Reinsurance Reform

The Office of the Superintendent of Financial Institutions (OSFI) in March 2009 issued its Response Paper: Reforming OSFI’s Regulatory and Supervisory Regime for Reinsurance. The response paper reflects the results of a lengthy review by OSFI of how reinsurance is regulated in Canada and is based on a significant amount of consultation with both insurers and reinsurers. It follows on an OSFI discussion paper in December 2008, in which the solvency regulator requested the views of the insurance industry on a number of key issues regarding the regulation of reinsurance in Canada.

The changes announced in the response paper are important and will have a significant effect on both insurers and reinsurers writing Canadian business in the future. The changes will likely be in effect by the end of 2010. Until such implementation, the current OSFI rules will remain in effect.

OSFI’S REFORMS

Elimination of the 25% unregistered reinsurance limit

Under the current reinsurance regulations, a federally regulated property and casualty insurer — either a company or a Canadian branch — cannot be reinsured by unregistered reinsurers against more than 25 % of its risks insured in any given year (the so-called “25% limit”). As a result, the 25% limit provides a significant limitation on the use of unregistered reinsurance. In addition, an unregistered reinsurer trust account must be established as security in order for a Canadian cedant to be able to take credit for the unregistered reinsurance.

OSFI originally introduced the 25% limit in the early 1990s. The move was in response to concerns about the ability to collect unregistered reinsurance during certain insolvencies of property and casualty insurers that had occurred in the 1980s. The 25% limit reflects OSFI’s view that there may be significant counterparty risk as a result of the use of unregistered reinsurance.

Historically, the 25% limit has caused problems for some insurers that inadvertently exceeded the limit in certain years due to unexpected increases in cessions under related party reinsurance or under fronting or pooling arrangements.

OSFI recognized the somewhat arbitrary nature of the 25% limit when it recently announced that some flexibility in the limit would be allowed in 2010 as a result of the implementation of the Part XIII changes to the Insurance Companies Act. OSFI also recognized the 25% limit tended to focus insurers on the total amount of unregistered reinsurance that they were using rather than the quality or collectability of it.

Elimination of the 75% registered reinsurance limit

Under the reinsurance regulations, a property and casualty insurer cannot be reinsured by registered reinsurers against more than 75% of its risks insured in any given year (the “75% limit”).

The 75% limit has never been a significant issue for Canadian insurers. Most insurers want to retain a reasonable net retention with respect to the business they write. The 75% limit reflected OSFI’s view that an insurer must act as a real risk-taker for at least a portion of the business it writes.

More corporate governance

OSFI plans to issue a revised Guideline B-3 by the end of 2010. OSFI will then repeal the 25% limit and the 75% limit.

Guideline B-3 will apply to all Canadian insurers and will provide OSFI’s expectations for risk management practices and procedures regarding the use of reinsurance. OSFI will require that insurers integrate their reinsurance program into their broader enterprise-wide risk management practices and procedures. The board of directors of an insurer will be required to review and approve an overall reinsurance strategy, processes and procedures, as well as all material reinsurance contracts. OSFI will also require an insurer to conduct some level of due diligence when assessing the ability of its reinsurers (particularly unregistered reinsurers) to meet their claims obligations.

The new Guideline B-3 will also stipulate that reinsurance agreements must be in writing and provide clarity and certainty regarding the coverage provided. Reinsurance contracts must be legally binding, governed by Canadian laws and not adversely affect the cedent (for example, any insolvency clause must meet OSFI’s requirements).

Finally, new guidance will be provided regarding capital credit available to ceding insurers. A capital credit will not be provided by OSFI to a ceding insurer unless it meets the requirements set out in the new Guideline B-3.

Use of letters of credit

Currently, there is no capital requirement for unregistered reinsurer default risk in the Minimum Capital Test (MCT). Effective Jan. 1, 2011, however, a 0.5% capital charge will be implemented for letters of credit used as security for unregistered reinsurance. Until recently, the use of letters of credit as collateral was limited to 15% of the risks ceded to unregistered reinsurers. This limit was recently increased to 30% in the revisions to the MCT test announced by OSFI in March 2010.

