Grandfathering Issues Under Part XIII

One of the most complex and potentially confusing areas about the implementation of the changes to the Part XIII of the Insurance Companies Act (which governs the operations of foreign insurance companies in Canada) is whether any grandfathering for business written prior to Jan. 1, 2010 will occur.

The Office of the Superintendent of the Financial Institutions (OSFI) indicated in its Implementation Instructions for Part XIII in December 2008 that no grandfathering for past business would be provided. However, it is arguable that grandfathering does exist on a practical basis with respect to certain types of business — and it clearly does not exist for others.

In order to review the regulatory and practical effects of the implementation of Part XIII, it is necessary to separately review insurance and reinsurance. An important distinction exists between the treatment of insurance and reinsurance under Part XIII. OSFI only regulates the reinsurer and not the policyholder in an insurance transaction. However, OSFI normally regulates both the cedant as well as the reinsurer in a reinsurance transaction. Since OSFI regulates both parties to a reinsurance transaction, it can impose a different set of rules and expectations than it can for an insurance transaction.

INSURANCE Fact Situation

The Canadian branch of a foreign insurance company has written a book of direct commercial business for a number of years. It does not intend to apply to OSFI for a release of any vested assets with respect to business previously reported to OSFI and written prior to Jan. 1, 2010.

Regulatory Status

In its Aug. 15, 2007 letter, OSFI stated that in order to ease the transition, it would presume all risks reported on the books of a Canadian branch as at Jan. 1, 2010 to have been insured in Canada unless OSFI otherwise comes to the view that they were not.

Some policies written by a Canadian branch of a foreign insurance company and reported to OSFI will be considered to still be licensed business provided that they are written prior to Jan. 1, 2010, with no additional action being necessary by either the Canadian branch or by policyholders. However, if OSFI otherwise comes to the view that the policy was not insured in Canada, it may insist that the risk be removed from the books.

Philipe-Antoine Sarrazin, director of legislation and policy initiatives at OSFI, has commented on this issue as follows: “This mechanism was put in place on the basis that more assets vested are better than less,” he said. “OSFI did not specify the circumstances where it could arrive at a different view. The presumption can certainly be used in cases where there is no evidence of where the policy was insured. However, where it can easily be established that a policy was not insured in Canada, an insurer should not use the presumption since OSFI could readily challenge this finding.”

On a practical basis, grandfathering can exist with respect to insurance written by the Canadian branches of foreign insurance companies that has previously been reported to OSFI and treated as licensed business, to the extent that it cannot really be established where the policy was insured from. It can be very difficult for individual policyholders to make a determination as to whether the applicable insurer had “insured in Canada” their risks. They would also not be in a position to be able to negotiate with the insurer for alternative security such as a letter of credit or a different form of trust account. The situation becomes even more complicated in situations where personal lines business is involved and a large number of policies may have been issued.

Legal Status

If an insurance policy is determined by a court not to have been “insured in Canada,” then the policyholder will not have access to the vested assets of the Canadian branch. This will only be a practical issue in the event of the liquidation of a Canadian branch. In this situation, a court would be required to make a determination under the Winding up and Restructuring Act as to whether or not policyholders are eligible to participate in the distribution of the vested assets of a Canadian branch.

Required Action Prior to 2010

The Canadian branch of a foreign insurance company will still have an obligation to review its business written prior to Jan. 1, 2010 to:

• identify policies that clearly have not been insured in Canada and apply to OSFI to have them removed from its books;

• use the Aug. 15, 2007 presumption to leave on its books other risks previously reported under the location of risks regime, and for which it has little information as to where they were insured;

• determine if it has written other business that has been “insured in Canada” and not previously reported to OSFI due to the location of the risk being outside Canada. Under such circumstances, it would be necessary to vest additional assets to cover the liabilities with respect to such unreported business.

REINSURANCE Fact Situation

A Canadian licensed insurance company cedes reinsurance to the Canadian branch of a foreign reinsurer. It has not received any notice from the reinsurer that an application will be made to OSFI for a release of vested assets with respect to business previously reported to OSFI and written prior to Jan. 1, 2010.

Regulatory Status

Business ceded prior to Jan. 1, 2010 may continue to be considered to be licensed reinsurance provided the cedant has a reasonable belief, based on a due inquiry and a review of its records, that the reinsurance had in fact been “insured in Canada.” The Canadian branch of the foreign reinsurer will be required to make a similar determination of the status of its business written prior to Jan. 1, 2010.

Information that could be used to form the cedant’s reasonable belief might include a review of underwriting files to determine where the offer or acceptance of the coverage occurred, as well as where the premiums for the reinsurance were paid. If a cedant in good faith forms a reasonable belief that reinsurance was “insured in Canada,” then it is likely OSFI will not dispute this determination unless the reinsurer treats this same policy differently. In cases of disagreements between cedant and reinsurer, OSFI could attempt to dictate proper treatment of the policy. It will also be necessary for the auditors of the cedant to agree with this determination.

