Raising the Bar

Canada’s solvency regulator, the Office of the Superintendent of Financial Institutions (OSFI), released a draft of Guideline B-3-Sound Reinsurance Practices and Procedures on Aug. 6, 2010, representing the latest development in its broader policy review of its regulatory and supervisory approach to reinsurance. It follows the release of OSFI’s Response Paper: Reforming OSFI’s Regulatory and Supervisory Regime for Reinsurance in March 2010. As expected, the draft guideline sets a high standard regarding reinsurance practices.

The draft guideline applies to all federally regulated insurers, including Canadian companies and fraternal benefit societies and branches of foreign companies in respect of their insurance business in Canada (which are collectively referred to in the draft guideline as “FRIs”).

The draft guideline takes a principles-based approach. However, in some areas, the draft guideline does set out OSFI’s expectations in a relatively detailed manner. Consequently, members of the insurance industry who previously expressed concern that Guideline B-3 would be overly prescriptive will likely have concerns regarding the draft guideline.

Comments on the draft guideline are due by Oct. 1, 2010. OSFI intends to release a final version of Guideline B-3 in the fall of 2010. The guideline is intended to become effective Jan. 1, 2011 and will be coordinated with OSFI’s recommendation that the 25% limit on unregistered reinsurance and the 75% fronting limit be repealed.

KEY PRINCIPLES

As detailed below, Guideline B-3 outlines four key principles: 1) a sound risk management plan, 2) a sufficient level of due diligence, 3) clear terms and conditions in reinsurance contracts and 4) taking care to ensure policyholders are not adversely affected by the terms and conditions of a reinsurance contract.

1) FRIs should have sound and comprehensive reinsurance risk management plans, subject to the oversight of the FRI’s board of directors and implementation by senior management.

OSFI expects FRIs to have a reinsurance risk management plan (RRMP), which should address the significant elements of the FRI’s approach to reinsurance — including the objectives for seeking reinsurance, risk diversification objectives, risk concentration limits, ceding limits and practices and procedures for managing and controlling reinsurance risks.

The draft guideline says FRIs generally should not in the normal course of their business cede 100%, or substantially all, of its risks in the main areas in which they conduct their business. However, the draft guideline states a FRI may occasionally cede some or all of a specific line of business or a particular type of risk that is ancillary to its core business; cessions of 100% of existing lines of business may, depending on the circumstances, also be acceptable to OSFI. Given this approach, some uncertainty remains about when “fronting” will be treated as unacceptable.

The draft guideline states a FRI must assess the adequacy and effectiveness of the reinsurance arrangements under its RRMP to ensure that exposures to large and catastrophic losses are adequately mitigated by reinsurance and that there are no gaps in reinsurance coverage. This may require stress testing of extreme but plausible scenarios.

The draft guideline says the RRMP should be overseen by the board of directors and implemented by senior management. At a minimum, OSFI expects boards to review and approve the RRMP as part of its annual review of the enterprise-wide risk management plan. The board is also expected to establish internal controls and procedures relating to the RRMP and to ensure senior management has the appropriate experience and expertise to develop a RRMP. Senior management is responsible for ensuring the RRMP is operationalized.

It is noteworthy that the draft guideline expressly provides that OSFI’s Guideline on Corporate Governance extends to reinsurance with respect to ensuring effective oversight and risk management policies and procedures.

2) A FRI should perform a sufficient level of due diligence on its reinsurance counterparties on an ongoing basis to ensure the FRI is aware of its counterparty risk and is able to assess and manage such risk.

Credit risk is obviously a major concern for OSFI. OSFI expects FRIs to evaluate the ability of all current and prospective reinsurance counterparties to meet their liabilities under exceptional but plausible adverse events on an ongoing basis. The draft guideline provides the following examples of what FRIs should consider as part of their due diligence:

• the reinsurer’s claims payment record;

• the reinsurer’s expected future claims obligations;

• the reinsurer’s balance sheet strength;

• the reinsurer’s funding sources;

• the reinsurer’s management, including the quality of its governance practices and procedures; and,

• the reinsurer’s retrocession arrangements and the impact they may have on the FRI’s arrangements with the reinsurer.

Due diligence is expected to be commensurate with the degree of exposure. It should not be any less when the reinsurer is a related party. The draft guideline makes it clear cedants are expected to do their own due diligence. Generally, they should not rely solely on third parties, including rating agencies and brokers.

