On August 6, 2010, the Office of the Superintendent of Financial Institutions (Canada) (OSFI), the Canadian federal prudential insurance regulator, released for comment a draft of Guideline B-3 Sound Reinsurance Practices and Procedures (the Guideline). The Guideline, which is open for comment until October 1, 2010, follows the March 2010 release by OSFI of its long-awaited response paper on its regulatory and supervisory approach to reinsurance. The Guideline applies to all federally-regulated insurers and reinsurers (each, a FRI) in respect of reinsurance cessions, retrocessions and, where applicable, assumption reinsurance transactions. Once adopted, the Guideline will significantly enhance OSFI's oversight of reinsurance arrangements and impose significant new internal requirements on FRIs
On August 6, 2010, the Office of the Superintendent of Financial Institutions (Canada) (OSFI), the Canadian federal prudential insurance regulator, released for comment a draft of Guideline B-3 Sound Reinsurance Practices and Procedures (the Guideline). The Guideline, which is open for comment until October 1, 2010, follows the March 2010 release by OSFI of its long-awaited response paper on its regulatory and supervisory approach to reinsurance. The Guideline applies to all federally-regulated insurers and reinsurers (each, a FRI) in respect of reinsurance cessions, retrocessions and, where applicable, assumption reinsurance transactions. Once adopted, the Guideline will significantly enhance OSFI's oversight of reinsurance arrangements and impose significant new internal requirements on FRIs.
This Insurance Law Update provides an overview of, and commentary on, the Guideline. OSFI has also simultaneously released draft guidance on reinsurance security agreements with unlicensed reinsurers. That draft guidance will be the subject of a separate Stikeman Elliott Insurance Law Update.
In general terms, the Guideline is intended to create a reinsurance governance regime that:
- reflects OSFI's elevated expectations with respect to sound reinsurance practices and procedures through principles-based guidance; and
- provides benchmarks to ensure a minimum level of consistency across FRIs and heightens the level of supervisory scrutiny of FRIs' reinsurance arrangements.
OSFI's governance framework for reinsurance is currently comprised of:&
- OSFI's Guideline on Corporate Governance, which applies to all FRIs and which emphasizes the need for an effective board and the development of sound risk management practices, generally;
- the previous Guideline B-3, which was revoked effective January 1, 2010, and which applied only to unregistered life reinsurance cessions and focused on the cedant's assessment of the creditworthiness of the reinsurer; and
- the Reinsurance (Canadian Companies) Regulations and Reinsurance (Foreign Companies) Regulations under the Insurance Companies Act (Canada) (the Act), applicable to FRIs and which impose specific limits on their ability to cede risks/premiums. The specific quantitative limits under those Regulations are proposed to be revoked upon the implementation of the Guideline.
OSFI noted that although the Canadian federal supervisory regime for reinsurance was perceived to be robust, certain aspects have been increasingly out-of-step with international regulatory best practices and that many of the core elements of OSFI's regulatory framework for reinsurance have existed since the 1990s without substantive reform or update. Further, much of the current regulatory regime was not applied to the life insurance sector. Meanwhile, the nature of insurance and reinsurance operations for both life and property and casualty insurers have been rapidly evolving and have become much more technically advanced, increasingly segmented and globally diversified.
Specifically, OSFI noted the current framework was ripe for significant supplementing and modernization as it did not:
- address critical elements of reinsurance arrangements (negotiation, approval, timing, contractual, etc.), which often follow industry practice rather than necessarily being consistent with prudent regulation;
- integrate an insurer's reinsurance program into its broader, enterprise-wide risk management practices and procedures;
- offer any express guidance to FRIs with respect to developing reinsurance risk management programs which reflect legal and counterparty risks involved with cessions to unregistered reinsurers (for example, there is currently no regulatory requirement for a cedant to conduct due diligence on the creditworthiness of a reinsurer);
- provide any guidance with respect to contract language and clauses increasingly common to reinsurance agreements but which can also lead to coverage ambiguity and adversely affect policyholders in the event of insurer insolvency; and
- require reinsurance agreements to contain a variety of important elements such as "insolvency" clauses.
In addition, OSFI currently provides cedants regulatory capital credit without having formally established a broad set of standards to ensure companies are appropriately managing their reinsurance risks. OSFI noted that this is contrary to regulatory practice in a number of other jurisdictions, where the existence of an acceptable insolvency clause in a reinsurance agreement, among other critical elements, is required before capital credit can be taken.
Draft Guideline - Key Principles
The Guideline is centred on four principles intended to assist FRIs in developing prudent approaches to managing their insurance risks. Although the focus on principles-based approach is to be commended, certain of the principles are actually quite prescriptive. The four key principles are:
1. A FRI should have a sound and comprehensive reinsurance risk management plan (RRMP) subject to the oversight of the FRI's board and implementation by the FRI's senior management.
OSFI expects that the RRMP will be an integral component of the FRI's overall enterprise-wide risk management plan. The RRMP should reflect the scale, nature and complexity of the FRI's business, and have regard for its risk appetite and risk tolerance. OSFI expects the RRMP to document the significant elements of the FRI's approach to managing risks through reinsurance, including the purpose and objectives for seeking reinsurance, risk diversification objectives, risk concentration limits, ceding limits and its practices and procedures for controlling reinsurance risks.
