Canada: OSFI Releases Reinsurance Framework Discussion Paper

Last Updated: June 27 2018
Article by Robert W. McDowell and Koker Christensen

On June 8, 2018, the Office of the Superintendent of Financial Institutions (OSFI) released its Discussion Paper on OSFI's Reinsurance Framework, outlining a number of proposed changes to the reinsurance regulatory framework. The Discussion Paper follows a multi-year review by OSFI of reinsurance practices, and addresses a number of concerns OSFI has identified. This is the first comprehensive review of the reinsurance framework in ten years, and proposes a number of significant changes.

The Discussion Paper highlights the increasing reliance by federally regulated insurers (FRIs) on reinsurance. OSFI is particularly concerned about the "leveraged business model", which involves writing large policies in Canada, and subsequently ceding a significant portion of these risks outside of Canada, with little capital or vested assets maintained in Canada to support the increased risk exposure. OSFI is also concerned about risks associated with large exposures and concentration of reinsurance counterparties. The Discussion Paper also discusses adjustments to the capital framework for reinsurance.

The process being undertaken by OSFI will be divided into three phases. Phase I involves a parallel consultation process for reinsurance related measures included in the draft Minimum Capital Test (MCT) Guideline for 2019. Phase II will involve amendments to guidelines addressing (1) prudential limits and restrictions (i.e. OSFI Guideline B-2 Investment Concentration Limits for P&C Insurers) and (2) sound business and financial practices (i.e. OSFI Guideline B-3 Sound Reinsurance Principles and Practices). Revised drafts of these two Guidelines will be released in 2019, and OSFI intends to finalize both of these Guidelines by January 1, 2020. Revised transaction instructions in respect of approvals for unregistered related party reinsurance will also be released in 2019. Phase III will involve revisions to the MCT Guideline and Life Insurance Capital Adequacy Test (LICAT) for 2022 or later years.

Comments on the Discussion Paper are to be submitted by September 15, 2018.

Background

The current reinsurance framework is comprised of the following elements.

Principles-based guidance - Guideline B-3 sets out OSFI's expectations regarding management by FRIs of reinsurance risks.

Capital framework - The MCT and LICAT Guidelines allow a FRI to reduce its required capital for insurance risk ceded. The reduction in required capital depends on whether the risks are ceded to another FRI (a registered reinsurer) or an unregistered reinsurer. In the latter case, a FRI is permitted to take capital credit for reinsurance when the unregistered reinsurer has posted acceptable collateral in Canada. Additional guidance in this regard is set out in OSFI's Guideline on Reinsurance Security Agreements.

Risk-Based Supervision - OSFI applies a risk-based approach to the supervision of reinsurance using regulatory returns, financial reports and stress tests of capital adequacy to determine the importance of a reinsurance program to a FRI and to understand the associated risks. OSFI can seek additional information as part of its periodic examinations of the FRI. OSFI has a number of tools if a FRI is not sufficiently managing its reinsurance risks, including denying capital credit for a reinsurance arrangement, and adjusting the FRI's capital requirements or internal target capital ratio.

Legislative Approval Requirements for Reinsurance with Unregistered Related Parties - Under the Insurance Companies Act, Superintendent approval is required for reinsurance with an unregistered related party reinsurer by either a company or a foreign company, (i.e. a branch).

Guiding principles

The Discussion Paper states that any changes to the reinsurance framework will be assessed against four guiding principles:

  1. Policyholders of FRIs must be adequately protected.
  2. Regulation and supervision must be balanced and risk-based.
  3. OSFI must have the ability to effectively assess risks.
  4. A level playing field among financial sector players should be maintained where appropriate.

Reinsurance Risk Management – Large Exposure and Concentrated Counterparty Risks

As noted above, OSFI is concerned about the "leveraged business model", which involves a FRI issuing high-limit policies in Canada and subsequently reinsuring a very significant portion of these risks, typically with an unregistered reinsurer. OSFI recognizes the validity of this practice for management of catastrophic risks. However, beyond that OSFI has concerns about the motivations and inherent risks relating to this practice.

The Discussion Paper notes that where reinsurance is used to mitigate the risks associated with low frequency and high severity exposures, little collateral is required to be held in Canada until the occurrence of a loss. At that time, a reinsurance recoverable is created, which introduces credit risk. Consequently, the leveraged business model can result in significant and highly concentrated counterparty credit risk, and a potential solvency issue, should the loss occur and the counterparty fails to promptly satisfy its reinsurance obligations to the cedant FRI.

OSFI intends to revise Guideline B-3 to clarify and enhance expectations related to the prudent management of reinsurance risks. This will include an expectation that a FRI establish reasonable limits on its overall reinsurance exposure to any one reinsurance entity or group, particularly where the cedant FRI relies on its reinsurance programs to underwrite high-limit policies.

