Charting a New Course

Reinsurance is a critical tool used by Canadian insurers to mitigate and reduce risk. Approximately 75% of the $3.6 billion of losses from the Fort McMurray fire will be paid by reinsurers located outside of Canada.

The global network of reinsurance that exists is critical for insurers to be able to write large risks with Cat exposure, such as British Columbia earthquake. Reinsurance has a variety of uses, including capital management and providing more stable results for insurers. However, the regulatory regime for reinsurance has recently become more ambiguous and complicated in Canada.

Brian Reeve, Partner, Cassels Brock & Blackwell LLP

Reinsurance has become one of the main areas of regulatory focus by the Office of the Superintendent of Financial Institutions (OSFI) due to its importance in the management of capital by Canadian insurers. In particular, OSFI has a concern with respect to counterparty risk that unlicensed or related party reinsurance may create for Canadian insurers.

REPEAL OF THE REINSURANCE REGULATIONS

Pursuant to the Reinsurance Regulations that were in effect until 2010, Canadian insurers were limited with respect to their ability to use reinsurance. It was possible for insurers to cede up to 25% of their total gross premiums to unlicensed reinsurers and 75% to licensed reinsurers.

During the period that the regulations were in effect, they were often criticized by insurers as being too restrictive, particularly with respect to the ability to cede reinsurance to unlicensed reinsurers that were related parties.

In December 2008, OSFI issued the Discussion Paper on OSFI’s Regulatory and Supervisory Approach to Reinsurance. The paper reviewed a number of important issues regarding the regulation of reinsurance.

OSFI issued a response paper in 2010 that provided OSFI’s views on the comments that it had received. One interesting comment was that OSFI believed that there should be “neutrality” between licensed and unlicensed reinsurance.

This comment was a recognition of the international nature of reinsurance.

In 2010, OSFI repealed the Reinsurance Regulations (as recommended in the response paper) on the basis that it acts as a principles-based, rather than a rules-based, regulator. Noting that it was not appropriate to provide specific limitations on the use of reinsurance, OSFI decided it would review each reinsurance arrangement on an individual basis.

There are two main types of risk that are applicable to reinsurance. With respect to third-party reinsurance, it is necessary to evaluate the counterparty risk of the reinsurers involved.

The second type of risk relates to related party unlicensed reinsurance. OSFI’s stated concern with respect to this type of arrangement is that it exposes a Canadian insurer to the solvency risk of its parent and other affiliated companies.

One of OSFI’s fundamental principles is the requirement that capital be “ring fenced” in Canada. The Canadian branch of a foreign insurer is required to have a vested trust account that is under the control of OSFI to ensure that adequate capital is available for Canadian policyholders in the event of an insolvency.

Canadian incorporated insurers are also required to maintain their assets in Canada in a custodian account.

OSFI has expressed concern that the use of large amounts of unlicensed reinsurance could create a solvency risk for this regulatory regime since adequate assets might not be maintained in Canada.

OSFI GUIDELINE B-3

OSFI has made several regulatory initiatives to help to manage some of the issues in connection with the use of reinsurance. OSFI Guideline B-3 was introduced in 2010 and is particularly important since it sets out OSFI’s expectations with respect to the use of reinsurance.

In particular, an insurer is required to have a reinsurance risk management policy (RRMP) that sets out how reinsurance is used. An annual review of the RRMP is required and an insurer must review the financial condition of all of the reinsurers that it is ceding business to on an annual basis.

Another response of OSFI has been to require that a reinsurance security agreement (RSA) arrangement must be maintained in Canada for credit for reinsurance to be taken with respect to unlicensed reinsurance. It is necessary for an unlicensed reinsurer to provide security in an RSA in an amount equal to 115% of the policy liabilities with respect to the business that is ceded.

OSFI has also attempted to manage counterparty risk by requiring the failure of a third-party reinsurer to be used as a stress testing scenario with respect to the dynamic capital adequacy testing (DCAT). Required to be done on an annual basis by all insurers, the scenario is used to determine whether or not the failure of the reinsurer could have a significant effect on the capital of a Canadian insurer.

Finally, OSFI has required that an approval of the Superintendent of Financial Institutions is necessary when an insurer enters into a reinsurance arrangement with a related party unlicensed reinsurer. OSFI now provides a one-time approval of each related party unlicensed reinsurer and requires annual updates of financial condition of the unlicensed reinsurer.

