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Canada’s solvency regulator, the Office of the Superintendent of Financial Institutions (OSFI), in December 2008 released its Discussion Paper on OSFI’s Regulatory and Supervisory Approach to Reinsurance. The discussion paper provides an overview of the Canadian regulatory and supervisory regime applicable to reinsurance, summarizes a number of current OSFI initiatives related to reinsurance and seeks input on the direction of reinsurance regulation and supervision. The paper is significant not only because it reveals OSFI’s thinking on reinsurance but also because it invites industry to comment on its approach to reinsurance, thus offering an opportunity for insurers and reinsurers to influence Canada’s reinsurance regulatory regime.

CONTEXT AND BACKGROUND

OSFI released the discussion paper in the midst of what is referred to in the paper as “recent developments in global markets.” The current global economic crisis has put a spotlight on the risk that financial institutions can fail and the significance of counterparty risk. This presumably informs OSFI’s thinking and is reflected in the fact that a central focus of the discussion paper is the availability of capital/collateral in Canada to satisfy policyholder claims in the event that an institution fails.

The discussion paper is also informed by international trends in reinsurance regulation and supervision. The International Association of Insurance Supervisors (IAIS) in October 2007 released its Discussion Paper on the Mutual Recognition of Reinsurance Supervision, which addresses a framework for an international reinsurance supervisory system. The IAIS followed this up in October 2008 with the Guidance Paper on the Mutual Recognition of Reinsurance Supervision. The National Association of Insurance Commissioners (NAIC), an organization of insurance regulators from the 50 states, the District of Columbia and the five U. S. territories, adopted the Reinsurance Regulatory Modernization Framework Proposal in December 2008. The proposal seeks to modernize U. S. state-based regulation of reinsurance. Similar initiatives are currently underway in other jurisdictions including the European Union and Australia.

OSFI’S GUIDING PRINCIPLES

The discussion paper sets out the following five “guiding principles” underlying OSFI’s regulatory and supervisory approach to reinsurance:

• policyholders of federally regulated insurers must be adequately protected;

• regulation and supervision should be proportionate to risk;

• OSFI must have the ability to assess those risks effectively;

• a level playing field among financial sector players should be maintained where appropriate; and

• effective coordination with other insurance regulators is critical.

Three general observations can be made about how these principles inform the discussion paper. First, it is clear from the discussion paper that OSFI’s top priority is policyholder protection; it is not a coincidence that this is the first of the five guiding principles. Second, OSFI is attempting to take a more risk-based approach to reinsurance regulation and supervision, and appears open-minded about eliminating or changing existing rules based on fixed percentages. Third, OSFI recognizes that the global nature of the reinsurance market requires coordination among insurance regulators, but also recognizes that this is difficult to achieve.

OSFI is soliciting views from the industry on a number of reinsurance issues, which the discussion paper has organized into three broad sections. The sections (and issues) are listed under the headings of unregistered reinsurance, registered reinsurance and governance.

UNREGISTERED REINSURANCE

Collateral requirements for unregistered reinsurance

If a federally regulated insurer cedes business to an unregistered reinsurer, it is only entitled to credit if the reinsurer vests collateral in trust to cover the ceded liabilities and the associated capital requirements. The United States has similar collateral requirements. These requirements have been criticized for failing to take account of the financial strength of the reinsurer: the same collateral requirements apply regardless of how well capitalized the unregistered reinsurer is. Some have argued that these types of collateral requirements put foreign reinsurers at a competitive disadvantage and amount to protectionism.

25% limit on risks ceded to unregistered reinsurers

Property and casualty insurers are only permitted to cede 25% of the risks insured by them (measured by premium) to unregistered reinsurers. This limit does not apply to life insurers. It has been argued that the 25% limit constrains appropriate management of risk by diversification and limits access to very strong reinsurers. As well, a premiums-based limit may not correspond to the amount of risk being transferred. The discussion paper notes that an alternative to the 25% limit would be to adopt a general requirement that companies adopt adequate reinsurance cession practices and procedures. This could be bolstered with guidance regarding wording and clauses to be included in reinsurance contracts.

Letters of credit as collateral

OSFI prescribes the types of assets that are acceptable as collateral for an insurer to obtain credit in situations in which it has ceded risks to an unregistered reinsurer. Letters of credit are recognized as acceptable collateral, but their use is limited to 15% of the risks ceded. Some argue the 15% limit is unjustified given how secure letters of credit are.

Mutual recognition for reinsurance supervision

It has been argued that collateral requirements and other prudential restrictions on ceding risks to unregistered reinsurers increase the cost and decrease the availability of reinsurance. Some say these restrictions would be unnecessary if there were an effective global regime of “mutual recognition” for reinsurance. Mutual recognition essentially involves regulators in different jurisdictions accepting and relying on one another’s regulatory systems. In this scenario, reinsurers would be regulated by regulators in their “home” jurisdiction; foreign reinsurers would be able to reinsure risks in “host” countries — and the ceding company could obtain credit for this reinsurance — without the reinsurer being regulated by regulators in the “host” country.

