Canada: OSFI Response Paper Outlines Reforms to Reinsurance Regulatory Regime

Last Updated: April 15 2010
Article by Stuart Carruthers

Introduction

Late last month, the Office of the Superintendent of Financial Institutions (Canada) (OSFI) released its long-awaited response paper (the Response Paper) on its regulatory and supervisory approach to reinsurance. The Response Paper followed an initial discussion paper (the Discussion Paper), which was released in late 2008 and summarized in the June 2009 edition of our Insurance Law Update.

The Response Paper contains numerous proposed changes to the regulation of reinsurance business in Canada, many of which OSFI hopes to implement by the end of 2010. The proposed changes will provide additional flexibility for insurers and will replace a number of quantitative limits with principles-based guidance relating to sound practices and governance.  This shift is consistent with OSFI's move away from a rules based regime and, further, is consistent with the principles contained in the Guideline on reinsurance risk management recently enacted in Quebec (as of April 1, 2010). The Quebec Guideline in proposed form was summarized in the July 2009 edition of our Insurance Law Update. Insurers will be required to comply with the OSFI guidance in order to receive capital credit for reinsured risks.

The proposed changes, which OSFI described as evidencing a "regulatory and supervisory shift", are also intended to result in enhanced and more equitable capital requirements, greater disclosure requirements and increased supervisory and regulatory scrutiny of reinsurance arrangements and contracts.

This Update provides an overview of the Response Paper and the key changes proposed by OSFI.

Background

OSFI's previous Discussion Paper (i) outlined OSFI's current regulatory regime for reinsurance; (ii) identified and provided an update on a number of OSFI's initiatives in this area; and (iii) was intended to effect a consultation with the industry on OSFI's overall policy direction in this area. OSFI received a total of 28 submissions from a wide range of industry stakeholders. Following several months of internal analysis (which included a review of recent developments in other jurisdictions such as Australia and the United States) and follow-up consultations with stakeholders, the Response Paper sets forth OSFI's finalized policy approach. While existing OSFI guidance remains in effect until the changes described below are enacted, OSFI expects companies to take into account the changes outlined in the Response Paper in their planning and business activities in order to prepare for the adoption of the changes.

OSFI noted that international regulatory and supervisory approaches to reinsurance vary widely and typically follow some mix of two perspectives. The first perspective regards purchasers of reinsurance as sophisticated entities that do not require intrusive oversight. The second view has historically regarded reinsurance as a tool that can mitigate insurance risk for the regulated insurer, but that can also present significant counterparty risk if the reinsurer is not able to honour its obligations. Canada has historically operated on the second basis. Stakeholders have commented recently that while OSFI's stricter approach may have been of benefit during the recent financial crisis, certain aspects of the Canadian framework may, as a result of reforms occurring in other jurisdictions, be diverging from international regulatory and supervisory standards and best practices. OSFI noted that many of the core limits of its framework have existed for decades without any substantial reform and that further, for reasons that may no longer be appropriate in the current environment, much of OSFI's framework is not applied to the life insurance sector (in the 1980s and earlier, life companies typically undertook less reinsurance and were more predominantly mutual companies; however, the life sector now heavily reinsures and many of the larger companies have demutalized). OSFI stated that its policy decisions, as detailed in the Discussion Paper, have been developed in reflection of the following five overarching regulatory and supervisory objectives:

  • Developing a more risk-based framework, which would be consistent with OSFI's overall regulatory approach, as well as with international trends;

  • Insuring regulatory "neutrality" between registered and unregistered reinsurance, recognizing that reinsurance is a diversified, international business and that most reinsurers operating in Canada are foreign-based;

  • Creating greater equality and consistency with respect to the regulatory (and more specifically, capital) treatment applicable to similar risks underwritten by the P&C and life sectors;

  • Bolstering OSFI's guidance on governance, with a focus on sound practices and procedures; and

  • Strengthening OSFI's supervisory tools.