IMPLICATIONS FOR INSURERS AND REINSURERS

The elimination of the 25% limit is likely to result in a significant increase in the use of unregistered reinsurance. OSFI has indicated it will be closely monitoring the effects of such changes on the overall risk profile of insurers as a result of the increase in counterparty risk. OSFI will use its discretion to address situations deemed prudentially unsound. It is important to note that the OSFI collateral requirements will still be in effect in order for a Canadian cedant to be able to take credit for the unregistered reinsurance.

It is also likely that fewer foreign reinsurers will now decide to become registered in Canada. It will be easier for an unregistered reinsurer simply to establish an unregistered reinsurer trust account in Canada for each of its cedants rather than establish a Canadian branch.

With the elimination of the 75% limit on registered reinsurance, insurers can now eliminate complicated and costly reinsurance arrangements between related companies. The elimination of the 75% limit will also greatly facilitate pooling arrangements that typically require participant insurers to cede 100% of their business into the pool and to then reinsure back a portion of the total risks of the pool.

It is possible that more foreign insurers will attempt to rely on fronting arrangements rather than becoming directly licensed in Canada as a result of the elimination of the 75% limit. How-ever, it is likely that fronting will continue to be expensive and will only be used on a temporary basis by most unlicensed insurers that wish to write Canadian business.

The linking of a capital credit with the quality and type of reinsurance obtained will likely result in insurers being required to undertake more due diligence so that they can be certain that their reinsurance arrangements comply with the requirements of the new Guideline B-3.

Various tax and transfer pricing issues may result from the new changes. For example, it may become very attractive for a Canadian insurer to cede most of its business to an unlicensed related party reinsurer in Bermuda that is not subject to income tax.

The 25% limit and the 75% limit are not currently applicable to Canadian registered reinsurers. As a result, the changes in the response paper will have no effect on their current retrocessional practices.

One of the advantages of the 25% limit and the 75% limit is that they provided certainty for insurers regarding what amount of reinsurance was permitted. In the future, OSFI may be more able to question whether a reinsurance arrangement is prudent and appropriate for a ceding insurer. The new Guideline B-3 will require an insurer to provide more disclosure and transparency to OSFI with respect to its reinsurance arrangements.

SUMMARY

OSFI acknowledged in its response paper that internatio nal approaches to regulatory reinsurance vary widely and that in some jurisdictions there is no regulation of reinsurance at all. Two key issues facing OSFI were the current collateral requirements for unregistered reinsurers and the 25% limit.

The response paper reflects a shift in OSFI’s approach to regulating reinsurance from a rules-based approach — the 25% limit and the 75% limit — to a more risk-based framework. OSFI will allow greater flexibility in how reinsurance is used, but it will also require better risk management and disclosure of reinsurance arrangements. OSFI will also provide more supervisory review of reinsurance arrangements.

Many Canadian insurers will be pleased with the changes, since they allow for more flexibility in ceding business to unregistered insurers. The greatest use of this additional flexibility is likely to come by ceding more business to related party reinsurers that are not registered in Canada. Reinsurers currently registered in Canada will be less enthusiastic about the changes since they may result in more competition from unregistered reinsurers.

The fact that there was no reduction of the collateral requirements for unlicensed reinsurance in the response paper is not surprising given the current global economic environment. The concept of mutual recognition of foreign insurance regulators makes sense for a global industry, but is likely to be deferred for a number of years before it is seriously considered. However, the decision to eliminate the 25% limit as well as the 75% limit was a surprise. Many members of the insurance industry had predicted the 25% limit would be relaxed (but not eliminated) and that the 75% limit would remain unchanged.

It appears OSFI has attempted to balance conflicting views in the Canadian insurance industry about how reinsurance should be regulated. For now, OSFI has clearly rejected the concepts of mutual recognition and the elimination of collateral requirements in Canada. However, greater use of both registered and unregistered reinsurance will be permitted, provided it is done in a prudent manner with a greater emphasis on the quality and collectability of the reinsurance involved.

———

The response paper reflects a shift in OSFI’s approach to regulating reinsurance from a rules-based approach — the 25% and the 75% limit — to a more risk-based framework.