Mutual Recognition

Canada is swept up right now in an international current flowing (albeit with glacial speed) towards the mutual recognition of reinsurance supervision. Mutual recognition describes a situation in which a supervisor or regulator in one jurisdiction agrees to abide by the standards of a regulator in a jurisdiction where the parent company of a global reinsurer resides — and vice versa. Reinsurers pleased with the direction of this current say a long-term move towards supervisors “mutually recognizing” each other’s licensing requirements would increase the free flow of a reinsurer’s capital from one jurisdiction to another. They argue mutual recognition is in keeping with a global reinsurer’s interest in being able to transfer capital across jurisdictions, making money available at a moment’s notice to pay claims on a balanced, global and diverse portfolio of risks. It would also reduce reinsurance premiums, they argue, since liquidity costs associated with posting collateral would be reduced, as would the costs of regulatory compliance. Several reinsurers in Canada, however, question whether this international drift is good for Canada. They argue that Canada’s solvency regulator, the Office of the Superintendent of Financial Institutions (OSFI), has a reputation as having one of the more stringent regimes in the world for capital and reinsurance collateral requirements. This is one reason why Canadian financial institutions have emerged from the global economic recession without wholesale financial distress, they say. And so why at this point would OSFI relinquish its supervisory authority to a supervisor in a different jurisdiction that has a different — and potentially lower — standard of protection for Canadian policyholders?

Call it the ‘Free Trade’ debate, reinsurance style.

In October 2007, a little less than a year before the U. S. housing market collapsed (triggering a lingering global economic recession), the International Association of Insurance Supervisors (IAIS) issued its Discussion Paper on the Mutual Recognition of Reinsurance Supervision. The paper was developed in consultation with 16 IAIS members, including Canada. The mission of the paper “is to facilitate [the international supply of] reinsurance by fostering the development of a framework for an efficient and effective international system. The framework should be sufficient to allow supervisors to mutually recognize the quality of the supervision exercised by one another in their respective jurisdictions and thus possibly remove or alleviate unnecessary regulatory and supervisory requirements for reinsurers in the host jurisdiction, to the extent that the home jurisdiction already applies and enforces equivalent regulation.”

The International Current

One year later, the IAIS followed up with a guidance paper on the issue, which was approved in Budapest on Oct. 17, 2008. This guidance paper notes that the objective of mutual recognition can be achieved in any one of a number of ways. For example, “unilateral recognition refers to a situation where a supervisor recognizes the supervision exercised by another, without requiring that the latter recognize the supervision exercised by the former.” In a bilateral approach, two supervisors would recognize each other’s supervision. And in a multilateral approach, three or more supervisors would recognize the supervision exercised by the others.

“Supervisory recognition may take place with or without the use of a formal agreement,” the IAIS guidance paper says. “It is important to note here, however, that all approaches to supervisory recognition rest on the assessment of the acceptability of the counterpart regime.”

One month after IAIS released its guidance paper, OSFI released a discussion paper designed to take into account the international debate about mutual recognition and other matters and “assess our own regulatory and supervisory approach to reinsurance.” OSFI’s Regulatory and Supervisory Approach is a broad work and outlines a number of hot-button issues within Canada’s reinsurance community. For example, in addition to mutual recognition, OSFI’s paper deals with topics such as:

• the country’s 25% limit on risks ceded to unregistered reinsurers;

• collateral requirements for unregistered reinsurance;

• capital requirements for registered reinsurers (i. e. reinsurers licensed with OSFI);

• the 75% fronting limit, which does not allow a Canadian property and casualty insurer to cede more than 75% of its gross premiums to a reinsurer;

• insolvency and other contract clauses; and

• corporate governance.

On the topic of mutual recognition, OSFI’s paper says: “mutual recognition is generally understood to mean that reinsurers registered in certain countries, and subject to a mutual recognition agreement, may write business in all other countries in the agreement without collateral or restrictions.” This is further subject to an agreement that the solvency requirements and regulations are mutually acceptable to each supervisor, reliance on the home jurisdiction for the regulation and supervision of the foreign (or in Canada, the “unregistered”) reinsurer, as well as information-sharing between supervisors regarding the relevant reinsurers.

OSFI’s paper does note “some significant challenges” to implementing a global scheme of mutual recognition. Among them, “in contrast to banking supervision/regulation, there is a wide variation in the regulatory and capital requirements for reinsurance across several jurisdictions, including Canada, the U. S., E. U., Switzerland, Japan and Bermuda, among others…” Canada’s solvency regulator goes on to note that: “OSFI’s regulation of reinsurers is generally more extensive than that of most countries. OSFI would need to be satisfied that the regulatory and capital requirements for reinsurers operating in other countries provide sufficient protection for Canadian policyholders before eliminating the collateral requirement for unregistered reinsurers.”