Policy Decisions/Reforms

25% Limit on Unregistered Reinsurance

Under regulations to the Insurance Companies Act (Canada) (the ICA), a federally regulated P&C insurer (but not a life insurer) cannot cede to unregistered reinsurers more than 25% of all of its risks insured in any given year. As OSFI noted, this 25% limit has historically been one of the more debated elements of the Canadian reinsurance regulatory framework. It has long been argued that this limit is inconsistent with the international nature of the reinsurance business, resulting in hindered access to very strong and well capitalized reinsurers not licensed in Canada. In addition, the limit appeared to be inconsistent with OSFI's general policy of neutrally treating registered versus unregistered reinsurance. In addition, OSFI noted that it did not provide any incentive for ceding companies to scrutinize the financial condition/capacity of unregistered reinsurers or other relevant factors relating to the unregistered reinsurer or jurisdiction in which it operated. Finally, because reinsurers themselves are not subject to the 25% limit, it did not act as a complete bar to companies gaining exposure to further additional unregistered reinsurance. In the Discussion Paper, OSFI hinted at possible alternatives, including a more generally-worded guideline requiring reinsurers to adopt adequate reinsurance practices and procedures, potentially bolstered with additional guidance on clearer wording in reinsurance contracts and inclusion of specific clauses in reinsurance contracts.

That approach has now been adopted by OSFI, which will be recommending the repeal of the 25% limit once OSFI Guideline B-3 (to be renamed Guideline on Sound Reinsurance Practices and Procedures) is bolstered and reissued (as discussed below) so that, among other things, insurers are required to consider the recoverability of reinsurance claims from registered and unregistered reinsurers as part of the insurer's overall risk management program and insurers are required to report to OSFI, upon request, a description of all of their reinsurance arrangements. OSFI acknowledged that, for some insurers, the removal of the limit may cause significant changes to business models and use of reinsurance. OSFI will carefully monitor the effects of such changes on the overall risk profiles of such insurers, and, where necessary, take appropriate prudential steps. OSFI is targeting implementing the revised Guideline B-3 by the end of 2010 and will thereafter be recommending repealing the 25% limit as soon as possible.

75% Fronting Limit

Under the same ICA regulations, a P&C insurer cannot cede more than 75% of all of its risks insured in any given year. This so-called "fronting" limit was intended to apply to the situation where a P&C insurer writes a risk for another insurer that is not licensed in Canada (often a captive). However, OSFI acknowledged that the limit also captures risks ceded because the Canadian insurer does not have the expertise with, or business focus on, a particular risk or type of risks and seeks to underwrite the business in Canada purely for relationship or marketing purposes. In this case, it is the reinsurer that has the requisite actuarial and risk assessment expertise. This second arrangement is quite common in the industry and acceptable from a prudential regulatory standpoint.

OSFI acknowledged that the limit in and of itself may not provided sufficient incentive for insurers to scrutinize the risks associated with the business underwritten and that the limit can effectively be circumvented using other risk transfer methods such as securitizations and catastrophe bonds. By removing the limit, it is possible that insurers would abandon the currently common complicated and costly reinsurance arrangements between affiliates and would be encouraged to pursue simplified arrangements that may in fact reduce the risk to an individual insurer. OSFI is accordingly recommending repealing the 75% limit once, as noted above, Guideline B-3 is bolstered and reissued, insurers are required to disclose all fronting/ceding arrangements to OSFI if requested, and, as discussed below, a minimum operational risk capital requirement is imposed on the P&C sector under OSFI's Minimum Capital Test (MCT) parallel to that being imposed on the life sector through OSFI's Minimum Continuing Capital and Surplus Requirements (MCCSR). Once the revised Guideline B-3 is promulgated, OSFI will recommend repealing the 75% fronting limit as soon as possible. In addition, OSFI will implement a gross minimum capital requirement in the next round of general amendments to the MCT, scheduled for 2012.

MCCSR Capital Charge for Reserves Ceded to Registered Insurers

Under the current MCCSR, life insurers are not required to hold any capital or recoverables from OSFI-regulated reinsurers or approved provincial reinsurers. OSFI has taken the position that companies should hold capital for recoverables and other amounts due from reinsurers, as these assets are subject to the same credit risk as bonds, loans, or obligations of a derivative counterparty. OSFI noted that the MCCSR is one of the few international insurance solvency tests that does not impose a capital charge for counterparty exposures to reinsurers. A counterparty risk capital charge will be developed in consultation with industry through the next round of amendments to the MCCSR scheduled for 2012 and analogous to the approach currently being imposed in the P&C sector under the MCT.

Reinsurance Governance

OSFI has determined that, in its view, enhanced guidance is required to ensure an effective regulatory and supervisory regime for reinsurance.

Guideline B-3 (which was revoked effective January 1, 2010), was perceived as inadequate as it applied only to the life sector and only in respect of unregistered reinsurance. Further, the Guideline did not address critical elements of reinsurance arrangements and did not require companies to integrate their reinsurance program into their broader enterprise-wide risk management practices and procedures. Moreover, it did not provide any guidance with respect to developing reinsurance risk management programs nor impose any obligation on insurers to conduct some level of due diligence on the ability of unregistered reinsurers to honour their obligations. OSFI noted in particular that there is evidence that ceding company due diligence on both registered and unregistered reinsurers in this connection is often weak.