In addition, OSFI intends to introduce a rule (emphasis added) that would limit the maximum policy limit that a P&C FRI could issue based on its level of capital and excess collateral, as well as the diversity of its reinsurance counterparties. The rule would be included in a revised Guideline B-2 for P&C. It would only apply to P&C FRIs that provide coverage directly to policyholders and to P&C FRI reinsurers in respect of direct business assumed by a registered affiliate.

The Capital Frameworks for Reinsurance

Counterparty Credit Risk

In the MCT Guideline, a capital charge is applied to P&C FRIs that cede risks to unassociated FRIs. However, this capital charge does not apply to P&C FRIs that cede risks to an associated FRI. OSFI's view that the risk that an associated FRI will not honour its obligations is the same as with an unassociated FRI. Therefore, OSFI plans to implement a capital charge on P&C FRIs that cede risks to associated FRIs to account for counterparty credit risk.1

The Discussion Paper notes that there is no intention at this time to apply counterparty credit risk charges to cessions within an OSFI approved intercompany pooling arrangement, which should be a relief to insurance groups that utilize this structure.

Unregistered Associated Reinsurance Funds Withheld

The MCT Guideline prescribes the forms of collateral that can be used to reduce the margin required for unregistered reinsurance, which includes funds withheld. For domestic P&C FRIs, OSFI imposes a restriction on funds withheld from reinsurers that are associates, and non-qualifying subsidiaries, by not recognizing the funds withheld payable as acceptable collateral. Foreign P&C FRIs are not subject to this same restriction, nor are life FRIs. OSFI does not believe the differing treatment between domestic and foreign P&C FRIs and between P&C and Life FRIs is justified. Accordingly, OSFI intends to remove the funds withheld restriction for domestic P&C FRIs and recognize the amount of funds held to secure payment from reinsurers that are associates and non-qualifying subsidiaries. However, conditions will be added to the MCT Guideline (and also to LICAT) in order to recognize funds withheld payables for cessions to both registered and unregistered associated and non-associated insurers.

MCT Guideline Margin Requirements for Unregistered Reinsurance

The Discussion Paper notes that the collateral requirement for unregistered reinsurance is, in essence, an alternative to OSFI's capital (or vested assets) requirements for FRIs, and states that OSFI does not intend that its collateral requirement either encourage or discourage the placement of reinsurance with FRIs or unregistered reinsurers. The key is that there be an adequate level of capital/collateral in Canada to protect the policyholders and creditors.

Currently, for a P&C FRI to obtain a full capital credit for risks ceded to an unregistered reinsurer, the collateral requirement is established at 115% of the ceded unpaid claim reserve and unearned premiums. This amount of collateral is equivalent to a 150% MCT, which is the minimum supervisory capital ratio for FRIs. However, in practice P&C FRIs maintain capital ratios at or in excess of their internal capital target, which are required to be above 150%. As a result, the 15% margin may result in fewer assets in Canada to support insurance risks when those risks are ceded to unregistered reinsurers. To address this, in the 2019 MCT Guideline, effective January 1, 2020, OSFI intends to increase the margin required for reinsurance ceded to an unregistered reinsurer from 15% to 20% in order for a FRI to obtain full capital/asset credit for that reinsurance.

Financial Resources Supporting Earthquake Risk Exposures

OSFI requires the establishment of an earthquake reserve, which can be reduced by a FRI using eligible financial resources. OSFI is reviewing the appropriateness of this on the basis that it may inappropriately reduce overall capitalization by counting the same resource twice.

Reinsurance Concentration Risk

OSFI has observed that some FRIs have material reinsurance programs with one or only a few reinsurers, or a few groups of related reinsurers. This raises concentration risk. The Discussion Paper notes that various jurisdictions include capital requirements relating to concentration risk, which focus on name concentration (i.e. risk arising from a concentration of exposures to an entity or a group of related entities). OSFI is considering introducing a concentration risk charge/limit on reinsurance assets in a future update of the capital guidelines. This would be part of Phase III.

Clarifications to Guideline B-3 and Other Potential Reinsurance Framework Adjustments

Worldwide Treaties and Flow of Reinsurance Funds

The Discussion Paper notes that it is not uncommon for large, international insurance groups to use "worldwide treaties" providing coverage of multiple insurance operations in different countries. OSFI has observed situations in which the home office of a foreign FRI enters into a reinsurance treaty that includes, but is not limited to, risks that have been insured in Canada by the foreign FRI.

The Discussion Paper highlights certain risks raised by worldwide treaties, including that given the multiple risks and locations covered by worldwide treaties, it is possible that a treaty's coverage limit could be exhausted following an event in another jurisdiction, such that subsequent events affecting Canadian policyholders are not covered. There is also a potential issue when the proceeds of a reinsurance treaty flow to the foreign entity arranging the coverage rather than directly to the FRI in Canada, creating the risk that reinsurance payments for claims of the FRI would not be recovered in a timely manner.

