Part XIII: The Countdown

Changes to Part XIII of the Insurance Companies Act, which govern the operations of foreign insurance companies in Canada, will come into effect on Jan. 1, 2010. Despite rumours the implementation of Part XIII may be delayed again, the Office of the Superintendent of Financial Institutions (OSFI) has confirmed that it will come into effect on schedule.

THE REVISED ADVISORY

OSFI issued a revised version of the Advisory on the “Insuring in Canada of Risks” in May 2009. This version of the advisory supersedes previous versions and attempts to provide greater clarification with respect to when a foreign insurer will be deemed to be “insuring in Canada a risk.” Section 2 of the revised advisory provides nine basic indicia that can be used to determine whether a foreign insurer is “insuring in Canada a risk.” The latest version of the advisory has dealt with some of the criticisms of earlier versions, including how the indicia are to be applied and which of them are the most important. The advisory now provides a clearer and more understandable set of indicia that may be used to confirm that the “insuring in Canada of a risk” is occurring. The relevant indicia occur when a foreign insurer or reinsurer:

(a) promotes insurance products in Canada;

(b) directly solicits a person in Canada to obtain coverage;

(c) receives in Canada a request for coverage;

(d) negotiates from Canada the terms and conditions of coverage;

(e) decides in Canada to bind coverage;

(f) communicates from Canada an offer to insure;

(g) receives in Canada acceptance of the offer to insure from a policyholder;

(h) receives in Canada the premium;

(i) interacts in Canada with a policyholder regarding coverage (including handling claims).

OSFI has indicated that a foreign insurer is “insuring in Canada a risk” when its business model includes:

Scenario 1

Two or more of the activities outlined in subparagraphs 2(b) to (h) of the advisory.

Scenario 2

Any one of the activities referred to in subparagraphs 2(b) to (h), and both of the activities referred to in subparagraphs 2(a) and (i).

Scenario 3

Reaching agreement on most or all of the material terms and conditions of coverage during the course of negotiations in Canada.

According to the advisory, OSFI considers that a foreign insurer or reinsurer is not “insuring in Canada a risk” if its business model encompasses only one of the activities referred to in the above list (i. e. Paragraph 2 of the advisory).

In December 2008, OSFI issued implementation instructions with respect to the Part XIII changes. OSFI is requiring Canadian branches of foreign insurers and reinsurers to provide regular updates to OSFI during 2009 with respect to their plans to prepare for the Part XIII changes. The first report to OSFI was due on May 31, 2009. It will be interesting to see if OSFI issues any additional clarifications as a result of its review of the initial Part XIII reports that it receives.

GRANDFATHERING OF PRIOR BUSINESS

OSFI has already advised that all risks written by a Canadian branch prior to Dec. 31, 2009 will be grandfathered — it will be considered to be licensed business — unless a company makes an application to OSFI for a release of the applicable vested assets. As a result, it will not be necessary for a foreign insurer or reinsurer to analyze business that is in run-off in order to determine if it qualifies as licensed business under the new rules. It will only be necessary to analyze business that will be in force after Jan. 1, 2010.

The only companies likely to apply to OSFI for a release of vested assets on the basis that their policies were not insured in Canada are ones that are attempting to withdraw their Canadian branches. There are a number of requirements necessary for a Canadian branch to apply to OSFI for a release of vested assets for business not insured in Canada. As a result, most companies will not likely believe there is sufficient benefit to become involved in this relatively complicated process.

TRANSITION ISSUES

In a sense, Part XIII is already in effect, since policies that are issued during 2009 with a term of one year or longer will have part of their term in effect in 2010. As a result, it is necessary for foreign insurers and reinsurers to begin making decisions now as to how the unearned premiums with respect to these policies will be reported in 2010.

Most foreign insurers and reinsurers with Canadian branches have now realized that maintenance of the status quo is likely the preferable outcome after Jan. 1, 2010. As a result, it will be necessary for many foreign insurers and reinsurers to make changes to their busi- ness models in order to be able to comply with the requirements of Part XIII.

A foreign insurer unable to comply with the requirements of Part XIII will face the following challenges:

• policies will now be considered to be unlicensed, making them more difficult to be sold by insurance brokers in Canada;

• insureds will be required to pay Excise Tax (unless the Excise Tax can be waived); and

• the provisions under the provincial insurance legislations against carrying on the business of insurance without a licence will still be applicable and will make it difficult to undertake various activities including promotion, negotiation of coverage, delivery of policies, collection of premiums and handling of claims.

Foreign reinsurers will also be at a competitive disadvantage if they are not licensed since ceding companies will be subject to the requirements of the Reinsurance Regulations, which limit the amount of unlicensed reinsurance they can use to 25% of gross written premiums. OSFI is currently reviewing this limitation, but no changes have been announced to it yet.