The discussion paper notes there are significant challenges to implementing a mutual recognition system on a global or even on a bilateral basis, including wide variation in regulatory and capital requirements across various jurisdictions. In addition, the discussion paper states that to eliminate or reduce collateral requirements through a mutual recognition system, risk-based capital requirements for federally regulated ceding companies would need to reflect the additional risk of conducting business with a company in a specific jurisdiction. The impact of a mutual recognition agreement on provincial regulatory regimes would also need to be considered.

An alternative to a mutual recognition system addressed in the discussion paper is risk-based collateral requirements. For example, under the Reinsurance Regulatory Modernization Framework Proposal recently adopted by the NAIC, collateral requirements would vary based on the rating assigned to a reinsurer.

Approvals for unregistered reinsurance with related parties

An insurance company entering into reinsurance arrangements with a related party unregistered reinsurer requires OSFI’s approval. According to the discussion paper, these approvals accounted for more than half of all reinsurance-related approvals administered by OSFI. And yet, the transactions for which approval is sought are often insignificant to the overall risk profile of the insurer and are subject to other controls. OSFI is soliciting the industry’s vie ws on what changes could be made to streamline approval requirements without putting policyholders at risk.

REGISTERED REINSURANCE

Capital Requirements

OSFI’s view is that property and casualty and life insurance companies face similar counterparty and operational risks related to reinsurance.

OSFI imposes a fixed capital/asset charge on property and casualty insurers ceding risks to registered reinsurers. A capital charge applicable to Canadian life insurers that cede risks to registered reinsurers will be implemented in the next round of major changes to the credit risk component of the Minimum Continuing Capital and Surplus Ratio (MCCSR) to address counterparty risk.

When insurers cede a significant portion of their insurance risks to a reinsurer, they are exposed to operational risk. Currently, life insurers have a 20% flat capital charge on business embedded in their 120% MCCSR to account for this risk. Since life insurers are not subject to any ceding limit, it is possible that the 20% flat charge could be inappropriately reduced to zero when an insurer cedes all of its business. To address this, OSFI will implement a minimum capital charge of 25% of MCCSR gross capital requirements for life insurers to account for operational risk. This is a temporary measure until a capital charge for operational risk is developed.

75% fronting limit

Property and casualty insurers cannot cede more than 75% of their risks (measured by premiums). The rationale for this is that when an insurer does not have sufficient “skin in the game,” it is less likely to engage in appropriate underwriting. The discussion paper states this limit may not be effective because certain lines of business may be fully fronted despite this limit. The discussion paper notes other OSFI tools and mitigating factors can encourage prudent underwriting and sound risk controls standards. It has been suggested that the 75% limit be replaced with an explicit operational risk capital charge on property and casualty insurers. The discussion paper also suggests that general principles regarding reinsurance risk could be set out in a guideline that would apply to life and property and casualty insurers.

Approvals for registered reinsurance transactions

A new approvals regime for Canadian insurance companies came into force in 2007. Similar changes for foreign companies are expected to come into force on Jan. 1, 2010.

GOVERNANCE

Guideline on corporate governance

The discussion paper highlights the importance of sound business practice and controls in managing reinsurance risk and refers to OSFI’s Guideline on Corporate Governance in this regard.

Guideline on sound reinsurance practices and procedures (B-3)

The discussion paper states that Guideline B-3 is currently being updated and will apply to all reinsurance cessions by federally regulated insurers (Guideline B-3 currently only applies to unregistered life reinsurance). The discussion paper states that revised Guideline B-3 will underscore OSFI’s expectation that insurers establish and implement sound reinsurance cession practices and procedures encompassing the following elements:

• a reinsurance management strategy;

• criteria for assessing the suitability of a reinsurer; • appropriate risk concentration limits;

• parameters for delegation of certain responsibilities;

• adequate internal systems for monitoring reinsurance transactions; and

• sound risk management and compliance mechanisms.

Guideline on reinsurance agreements (B-13)

OSFI is concerned about the uncertainty regarding coverage when there is a time lag between the initiation of a reinsurance arrangement, the execution of a summary document and the execution of the full agreement. Guideline B-13 (a draft of which was released in December 2006) will set out prudential considerations relating to time lags in reinsurance arrangements and will address wording used in reinsurance agreements.

Insolvency and other contract clauses

Guideline B-13 will also address appropriate wording and clauses for reinsurance agreements. The discussion paper highlights the importance of insolvency clauses, which are provisions that specify that a reinsurer must continue to make full payments to an insolvent insurer without reduction resulting from the ceding company’s insolvency. While most reinsurance agreements in Canada contain an insolvency clause, an insolvency clause is not required for the reinsurance receivable to be recognized as an asset for regulatory capital purposes. The discussion paper states consideration will be given to amending existing guidelines regarding contract clause requirements with respect to insolvency, offset, cut-through and other clauses. The Property and Casualty Insurance Compensation Corporation recommended in its November 2008 issue paper (Re)Assurance of Solvency: Reinsurance assets in insurance company liquidations that only reinsurance arrangements that include an appropriate insolvency clause should be recognized as allowable assets under MCT/BAAT for property and casualty insurers.

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The paper is significant not only because it reveals OSFI’s thinking on reinsurance but also because it invites the industry to comment on its approach to reinsurance.