Canada: OSFI Releases Letter and Draft Guidance on Reinsurance Security Agreements

On August 9, 2010, the Office of the Superintendent of Financial Institutions (Canada) (OSFI), the Canadian federal prudential insurance regulator, released for comment draft Guidance (the Guidance) on the use of Reinsurance Security Agreements (RSAs). The Guidance was accompanied by a letter (the Letter) that summarized OSFI's rationale for discontinuing the previously utilized mechanic of standard form reinsurance trust agreements (RTAs) and outlined OSFI's new approach to RSAs. The Guidance, which is open for comment until October 1, 2010, applies to all federally-regulated insurers and reinsurers (each, a FRI) in respect of reinsurance cessions and retrocessions with reinsurers not licensed in Canada, and also outlines OSFI's expectations of FRIs in connection with the RSA process. Once adopted, the Guidance will significantly increase the administrative burden on FRIs seeking to reinsure with unlicensed reinsurers and may, as a result, significantly discourage the use of unlicensed reinsurance.

This Insurance Law Update provides an overview of, and a commentary on, the Guidance and Letter. OSFI has also simultaneously released a draft Guideline on sound reinsurance practices and procedures. Information regarding the draft Guideline can be found in Stikeman Elliott's earlier September 2010 Insurance Law Update.

Historical Background

The Letter advised that OSFI would no longer develop or be party to standard form RTAs. Previously, OSFI had developed standard form RTAs to which OSFI was a party and which FRIs were required to use in order to be eligible for regulatory capital/asset credit in respect of risks reinsured with unlicensed reinsurers.

OSFI's desire to change its role is understandable, as OSFI practically does not have the expertise or resources to continuously monitor and assess all applicable provincial legislation. Nor, conceptually, should such drafting or monitoring be OSFI's role or responsibility, and indeed, by comparison, OSFI does not draft or become a party to commercial agreements entered into by deposit-taking institutions it regulates.

In the Guidance, OSFI noted that its decision to discontinue use of RTAs was supported by a number of factors, including the desire to:

  • require FRIs to better manage their own risks related to unlicensed reinsurance;
  • provide FRIs flexibility to create their own forms of security agreements;
  • as noted above, harmonize with the practice for other security and collateral arrangements utilized by deposit-taking institutions;
  • recognize that the use of an appropriate standard form agreement is a fact-specific determination and that the creation of a first-ranking, perfected security interest depends on more than just the form of the agreement;
  • maintain access to Canadian courts; and
  • as noted above, minimize OSFI's costs and responsibility associated with reviewing all applicable Canadian personal property legislation and securities transfer legislation (as would have been required in connection with the development of a standard form RSA).

New Approach

OSFI will now require FRIs to negotiate and enter into suitable arrangements and take all necessary practical and operational measures to create and maintain a valid, first-ranking security interest in assets of an unlicensed reinsurer that are held in Canada. Further, FRIs will be required to provide a legal opinion addressed to the FRI and OSFI, and on which OSFI will be entitled to rely, asserting that such an interest has been created in its favour.

All agreements entered into after January 1, 2011 will be required to comply with the new approach, although FRIs are encouraged to migrate to the new regime as soon as possible. Practically, this represents a very short timeline for compliance. In addition, and importantly, OSFI expects that companies will replace all existing agreements by January 1, 2012. That is also practically a very short timeline for compliance with such a requirement and, as noted below, may present significant commercial consequences for FRIs.

In the Guidance, OSFI indicated that it will permit capital/asset credit for reinsurance agreements in certain circumstances including where the following criteria, among others, are met:

  • the assets of the unlicensed reinsurer are pledged to the FRI pursuant to a security agreement made under provincial law;
  • the pledged assets are held in Canada by a collateral agent, which must be a Canadian financial institution not affiliated with the unlicensed reinsurer;
  • all relevant documentation is binding on the parties and legally enforceable in all relevant jurisdictions;
  • the FRI takes all necessary steps to create and maintain a valid, first-ranking interest in the collateral;
  • if the pledged assets are financial assets to which securities transfer legislation applies, the collateral agent maintains control of the assets on behalf of the FRI;
  • the FRI provides OSFI with a legal opinion, addressed to the FRI and OSFI and on which OSFI is entitled to rely, asserting that a valid and enforceable first-ranking security interest in the pledged assets has been created in its favour; and
  • the credit quality of the reinsurer and the value of the collateral must not have a material positive correlation (for example, securities issued by the reinsurer or any related entity would provide little protection and would therefore be ineligible).

The legal opinion and accompanying RSA will be required to be filed with the OSFI Securities Administration Unit.

OSFI expects FRIs to have a policy, approved by the board or a committee of the board, requiring management to confirm to the board/committee from time to time (but at least once every two years) that a valid and enforceable first-ranking security interest in the pledged assets continues to be created in the FRI's favour, including where changes have been made to applicable provincial/territorial personal property security legislation or securities transfer legislation. It would appear that this reconfirmation obligation will require FRIs to obtain reaffirmation of existing opinions every two years, which will impose an additional significant administrative burden and cost on FRIs. For FRIs that are branches, OSFI expects that the Chief Agent will ensure that the branch has an approved policy.

