SOUTHAMPTON, Bermuda-Captive insurers should expect their future to involve fronting difficulties, higher reinsurance costs and larger retentions, according to a panel of experts.

"Fronting is going to be one of the biggest challenges," said Peter J. Mullen, president of Hamilton, Bermuda-based ARTEX Underwriting Managers Ltd. Few fronting companies are available to captives, and many of those that are around, are inexperienced, he noted.

Mr. Mullen was part of a panel at the fifth discussing challenges that captives face. The symposium was held Feb. 19-22 at the Fairmont Southampton Princess Hotel in Southampton, Bermuda.

The bloom is off the rose for many fronting companies, according to panel moderator David McManus, president of Arthur J. Gallagher & Co. (Bermuda) Ltd. The fronting companies "were the darlings," he said, and "the market promoted them. For many years, they performed fantastically and creatively because they were trailblazers." Fronting arrangements were seen by insurers as "this fabulous, no-risk insurance contract," he said.

But, Mr. Mullen said, fronting is not a risk-free transaction. The companies "take 100% of the risk and then they try and lay that risk off," he said. "We all understand the theory of that. The practice of it, though, is something else."

As proved by Legion Insurance Group, fronting companies are exposed to risks. Legion, a unit of Bermuda-based Mutual Risk Management Ltd., last year added $30 million on an aftertax basis to net loss reserves because program losses from prior years are expected to exceed reinsurance limits. A.M. Best Co. has downgraded Legion's financial strength rating to B from A.

Mr. Mullen pointed out that there are a lot of players that are much less experienced than Legion. In soft markets, such as the one that recently ended, "the amateurs tend to stray into our business," he said. "Companies who reduce pricing on the guaranteed-cost side look to earn fees for just issuing paper. They see it as an attractive business and get into it."

But many stick around only until market conditions change, Mr. Mullen said.

As reinsurance prices rise, captives are being forced to increase their retentions, Mr. Mullen said. And some, he noted, are in a better position to do so than others.

Those that have built up their capital will be able to comfortably boost their retention levels, but those lacking capital will have to approach their parents and answer some questions as to why they need funding, Mr. Mullen said.

Panelist Henry Good, director of insurance at Rohm & Haas Co. in Philadelphia, told symposium attendees that a captive's parent is bound to be asking questions these days about the viability of the vehicles. Providing answers is not always easy.

"I challenge you to find many (chief financial officers) who understand what a captive really is," Mr. Good said. But with the pressure on management created by the "Enrons of the world" to better understand all aspects of their business and to be able to answer questions from their boards, risk managers are seeing a lot more management interest in their captives.

In Rohm & Haas' case, one question from upper management has been why a specialty chemical manufacturer needs an insurance subsidiary. "The answer there, partly, is that there are certain insurance companies that will sell insurance to our captive, but will not sell insurance to the parent company," Mr. Good said.

Also tricky is explaining how such items as reserves and incurred-but-not-reported losses can be listed on the captive's books but not the parent's, Mr. Good remarked. Such offshore transactions tend to raise eyebrows.

He also pointed out that Rohm & Haas forms captives only if they offer a tax benefit. In fact, without such a benefit, there would be "no need at all for a captive," Mr. Good said. "You sit back and say, `Should you form a captive just for tax benefits?' And the answer is `no.' But, in fact, that's what happens."

Richard Irvine, director of tax for PricewaterhouseCoopers L.L.P. in Bermuda, said that although the Internal Revenue Service's position on captive tax issues is "clear as mud, as usual," the U.S. government is indicating it wants to see "good, arm's-length pricing, not just some number we pulled out of the air." The government also wants "evidence of a business reason for (using a captive), absent a pure tax benefit," he said.

To pass government scrutiny, "There can't be parental guarantees in place or hold-harmless agreements" between the parent and captive, Mr. Irvine said. "And finally, the issue of loan-backs and circular cash flow are issues that the (IRS) will probably look at," he suggested.

The IRS will look closely at whether dealings between captives and their parents meet the definition of an insurance transaction, Mr. Irvine said.

Also on the panel was Clark Hontz, senior vp with Max Re Ltd. in Hamilton.