Reinsurance Governance

In its recently released Response Paper: Reforming OSFI’s Regulatory and Supervisory Regime for Reinsurance, Canada’s Office of the Superintendent of Financial Institutions (OSFI) outlines proposed changes to its approach to reinsurance regulation and supervision. These proposed changes represent a significant increase in the standard of governance and risk management OSFI expects from cedants. The proposed changes will require insurers to take a hard look at — and in many cases, make significant changes to — their reinsurance practices.

The response paper is the culmination of a policy review by OSFI that included the release of the Discussion Paper on OSFI’s Regulatory and Supervisory Approach to Reinsurance in December 2008 and responses to it. OSFI’s policy review has taken place in the context of similar reviews in other countries, including the United States and Australia, and initiatives by the International Association of Insurance Supervisors to develop international standards.

OVERVIEW OF THE RESPONSE PAPER

The major themes of the response paper are

1. the move from a rules-based approach to a principles-based approach;

2. the need for enhanced governance in relation to reinsurance practices; and

3. ensuring regulatory “neutrality” between registered and unregistered reinsurance.

THE 25% LIMIT ON UNREGISTERED REINSURANCE

Under existing regulations, a federally regulated property and casualty insurer cannot cause itself to be reinsured by unregistered reinsurers against more than 25% of its risks. Many see this as favouring registered reinsurance over unregistered reinsurance. The response paper notes this limit does not provide an incentive for ceding companies to scrutinize relevant risks (including credit risk) and that this limit does not necessarily prevent companies from gaining exposure to additional unregistered reinsurance (e. g., retrocession by the reinsurer to an unregistered reinsurer that is a captive of the direct insurer).

OSFI will recommend that the 25% limit be repealed once the following measures are in place:

•Guideline B-3 is expanded and reinstituted so that, among other things, insurers are required to consider the likelihood of recoverability of reinsurance claims from both registered and unregistered reinsurance; and

• insurers are required, upon request, to report to OSFI a description of all of their reinsurance arrangements, including the levels of reinsurance and the proportion of registered and unregistered reinsurance.

THE 75% FRONTING LIMIT

Under existing regulations, a property and casualty insurer cannot cede more than 75% of all of its risks in a given year. The response paper draws a distinction between “fronting” and ceding risks. The 75% limit does not distinguish between fronting arrangements, which are a concern to OSFI, and situations in which the insurer has valid reasons to cede risks. The response paper states the 75% limit does not provide an incentive for ceding companies to scrutinize the risk associated with underwriting business. In addition, the 75% limit can be bypassed using other risk transfer methods.

OSFI will recommend repealing the 75% limit once the following measures are in place:

• Guideline B-3 is expanded and reinstituted to, among other things, set out OSFI’s expectations with respect to insurance fronting/ceding arrangements and applying underwriting standards to federally regulated ceding companies;

• insurance companies are required to disclose all fronting/ceding arrangements to OSFI if requested; and

• a minimum operational risk capital requirement is imposed on the property and casualty sector in the Minimum Capital Test (MCT) that is parallel to the requirement imposed on the life sector through the Minimum Continuing Capital and Surplus Requirements (MCCSR).

REINSURANCE GOVERNANCE

OSFI’s governance framework for reinsurance currently includes the Guideline on Corporate Governance, Guideline B-3 (Unregistered Reinsurance) (which OSFI regards as inadequate and revoked effective Jan. 1, 2010), and Draft Guideline B-13 (Reinsurance Agreements).

OSFI is clearly of the view that reinsurance governance at some companies does not measure up to OSFI’s expectations. The response paper says ample evidence exists that boards of directors are not always involved in establishing a company’s reinsurance program; in some cases, boards do not review material reinsurance agreements.

Enhanced guidance in this area is required, according to OSFI. Thus, OSFI will enact additional guidance by expanding and reinstituting Guideline B-3 (which, as noted above, will be renamed Guideline on Sound Reinsurance Practices and Procedures).

Some have asked whether additional guidance in this area is necessary, since OSFI has already articulated general governance and risk management expectations. OSFI’s view is that existing guidance does not address issues unique to reinsurance.

OSFI has indicated the new guideline will be principles-based; an overly detailed document is not expected. According to the response paper, the new Guideline B-3 will provide the following:

The Guideline on Corporate Governance applies to all insurance companies with respect to effective risk management practices and procedures (including underwriting).

The response paper notes in the context of internal controls that “pure fronting” is not acceptable. Concerns have been raised that this is overly prescriptive and it is not clear what OSFI considers pure fronting to be.

Ceding companies should have a sound and comprehensive reinsurance risk management strategy and processes.

The board should review and approve the company’s overall reinsurance strategy, processes and material reinsurance contracts. These are significant expectations to place on the board; they might go beyond the practices of many companies.

Ceding companies should perform an adequate level of due diligence on their reinsurance partners.