LEVERAGED BUSINESS MODEL

It appeared that as a result of these initiatives, OSFI had put in place an adequate number of safeguards that controlled and monitored the use of reinsurance on both a licensed and unlicensed basis. However, OSFI has recently expressed concern that a trend was developing regarding the use of large amounts of related party unlicensed reinsurance.

It has become a common practice for large quota share reinsurance arrangements to be entered into with unlicensed reinsurers in offshore jurisdictions, such as Bermuda.

OSFI Superintendent Jeremy Rudin has referred to the use of large amounts of related party unlicensed reinsurance as a “leveraged business model.”

“Taken to extremes, this model introduces a highly concentrated counterparty credit risk to the direct writer. This risk could, ultimately, impair its ability to compensate policyholders in a severe, but plausible,” event, Rudin said during his presentation at the National Insurance Conference of Canada in Vancouver last September.

Rudin indicated OSFI had identified a group of insurers that write a relatively large amount of commercial business in Canada that have concentrated counterparty credit risk issues. He confirmed that OSFI was reviewing concentrated counterparty credit risk and deciding whether or not additional regulation of it was necessary.

Rudin also indicated that OSFI would be reviewing other approaches to the use of reinsurance that are outside of the “leveraged business model” to determine if the counterparty credit risk issues can be better managed for them as well.

NEED FOR GREATER CERTAINTY

The Reinsurance Regulations were introduced by OSFI in the early 1990s as a response to the failure of several Canadian insurers that had relied heavily on unlicensed reinsurance. In recent years, there have not been any significant failures of unlicensed reinsurers that have had a material effect on the solvency of Canadian insurers.

It is likely that neither OSFI nor Canadian insurers would prefer to return to the restrictive regime provided by the Reinsurance Regulations.

However, one advantage of the regulations was that they provided certainty and a specific set of rules that enabled insurers to know exactly how much reinsurance could be used.

In the current environment, it is difficult for many insurers to determine exactly how OSFI would react to a particular reinsurance model.

OSFI has provided some guidance regarding when it will find larger amounts of reinsurance to be acceptable. For example, OSFI has indicated that reinsurance use for real loss transfer purposes or to handle large Cat losses will normally be acceptable. However, the use of reinsurance primarily for capital arbitrage or to transfer profitable business to a low tax jurisdiction may not be acceptable.

Many insurers believe that additional rules are not necessary and that the “leveraged business model” plays a valuable role in the Canadian market. OSFI has already attempted to control the counterparty credit risk with respect to unlicensed reinsurance by requiring an RSA, as well as imposing a capital charge with respect to the use of unlicensed reinsurance.

LOOKING FORWARD

One of the issues with OSFI’s approach is that it does not fully recognize the international nature of reinsurance. OSFI has already announced it will not be adopting Solvency II or seeking “equivalency” with other foreign insurance regulators.

It can be argued that the issues OSFI has with respect to the “leveraged business model” would be eliminated if it accepted the concept of mutual recognition. OSFI’s reliance on a “ring fenced” approach to capital may, in the long term, be in conflict with international insurance regulatory trends.

The best approach in the short term would likely be for OSFI to provide additional guidance in Guideline B-3 with respect to its expectations regarding the use of insurance on both a licensed and unlicensed basis.

In the long term, OSFI should consider whether or not an approach that relies more upon mutual recognition would provide greater benefits to Canadian policyholders.

One of the benefits of the “leveraged business model” is that it allows Canadian insurers that write commercial business to be able to offer larger policy limits and more capacity.

An overly restrictive approach to the use of reinsurance by OSFI could lead many insurers to either reduce their capacity or to withdraw from writing business in Canada on a licensed basis.

As a regulator, OSFI needs to chart a course that results in an appropriate balance between the protection of Canadian policyholders and ensuring that a competitive insurance market exists in Canada that is able to operate in an efficient manner. It is likely that imposing additional rules on Canadian insurers regarding the use of reinsurance is not the best approach.

It can be argued that OSFI already has a number of tools in place that can be used to manage reinsurance risk.

The types of Cat and other large exposures that exist in Canada will always result in reinsurance playing a very important role for Canadian insurers in capital management. The regulation of reinsurance will likely remain one of the key issues in the future facing both OSFI and Canadian insurers.