Upcoming Changes to the Regulation of Reinsurance 

publication 

Fall 2010 - (Corporate Insurance Brief Fall 2010 )

Corporate Insurance Brief Fall 2010

Introduction

Comparatively speaking, Canadian financial institutions managed to come out of the global financial crisis unscathed. The Office of the Superintendent of Financial Institutions (OSFI) - the federal regulator that oversees Canadian financial institutions, including banks, insurance companies and loan and trust companies - has largely been credited with maintaining a level and style of regulation that has kept these institutions out of trouble, perhaps deservedly so.

However, in December 2008 OSFI issued a discussion paper containing a number of proposed changes that could have significantly liberalized the regulation of reinsurance. These proposals included the possibility of doing away with or lessening the requirements for collateralization in the case of reinsurance placed with non-Canadian licensed reinsurers ("unregistered reinsurance") and taking steps to opt into a global system of mutual recognition of reinsurance regulation (for further details please see my prior article entitled "Proposed Changes to Reinsurance Regulation". The proposed changes could potentially have made Canadian licensed insurers' reinsurance arrangements significantly riskier. In addition, rather than leveling the playing field for foreign unlicensed reinsurers wishing to do business in Canada, the proposals arguably would have materially disadvantaged reinsurers that are licensed in Canada (especially reinsurers incorporated in Canada).

After reviewing submissions in response to the discussion paper and several months of internal analysis (and, of course, having the benefit of hindsight given the recent global market turmoil), on March 31 2010 OSFI published its response paper: "Reforming OSFI's Regulatory and Supervisory Regime for Reinsurance". The response paper sets out OSFI's conclusions and decisions as to which of the proposed changes will be implemented. In summary, there will not be the broad liberalization of reinsurance regulation that some stakeholders were concerned might ensue (or others had hoped would ensue). This update highlights OSFI's conclusions and decisions.

Repeal of 25% Rule and 75% Limit

At present, Canadian licensed property and casualty insurers - both insurance companies and qualified branches - face a 25% limit (risks insured) on the amount of unregistered reinsurance that they can cede. OSFI has decided that this limit should be repealed. However, the repeal will not be effective until OSFI has first issued a revised Guideline on Sound Reinsurance Practices and Procedures (the new reinsurance guideline) designed to provide a framework for reinsurance governance that Canadian licensed insurers will be expected to adhere to as part of their overall enterprise risk management. The new reinsurance guideline is discussed in more detail below. In addition, OSFI will impose new disclosure requirements on Canadian licensed insurers with respect to all of their reinsurance arrangements.

The regulations also stipulate that a property and casualty insurer cannot reinsure more than 75% of its gross written premiums. Similarly, OSFI has decided that this limit should be repealed. In its place, OSFI will institute the new reinsurance guideline, new disclosure requirements with respect to all fronting/ceding arrangements and a minimum operational risk capital requirement on property and casualty insurers as part of the Minimum Capital Test (the regulatory solvency test for the property and casualty sector).

These changes are expected to come into effect soon after the end of 2010, coincident with OSFI's effective implementation of the new reinsurance guideline.

New Capital Charges for Life Insurers

At present, OSFI imposes a "counterparty credit risk" capital charge on property and casualty insurers with respect to reinsurance with a Canadian licensed insurer. This capital charge does not apply to life insurers. As discussed in the response paper, there may have been a historical significance for this differentiation, but OSFI's view is that today there is no reason to make any distinction between the life and non-life sectors. OSFI will develop a capital charge that will apply to life insurers and is similar to the approach taken in the property and casualty sector. This credit charge will form part of the Minimum Continuing Capital and Surplus Requirements (the regulatory solvency test for the life sector).

New Reinsurance Guideline

Governance

The new reinsurance guideline promises to be comprehensive. It will contain OSFI's expectations for Canadian licensed insurers with respect to the design and implementation of sound reinsurance practices and procedures as part of their overall enterprise risk management. It appears that the new reinsurance guideline may require ceding companies to obtain approval from their boards of directors (where reinsurance arrangements will be material) and implement special procedures to manage large risk exposures to catastrophic losses. In a speech given to the Canadian Reinsurance Conference on April 29 2010, Canada's Superintendent of Financial Institutions, Julie Dickson, stated that it is OSFI's expectation that the boards of both ceding and assuming companies will be "more engaged in the risk taking policy of the companies which they govern." As part of sound risk management, Dickson envisages that companies should have a risk management policy for reinsurance that is presented by senior management to the board. Therefore, it is likely that boards (at least for domestic companies) will be required to play an important governance role in respect of reinsurance practices under the new reinsurance guideline.

Due Diligence

According to the response paper, the new reinsurance guideline will require ceding companies to perform due diligence on proposed reinsurers, including performing an independent financial evaluation over and above reliance on rating agency assessments, and even including consideration (where possible) of the reinsurers' retrocession arrangements. In the case of unregistered reinsurance, the ceding insurer will also be required to consider the legal framework and solvency regulation in place in the unregistered reinsurer's home jurisdiction.

Contractual Clauses

The new reinsurance guideline will contain specific requirements with respect to the contents of reinsurance agreements. The existing OSFI guidance on these contracts will be consolidated into the new reinsurance guideline. Reinsurance agreements will need to be legally binding and without material ambiguity as to their terms. Ceding companies will be strongly urged to ensure that reinsurance agreements contain 'insolvency clauses', ensuring the preference of policyholders of the ceding companies over creditors of an insolvent reinsurer. In the response paper, OSFI cites, as an example, the undesirability of arrangements whereby the reinsurance is administered on a 'funds withheld' basis because the legal rights of the ceding company to the funds of the reinsurer could be called into question. Whether such arrangements will be proscribed remains to be seen. The new reinsurance guideline will also strongly encourage Canadian licensed ceding companies to ensure that their reinsurance agreements are governed by Canadian law and that disputes be resolved in a Canadian forum.