CHANGING THE BUSINESS MODEL

Insurers and reinsurers operating in Canada without an office will be required to ensure that their chief agent is involved in a sufficient number of the indicia in the advisory. For example, the chief agent might be involved in the receiving of premiums, as well as in the delivery of the policies. Commercial insurers and reinsurers that issue a relatively small number of policies in Canada should ensure as much as possible that their underwriters visit with policyholders — or their brokers — in Canada to negotiate the terms and conditions of coverage. All trips by underwriters to Canada should be tracked; a record should be kept of with whom they met and what was discussed for both new business as well as renewals.

It will be necessary for insurers and reinsurers that have an office in Canada, but that do some or all of the underwriting for particular business outside of Canada, to take similar steps to ensure a sufficient number of the indicia are met.

PROVINCIAL ISSUES

Another important issue with respect to the implementation of Part XIII is how the provinces are reacting to it. Quebec, British Columbia and Alberta have indicated they are not happy with the changes and may retain some aspects of the current reporting system for their own purposes. The current reporting system OSFI uses is based on the location of risk and is the one the provinces also use to assess provincial premium tax. The provinces want to make sure there is no deterioration of their tax revenue as a result of the Part XIII changes. It is clearly preferable for foreign insurers to be able to report the same business to OSFI as well as for provincial premium tax.

It appears the provinces have reached a compromise with OSFI: additional pages will be added to the annual return that will disclose the gross premiums written by provinces using the current test based on location of risk. The provinces will allow the new OSFI test to be used for the purposes of preparing financial statements as well as for the Branch Adequacy of Assets (BAAT) test. This compromise will allow for the provinces to still be able to collect the same amount of premium tax that they are currently receiving.

BROKER ISSUES

Insurance brokers, as well as reinsurance brokers, have started to realize there are significant issues that must be dealt with regarding Part XIII as well as potential liabilities. If an insurance broker accidentally places an unlicensed policy with an insured, it is possible that Excise Tax will be payable by the insured. The result is that the broker may have an errors and omissions claim with respect to the policy. The broker may also be liable to pay the Excise Tax in the event that the insured does not pay it. In some cases, it may be a number of years before it is discovered that a policy was in fact unlicensed and that Excise Tax was payable.

Many reinsurance brokers are now asking foreign reinsurers to sign certifications that their reinsurance agreements will comply with the requirements of Part XIII. It is difficult for any foreign reinsurer to provide an absolute certification that a reinsurance agreement

complies with Part XIII until OSFI provides additional guidance or rulings with respect to it. At this point, a better approach for a foreign reinsurer would be to indicate that to the best of its knowledge, its reinsurance agreements comply with Part XIII and also that it intends to report the business to OSFI as being licensed.

A clear indication on the signing page of a policy or reinsurance agreement that the risks covered are being insured in Canada should be used in the future. Although the intention of the parties is not listed among the indicia in the advisory, it is still an important fact to confirm.

Brokers should not simply rely upon the certification of the insurer and reinsurer and should, when necessary, do their own due diligence with respect to the applicable business model that is involved.

AUDIT ISSUES

It is unlikely that, once Part XIII comes into effect, OSFI will do audits on insurers and reinsurers to determine whether every individual policy or reinsurance agreement complies with Part XIII. It is more likely the auditors will be responsible for ensuring compliance with the requirements of Part XIII. Part of the audit process will include determining whether all policies have been properly reported to OSFI and included as part of the financial statements for a Canadian branch. The preliminary view of some auditors appears to be that they will not examine every policy or reinsurance agreement. As an alternative, they will focus on the internal controls and reporting systems that a foreign insurer or reinsurer uses to track the Canadian business that it is reporting. Auditors will also likely rely on management representation letters from senior management of foreign insurers and reinsurers to give them additional comfort.

SUMMARY

The latest version of the advisory is an improvement over earlier versions and clarifies what will be required in order for a foreign insurer or reinsurer to be considered to be “insuring in Canada a risk.”

The pending implementation of the Part XIII changes has definitely created a level of anticipation (and even anxiety) among many foreign insurers and reinsurers operating in Canada as well as the brokers with which they work. The latest version of the advisory confirms that almost all foreign insurers and reinsurers operating in Canada will be able to comply with Part XIII with either minimal or no changes to their current business models. As a result, they will be able to continue to write their Canadian business in substantially the same manner as it is currently being done.

———

It appears the provinces have reached a compromise with

OSFI…This compromise will allow for the provinces to still be able to collect the same amount of premium tax that they are currently receiving.

———

The latest version of the advisory confirms that almost all foreign insurers and reinsurers operating in Canada will be able to comply with Part XIII with either minimal or no changes to their current business models.