Seductive Solution?

As the July 1, 2011 implementation date for the new form of unlicensed reinsurer security arrangement approaches, cedants and unregistered reinsurers are looking for simpler ways to take capital/asset credit for unregistered reinsurance. A funds withheld arrangement may offer an attractive alternative to other forms of security, provided that both cedants and reinsurers fully understand the implications of entering into such an arrangement. Many cedants and unregistered reinsurers are concerned about the prospects of negotiating and settling a Reinsurance Security Agreement (RSA) in time, as well as the additional cost that may be involved.

The Office of the Superintendent of Financial Institutions (OSFI) issued its final version of Guideline B-3: Sound Reinsurance Practices and Procedures (Guideline B-3) and its new Guidance for Reinsurance Security Agreements (Guidance) in December 2010. Guideline B-3 and the new Guidance fundamentally changed the reinsurance regime in Canada. In particular, OSFI has changed the manner by which a federally regulated insurance company is eligible to take credit for reinsurance placed with unregistered reinsurers. As of July 1, 2011, all new collateral arrangements involving unregistered reinsurance must comply with Guideline B-3 and the new Guidance.

Reinsurance Security Agreements

Starting July 1, 2011, in order for a cedant to take credit for unregistered reinsurance, the unregistered reinsurer will be required to pledge assets to the cedant to secure payment of potential liabilities under one or more reinsurance agreements pursuant to an RSA made under provincial law. As a result, on or before July 1, 2011, the cedant will be required to negotiate and enter into a suitable RSA in order to create and maintain a valid and enforceable security interest in the pledged assets that has priority over any other security interests. The pledged assets must be held in Canada by a collateral agent. The agent must be a Canadian financial institution not affiliated with the unregistered reinsurer. OSFI will not be a party to the RSA, and the cedant and unregistered reinsurer will not require OSFI’s approval to withdraw funds held by the collateral agent. However, the cedant must obtain a legal opinion, on which both the cedant and OSFI can rely, confirming that such a security interest has been or will be created in the cedant’s favour.

The Funds Withheld Alternative

As an alternative to an RSA, Guideline B-3 also provides that credit for unregistered reinsurance is permitted for a ‘funds withheld’ arrangement. The reinsurance agreement must clearly provide that, in the event of the cedant’s insolvency, the funds withheld (less any excess amount due back to the reinsurer) must form part of the property of the cedant’s general estate (or part of the assets in Canada of a foreign insurance company) as defined under the Winding-Up and Restructuring Act (Canada) (WURA) and the Insurance Companies Act (Canada).

Funds Withheld Arrangements

A funds withheld arrangement generally consists of a contractual arrangement (usually set out in the reinsurance agreement) whereby assets, generally the premiums, that would normally be paid to an unregistered reinsurer as consideration under the reinsurance agreement are instead withheld and retained by the cedant as a form of security permitting credit for the unregistered reinsurance. In a funds withheld arrangement, there can be no encumbrance on the pledged assets; the cedant must have exclusive control over such assets. Funds withheld arrangements are commonly used in the life insurance sector. Guideline B-3 now contemplates their use in the property and casualty sector as well.

Advantages

A funds withheld arrangement would likely be a cedant’s preferred method of collateralizing reinsurance obligations, since the cedant would retain full control over the applicable assets at all times. Funds withheld arrangements have the following additional advantages:
• fewer implementation steps;
• no collateral agent is involved;
• no legal opinion is required (however, the cedant may wish to request a legal opinion from its Canadian legal counsel as to whether or not the funds withheld arrangement ensures that the funds withheld form part of the property of the cedant in the event of an insolvency); and
• they can be documented within the body of the reinsurance agreement itself.

A funds withheld arrangement provides a simpler, lower-cost alternative to an RSA. A funds withheld arrangement is also attractive to OSFI since 100% of the withheld funds are maintained in the general funds of the cedant in Canada for the benefit of Canadian policyholders in the event of insolvency.

Disadvantages

However, there are also significant disadvantages to a funds withheld arrangement. Funds withheld arrangements are generally less attractive to unregistered reinsurers than cedants, because the unregistered reinsurer assumes the credit risk of the cedant. Such an arrangement may be convenient, but offers little protection to the unregistered reinsurer. In the event of insolvency, the unregistered reinsurer assumes the role of a general creditor. Moreover, the unregistered reinsurer is prevented from asserting the assets are held in trust on its behalf (as that would be contrary to the WURA). An unregistered reinsurer cannot have a priority over other creditors with respect to the pledged assets in the event of an insolvency of the cedant.