The draft guideline says OSFI expects a higher level of due diligence in respect of unregistered reinsurance. This includes a review of the unregistered reinsurer’s regulatory and supervisory regime, as well as its legal and insolvency frameworks. It also includes an assessment of how the reinsurer and its affiliates are likely to react during a period of extreme but plausible stress.

Conducting the sort of due diligence OSFI expects will likely be a source of significant new work for many cedants. Those concerned that OSFI is taking an overly prescriptive approach might be concerned about the approach taken in the draft guideline to articulating OSFI’s due diligence expectations.

OSFI expects federally regulated reinsurers to conduct due diligence on the risk management and risk assessment criteria of ceding companies. This is a significant new regulatory expectation and it will be very interesting to see how it is applied over time.

3) The terms and conditions of the reinsurance contract should provide clarity and certainty on reinsurance coverage.

The draft guideline says processes and procedures should be in place to ensure that comprehensive, written and binding contracts are executed before the effective date of coverage. If a comprehensive agreement cannot be executed until after the effective date of coverage, OSFI expects FRIs to:

• obtain contractually binding, signed summary documents prior to the effective date of reinsurance coverage that set out specified terms;

• address within the summary document any material issues most likely to arise, including all variable or unique agreement terms; and

• ensure all comprehensive reinsurance contracts, including any amendments thereto, are signed by authorized persons within a relatively short timeframe (120 days is given as an example).

4) A ceding company, its policyholders and its creditors should not be adversely affected by the terms and conditions of a reinsurance contract.

The draft guideline says the terms and conditions of a reinsurance agreement should not raise legal questions regarding the availability of funds to cover policyholder claims in the event of a cedant’s insolvency. Cedants should ensure all reinsurance contracts contain an insolvency clause (i. e., a clause spec- ifying that the reinsurer must continue to make full payments to an insolvent cedant without any reduction resulting from the cedant’s insolvency). Reinsur ance contracts should not contain provisions that may limit a troubled or insolvent cedant’s ability to enforce the contractual obligations of a reinsurer (e. g., off-set and cut-through clauses). In a funds withheld arrangement, the FRI should ensure that the funds are under the continuous control of the FRI and form part of the property of the FRI’s general estate.

OSFI expects all reinsurance contracts in which a FRI is a cedant to be subject to Canadian laws or to the laws of another acceptable jurisdiction. In the latter case, OSFI expects to receive a submission from the FRI’s counsel regarding why the applicability of non- Canadian laws will not disadvantage the FRI. Reinsurance contracts should also provide that any disputes will be subject to the non-exclusive jurisdiction of a Canadian court and that any foreign or non-Canadian counterparty has taken steps to ensure it may be served in Canada to commence a legal proceeding.

SUPERVISORY INFORMATION

The draft guideline says FRIs must provide a copy of their RRMP and a complete description of all reinsurance arrangements to OSFI upon request. OSFI expects a FRI to promptly inform the regulator if the FRI makes a material change to its RRMP, or if a problem has arisen or is likely to arise in connection with its reinsurance arrangements.

CAPITAL/ASSET REQUIREMENTS

The draft guideline states that if a FRI fails to meet the principles set out in the guideline, OSFI may not grant a capital/ asset credit for the reinsurance arrangement, or it might adjust the FRI’s capital/asset requirements or target solvency ratios. The draft guideline also states that federally approved provincial or territorial reinsurers may lose their status if they fail to meet the expectations set out in the guideline.

REINSURANCE DECLARATION

The draft guideline states that a senior officer of a FRI should make an annual reinsurance declaration to the board addressing specified matters relating to Guideline B-3 and attesting that:

• the reinsurance arrangements convey a true transfer of risk,

• the FRI’s reinsurance arrangements are properly documented and binding, and

• all reinsurance arrangements with related parties are on terms and conditions at least as favourable to the FRI as market terms and conditions.

When a deviation from Guideline B-3 has taken place over such year, the nature, extent and proposed plan to address such deviation should be disclosed to the board and to OSFI.

———

The draft guideline takes a principles-based approach. However, in some areas, the draft guideline does set out OSFI’s expectations in a relatively detailed manner. Members of the insurance industry who worried Guideline B-3 might be overly prescriptive will likely have concerns.