In December 2008 the Office of the Superintendent of Financial Institutions (“OSFI”) released its Discussion Paper on OSFI’s Regulatory and Supervisory Approach to Reinsurance (the “Discussion Paper”). The Discussion Paper provides an overview of the Canadian regulatory and supervisory regime applicable to reinsurance, summarizes a number of current OSFI initiatives relating to reinsurance and seeks input on the direction of reinsurance regulation and supervision. The Discussion Paper is significant not only because it reveals OSFI’s thinking on reinsurance but also because it invites industry to comment on its approach to reinsurance and so offers an opportunity for insurers and reinsurers to influence Canada’s reinsurance regulatory regime.
Context and Background
OSFI has released the Discussion Paper in the midst of what is referred to in the paper as “Recent developments in global markets”. The current global economic crisis has put a spotlight on the risk that financial institutions can fail and the significance of counterparty risk. This presumably informs OSFI’s thinking and is reflected in the fact that a central focus of the Discussion Paper is the availability of capital/collateral in Canada to satisfy policyholder claims in the event that an institution fails.
The Discussion Paper is also informed by international trends in reinsurance regulation and supervision. In October 2007, the International Association of Insurance Supervisors (the “IAIS”) released its Discussion Paper on the Mutual Recognition of Reinsurance Supervision addressing a framework for an international reinsurance supervisory system. The IAIS followed this up in October 2008 with the Guidance Paper on the Mutual Recognition of Reinsurance Supervision. In December 2008, the National Association of Insurance Commissioners (the “NAIC”), an organization of insurance regulators from the 50 states, the District of Columbia and the five U.S. territories, adopted the Reinsurance Regulatory Modernization Framework Proposal, which modernizes U.S. state-based regulation of reinsurance. Similar initiatives are currently underway in other jurisdictions including the European Union and Australia.
OSFI’s Guiding Principles
The Discussion Paper sets out the following five “guiding principles” underlying OSFI’s regulatory and supervisory approach to reinsurance:
- policyholders of federally regulated insurers must be adequately protected;
- regulation and supervision should be proportionate to risk;
- OSFI must have the ability to effectively assess those risks;
- a level playing field among financial sector players should be maintained where appropriate; and
- effective coordination with other insurance regulators is critical.
Three general observations can be made about how these principles inform the Discussion Paper. First, it is clear from the Discussion Paper that OSFI’s top priority is policyholder protection – it is no coincidence that this is the first of the five guiding principles. Second, OSFI is attempting to take a more risk-based approach to reinsurance regulation and supervision and appears open-minded about eliminating or changing existing rules based on fixed percentages. Third, OSFI recognizes that the global nature of the reinsurance market requires coordination among insurance regulators, but also recognizes that this is difficult to achieve.
(a) Collateral Requirements for Unregistered Reinsurance
If a federally regulated insurer cedes business to an unregistered reinsurer, it is only entitled to credit if the reinsurer vests collateral in trust to cover the ceded liabilities and the associated capital requirements. The U.S. has similar collateral requirements. These requirements have been criticized for failing to take account of the financial strength of the reinsurer: the same collateral requirements apply regardless of how well capitalized the unregistered reinsurer is. Some have argued that these types of collateral requirements put foreign reinsurers at a competitive disadvantage and amount to protectionism.
(b) 25% Limit on Risks Ceded to Unregistered Reinsurers
Property and casualty (“P&C”) insurers are only permitted to cede 25% of the risks insured by them (measured by premium) to unregistered reinsurers. This limit does not apply to life insurers. It has been argued that the 25% limit constrains appropriate management of risk by diversification and limits access to very strong reinsurers. As well, a premiums-based limit may not correspond to the amount of risk being transferred. The Discussion Paper notes that an alternative to the 25% limit would be to adopt a general requirement that companies adopt adequate reinsurance cession practices and procedures. This could be bolstered with guidance regarding wording and clauses to be included in reinsurance contracts. OSFI is soliciting industry views on the 25% limit and alternatives to addressing concentration and other risks.
(c) Letters of Credit as Collateral
OSFI prescribes the types of assets that are acceptable as collateral for an insurer to obtain credit where it has ceded risks to an unregistered reinsurer. Letters of credit are recognized as acceptable collateral but their use is limited to 15% of the risks ceded. Some argue that the 15% limit is unjustified given how secure letters of credit are. The Discussion Paper states that OSFI will review its policy on using letters of credit as collateral and invites comments from the industry on this subject.
(d) Mutual Recognition for Reinsurance Supervision
It has been argued that collateral requirements and other prudential restrictions on ceding risks to unregistered reinsurers increase the cost and decrease the availability of reinsurance and that these restrictions would be unnecessary if there were an effective global regime of “mutual recognition” for reinsurance. Mutual recognition essentially involves regulators in different jurisdictions accepting and relying on one another’s regulatory systems. Reinsurers would be regulated by regulators in their “home” jurisdiction and foreign reinsurers would be able to reinsure risks in “host” countries (and the ceding company could obtain credit for this reinsurance) without the reinsurer being regulated by regulators in the “host” country.
The Discussion Paper notes that there are significant challenges to implementing a mutual recognition system on a global or even on a bilateral basis, including wide variation in regulatory and capital requirements across various jurisdictions. As well, the Discussion Paper states that to eliminate or reduce collateral requirements through a mutual recognition system, risk-based capital requirements for federally regulated ceding companies would need to reflect the additional risk of conducting business with a company in a specific jurisdiction. The impact of a mutual recognition agreement on provincial regulatory regimes would also need to be considered.
