Conversion process: issues and challenges
New OSFI Q&As
Other practical and legal issues
As reported in "New collateralisation rules for unlicensed reinsurance", the Office of the Superintendent of Financial Institutions (OSFI) – Canada's federal regulator of banks, insurers, loan and trust companies and similar institutions – issued new guidance for reinsurance security agreements in December 2010. The guidance requires Canadian insurance companies that reinsure with reinsurers not registered in Canada (ie, unregistered reinsurers) to convert their existing security arrangements governed by reinsurance trust agreements into reinsurance security agreements in order to continue to receive capital or asset credit in respect of the unregistered reinsurance.
Conversion process: issues and challenges
The guidance targeted January 1 2012 as the deadline for completing reinsurance trust agreement conversions for all insurers in Canada. Although many conversions have been started, relatively few have been finalised to date. One reason for the slow progress is that various practical issues that were not anticipated are coming to light as the conversion process unfolds. Another probable reason is that ceding insurers and their unregistered reinsurers have no single standard-form template for the reinsurance security agreement, which has necessitated negotiation of the terms of the agreement on a one-off basis. In contrast, the template formerly in use in use had been prepared on OSFI's behalf and was, by OSFI's edict, virtually immutable. Having a single form of reinsurance trust agreement whose terms could not be altered came with the obvious benefit of forestalling any negotiation of those terms. Although 'neutral' templates for reinsurance security arrangements are generally publicly available in Canada, no de facto standard has evolved – partly because each custodian appears to have its own views and preferences as to what provisions it favours. The difficulty arises when these views and preferences diverge from the available 'neutral' templates – and indeed in some cases from the guidance. Consequently, negotiating the reinsurance security agreement terms has been taking more time, effort and expense than either the ceding companies or their unregistered reinsurers had initially expected.
In the course of these negotiations, some insurers and their counsel have been appealing to OSFI to help deal with some of the practical realities involved in the conversion process, as well as to act as a sort of umpire to rule on whether including certain proposed reinsurance security agreements and other related agreement provisions would comply with the guidance. In response to these enquiries, on November 25 2011 OSFI issued a document entitled Questions and Answers – Guidance for Reinsurance Security Agreements ('Q&As'). This update summarises some of the highlights of the document, which should bring greater certainty (if not speed) to the conversion process.
Termination and transition period
In the Q&As, OSFI outlines its reasons for choosing to replace the reinsurance trust agreement with the reinsurance security agreement regime. It also describes the main features of the new regime and confirms that it has moved away from the approach of providing a standard-form reinsurance security agreement to replace the standard-form reinsurance trust agreement.
In addition, OSFI clarifies the approval requirements (an OSFI 298 form) and other documentary requirements needed to release the assets from the existing reinsurance trust agreements. The Q&As also note that "pursuant to [the reinsurance security agreement] Guidance, OSFI expects companies to take all commercially reasonable efforts to replace existing [reinsurance trust agreements]" with reinsurance security agreements by the original January 1 2012 deadline, and further state that all insurers which anticipate that they will be unable to meet the deadline must notify their OSFI relationship managers. Relationship managers will apparently have the authority to determine whether 'commercially reasonable' efforts have been made, and to determine whether and under what conditions capital or asset credit should be permitted for arrangements that have not been converted by the set deadline.
The Q&As also address alternatives to converting to an reinsurance security agreement, such as the use of letters of credit (albeit restricted) and funds-withheld arrangements. The latter vehicle is proving to be a somewhat cumbersome and difficult alternative, due to OSFI's requirements with respect to the enforceability of the arrangement (eg, on insolvency of the reinsurer).
As a result of questions raised by the ceding companies, unregistered reinsurers and their counsel, the Q&As attempt to clarify a number of other questions, such as:
- the amount of collateral that is required in order to meet the capital or margin requirements for unregistered reinsurance;
- the types of assets that are permitted as collateral and possible legal issues associated with posting cash collateral;
- the location where assets must be held (ie, in Canada) and the corresponding non-permitted use of foreign custodians;
- the types of documents that may be used to evidence the reinsurance security agreement arrangement;
- which party is responsible for monitoring the reinsurance security agreement arrangement's compliance with OSFI guidance; and
- the limited circumstances in which OSFI will permit the custodian to include in the reinsurance security agreement documentation either a right of set-off or a priority security interest in its favour.
A hallmark of the OSFI guidance is the requirement for a legal opinion – on which the ceding company and OSFI will be entitled to rely – which asserts that the ceding company has obtained and will maintain a valid and enforceable first priority security interest in the collateral pledged by the unregistered reinsurer.
The Q&As reiterate that the opinion must:
- be provided by legal counsel with the appropriate expertise in personal property security legislation in the Canadian province where the assets are held; and
- contain guidance where a 'local' opinion is provided by in-house counsel.
The Q&As also address the circumstances in which an additional legal opinion will be required for the reinsurance security agreement arrangement – namely, where a new type of asset not already covered by the legal opinion is approved by the ceding company. They also confirm that the ceding company need not file the legal opinion with OSFI, but should instead keep it on file to be produced on request.
Further, the Q&As modify OSFI's statement in the guidance to the effect that copies of the reinsurance agreements in question must be appended to the legal opinion. As the reinsurance security agreement process has unfolded, it has become apparent that some arrangements with unregistered reinsurers are annual reinsurance programmes that have spanned a number of years, sometimes dating well back into the last century. As a consequence, locating and appending all reinsurance agreements to the legal opinion has proven to be impractical, if not impossible. Although not directly addressing this difficult issue, OSFI has left it to insurers and their legal counsel to determine what – if any – documentation must be appended to the legal opinion.
