Danger Ahead

The Canadian reinsurance sector stands at a crossroads: the direction it takes in the future could significantly affect the degree of competition and choice within the market. As matters stand, when the country’s amended Insurance Companies Act (ICA) comes into force on Jan. 1, 2010, a number of the market’s current reinsurance players will be required to change significantly the way they engage with the market.

In broad terms, the ICA provides for federal regulation of insurers and reinsurers, laying down various requirements relating to (among other things) licensing, reporting, record-keeping, the levels of reserves to be maintained in Canada and other measures. It also effectively defines the terms under which an entity can write registered reinsurance in Canada.

Here is where the current cause for concern lies. Under the revised legislation, the Office of the Superintendent of Financial Institutions (OSFI) is seeking to align the definition of registered reinsurance business with the definition of “insure in Canada a risk” so that, in effect, only reinsurance business written in Canada will be regarded as registered reinsurance. The question is what commercial impact this will have on the reinsurance market in Canada.

As ever with legislative change, the devil is in the details. In this instance, the question centres on the definition of what “insuring in Canada a risk” will actually mean in practice when it’s applied to those seeking to write registered reinsurance.

Although the ICA itself does not provide guidance on how to interpret this phrase, OSFI has issued guidelines, in the form of an advisory published in September last year, designed to bring some clarity to the question. The advisory makes it clear the determining factors will not be simply confined to the location of the insured, the broker, the insured property or risk, but will take into account a large number of other subsidiary activities related to insurance and reinsurance contracts — including where the business of insurance is being conducted, where it was solicited, where the policy was negotiated and where decisions were made regarding the issuance of the policy.

“INSURING IN CANADA A RISK”

However, in the final analysis, it seems clear that in situations in which underwriting, policy issuance and administration and premium collection is conducted outside Canada, reinsurance is likely to be deemed to be unregistered.

In addition, according to the advisory, it would be insufficient simply to have some form of local office as a means to steer clear of this issue. The guidelines clearly state OSFI would generally conclude that a foreign insurer or reinsurer is insuring a risk outside of Canada in situations in which it represents to its policyholders that: “Its office in Canada will merely act as a liaison between them and another office located outside Canada…will decide on all matters related to their policies.”These provisions mean many foreign reinsurers that have conducted business in Canada efficiently and effectively for many years — to the satisfaction of cedants and regulators alike — are now facing a real conundrum.

Just as important, the potential commercial implications of the amended ICA are a real issue for the reinsurers affected; they are a real issue for the Canadian insurance market as a whole.

If reinsurers wish to retain their registered status, they must now either re-invent their business processes in such a manner that they will be able to tick a sufficient number of boxes required in order to be deemed to be “insuring in Canada a risk,” or they must put an underwriting team on the ground in Canada, with all the costs and possible risks that that entails.

CREATING SYSTEMIC RISK?

In the example of an entity such as Lloyd’s, which is a market rather than one specific risk carrier, the option of how to create a local underwriting presence is far more complicated than straightforward.

Foreign insurers can go some way towards tackling the issue by moving to work through local cover-holders. But this is not a practical solution for reinsurance, which involves complex, carefully- tailored contracts that need the oversight of senior underwriters.

The hard reality is that the expertise and capital needed to underwrite reinsurance programs most effectively — and to which Canadian policyholders should have unfettered access — exists in global hubs such as London, England.

Although it is not essential for reinsurance to be registered, the status confers considerable advantages, both real and perceived.

The real advantages relate to the processes involved, both for cedants and reinsurers, in meeting security and capital requirements.

Equally important are the perceived advantages. Due to the fact that current regulations place a limit of 25% on the proportion of a cedant’s total reinsurance cessions that can be in the form of unregistered reinsurance, there is concern that some reinsurers — however strong their security and track record — will be seen as ‘second-class’ suppliers.

Depending on how reinsurers choose to tackle the issue, there is a danger, at least in theory, of the registered reinsurance market contracting significantly.

Given the scale of the players that already have a local presence, there is no indication that there will be an immediate shortage of reinsurance capacity. But as any student of economics knows, diminished consumer choice rarely bodes well from a competition — and therefore pricing — standpoint.

This may not seem like a significant threat at present. But it could become a real concern when the underwriting cycle hardens on the back of further capacity reductions, either on the international stage or locally.

At such times, the ability of international reinsurers to divert underwriting capital simply and easily to highly-priced markets is a critical part of the rebalancing process that returns pricing to more normal levels. However, to work efficiently, it is important that the process does not become too complicated when compared to the other opportunities to which that underwriting capital could be applied. In other words, barriers to entry need to be sufficiently high to ensure the right quality of capital is being offered, but need to be sufficiently low to avoid a shortage of such quality capital.

In this context, the ICA changes, it might be argued, create the kind of systemic risk that regulators around the world are currently trying to avoid as part of their objective to create sustainable industry models.

LIGHT ON THE HORIZON

The answer to how these issues can be tackled is far from simple. The desire of any regulator to verify that the businesses operating within its borders are sound, as well as to ensure that policyholders are adequately protected against cross-border trading risks, is both more than understandable and laudable. But in an increasingly global trading environment, such imperatives need to be balanced against the importance of encouraging the best security and capital to engage with a particular territory — rather than diverting those resources elsewhere — and facilitating effective access for policyholders to the most expert underwriters.

If an underwriting entity is well-controlled, well-managed, understands the business and is financially strong, that should be sufficient. In the case of reinsurance, this argument is further strengthened by the status of reinsurance as a business-to-business contract between two sophisticated parties, and by the fact that rating agencies and broker security committees are commonly used across the reinsurance world to help cedants chose strong partners.

There is still some way to go before the ICA comes into force. OSFI is currently working with reinsurers to review proposed working methods in order to determine whether they meet the new requirements. As a result, it is possible furthe r meat will be put on the bones of the ICA outline. It can only be hoped that this additional information will go some way to proving that there can be many angels, as well as devils, in the detail.

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The ICA changes, it might be argued, create the kind of systemic risk that regulators around the world are currently trying to avoid.