In a funds withheld arrangement, the only protection for an unregistered reinsurer is to rely on the set-off provisions in the reinsurance agreement. In a non-insolvency situation, the reinsurer must argue the funds withheld should be set-off against the amounts the reinsurer owes to the cedant for incurred claims [as well incurred but not reported (IBNR)]. A set-off provision may only provide partial protection to the reinsurer: the cedant may be in a position to retain more funds (representing unpaid premiums) than are necessary to satisfy incurred losses. In addition, the form of set-off provision OSFI now mandates for reinsurance agreements may provide further limitations on the ability of an unregistered reinsurer to rely on set-off provisions in the event of the insolvency of the cedant.

Use of a Separate Funds Withheld Agreement

A properly documented funds withheld arrangement should delineate the rights and obligations of the cedant and the unregistered reinsurer. Funds withheld provisions are sometimes included in unregistered reinsurance agreements. A standard funds withheld provision generally includes:
• the cedant’s agreement to deliver a statement showing the proportion of reserves applicable to the unregistered reinsurance;
• an agreement to fund reserves by funds withheld;
• the maximum amount of funds withheld at any time;
• any adjustments or reconciliation of the funds withheld, commonly at the end of each quarterly accounting period; and
• a statement that the funds withheld do not create a trust or fiduciary relationship between the cedant and the unregistered reinsurer, but rather a relationship of debtor and creditor.

Although these standard funds withheld provisions may be adequate, it may be preferable for the parties to enter into a separate Funds Withheld Agreement. Such a Funds Withheld Agreement could provide for the provisions set out above, but should also include more detailed provisions as to:
• the funds withheld, and any adjustment mechanisms;
• the rights and obligations of the parties participating in the funds withheld arrangement, including the unregistered reinsurer’s rights to any surplus funds;
• use of funds withheld, including payment of claims;
• audit rights;
• set-off provisions;
• ownership of interest accrued on
funds withheld;
• insolvency provisions; and
• a right of conversion to an RSA at the option of unregistered reinsurer based on certain triggers.

A Funds Withheld Agreement would be a separate legal agreement governed by the laws of the applicable province in Canada. It would be referenced in and/or attached as a schedule to the main reinsurance agreement (which may not be governed by Canadian law). One of the most significant advantages of a separate Funds Withheld Agreement is that it would allow the parties to include specific provisions and mechanics for the operation of the arrangement. The parties could define how to determine the quarterly reductions or increases of the amount of funds required to be withheld. The parties could also provide for who will receive credit for the investment income on the funds that are withheld; how disputes over claims and reserves will be resolved; and what events will trigger the termination of the arrangement.

By creating a separate Funds Withheld Agreement, the parties could at least partially mitigate their credit
risk exposures and better define their respective obligations under the arrangement.

Summary

Funds withheld arrangements offer a tempting – but not risk-free – way for credit for unregistered reinsurance to be obtained pursuant to the requirements of Guideline B-3. Although funds withheld arrangements are very appealing due to their simplicity and low implementation costs, unregistered reinsurers must carefully evaluate these cost advantages against inherent risks.
For example, it is obvious an unregistered reinsurer must be very comfortable with the credit risk it is assuming with respect to the cedant. An unregistered reinsurer should perform comprehensive due diligence on the financial condition of the cedant before agreeing to a funds withheld arrangement. An unregistered reinsurer should also carefully monitor the MCT or BAAT margin of the cedant in order to ensure that the cedant is maintaining adequate regulatory capital at all times. A drop in the MCT or BAAT margin of the cedant below a predetermined level could be used as a trigger to either terminate the funds withheld arrangement or convert it to an RSA.

Funds withheld arrangements offer an attractive alternative to unregistered reinsurers that have very good long-term relationships with Canadian cedants with high levels of regulatory capital. The material risk of a funds withheld arrangement is the loss of control of the funds. The unregistered reinsurer will assume the role of an unsecured general creditor as compared to a secured creditor with a first charge security interest under an RSA. It is important to note this loss of control over the funds can affect the negotiating position of the unregistered reinsurer in the event of a dispute with a solvent cedant. By employing a well-drafted Funds Withheld Agreement that includes triggers and termination provisions, the unregistered reinsurer may be able to mitigate this loss of
control.