An alternative to a mutual recognition system addressed in the Discussion Paper is risk-based collateral requirements. For example, under the Reinsurance Regulatory Modernization Framework Proposal recently adopted by the NAIC collateral requirements would vary based on the rating assigned to a reinsurer. The Discussion Paper identifies a number of factors that would need to be considered in connection with a risk-based approach to collateral requirements and requests comments on the current capital/collateral regime for unregistered reinsurance activities.
(e) Approvals for Unregistered Reinsurance with Related Parties
An insurance company that enters into reinsurance arrangements with a related party unregistered reinsurer requires the approval of the Superintendent of Financial Institutions. According to the Discussion Paper, these approvals accounted for more than half of all reinsurance-related approvals administered by OSFI yet the transactions for which this approval is sought are often insignificant to the overall risk profile of the insurer and are subject to other controls. OSFI is soliciting the industry’s views on what changes could be made to streamline approval requirements without putting policyholders at risk.
(a) Capital Requirements
OSFI’s view is that P&C and life insurance companies face similar counterparty and operational risks relating to reinsurance.
OSFI imposes a fixed capital/asset charge on P&C insurers ceding risks to registered reinsurers. A capital charge applicable to Canadian life insurers that cede risks to registered reinsurers will be implemented in the next round of major changes to the credit risk component in the Minimum Continuing Capital and Surplus Ratio (“MCCSR”) to address counterparty risk.
When insurers cede a significant portion of their insurance risks to a reinsurer, they are exposed to operational risk. Currently, life insurers have a 20% flat capital charge on business embedded in their 120% MCCSR to account for this risk. Since life insurers are not subject to any ceding limit, it is possible that the 20% flat charge could be inappropriately reduced to zero when an insurer cedes all of its business. To address this, OSFI will implement a minimum capital charge of 25% of MCCSR gross capital requirements for life insurers to account for operational risk. This is a temporary measure until a capital charge for operational risk is developed.
(b) 75% Fronting Limit
P&C insurers cannot cede more than 75% of their risks (measured by premiums). The rationale for this is that where an insurer does not have sufficient “skin in the game”, it is less likely to engage in appropriate underwriting. The Discussion Paper states that this limit may not be effective because certain lines of business may be fully fronted despite this limit. The Discussion Paper notes that there are other OSFI tools and mitigating factors that encourage prudent underwriting and sound risk controls standards. It has been suggested that the 75% limit be replaced with an explicit operational risk capital charge on P&C insurers. The Discussion Paper also suggests that general principles regarding reinsurance risk could be set out in a guideline that would apply to life and P&C insurers. OSFI is soliciting industry views on the 75% limit.
(c) Approvals for Registered Reinsurance Transactions
A new approvals regime for Canadian insurance companies came into force in 2007. Similar changes for foreign companies are expected to come into force on January 1, 2010. OSFI is soliciting stakeholder views on the reinsurance approval regime in light of issues raised in the Discussion Paper.
(a) Guideline on Corporate Governance
The Discussion Paper highlights the important of sound business practice and controls in managing reinsurance risk and refers to OSFI’s Guideline on Corporate Governance in this regard.
(b) Guideline on Sound Reinsurance Practices and Procedures (B-3)
The Discussion Paper states that Guideline B-3 is currently being updated and will apply to all reinsurance cessions by federally regulated insurers (Guideline B-3 currently only applies to unregistered life reinsurance). The Discussion Paper states that revised Guideline B-3 will underscore OSFI’s expectation that insurers establish and implement sound reinsurance cession practices and procedures encompassing the following elements:
- a reinsurance management strategy;
- criteria for assessing the suitability of a reinsurer;
- appropriate risk concentration limits;
- parameters for delegation of certain responsibilities;
- adequate internal systems for monitoring reinsurance transactions; and
- sound risk management and compliance mechanisms.
OSFI welcomes views from the industry regarding whether the above principles are adequate to control reinsurance risks.
(c) Guideline on Reinsurance Agreements (B-13)
OSFI is concerned about the uncertainty regarding coverage where there is a time lag between the initiation of a reinsurance arrangement, the execution of a summary document and the execution of the full agreement. Guideline B-13 (a draft of which was released in December 2006) will set out prudential considerations relating to time lags in reinsurance arrangements and will address wording used in reinsurance agreements.
(d) Insolvency and Other Contract Clauses
Guideline B-13 will also address appropriate wording and clauses for reinsurance agreements. The Discussion Paper highlights the importance of insolvency clauses, which are provisions that specify that a reinsurer must continue to make full payments to an insolvent insurer without reduction resulting from the ceding company’s insolvency. While most reinsurance agreements in Canada contain an insolvency clause, an insolvency clause is not required for the reinsurance receivable to be recognized as an asset for regulatory capital purposes. The Discussion Paper states that consideration will be given to amending existing guidelines regarding contract clause requirements with respect to insolvency, offset, cut through and other clauses. The Property and Casualty Insurance Compensation Corporation recommended in its November 2008 issue paper (Re)Assurance of Solvency: Reinsurance assets in insurance company liquidations that only reinsurance arrangements that include an appropriate insolvency clause should be recognized as allowable assets under MCT/BAAT for P&C insurers.
The Discussion Paper addresses, and solicits input from the industry on, a number of critical issues relating to Canada’s reinsurance regime. The current economic crisis and the attention being paid to reinsurance by regulators around the world makes this an ideal time to try to shape OSFI’s approach to this area. Accordingly, the time for insurers and reinsurers to make their views on how reinsurance should be regulated and supervised known to OSFI is now.
This article originally appeared in Canadian Underwriter in February 2009.