Meanwhile, draft OSFI Guideline B-13, which had been intended to address the issue of the time lags between the commencement of the reinsurance arrangements and the execution of definitive documentation, has been on hold during the course of OSFI's policy review.

OSFI also noted that it does not currently provide any guidance with respect to contract language and increasingly common clauses that can lead to coverage uncertainty and adversely affect policyholders in the event of insurer insolvency. Such provisions include "offset" and "cut-through" clauses, which can effectively place reinsurers' claims (or the claims of a specific policyholder or creditor of the cedant) ahead of statutory claims against the estate under the Winding-Up and Restructuring Act (Canada). Further, it is not a regulatory requirement in Canada that reinsurance treaties contain a variety of important elements, such as "insolvency clauses" providing that the reinsurer must continue to make payments to an insolvent insurer without reduction resulting from the insurer's insolvency. Rather, OSFI currently provides credit to ceding companies for regulatory purposes without having regard to a broad set of standards to provide comfort that companies are appropriately managing all of their reinsurance risks. This is contrary to regulatory practice in a number of other jurisdictions, where the existence of an acceptable insolvency clause, among other critical elements, is mandatory before capital credit is provided by the local regulator.

OSFI has determined that it will expand and reissue Guideline B-3 to expressly state that it relates to all reinsurance arrangements and that more specifically, among other things:

  • OSFI's Guideline on Corporate Governance applies to all insurance companies with respect to effective risk management practices and procedures;

  • Ceding companies should have sound and comprehensive reinsurance risk management strategies and processes;

  • Ceding companies should perform an adequate level of due diligence on their reinsurers;

  • There should be clarity and certainty in insurance coverage under the terms of a reinsurance agreement; and

  • Cedants should not be adversely affected by the terms of a reinsurance contract in that:

    • The reinsurance agreement should contain an insolvency clause that meets OSFI's expectations (OSFI will work with industry to confirm acceptable language). Although OSFI may provide guidance on the merits of "offset" or "cut-through" or other legal clauses, it will remain the responsibility of the ceding company to ensure such clauses are understood and appropriate;

    • Arrangements should not raise legal questions as to the availability of funds to cover policyholders claims (such as "funds withheld" arrangements in the event of a reinsurer insolvency); and

    • Reinsurance contracts should be subject to Canadian law and the parties should attorn to Canadian courts.

This principles-based approach and emphasis on governance is broadly consistent with the approach set forth in the Quebec Guideline on reinsurance risk management.

As capital credit is OSFI's key regulatory and supervisory "tool" with respect to reinsurance, the new guidance will be tied to OSFI's provision of capital credit. Capital credit will not be provided unless the company meets the expectations set out in the new Guideline. Companies may be asked to provide an attestation, prior to receiving capital credit, that the arrangement meets the Guideline B-3 criteria. As noted above, OSFI is targeting reissuing Guideline B-3 by the end of 2010.

Collateral Requirements and Mutual Recognition

OSFI noted that, based on responses to the Discussion Paper, there was broad industry support for movement to a more sophisticated system of risk-based collateral, but not for a system of full mutual recognition of other jurisdictions' collateral requirements. OSFI has determined that it would not be prudent to discontinue or lessen its collateral regime for unregistered reinsurance, particularly in light of recent financial market developments that have stressed the importance of collateral. Further, at this time it would be premature for OSFI to consider the adoption of a "mutual recognition" regime.

OSFI will, however, undertake policy work to identify issues and parameters associated with implementing a more sophisticated, graduated risk-based capital/collateral framework for unregistered reinsurance. OSFI will also be assessing the overall quality of collateral being posted by unregistered reinsurers and continue the ongoing discussions with the Canadian legal community as to whether the enforceability of OSFI's current reinsurance trust agreements could be challenged. OSFI will also continue to assess its policy on the use of letters of credit as collateral by unregistered reinsurers (the limit on the use of letters of credit was recently increased from 15% of risks to ceded to unregistered reinsurers to 30% of risks ceded to unregistered reinsurers). OSFI will also continue to review its capital rules to ensure that adequate capital is maintained by the insurer in respect of the risks posed by collateral arrangements with licensed reinsurers.

Regulatory Approvals

Given recent changes to the reinsurance approvals regime which came into effect in 2007 (with some portions coming into force in 2010), OSFI is not planning amendments to that regime at this time.

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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