Will Canada Become an Island?

Co-ordinated and consistent international regulatory standards, such as Basel III for banks, will become an essential foundation of global commerce. For insurers, the movement to adopt Solvency II (or equivalency under those rules) has become the key international regulatory initiative. The new Solvency II regime, scheduled to come into force in January 2014, is aimed at better regulating insurers, particularly through new capital requirements.

Solvency II was adopted by the Council of the European Union and Parliament in November 2009. Since then, however, it has become an international movement. In an attempt to harmonize the global insurance market, Solvency II has established a mutual recognition/equivalency regime for countries outside of the European Economic Area (EEA). “Equivalency” allows subsidiaries or group entities within other countries to converge with EEA-based group supervisors under Solvency II. The main benefit is the ability to align capital requirements.

Numerous countries outside the EEA – such as Bermuda, Switzerland and Japan – have either committed to adopting Solvency II or have expressed interest in forming a transitional regime. The National Association of Insurance Commissioners in the United States is also considering its position and participation in Solvency II, and equivalency has not been ruled out.

A key issue for insurers operating in Canada is how the Office of the Superintendent of Financial Institutions (OSFI) will position Canada within the international regulatory movement of Solvency II. OSFI has not yet formally announced any intention to adopt Solvency II or to seek equivalency. It appears that OSFI has decided to defer adopting Solvency II and, instead, is continuing to develop its own similar, but not identical, regulatory system. As such, Canada remains one of the few major jurisdictions that has not expressed a formal decision to adopt Solvency II or to seek equivalency under it.

WHAT IS SOLVENCY II?

Solvency II creates a principles-based focus on policyholder protection through enhanced risk management, financial reporting and group supervision. Solvency II can be conceptualized as containing three pillars and a roof.

Pillar 1: Quantitative Requirements

The first pillar of Solvency II sets out the main capital management criteria, including minimum capital requirements and a “prudent person” approach to investments. It is important to note that OSFI has also used a principles-based approach to regulation for a number of years and the regulator already requires some, although not all, of the reforms provided by Solvency II. For example, Solvency II and OSFI guidelines have similar two-tier capital requirements (target and minimum capital levels).

A fundamental change under Solvency II is the option for companies to use internally developed market-based models to analyze their own solvency risk and to set their target capitalization. In contrast, the previous Solvency I framework focused primarily on standard scenarios – which is what OSFI now requires – to calculate required capital.

Although companies will still face minimum capital requirements, the move is intended to allow insurers to more efficiently use their capital. Insurers often criticize capital models imposed by regulators as being arbitrary and not always appropriate for the types of business that they write.

It remains unclear if OSFI will commit to the use of internal capital models. OSFI has a conservative approach to quantitative analysis and may be wary of the risk factors used by insurers’

internal models. There may be concerns regarding whether or not the appropriate risks have been identified and included in a given model. A recent OSFI vision paper points out that the implementation of an internal capital model approach is scheduled to occur no earlier than 2015.

Pillar 2: Qualitative Requirements

The second pillar addresses fundamental risk management issues through enhanced self-governance and harmonized group supervision. The core component for insurers will be developing their own risk and solvency assessments (ORSA), which are designed to identify various internal controls necessary to ensure solvency requirements are met.

OSFI has already employed a similar requirement to internal risk analysis through stress testing and forward-looking analyses. Each year, all licensed insurers in Canada must have an appointed actuary prepare a dynamic capital adequacy test. This tests the effects of various adverse scenarios (e.g., changes in interest rates and multiple large losses) on an insurer’s capital levels.

Pillar 3: Prudential Reporting and Transparency

The third pillar requires better disclosure of capital management, risk and other governance elements. Enhanced transparency is expected to encourage market discipline and to allow better monitoring of compliance. Insurers will be required to provide both an annual disclosure document to the public and a private report to the group supervisor. The disclosure offers greater transparency on the financial condition of insurers by requiring public access to their financial statements and material undertakings. Although OSFI similarly requires certain levels of private disclosure, public disclosure is not currently required in Canada. That said, OSFI does provide access to some financial information regarding Canadian licensed insurers on its website.

Roof: Consolidated Group Supervision

Group insurance supervision is a new and important concept. It addresses the concern that large insurance groups may operate in a number of jurisdictions, but jurisdictions are only able to regulate the local operations of global insurance companies (i.e., within their own country). Group supervision will allow one regulator to be appointed as the lead and to co-ordinate the activities of regulators in other jurisdictions.

OSFI also appears to be interested in group supervision as a proactive measure to managing capital risk. During a speech last summer, OSFI superintendent Julie Dickson confirmed the office considers group supervision to be a very good idea since it allows insurance supervisors to have a full understanding of the risks in a financial group.

IMPLICATIONS FOR THE FUTURE

Solvency II allows insurers to align their capital requirements by having the same set of capital requirements for all jurisdictions in which they operate. This harmonization will then allow for a more efficient use of capital. It is likely that European insurers with Canadian branches will impose either most or all Solvency II requirements on their Canadian subsidiaries. As a result, Solvency II will start to become more well-known in Canada, regardless of whether or not is it formally recognized by OSFI.

OSFI’s approach to insurance regulation is principles-based and is clearly similar to Solvency II in a number of respects. Since OSFI has adopted the International Association of Insurance Supervisors’ (IAIS) core principles and methodology, the two frameworks agree on similar reporting standards, disclosure and some quantitative aspects, such as a similar approach to minimum and target capital requirements. OSFI has continued work on a parallel track to evolve the capital framework for Canadian licensed insurers.

OSFI appears to be committed to being part of the international insurance regulatory community and is an active member in IAIS. In particular, OSFI is currently consulting with IAIS to develop the ComFrame initiative, or Common Framework for the Supervision of Internationally Active Insurance Groups. ComFrame was developed by IAIS to harmonize group-wide supervision.

On August 2, 2012, OSFI announced it had signed the IAIS Multilateral Memorandum of Understanding (MMoU). The MMoU is an international supervisory co-operation and information-sharing agreement that has been signed by 30 countries. It will now allow OSFI to requ
est and share information about the insurers it regulates on a formal basis with insurance supervisors in other jurisdictions, an important development that will allow OSFI to obtain better information on the insurers it regulates.

Since OSFI seems to be in favour of many aspects of Solvency II, the apparent decision not to seek equivalency at this time is interesting. One issue for OSFI may be a reluctance to relinquish full control over how insurers are regulated in Canada.

Even if OSFI agreed with all current aspects of Solvency II, a danger still exists that it might disagree with future changes or amendments. Another issue is that OSFI’s current solvency and risk management regulatory framework may in fact be more evolved than Solvency II. As a result, it is possible that OSFI might view the adoption of Solvency II as a step backward in some respects.

Despite OSFI’s reluctance to formally adopt Solvency II, it has taken a number of significant steps to update insurance regulation in Canada. The regulator needs to continue to evaluate if a similar but separate regulatory framework is the most optimal approach for Canadian licensed insurers and their policyholders. Making that choice may be a difficult one since the Canadian insurance regulatory framework may arguably be viewed as being superior to Solvency II.

An approach where Canada remains an island with its own set of rules – even if the rules are seen as better – may provide better protection to Canadian policyholders in the short term, but may ultimately lead to a less competitive and more inefficient insurance market in which consumers have less choice and pay more for their insurance. In the long term, Canada may have no choice other than to adopt Solvency II to remain a competitive player in the international insurance community.

The research and preparation of this article was greatly assisted by Jared Puterman, a summer law student at Cassels Brock & Blackwell LLP.