Responding to this issue, Sarrazin said: “It is for this reason that OSFI issued a Note to Cedants recommending that, where their risks were reinsured outside Canada or where uncertainty remains on the location of the reinsurance, a cedant should not take a credit unless it holds funds as specified in the capital/asset adequacy guidelines.”

Legal Status

If it is determined by a court that the reinsurance was not “insured in Canada,” then no access to the vested assets of the Canadian assets of the reinsurer will be available. This will only be a practical issue in the event of the liquidation of the Canadian branch of a foreign reinsurer.

Required Action Prior to 2010

A foreign reinsurer will be required to review the business reported to OSFI by its Canadian branch prior to Jan. 1, 2010 in order to determine if its was “insured in Canada.” If part or all of the business was not “insured in Canada,” then the foreign reinsurer can make an application to OSFI for a release of the applicable vested assets.

A foreign reinsurer will also be required to review its business written prior to Jan. 1, 2010 to determine whether any part of it was insured in Canada but not previously reported to OSFI due to the location of the risks being outside of Canada. In that event, it would also be necessary to report these risks and vest additional assets to cover these liabilities.

PRACTICAL ISSUES REGARDING REINSURANCE

Here are some practical issues related to reinsurance under Part XIII:

• It appears cedants and reinsurers would be required to go back a number of years and review every reinsurance agreement that may still be applicable to their business in run-off that was written prior to Jan. 1, 2010.

• It would be necessary for a cedant to do this review with respect to each reinsurer with which it has previously dealt. This could potentially cover a large number of reinsurance agreements.

• There could be a significant amount of work required to review each individual reinsurance agreement in order to make a determination as to whether it was “insured in Canada.”

• The documentation necessary to confirm whether a reinsurance agreement was “insured in Canada” may no longer exist or may not be easily available (this would be particularly true for older reinsurance agreements or for lines of business that are in run-off).

Cedants and reinsurers might feel a bit overwhelmed by the potential amount of work required to be done prior to the implementation of Part XIII. However, it will likely not be adequate for a cedant to rely merely on the fact that it has not received a notice from a reinsurer that intends to apply to OSFI for a release of vested assets.

A SUGGESTED PROCEDURE

The following is a practical procedure that can be followed by cedants, insurance brokers and reinsurers to assist in ensuring compliance with Part XIII:

1. The cedant (or its reinsurance broker) would contact the reinsurer and request confirmation regarding the status of reinsurance ceded prior to Jan. 1, 2010.

2. The reinsurer would provide a letter to the cedant that would confirm the following:

(a) the reinsurer does not intend to request a release of its vested assets from OSFI with respect to the applicable business;

(b)the reinsurer believes to the best of its knowledge that it has insured in Canada the risks based on due inquiry (and states which of the indicia it considers to have occurred in Canada) and that a review of its records does not indicate otherwise.

If a cedant receives a letter from a reinsurer that confirms both of these points, it should then be able to rely on the letter and continue to take credit for the reinsurance. It should not be necessary for the cedant to take additional steps to determine whether the business model of the reinsurer in fact complied with the requirements of Part XIII unless it has actual knowledge of facts that would suggest its business was not “insured in Canada.”

In the event that a reinsurer refuses to provide a confirmation letter, it would then be necessary for the cedant to make its own determination as to whether there was reasonable basis for believing that the reinsurance has been “insured in Canada.” Under such circumstances, it would be necessary for the cedant to review its own records in order to determine whether the reinsurance agreement had been “insured in Canada.” If a cedant reached a conclusion that a reinsurance agreement was not “insured in Canada,” then it would no longer be able to take credit for the reinsurance. It would then be necessary for the cedant to make a demand for additional security from the reinsurer.

SUMMARY

The effect of the Part XIII changes on business written prior to Jan. 1, 2010 will vary depending upon whether insurance or reinsurance is involved. The Part XIII issues are complex; legal advice should be obtained if there is uncertainty regarding the status of any particular business.

It is also important to recognize there may be a slight distinction between regulatory status and legal status after Part XIII is implemented. The fact that OSFI will allow a particular policy or reinsurance agreement to continue to be treated as being licensed does not guarantee that it will be considered to be “insured in Canada” by a court. The reality is that Part XIII will not change the legal nature of a contract. A policy or reinsurance agreement was either “insured in Canada” or it was not. Part XIII changes and OSFI’s Advisory on the Insuring in Canada of Risks attempt to provide guidance with respect to whether a contract was “insured in Canada.” However, ultimately it will be up to the courts to make a final determination of the status of a contract if it is necessary.

The grandfathering aspects of Part XIII have resulted in a complex and challenging set of issues. However, as a result, there should be a higher level of certainty about whether the protection provided by vested assets that are maintained in Canada will be available in the event the obligations under a particular policy or reinsurance agreement are unable to be met.

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It is arguable that grandfathering does exist on a practical basis with respect to certain types of business — and not others.