Reinsurance agreement provisions
Finally, the Q&As clarify that OSFI does not provide or endorse any particular language or wording for reinsurance agreements. OSFI notes that industry associations, such as the Reinsurance Research Council and the Property and Casualty Insurance Compensation Corporation, issue various wordings for reinsurance contracts. In addition, companies are encouraged to consult with their legal counsel to ensure that reinsurance agreement provisions are consistent with OSFI's specific guidance on reinsurance practices and procedures.
Other practical and legal issues
In addition to the questions addressed in the Q&As, a number of other issues may arise in the course of negotiating reinsurance security agreement documentation. The following discussion elaborates on some of the Q&A issues and highlights some others that insurers may encounter.
As noted above and in the Q&As, there is no standard-form reinsurance security agreement, and in the Q&As OSFI confirms that it is acceptable to combine a securities account control agreement and the reinsurance security agreement into a single document. Besides reducing the number of documents, this approach has the advantage of ensuring consistency in definitions, remedies, boilerplate and other provisions that must work together in the two documents. However, as a party to the combined agreement, the custodian may want to take part in negotiations that would otherwise involve only the reinsurer and the ceding company, thus potentially protracting the process and increasing costs. Some institutional custodians prefer to go even further and combine the reinsurance security agreement, the control agreement and the custodian's own form of custodial agreement between the custodian and the reinsurer into a single omnibus agreement. While this approach also has advantages, the custodian's principal concern may be to protect its own interests by including appropriate disclaimers of liability, rights of indemnity and security, and ensuring that – operationally – it can meet the needs of the other two parties. However, in order to prevent time delays and price escalation, counsel for the ceding company and the reinsurer must ensure that:
- the documentation meets the OSFI requirements for a satisfactory reinsurance security agreement and control agreement; and
- the custodian's input in the negotiations is restricted to provisions that directly impact its duties, liabilities and obligations.
First priority security interests
As noted above, one of the OSFI requirements is that the legal opinion to be delivered in connection with an reinsurance security agreement confirm that the security interest in the collateral "has priority over any other security interests". However, the custodian (whether in a separate custodial agreement or in a combined reinsurance security agreement) may ask for a first priority security interest in and right of set-off against the collateral to secure all obligations owed to it from time to time by the reinsurer. If such a security interest were permitted, the first priority opinion obviously could not be given and thus the reinsurance security agreement itself would be offside. In the Q&As, OSFI notes that
"it will not object to the parties including a right of set-off or allow a priority interest in favour of the custodian in either of two cases:(i) to secure the payment of the custodian's customary fees and commissions payable under the custodian or control agreement and (ii) with respect to an involuntary overdraft (eg, to settle a transaction that could otherwise fail).
However, [it] will not accept a broad right of set-off or priority created in favour of the custodian for other types of obligations, liabilities, indebtedness, or indemnification."
Often the form of reinsurance security agreement offered by the custodian will initially include an 'all obligations' security interest and right of set-off. The scope of these provisions must be cut down to the parameters acceptable to OSFI. In addition, since the custodian will typically be the securities intermediary, and as such will automatically have a first priority security interest in the assets credited to the collateral account maintained with it, the agreement must contain language expressly subordinating the custodian's security interest to that of the ceding company, except with respect to the two classes of obligations acceptable to OSFI. Further, the legal opinion as to the priority of the ceding company's security interest must expressly carve out the limited security interest in favour of the custodian.
Payment of interest on collateral to the reinsurer
Existing reinsurance trust agreements typically provide that interest, dividends and other income on assets held in trust by the trustee are to be remitted to the reinsurer. However, some reinsurance security agreement custodians have refused to implement such arrangements with respect to securities in the collateral account, advising that their internal controls cannot accommodate such a request and that instead any withdrawals from the account will not be permitted, except on the joint direction of the reinsurer and the ceding company or the ceding company alone after it has notified the custodian that it has assumed exclusive control of the account.
Location of collateral
As noted above, OSFI requires that all collateral reinsurance security agreements be "held in Canada". Since most of the collateral will typically consist of book-based or 'dematerialised' securities that may be evidenced only by entries in the computer ledgers of the issuer or a clearing agency, it may be difficult to determine exactly where the securities are held. However, the guidance implies and the Q&As confirm that securities held with CDS Clearing and Depository Services will be regarded as being held in Canada. One difficult issue that may require some negotiation with the custodian is obtaining confirmation that all the securities credited to the collateral account are indeed ultimately held with CDS. The custodian may resist warranting this is so, partly because custodians commonly use sub-custodians which in theory could use other clearing agencies. Nevertheless, since in the Q&As OSFI has expressly ruled out using foreign sub-custodians, and since CDS is now in effect the only Canadian clearing agency that handles debt securities of the type likely to be pledged as collateral, giving such a warranty should in principle not be difficult.
As the January 1 2012 deadline draws near, Canadian ceding companies that use unregistered reinsurers will no doubt be spending considerable time on pondering these and many other questions that must be answered before their reinsurance trust agreements become reinsurance security agreements in the new year.
For further information on this topic please contact Carol Lyons or Robert M Scavone at McMillan LLP by telephone (+1 416 865 7000), fax (+1 416 865 7048) or email ([email protected] or [email protected]).