OSFI gave reinsurers a Mar. 6, 2009 deadline to comment on the paper; as of press time, OSFI is reviewing the comments. “In undertaking such a broad and comprehensive policy review, with so many inter-linked issues, it would have been unfair and imprudent to set impractical time and process constraints (on OSFI and on the industry) at the beginning of this exercise,” OSFI communications director Rod Giles said in an e-mail exchange. “However, having assessed the industry response to the reinsurance paper, we hope to be in a position to make some notable changes to the reinsurance regulatory and supervisory framework this fiscal year.”

Free-flowing Capital

Supporters of mutual recognition discuss the benefits for a reinsurer of being able to move capital around the globe with fewer restrictions.

“The whole concept, the foundation of mutual recognition is that OSFI, along with all of the international regulators around the world, all of those jurisdictions, would in fact mutually recognize that reinsurer as domiciled in the local country and therefore give credit without the significant collateral requirement,” says Sharon Ludlow, the chief financial officer for Swiss Re Canada. “Under the current regime, OSFI, in the protection of policyholders, requires the collateral so that those assets are basically here in Canada. So if that foreign reinsurer were to go insolvent, the assets are actually sitting here and be just for Canadian claims. They wouldn’t become part of foreign insurer’s or reinsurer’s solvency pool, if you were….

“What mutual recognition really means is that capital is fungible. It moves a lot more easily. You wouldn’t be stuck with an arbitrary collateral requirement in one country if everyone were to be regulated at the same level. OSFI would say, ‘Oh yes, I recognize Switzerland or Germany as having the same type of solvency requirements we have in Canada, so we will permit and give credit for reinsurance. We ‘re therefore not worried that the Swiss regulator is going to allow that reinsurer to fail. They have the same stringent requirements.”

Francis Blumberg, chief agent in Canada for PartnerRe, says that the ability to shift capital quickly from one part of the globe to the other also underpins an important element of the reinsurance model, namely to diversify risk over lines of business, markets and geographies. “The basic model of reinsurance involves moving capital around,” he says. “We can write earthquake risk in B. C. and combine that with writing windstorm risk in Japan efficiently because [those risks are] not correlated. A reinsurer needs to be able to move capital around to continue to optimize the diversification benefit and balance of risk across their portfolio. And that is fundamentally not possible here because capital inside [Canada] is effectively locked.”

Locking capital in Canada, the result of imposing collateral requirements, costs reinsurers in at least two significant ways. First, there is a liquidity cost associated with posting collateral. “Some of the collateral is in the form of letters of credit, and so you are basically tying up your liquidity lines for the purposes of regulatory credit in a specific jurisdiction,” Ludlow says. “In a risk diversification business, particularly at Swiss Re, we write significant business in jurisdictions that are complementary. We’re not worried if we have a hurricane in one location, because the chance of that happening and another catastrophe happening in another jurisdiction are completely diversified based on the number of jurisdictions in which we write around the world. If we didn’t have the ability to write in so many places in the world and have that risk diversification, the cost of us providing that reinsurance would be higher, including the cost of the liquidity lines.”

Depending on the reinsurer, these liquidity costs could amount to between “tens and hundreds of million of dollars,” one source says.

There are also costs associated with a reinsurer’s compliance to the various regional requirements of supervisors around the globe, Blumberg says. “Regulation is necessary, but we think that if a country has good regulation, there’s no need to duplicate it,” he said. “Having different rules in different countries is inefficient from a number of perspectives, reporting costs being a significant factor.”

Both the liquidity and regulatory costs are passed along to policyholders in the form of higher premiums, advocates of mutual recognition point out. By reducing such costs, reinsurers will be able to pass their savings along to policyholders in the form of cheaper premiums.

Most supporters of mutual recognition realize that even if it were to happen, it won’t happen for some time. “Solvency II implementation in the E. U. is 2012, so it’s not going to happen before that,” Ludlow says. “Both of the life and P&C industry associations in Canada are working with OSFI on our economic internal capital modeling….All of those things have to be fundamentally in place, and the timeline on that is maybe 2014. I don’t think mutual recognition is going to come any sooner.”

Supervisory Sovereignty

Several reinsurers in Canada are skeptical it will even happen at all. “If it ain’t broke, why fix it?” André Fredette, vice president and general manager of the Caisse Centrale de Reassurance (CCR), said of Canada’s current regulatory system.

