Canada: OSFI Shakes Up Earthquake Exposure Sound Practices

The Office of the Superintendent of Financial Institutions ("OSFI") is proposing changes to Guideline B-9 Earthquake Exposure Sound Practices (the "Guideline") that will impact property and casualty insurance companies in Canada effective January 1, 2014. The consultation period on the proposed revisions ended in 2012 and the revised Guideline is expected to be issued in the next few months.

OSFI has said that the complexities associated with managing earthquake exposures, combined with the potential severity of losses, the difficulty of mitigating the risk post-event, and the high public profile of a major earthquake require insurers to have comprehensive earthquake exposure risk management policies and procedures ("EPP") in place, along with an appropriate level of oversight. The draft Guideline (the "Draft Guideline"), issued on August 15, 2012, sets out OSFI's expectations for EPP applicable to insurers that write business materially exposed to earthquake-related losses. These EPP are expected to form part of an insurer's overall catastrophe risk management framework.

The revisions include refinements in the areas of measuring risk and capitalizing against earthquakes and also set out common parameters and other factors to be considered when calculating probable maximum loss ("PML"). This information, when compared to the level of financial resources available, will enable an insurer to assess its capacity and financial preparedness to handle claims that may arise from a major earthquake.

Key principles

OSFI has set out the following key principles to assist those insurers that write business materially exposed to earthquake-related losses in developing a "prudent approach" to managing earthquake risk:

  1. Boards of insurers should (i) review EPP as part of their annual review of overall risk management and (ii) along with senior management, rely on appropriate internal controls to monitor the effectiveness of and operational compliance with EPP on an ongoing basis.
  2. Insurers are asked to ensure that they have an adequate level of financial resources and appropriate contingency plans to successfully manage through a major earthquake. Specifically, EPP should quantify the willingness to take on insurance risk and outline how the financial resources cover gross PML. Insurers are asked to refer to OSFI's Guideline Minimum Capital Test for Federally Regulated Property and Casualty Companies in order to determine if they meet the regulatory test of financial preparedness for earthquakes.
  3. To counter the inherent uncertainty in earthquake models, insurers should consider using more than one model and should implement material updates to commercially available models in a timely manner. When models are not revised within a year of the release of a material update, an explanation must be provided. Models developed in-house are expected to be updated regularly and periodically tested and compared against other commercially available models.
  4. Earthquake PMLs have historically been based on the larger of the British Columbia or Quebec PMLs. OSFI says this approach understates the PML for insurers with significant exposures in both earthquake zones and ignores earthquake exposure elsewhere, thereby leading to a material impact on the exceeding probability curve. Earthquake PMLs are expected to be based on exceeding probability curves based on Canada wide exposure for foreign insurers or worldwide insurers.
  5. Earthquake exposure data should be subject to periodic (at least annual) review by individuals independent of those responsible for data collection and data quality, to ensure consistency, accuracy and completeness.

Regulatory reporting and administration

  • OSFI may use its discretionary authority, on a case-by-case basis, to increase the capital/asset requirements or target solvency ratios of insurers who fail to meet the principles set out in the Draft Guideline.
  • All insurers will be required to annually file an Earthquake Exposure Data form. Insurers without earthquake exposure are required to submit a letter stating the fact.
  • All insurers with earthquake exposure are required to maintain and provide their EPP and PML and supporting reinsurance program upon request. OSFI expects insurers' annual Dynamic Capital Adequacy Testing ("DCAT") to consider an earthquake event, and to document the rationale for exclusion if such an event is not included.
  • OSFI encourages insurers to implement the principles set out in the Draft Guideline as soon as practically possible, but expects that each insurer will comply by January 1, 2014.  The Draft Guideline is expected to be finalized in early 2013.

Commentary

  • From a practical perspective, the revisions will simply put the onus on individual companies and their boards to determine exactly how to implement the suggested and mandated changes.
  • It can be argued that OSFI is simply tackling the uncertainty surrounding earthquake exposure by requiring insurers to throw more money at the problem. The anticipated costs of meeting the new requirements and the possibility of higher capital requirements may induce insurers to withdraw their business from select markets.
  • Global insurers who may be reluctant to put money into building Canadian models may struggle with the question of how best to respond to the changes.
  • By failing to address the fact that reinsurance can be either event-based or region-based while capital requirements are Canada-wide, the revisions could lead to a situation where Canada-wide insurers withdraw business from select markets or seek to create structures (such as local provincial companies) to reduce reinsurance costs. Local provincial companies would be more at risk from an earthquake than a Canada-wide company is, at proportionally comparable capital levels and reinsurance treaty levels. This would be counterproductive to OSFI's goals of increased solvency and stronger policyholder protection.

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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Authors
Nilanka Maldeniya
Richard Da Costa
Miho Felicio
Gordon Goodman
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