Pan-American Surety Association Newsletter
"News@PASA" 4/4 of 2004

Problems and Solutions For a Fronting Surety Part III: Issues Between the Fronting Surety and the Backing Surety

By: William J. Taylor, Esquire
Philadelphia, PA
USA

As we discussed in the last two PASA newsletters, the use of "fronting" is becoming more and more common in the surety industry. However, as the practice of fronting becomes increasingly prevalent, more and more problems regarding the fronting relationship have come to the forefront, and numerous issues should be considered before entering into such a relationship. Previously we have discussed the fronting surety's right to the backing surety's reinsurance proceeds and its indemnity rights against the bonded principal. In this article we will discuss several issues that arise between a fronting surety and the backing surety.

Probably one of the most basic principles to keep in mind is that the fronting surety and the backing surety do not have a surety-principal relationship between themselves. The backing surety is not a party to the bond and is not part of the tri-partite relationship between the surety, the principal, and the obligee. Thus, the common law rights and remedies that inure to a party by virtue of its status as a surety are not available to the fronting surety in its dealings with the backing surety. Rather, the rights of a fronting surety are dictated by the specific agreement between it and the backing surety. This agreement, whether it is called a guaranty or an indemnity agreement, generally provides that the backing surety will indemnify the fronting surety for any and all losses incurred as a result of issuing the fronted bonds. The fronting surety should examine this document very closely before entering into a fronting relationship so that it is fully aware of all of its rights and all of the obligations it is incurring with regard to the backing surety. There are numerous questions that should be answered by the fronting surety before entering into this agreement.

The first question for the fronting surety is whether it seeks to be indemnified against liability on the fronted bond or indemnified against loss, damage, or injury. The backing surety's obligations are different depending on the type of agreement used. If the fronting agreement indemnifies only against loss or damage, the backing surety's obligations do not arise until the fronting surety actually suffers loss or damage arising out of the fronted bond. Further, if the agreement requires that the surety must suffer a loss before it may recover, the surety must prove its damages. By contrast, when the agreement is an indemnity against liability the backing surety's obligations to the fronting surety arise as soon as the fronting surety incurs any liability on a fronted bond, regardless of whether the fronting surety has actually suffered loss or damage. In fact, there are some cases in the United States that hold that actual liability is not required for the surety to be entitled to indemnity - rather all that is required is a good faith belief that the surety might be liable under its bond. Whether an indemnity is one against liability or against loss is dependent upon the specific language of the agreement, and great care should be taken in selecting the appropriate language to meet the needs and expectations of the parties.

The fronting surety should also determine what contractual indemnity rights the backing surety has against the principal. Obviously the typical contractual indemnity agreement provides that the principal and indemnitors that execute the agreement will indemnify the surety for any and all losses incurred by the surety as a result of issuing bonds for the principal. However, many standard indemnity agreements in the United States also provide that the indemnity obligations of the principal/indemnitors apply not only to the surety that issues a bond on their behalf but also to co-sureties, reinsurers, and fronting sureties who issue a bond at the request of the backing surety for whose benefit the indemnity agreement was signed. The fronting surety should request that the backing surety provide to it copies of all indemnity agreements executed by the principal so that it can determine whether it, as a fronting surety, is covered by its terms.

The agreement between the fronting surety and the backing surety should also spell out the parties' respective claim administration responsibilities. Usually, since the bond itself is on the fronting surety's paper, the fronting surety will assume all claim administration duties. However, if the fronting surety is simply that - a "front" - and the principal on a fronted bond is a regular client of the backing surety, the backing surety may wish to undertake all claims handling in regard to the fronted bond. If this is so the agreement between the fronting surety and the backing surety should clearly spell this out. Assigning these duties to the backing surety is generally not a good idea, since the fronting surety that actually issues the bond incurs all claims administration responsibilities by operation of law and will be liable to the obligee and the principal if these duties are not carried out. Further, if the backing surety acts in bad faith in the course of its claim administration activities the fronting surety, as the named surety on the bond, could be liable for the bad faith claim administration conduct of the backing surety.

Conversely, if claims administration is to be handled by the fronting surety, the agreement between it and the backing surety should also make clear that the fronting surety is to be indemnified for its loss adjustment expenses as well as its actual losses incurred on the fronted bond.

The prudent fronting surety should also make itself aware of the backing surety's reinsurance for the risk in question. While generally under U.S. common law an original insured has no direct rights against the reinsurer in the event of a loss, the reinsurer and reinsured may include language in their reinsurance policy which indicates an intent by the reinsurer to become directly liable to the original insured. Usually this "cut-through" provision must appear in the language of the reinsurance policy itself to bestow an independent right of action on the insured. A fronting surety should determine if this right exists before it enters into a fronting arrangement with another surety.

A cut-through provision in a reinsurance agreement is especially relevant when the backing surety becomes insolvent, as there will be many creditors competing for the insolvent surety's assets, including its reinsurance proceeds. Indeed, a fronting surety may encounter a great deal of difficulty enforcing its rights against a backing surety if the backing surety becomes insolvent. In the United States, an insolvent surety is usually taken over by the Insurance Department of the surety's domicile state, which then liquidates the insolvent surety or attempts to "rehabilitate" the surety, i.e., bring it out of insolvency, through strict control of its assets and claims. These insolvency proceedings usually include an injunction restraining all claims against the insolvent surety, and thus a claim under a fronting agreement with an insolvent backing surety will be difficult to enforce.

Claims under a fronting agreement are also given low priority in a surety insolvency proceeding. In the United States fronting agreements are generally considered to be a form of reinsurance. Under the Uniform Insurers Liquidation Act, which has been adopted in many U.S. jurisdictions, a reinsurance claim asserted against an insolvent insurer is afforded low priority in the order of distribution of claims, far below claims under the insured's policies and bonds, claims for unearned premiums, claims for unpaid wages, and tax claims. Often a fronting surety with a claim under a fronting agreement is treated just as a general creditor of the insolvent backing surety, and will get paid only after all claims under the insolvent insurer's policies and bonds are satisfied in full. Moreover, the reinsurance funds paid by the reinsurer for a claim made under a fronting agreement, absent a cut-through provision in the reinsurance agreement, will not be paid directly to the fronting surety but rather will become part of the insolvent backing surety's general assets. As part of the insolvent's general assets, these funds thereafter are distributed to all claimants, including, first, those claimants with a higher priority than the fronting surety with a reinsurance claim.

The fronting agreement should also determine whether the backing surety's claims against the principal are subordinated to the fronting surety's common law and contractual claims against the principal for losses incurred on the fronted bond. In the event that the principal becomes insolvent and losses are incurred on the fronted bonds, the fronting surety may not want to compete with the backing surety for the limited assets of the principal (if the backing surety has its own claims against the principal). The fronting surety should insist that the backing surety's claims against the principal be subordinated to the fronting surety's claims until the fronting surety is paid in full.

Finally, the fronting agreement should specify what law governs the relationship, and in which jurisdiction claims shall be brought. Obviously, it is often difficult to pursue a backing surety in another jurisdiction, and as many procedural and jurisdictional questions as possible should be settled in the fronting agreement at the time that it is executed.