Capital Credit to Ceding Companies

At present, Canadian licensed ceding insurers are generally permitted to receive a capital credit for reinsurance if the reinsurance is placed with a Canadian licensed reinsurer or if assets are vested in trust under OSFI's control (collateralization) in the case of unregistered reinsurance. Going forward, OSFI will link the ceding insurer's ability to receive capital credit directly to the insurer's compliance with the requirements set out in the new reinsurance guideline. In the response paper OSFI states that it may accept a certification or attestation from the ceding insurer as a "minimum level of comfort" of compliance. It is not clear at this point whether OSFI intends to look behind certifications and attestations. In any case it appears that receiving a capital credit for reinsurance once the new reinsurance guideline is in place will be more complex and possibly more difficult, depending on the level of OSFI's oversight of ceding insurers' reinsurance processes.

No Material Changes to Collateral Requirements for Unregistered Reinsurance

It is evident from the response paper that OSFI gave serious consideration to changes in the existing collateral requirements for unregistered reinsurance and possibly to moving towards a regime of mutual recognition of other jurisdictions (i.e., where the regulatory environment is sufficiently robust to provide a comfort level with respect to reinsurer solvency). It may be that OSFI pursued this as a possibility early on in the process because of influence by other insurance regulators that are making moves either to do away with or to lessen collateral requirements for unregistered reinsurance in their jurisdictions. In today's global community, most regulators would not want to appear to be bucking a modern trend. The examples cited by OSFI included the European Union - which has done away with collateral requirements for EU member states - and Australia and the United States, each of which is either taking or contemplating initiatives to move towards a collateral regime that is graduated and risk based. In addition, it appears that OSFI was lobbied by unlicensed foreign reinsurers wishing to gain access to the Canadian reinsurance market, as well as by Canadian direct writers that were concerned about capacity and pricing in the Canadian marketplace. However, in the response paper, OSFI concludes that it would be imprudent to do away with or lessen its collateral regime for unregistered reinsurance at this time. In fact, OSFI recognizes that recent events have underscored the importance of these requirements. Therefore, although in her recent speech given to the Canadian Reinsurance Conference on April 29 2010 Dickson indicated that the changes OSFI has chosen to implement seek, among other things, "to lead to Canada making further changes in line with other jurisdictions", for the present, collateralization requirements for unregistered reinsurance will remain in effect. As stated by Dickson in that same speech, "We are still of the strong opinion that collateral must be posted by non-registered reinsurers to secure the benefits of the Canadian ceding company and its Canadian policyholders."

For those stakeholders that were disappointed with this decision, OSFI promises to undertake policy work towards the establishment of a more sophisticated, risk-based capital/collateral framework for unregistered reinsurance. OSFI has stated that it may give consideration to a framework that takes into account the financial strength of the reinsurer. OSFI has also undertaken to assess issues such as quality of capital in the context of collateralization. OSFI has also stated that it will investigate legal concerns with respect to the enforceability of the current forms of reinsurance trust agreement used when assets are vested under OSFI's control. Finally, OSFI plans to consider whether capital charges should be made for different types of collateral.

Increase in Permitted Use of Letters of Credit

Previously, letters of credit (as qualifying collateral in the case of unregistered reinsurance) were limited to 15% of the risks ceded to unregistered reinsurers. The response paper notes that OSFI recently increased this limit to 30% for both the life and property and casualty sectors.

In a speech delivered to the Property and Casualty Insurance Invitational Forum on May 13 2010, Assistant Superintendent of the Regulation Sector of OSFI, Mark E White, stated that the new reinsurance guideline will support more liberal use of letters of credit as collateral for unregistered reinsurance and will permit greater flexibility in unregistered reinsurance collateral arrangements. It is unclear at present whether this means that further changes - over and above the increase of the limit to 30% - will be made to the allowable use of letters of credit.

No Change to Approvals for Related-party Unregistered Reinsurance

OSFI had considered doing away with the requirement for Canadian licensed companies and branches to obtain OSFI approval to unregistered reinsurance with "related parties" on the basis that it appeared that the regulatory burden involved in administering these approval processes outweighed the benefit of regulating these arrangements. At present, there will be no repeal or relaxation of these requirements, as OSFI recognizes that related-party reinsurance arrangements can be significant and can present a material exposure, particularly in the case of catastrophic coverage.

Comment

It may be that back in 2008 OSFI considered making more significant changes to the regulation of reinsurance in Canada, likely driven by initiatives taken by regulators in other jurisdictions, as well as lobbying by stakeholders wanting greater access to the Canadian reinsurance market and ceding companies seeking more accessible and affordable reinsurance. However, just after OSFI announced its intention in Summer 2008 to issue the discussion paper, the financial crisis intervened. At least in terms of collateralization and mutual recognition, OSFI opted for a more conservative approach in the short term. It will be interesting to see the results of OSFI's promised policy analysis regarding changes to the existing collateralization regime and what, if any, significant changes ultimately will be brought forward. At present, a few concessions have been made - such as repealing the 25% to 75% reinsurance limits and permitting increased use of letters of credit. It is possible that as a result of the new reinsurance guideline, it may be harder for Canadian licensed ceding insurers to obtain capital credit for reinsurance, since there will be other factors (in addition to Canadian regulated capital and collateralization alone) that OSFI will be taking into account.

This article appeared in the Lang Michener LLP Corporate Insurance Brief Fall 2010  and in International Law Office (ILO), June 2010 .