As part of this, a ceding company should thoroughly evaluate the financial ability of reinsurers to meet claims obligations. Given the fate of highly-rated securities during the recent subprime mortgage crisis, it is not surprising that OSFI states ceding companies should not rely solely on rating agency assessments.

The response paper says cedants should consider the reinsurer’s retrocession arrangements, as well as how those arrangements might indirectly affect the ceding company’s agreement with the reinsurer. It has been observed that singling out retrocession arrangements is rather prescriptive. Also, it is debatable whether or not this is workable: it will be difficult for ceding companies to obtain the information necessary to asses a reinsurer’s retrocession arrangements; in any case, these arrangements are subject to ongoing change.

The response paper also states ceding companies need to carefully examine counterparty risk when dealing with unregistered reinsurers.

The response paper sends the message that OSFI is not satisfied with the degree to which companies have clear and legally binding agreements. To address this, companies will need to change the long-standing practice of taking a significant time to reduce reinsurance agreements to writing.

Policyholders (i. e., ceding companies) should not be adversely affected by the terms of a reinsurance agreement.

A reinsurance agreement should contain an insolvency clause that meets OSFI’s expectations. Such a clause would specify that a reinsurer must continue to make full payments to an insolvent insurer without reduction resulting from the ceding company’s insolvency.

I n addition, although OSFI may provide guidance in the future on whether a reinsurance agreement should contain “offset,” “cut-through” or other provisions that could effectively give certain creditors preferential treatment over policyholders, it remains the ceding company’s responsibility to ensure that such clauses are understood and prudent. The point has been made that while cut-through clauses are in essence a way for certain creditors to “jump the queue,” offset clauses play a legitimate function by protecting reinsurers in the event of the insolvency of a ceding company.

The response paper also says arrangements under reinsurance contracts should not raise legal questions regarding the availability of funds — for example, “funds withheld” arrangements — in the event of reinsurer insolvency. Reinsurance agreements should be subject to Canadian laws and disputes should be heard in a Canadian court.

The response paper states the availability of a capital credit to a ceding company will be contingent on the ceding company meeting the expectations set out in the new Guideline B-3. That is to say, the terms of the reinsurance agreement must be clear and legally binding and the agreement must not in any way adversely affect the policyholder (e. g., the agreement must contain an insolvency clause). There is reason to think OSFI may take a broad approach to this new regulatory tool. In recent remarks to the Canadian Reinsurance Conference, OSFI superintendent Julie Dickson said: “To the extent that insurers do not meet OSFI’s minimum expectations on sound reinsurance practices and procedures, capital credit for reinsurance arrangements may not be granted.”

Companies entering into reinsurance arrangements may be asked to provide an attestation to OSFI that the arrangements meet the criteria in Guideline B-3.

COLLATERAL REQUIREMENTS AND MUTUAL RECOGNITION

The issue of collateral requirements for unregistered reinsurance has been the subject of significant debate in recent years. Currently, if a federally regulated insurer cedes business to an unregistered reinsurer, the ceding company is only entitled to credit if the reinsurer vests collateral in trust to cover the ceded liabilities and the associated capital. The current collateral requirements do not take into account the risks associated with the collateral arrangement, nor the different risks presented by unregistered reinsurers of varying strength.

In this context, a number of proposals have been considered. Among them are:

• moving to a more sophisticated risk-based collateral regime; and

• replacing the current approach with a mutual recognition regime. This would place reliance on the regulation and supervision of a reinsurer’s home jurisdiction and not require collateral in Canada.

According to the response paper, responses to the discussion paper indicate broad support for a move towards a system of risk-based collateral requirements.

OSFI believes it would be imprudent to weaken the collateral regime for unregistered reinsurance given recent financial market developments, and that it is premature to consider the adoption of a mutual recognition regime.

The response paper indicates OSFI will, nevertheless, work on identifying the issues and parameters associated with establishing a more sophisticated, graduated, risk-based capital/collateral framework for unregistered reinsurance. As well, OSFI will assess the quality of collateral being posted in addition to its policy on the use of letters of credit as collateral (this was previously limited to 15% of risks; recently this was increased to 30%).

Finally, the response paper says OSFI will continue to review its capital rules to ensure that adequate capital is maintained by ceding insurers in respect of the risk posed by collateral arrangements.

NEXT STEPS

OSFI’s stated objective is to revise and reinstitute Guideline B-3 and to adopt new disclosure requirements by the end of 2010. According to Philipe Sarrazin of OSFI, “it is anticipated that a draft of Guideline B-3 will be circulated for comment before the summer.”

The response paper indicates that until the changes are implemented, existing guidance remains in effect. However, during the transition period, OSFI expects companies to take the changes into account in their planning and business activities and to prepare for such changes.

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OSFI has already articulated general governance and risk expectations, but OSFI’s view is that existing guidance does not address issues unique to reinsurance.