Many wonder why OSFI would even consider reducing or waiving its collateral requirements through a mutual recognition agreement with another jurisdiction — especially after the global economic downturn exposed flaws in regulatory schemes throughout the world. “It’s kind of naïve,” Fredette said. “If the reinsurer goes belly-up, a Canadian insurance company is in a much better position to get paid on its claims if the [reinsurer’s] assets are in Canada, and they cannot take those assets out of Canada without OSFI’s permission. Which means OSFI will not let them take it out unless all of the liabilities have been met or extinguished. But if you have a [reinsurance] company over in Europe and they go belly-up, well guess what? Get in line with all of the other hundreds of clients that are probably trying to collect money from them. Do you really think a European regulator is going to play favourites with a Canadian insurance company [i. e. a policyholder of the bankrupt European reinsurer]? Are they really going to look after your interests as well as OSFI over here? That’s just the real world.”

Henry Klecan Jr., president and CEO of SCOR Canada Reinsurance Company, said he sees Canada getting caught in the current of a movement in the United States and Europe towards mutual recognition. “In the Canadian marketplace, considering how small it is, we have a very good regulatory system the way it is right now. My question is: Why has OSFI decided to jump on a bandwagon because the U. S. is making so much noise with the European and Bermudian market? I don’t understand why they feel they must be involved in some kind of new process.

“In the U. S. in particular, the process is found wanting because you’ve got 50 jurisdictions with 50 little bodies doing their own thing, whatever that may be. And so the desire in the United States is to get a consolidated methodology, so that we have one source to go to rather than a multiple of sources and there’s a consistency in how regulations are applied…

“A number of companies in the U. S. are in favour of mutual recognition, and that’s because the big players, the European players, are saying: ‘Let’s stop trying to continually oversee something that’s already overseen.’ The point of coming into Canada, though, you’ve got to wonder….”

Especially when, as several reinsurers pointed out, there aren’t really any Canadian reinsurers that would benefit from mutual recognition going the other way. OdysseyRe is as close as many can come to naming a so-called “Canadian reinsurer,” since OdysseyRe’s parent company is Canadian-owned Fairfax. But OdysseyRe’s reinsurance operations are based in New York.

Fredette said he is well aware of why European reinsurers covet unlimited access to how much business they can write in Canada. “All reinsurance companies, including mine, if they could bring all of the assets to their head offices, they would rather do that,” he said. “All companies, if they can put all of their resources, all of their assets into head office, where they can control them and disperse them, that’s their preference…I mean sure they would like that: it’s in their interests. But I mean, we have our interests. Let’s not be naïve about this. I think we have to look after the Canadian interests first.”

But just as easily as capital can move into Canada under mutual recognition, it can also move out, Klecan says. Mutual recognition “makes it that much easier for reinsurers to say: ‘Okay, we’re not supporting Canada in the next year or the next five years because it’s too competitive, it’s too small of a market, everybody’s just focused on price and nothing else. There’s no value-added, therefore we are going to move out our capital and put it to better use in Egypt, let’s say, or in developing countries, for instance.’ This kind of thing facilitates that kind of decision.”

When this debate was put to OSFI, the Canadian solvency regulator confirmed it is working within the IAIS context, which is working towards some form of mutual recognition. Nevertheless, OSFI says it always retains its own authority to regulate and supervise within the Canadian context.

“OSFI has the authority to act independently on any matter respecting the safety and soundness of financial institutions and the stability of the financial system,” Giles said in an email. “Note there is a ‘prudential’ carve-out for financial services in the WTO and NAFTA trade agreements.

“Having said that, it is not OSFI’s intention to act independently of the IAIS, of which OSFI is a key member, or to be out of step wi th broader international regulatory practice. Although achieving a system of full mutual recognition for reinsurance regulation and supervision (i. e. relying entirely on the home-jurisdiction regulator/supervisor) is a chal- lenge in the short-term (as noted in the discussion paper), OSFI is giving consideration to moving toward a system of risk-based collateral requirements similar to what is being proposed in the United States and what is currently in effect in Australia. OSFI will, however, continue to work closely with its IAIS counterparts in the possible pursuit of a full system of mutual recognition in the long-term.”

