Risks must be insured: foreign reinsurers employ 'fronting' practice to bypass rules: SECP

The Securities and Exchange Commission of Pakistan (SECP) has conveyed to insurance sector that businesses or individuals situated in Pakistan must get their risks insured by local insurers, as foreign reinsurers/brokers often employ 'fronting' practice to bypass insurance rules.
According to an order issued by the SECP Commissioner Insurance, another issue highlighted by the Commission was fronting. Fronting occurs when a broker or foreign insurer/reinsurer uses a local insurer as a fronting agent to place risks outside Pakistan in the form of reinsurance. In such cases, a very small portion of the risk is retained in Pakistan and a major portion of the risk is placed abroad in the form of facultative reinsurance placements. In such cases, the local insurer sometimes receives instructions from the foreign reinsurer, local insured and brokers. Rule 23 ensures that no property or interest located within Pakistan is insured outside Pakistan, unless approved by the federal government. This implies that businesses or individuals situated in Pakistan must get their risks insured by local insurers. Insureds, foreign reinsurers and brokers often employ the practice of fronting to bypass this regulation. The practice of fronting is also an indirect violation of Rule 7 of the Rules, which stipulates that local insurance risks could only be placed outside Pakistan in the form of reinsurance after determining that such risks cannot be suitably reinsured within the country. In cases involving fronting, the broker, insured or foreign reinsurer often dictate terms to the local insurer and try to minimize the local retention, SECP added.
The SECP order said that the Order shall dispose of the proceedings initiated against an insurance company (the "Company"), its Chief Executive and Directors for alleged contravention of Rule 7 & Rule 23 of the Insurance Rules, 2002 (the "Rules") and Section 165 of the Insurance Ordinance, 2000 (the "Ordinance"). The Company and its Directors shall be collectively referred to as the "Respondents" hereinafter.
The Company is licensed by the Commission as a broker to carry on the direct insurance broking business in Pakistan in pursuance of Section 102 of the Ordinance.
During the year 2016, the Company reported its major part of the revenue i.e. 68% (2015: 65%) from the consultancy services i.e. reinsurance related services, although the Company was licensed as a direct insurance broker. Furthermore, the Company did not have any formal agreement with company-2 for carrying out reinsurance broking or placement facilitation.
The Company, in its response regarding reinsurance related transactions, stated that it was not acting as a reinsurance broker but merely as a Correspondent of company-2 for providing local services like liaising with the clients and acting as a facilitator for the transactions.
The Company was taking active part in the reinsurance placement broking/ facilitation as it was obtaining substantial amounts in the form of fees from these transactions.
As per Rule 14(1)(iv) of the Rules, an application for grant/ renewal of license to act as an insurance broker shall contain "a description of business carried on by it (other than insurance broking). However, the Company did not mention the reinsurance placement broking/facilitation in the application and merely stated "Insurance Broking, Insurance Risk Management, Insurance Consultancy and Insurance Advisory Service" under serial number (iv) of its application for renewal of insurance broker's license.
The Company was also prima facie involved in fronting transactions routed through company-2, which were used to subvert the provisions of Rule 23 of the Rules read with Section 165 of the Ordinance and Rule 7(2) of the Rules. The Company explicitly informed the clients that it would try to keep the local retention at a minimum. The Company then proposed the name of an insurer as the fronting agent and then stated that if the proposed insurer did not agree with the level of retention desired by the client then the Company would look for another insurer who would comply with the demands of the client. In such fronting cases, the Company was communicating directly with the original insured without the involvement of the insurer. In one of the case, the original policyholder's confirmation was sought by the Company regarding the reinsurance orders and local retention of insurers involved in the transaction. This signified that the Company, to circumvent the provisions of Rule 23 of the Rules and Section 165 of the Ordinance, placed insurance business outside Pakistan in the form of reinsurance through the practice of fronting and by including cut-through clauses in the reinsurance policies. The Company was prima facie assisting the insureds in this practice.
Furthermore, in cases involving fronting, it was also observed that the dates on the reinsurance placement slips were earlier than that of the policies issued by the local insurer, signifying that such risks were placed with the reinsurers before issuance of the policies by the local insurer. Moreover, in one of the cases, it was observed that the name of the insurer was listed as TBA (To Be Advised) on the reinsurance placement slip issued by Company-2, which showed that reinsurance was placed before deciding the insurer for fronting the transaction. This was further supported by the communication between the Company and the insured, where the Company stated that it would choose an insurer that would agree to minimize local retention.
In view of the above, it appeared that the Company was involved in fronting transactions routed through company-2 in circumvention of the provisions of Rule 23 of the Rules and Section 165 of the Ordinance and also subverted the provisions of Rule 7(2) of the Rules.
The Section 41(5) of the Ordinance states that the "Requirement to effect and maintain reinsurance arrangements:- The Federal Government may make rules, not inconsistent with sub-section (1), governing the reinsurance outside Pakistan, other than on a treaty basis, of insurance business underwritten by an insurer in Pakistan."
The Rule 7 of the Rules states that: "Reinsurance outside Pakistan. - ( 1) For the purposes of sub-section (5) of section 41 of the Ordinance, no insurer shall reinsure facultatively outside Pakistan any insurance business or any part thereof underwritten by it in Pakistan without the permission of the Commission.
The Section 165 of the Ordinance states that "Insurance of interests in Pakistan. (1) The Federal Government may make rules, not inconsistent with this Ordinance, imposing conditions on the ability of any person to insure outside Pakistan any risk or part thereof in respect of any property or interests which are located in Pakistan at the time the insurance is effected.
The Federal Government may make rules, not inconsistent with this Ordinance, imposing conditions on the ability of any insurer to issue life insurance policies denominated in currencies other than the Pakistan Rupee to persons who are citizens of Pakistan and resident in Pakistan at the time the insurance is effected."
Accordingly, a show cause notice (SCN) was issued to the Respondents, calling upon them to show cause as to why the action under Section 102(6)of the Ordinance should not be taken against the Company for the aforementioned alleged contraventions of the law.
It is notable that while fronting is apparently riskless, it poses a number of risks to local insurers and is against the spirit of Rule 7 and Rule 23 of the Rules and Section 165 of the Ordinance. In case of failure of a reinsurer, the insurer is held responsible to bear all risks incurred by the insured. Secondly, fronting often distorts the underwriting practices of a jurisdiction where insurers focus on commission instead of premium retention and the performance of the underlying risks. Finally, fronting negates the spirit of local legislation by allowing foreign companies to circumvent local licensing and retention requirements. The Commission is of the view that both the insurer as well as the broker, directly or through their advisory and other consultancy services, cannot indulge into the practice of fronting to negate the provisions of the Ordinance.
The Company has facilitated the fronting transactions routed through company-2 in circumvention of the provisions of Rule 23 of the Rules and Section 165of the Ordinance and has also subverted the provisions of Rule 7(2) of the Rules.
The SECP has carefully examined and given due consideration to the written and verbal submissions of the Respondents, and have also referred to the provisions of the Ordinance, the Rules made thereunder and/ or other legal references. The SECP is of the view that the violations of Rule 7 & Rule 23 of the Rules and Section 165 of the Ordinance are clearly established, for which the Respondents may be penalized in terms of Section 102(2) of the Ordinance.
"In exercise of the power conferred on me under Section 102(6) of the Ordinance, the SECP instead of canceling the license as provided under the said provision hereby strictly warn the Company to desist from facilitating / indulging in the fronting transactions," the SECP said. The Company is also directed to submit its revised Agreement after incorporating the issues highlighted by the Commission, the SECP added.