OSFI's expectation is that worldwide reinsurance treaties should only be granted credit in the determination of target operating capital levels if the reinsurance payments flow directly to the FRI in Canada. OSFI is also considering providing more detailed guidance on this subject and obtaining more information on worldwide treaties.

Significant Quota Share Treaties

The Discussion Paper raises concerns about the degree of reliance on significant quota share treaties in recent years, as well as concentration with one reinsurer or reinsurance group. There is a concern that heavy reliance on reinsurance could weaken underwriting standards and discipline, which in turn could harm a FRI's ability to renew or replace its reinsurance. Reinsurance could also suddenly disappear due to reinsurer distress.

Guideline B-3 states that a FRI should not, in the normal course of its business, cede "substantially all" of its risks. Recognizing that there is a range of interpretations with respect to this phrase, OSFI is seeking views on the concept of "substantially all of [an insurer's] risks" and how this concept could be expressed in a more objective manner.

Fronting Arrangements

"Fronting" in the Discussion Paper refers to insuring a risk and then reinsuring 100% of that risk. The Discussion Paper notes that there are certain fronting arrangements that are generally acceptable. However, the Discussion Paper highlights types of fronting arrangements that raise prudential concerns:

  • fronting arrangements that are not reasonably ancillary to the FRI's existing business;
  • fronting arrangements for which the FRI has little or no in-house underwriting experience; and
  • fronting arrangements for which all (or nearly all) of the insurance-related activities related to the fronted business are carried out by the unregistered unrelated foreign insurer (UUFI), including underwriting.

OSFI is concerned about the FRI having inadequate knowledge of the risks it has insured, and about underwriting discipline being compromised. A fronting arrangement involving an insured's captive UUFI could also raise prudential concerns to the extent that the arrangement represents a large exposure.

The Discussion Paper states that OSFI expects FRIs have sufficient knowledge and expertise when entering into fronting arrangements that expose the FRI to material risks, or that represent a material portion of the FRI's insurance business in Canada. OSFI plans to revise Guideline B-3 to require FRIs to take reasonable measures to satisfy themselves that legal risks related to contract wording in respect of reinsurance arrangements with captive UUFIs are appropriately managed.

Foreign FRIs Ceding Risks back to the Home Office

The Discussion Paper refers to situations where foreign FRIs cede risks insured in Canada to an unregistered affiliated reinsurer, which then retrocedes the risks back to the home office of the FRIs, and the foreign FRIs then recognize the reinsurance arrangement for the purposes of determining their required vested assets. When a loss occurs in Canada, reinsurance proceeds flow from the FRI's foreign accounts to the FRI's affiliated reinsurer in the first instance, before flowing to the FRI's branch in Canada.

OSFI has observed arrangements that involve material cessions to a FRI's home office that raise prudential concerns. In particular, OSFI is concerned about arrangements that have the potential to inappropriately reduce the total available assets in Canada.

One measure raised in the Discussion Paper to address this is denying credit to a foreign FRI for the risks that are ultimately retroceded, exclusively through entities within the FRI's group, back to the FRI in its home jurisdiction. Alternatively, OSFI may require that additional collateral be maintained in Canada to mitigate concerns resulting from such arrangements.

Legislative Approvals for Reinsurance with Related Parties

OSFI plans to request additional information when a FRI requests the Superintendent's approval to reinsure with an unregistered related party reinsurer. As well, OSFI plans to expand the scope of the information to be submitted annually in respect of such relationships. The Discussion Paper states that OSFI would generally only recommend that the Superintendent grant an approval where both (emphasis added) the related party reinsurer and the group to which it belongs appear to be in sound financial condition. As well, OSFI may recommend that the Superintendent revoke an approval if it is subsequently determined that either (emphasis added) the related party reinsurer or the group to which it belongs is no longer appear to be in sound financial condition.

This will result in an amendment to the transaction instructions for this application.

Insurance Linked Securities

The Discussion Paper briefly discusses insurance-linked securities (ILS). ILS are financial instruments used to transfer insurance risks to capital markets, and include cat bonds, industry loss warranties, derivatives contracts and sidecars. For a discussion of regulatory issues relating to ILS, see our prior bulletin (PDF).

The Discussion Paper states that a reinsurer that transfers risks to investors via ILS may have a very different risk profile relative to a traditional reinsurer, and that OSFI expects a FRI to conduct a commensurately higher level of due diligence in respect of a reinsurer that relies on non-traditional sources of funding.

No change to OSFI's expectations regarding a FRI's direct issuance of capital market instruments, as contemplated in Guideline B-9: Earthquake Exposure Sound Practices, is being considered at this time.

Footnote

1 For life FRIs, the 2018 LICAT implemented counterparty credit risk factors for risks ceded to associated FRIs.

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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