OSFI expects that the RSA will, at a minimum:

  • include a reference to the applicable statute pursuant to which the RSA is made;
  • provide that the pledged assets shall be held in the province pursuant to which the RSA has been made;
  • provide that the collateral agent will, in respect of the pledge, act solely as agent for the FRI and not as agent for the reinsurer (which, we note, does not reflect the current securities transfer legislation in respect of securities in the possession of a securities intermediary);
  • provide that the pledged assets will be held by the collateral agent in one or more accounts identified in its records as separate and distinct from other accounts of the collateral agent; and
  • provide that the reinsurer agrees to deliver to, and maintain with, the collateral agent as collateral under the RSA, assets having a market value at all times at least equal to a specific amount or to an amount determined by formula.

OSFI expects the legal opinion to include:

  • an assertion that the security interest in the pledged assets is valid and enforceable against all other creditors of the unlicensed reinsurer, including in the event of insolvency;
  • a reference to the applicable provincial statute pursuant to which the arrangement is made;
  • a statement as to the validity and enforceability of the security interest in the context of the applicable rules governing conflicts of laws; and
  • an assertion that a first-ranking priority is created by such security interest.

OSFI will continue to require ceding companies to obtain OSFI approval (i) for the removal of pledged assets; (ii) to obtain credit for assets that are not listed on Schedule A to the Guidance; (iii) or for any transaction involving foreign currency assets. The ceding company may, without OSFI's prior written approval, accept a pledge of assets listed in Schedule A, and allow the reinsurer to withdraw any asset if the asset withdrawn is replaced either prior to or simultaneously with an asset listed in Schedule A, the market value of which on the date of the replacement is, and is certified by the ceding company to OSFI to be, at least equal to the market value of the asset withdrawn. If an asset is to be replaced with an asset not on Schedule A, it will require OSFI approval. Schedule A assets are limited to bonds, debentures and other evidences of indebtedness of Canadian governmental entities and Canadian companies holding a minimum rating, potentially A-, from a nationally recognized rating agency, as well as common and preferred shares traded on a recognized stock exchange in Canada.

Commentary

As noted above, the new approach is commendable in the sense that it gets OSFI out of the business of drafting or being a party to commercial contracts, and to that extent is consistent with the approach taken to the deposit-taking sector.

However, the abandoning of the use of a standard form agreement will impose substantial new burdens on FRIs seeking to utilize unlicensed reinsurers, as FRIs will now be required to negotiate the forms of (i) RSAs having regard to both the applicable provincial law and the laws of the jurisdiction of the unlicensed reinsurer, (ii) related opinions under applicable provincial law and (iii) appropriately (although not expressly required by the Guidance), related opinions under the laws of the jurisdiction of the unlicensed reinsurer. Further, FRIs will face the uncertainty of whether OSFI, upon a review of an FRI's RSA and related opinions, would challenge the form/acceptability of the RSA and related opinions and deny capital/asset credit on that basis. Consequently, the new regime may significantly discourage the use of unlicensed reinsurers, as the increased internal and external costs may make many such arrangements uneconomical. Practically, FRIs may wish to attempt, including through their industry associations, to settle a number of standard form RSAs and related opinions for use in connection with the small number of domiciles of the leading unlicensed reinsurers.

Although the Letter and Guidance take a principles-based approach and are intended to provide FRIs with increased flexibility, certain requirements under the Guidance are actually quite prescriptive and, further, are inconsistent with the approach taken for banks in respect of collateral for derivatives. It is not clear why it is necessary that RSAs be made under provincial law, that the pledged assets be held in Canada or that the collateral agent be a Canadian financial institution, as none of those requirements apply to banks in the context of derivatives. With respect to the requirement for legal opinions from a number of jurisdictions, over time hopefully it will be possible for FRIs, including through their industry associations, to collectively develop and rely on general advice and opinions such as those published by the International Swap Dealers Association in respect of swaps in relation to various jurisdictions.

While OSFI obviously has an interest in the quality of the collateral pledged, it could address this issue directly rather than by imposing constraints relating to the form and jurisdiction of the pledge. In general, security arrangements are more flexible and allow for the taking of the security in other jurisdictions. As in the case of deposit-taking institutions, the onus should reasonably be on the FRI to satisfy itself that it has taken all appropriate steps and obtained all necessary documentation under applicable foreign law. As a result of recent developments under Canadian and foreign law, it has become much easier to obtain valid and perfected security in certain foreign jurisdictions.

The lack of any grandfathering of existing RTAs will require FRIs to obtain the cooperation of their unlicensed reinsurers in order to replace existing RTAs with new RSAs. This will impose a significant commercial risk on FRIs, as they will be forced to reopen negotiations and face the prospect of being forced to agree to less favourable terms than at present.

Further, certain of the quite prescriptive requirements with respect to the required legal opinions are not consistent with market practice, may likely make compliance difficult. In particular, opinions are typically subject to standard assumptions and exceptions with respect to priority, and to a qualification with respect to enforceability under insolvency laws, all of which OSFI will ideally appreciate and accept, consistent with current market practice.

Lastly, it is not yet clear whether OSFI's RSA mechanic and form will be acceptable to any provincial insurance regulators asserting co-jurisdiction over capital/asset levels supporting risks located in their provinces and written by federally-licensed insurers also licensed and carrying on business in the applicable province (or, conversely, whether any required provincial mechanism/agreements will be satisfactory to OSFI), although we understand that discussions are to occur in that connection.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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