinsurance transaction occurs when the insurance company that directly insured the person or entity buys insurance from another insurance company ('the reinsurer') to cover the risks associated with the direct insurance policy."³³⁰ "[R]einsurance permits the cedent insurer to minimize its exposure to catastrophic loss, reduce the amount of the legally required reserves held for the protection of policyholders, and increase [its] ability to underwrite other policies or make other investments."³³¹ As the Supreme Court has described it, reinsurance "serve[s] at least two purposes, protecting the primary insurer from catastrophic loss, and allowing the primary insurer to sell more insurance than its own financial capacity might otherwise permit."³³²

[5] Indemnification Agreements

Indemnification agreements are contractual obligations by one party to pay or compensate for the losses, damages, defense costs, or liabilities incurred by the other party to the agreement. Indemnification agreements are "generally valid and enforceable contracts,"³³³ although they can be void and unenforceable in certain situations.³³⁴ Jurisdictions differ on how to interpret indemnification agreements with regard to the indemnitee's own negligence. Many construe indemnification clauses...