Risk-based Mutual Recognition

In keeping with OSFI’s reflections about “risk-based” collateral models, Ludlow points out that mutual recognition would not necessarily signal the death knell for collateral requirements. “The point we made directly to OSFI is that if you move to mutual recognition magically in four or five years’ time, that wouldn’t prohibit two independent companies from agreeing that they might want to have collateral for whatever reason,” Ludlow says. “We don’t think we should give up on a risk-based approach. We feel very strongly that companies should have the right risk management framework, and that they should be assessing the credit-worthiness of their reinsurers based on financial strength ratings, etc. etc. Using Bermuda as an illustration, let’s say Bermuda has the equivalency and I should give credit. But I’m not happy because they don’t fit all of the criteria in my risk management box. So then those two parties should be free to say: ‘Yes, I’d like collateral from you, ABC Re.’ The regs shouldn’t stand in the way of good business practice.”

But then doesn’t such use of collateral defeat the purpose of mutual recognition in the first place? critics argue. “Are you going to turn around and [establish] trust accounts that are going to require OSFI’s approval?” Klecan said. “Okay, so what has changed?”

Short-term Flexibility

In the absence of mutual recognition anytime soon, some global reinsurers would like to see more flexibility in some of OSFI’s existing rules around reinsurance arrangements. OSFI proposes a number of possibilities in its paper. One is to expand an existing limit on reinsuring through an unlicensed reinsurer up from 25% to 30%.

It should be noted that representatives of reinsurers opposed to mutual recognition similarly balk at changing existing limits on the use of unregistered reinsurance. The existing limits are fine, many say. And besides, “to whom are you doing favours?” Klecan asks. “Are you doing favours to the unlicensed market? It’s a market that [OSFI] doesn’t oversee and they’re doing them a favour? That just doesn’t make sense… The [licensed] industry has more than adequate capacity to service the insurers in this country. Okay, you might not like the price, but by the same token, what are you going to do? Are you going to buy your reinsurance from a company called Banana Republic Re and expect them to meet up with their obligations somewhere down the road — long-tail business, in many cases? This movement from 25-30% is for a very narrow, self-interested group, but it doesn’t benefit the industry as a whole.”

The Insolvency Viewpoint

Certainly, much within OSFI’s paper is premised on what is the best protection afforded to Canadian policyholders if capital is pulled out of the country — or if a foreign reinsurer goes bankrupt and cannot meet its obligations. But interestingly enough, and to show how muddy the reinsurance waters can get, insurance company insolvencies caused by reinsurer insolvencies aren’t at all common in Canada. “We’ve looked at [insolvencies] over the last 50 years, and it is incredibly unusual — that is, we can’t find a case in Canada — where a reinsurer went bankrupt and that caused an insurer to go bankrupt,” said Paul Kovacs, president and CEO of the Property and Casualty Insurance Compensation Corporation. (PACICC). PACICC, which did not take a position on mutual reinsurance in its submission to OSFI, pays claims to Canadian policyholders in the event that an insurance company goes bankrupt.

“However, what is really, really, really common is that in a very large number of the 35 P&C failures that we’ve studied in Canada over the past 50 years, it was quite common that reinsurance didn’t quite go right.”

That is to say, there is a debate over whether the primary insurer has access to its reinsurance funds if it were to go bankrupt. “There’s not much other money around when [a primary insurance company has] gone bankrupt, so [reinsurance] is the largest source of money, it is very contentious and it is inevitably a challenge to sort out,” says Kovacs. “So coming from where we come from, what we put in our response to OSFI’s discussion paper, is: Is there anything in OSFI’s rules and regulations that would make it easier to sort things out in those rare occasions when a company fails and they need to recover the reinsurance? It turns out there is something called an insolvency clause, and the insolvency clause says: ‘I’m going to give you reinsurance.'”

OSFI has included a section in its paper on insolvency and other contract clauses. It defines an insurance clause as a section in a reinsurance contract that clarifies: “a reinsurer must continue to make full payments to an insolvent insurer without reduction resulting from the ceding company’s insolvency.” OSFI’s paper goes on to say that it proposes to “issue guidance, or to amend existing guidelines, on its expectations regarding good business practice associated with reinsurance contracts, including its expectations regarding insolvency and other clauses contained in such contracts.”

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What mutual recognition really means is that capital is fungible. It moves a lot more easily. You wouldn’t be stuck with an arbitrary collateral requirement in one country if everyone were to be regulated at the same level.

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Regulation is necessary, but we think that if a country has good regulation, there’s no need to duplicate it. Having different rules in different countries is inefficient from a number of perspectives, reporting costs being a significant factor.

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If you have a [reinsurance] company over in Europe and they go belly-up, well guess what? Get in line with all of the other hundreds of clients that are probably trying to collect money from them. Do you really think a European regulator is going to play favourites with a Canadian insurance company? Are they really going to look after your interests as well as OSFI over here?