In a footnote to the Guideline, OSFI states that a FRI generally should not, in the normal course of business, cede 100% or substantially all of its risks in its main areas where it conducts business as, absent extenuating circumstances, this could weaken the underwriting standards and discipline at the ceding FRI. A FRI may, however, occasionally cede a portion, or even 100%, of a specific line of business or a particular type of risk that is ancillary to its core business where, for example, it is underwriting the business for purely marketing relationship purposes. One hundred percent cessions of existing lines of business may, depending on the circumstances, also be acceptable, perhaps including the circumstance where the insurer is exiting the applicable line of business.
The RRMP should detail, for example:
- the FRI's policy on the use of registered versus unregistered reinsurance;
- the roles and responsibilities for those officers charged with implementing the RRMP;
- the methodologies and processes for selecting, documenting, approving, implementing, monitoring and reporting on reinsurance arrangements; and
- the process for ensuring that the RRMP is updated to reflect changing market conditions.
Additionally, the 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 RRMP should be overseen by the board and, at a minimum, the board should review and approve the RRMP as part of its annual review of the enterprise-wide risk management plan. The board may delegate responsibility for the RRMP to a committee of a board. Senior management has the responsibility for ensuring that the RRMP is operationalized through the dedication of adequate resources and implemented by the risk management and business line officers and managers charged with day-to-day responsibility for the RRMP. The board should also ensure that senior management possess the appropriate experience and expertise to develop the RRMP, and to establish internal controls and procedures to monitor the effectiveness of, and operational compliance with, the RRMP on an ongoing basis.
2. A FRI should perform a sufficient level of due diligence on its reinsurance counterparties on an ongoing basis to ensure that the FRI is aware of its counterparty risk and able to assess and manage that risk.
A FRI should evaluate the ability of all current and prospective reinsurance counterparties to meet their liabilities under exceptional, but plausible, adverse events, on an ongoing basis. Similarly, a FRI which is a reinsurer should conduct its own due diligence on the risk management and risk assessment criteria of the companies ceding to it. The level of due diligence should be commensurate with the level of exposure to the particular counterparty and should not be any less thorough if the counterparty is a related party. The evaluation would not generally rely solely on third parties and, rather, where appropriate the FRI should conduct its own due diligence on the financial strength and capabilities of all current and prospective reinsurance counterparties. This assessment should be updated throughout the period during which claims could be made under the primary policy and which would be subject to the reinsurance.
OSFI expects a higher level of diligence to be conducted in respect of current and prospective reinsurance with unregistered reinsurers. OSFI expects this to include a review of the regulatory and supervisory regime and the legal and insolvency frameworks of the unregistered reinsurer's home jurisdiction (which should include the quality of the regulatory and supervisory regime, compliance with international standards and best practices, and the adequacy of the insolvency laws governing proceedings in the unregistered reinsurer's home jurisdiction). This requirement will likely impose significant new due diligence burdens on most FRIs proposing to cede to unlicensed reinsures and may, as a result, significantly discourage use of unlicensed reinsurers.
3. Terms and conditions of the reinsurance contract should provide clarity and certainty with respect to the reinsurance coverage.
A FRI should have processes and procedures in place to ensure that a comprehensive, written, binding contract is executed in respect of all reinsurance coverage prior to the effective date of the reinsurance coverage. The contract should be unambiguous and there should be complete and final agreement on all material terms and conditions, documented in writing by all parties prior to the effective date. For many ceding companies, this requirement may impose substantial new practical requirements as compared to prior practice.
That said, OSFI recognizes that there may be situations where a comprehensive contract is only executed by the parties after the effective date and that during the interim period of, say 30 days, a slip, cover note or other summary document will typically be evidence of the arrangement. In that circumstance, in order to mitigate the associated risks during that interim period, OSFI expects FRIs to (i) obtain contractually binding summary documents prior to the effective date of the reinsurance coverage, including, but not limited to, electronic copies or original hard copies, of signed documents that address the key provisions, and any material issues most likely to arise; and (ii) ensure that all comprehensive reinsurance contracts, including any amendments thereto, bear the duly authorized signature of both parties within a relatively short timeframe having regard for the complexity and materiality of the agreement (for example, within 120 days of execution). In the event that it is necessary and appropriate for a FRI to enter into a side letter or other arrangement that is ancillary to and forms part of the main reinsurance contract, the FRI should, in addition, be transparent with stakeholders about such arrangements and ensure that they do not adversely change the terms or conditions of the original contract to the determent of policyholders or creditors.
4. A ceding company, its policy holders and creditors should not be adversely affected by the terms and conditions of a reinsurance contract.
In the Guideline, OSFI notes that the terms and conditions of the binding insurance agreement should not raise legal questions as to the availability of funds to cover policyholder claims in the event of the cedant's insolvency. Particular attention should be paid to "insolvency" clauses, "off set" or "cut-through" clauses, "funds withheld" arrangements and other types of similar terms and conditions. (An insolvency clause states that the reinsurer remains liable for its predetermined share of a policyholder claim even though the ceding insurer is insolvent. Under funds withheld arrangements, assets that would be normally be paid to the reinsurer as consideration under the reinsurance agreement are instead withheld and retained by the ceding company as a form of security, enabling capital credit for unregistered reinsurance).
In the Guideline, OSFI indicates that ceding companies should ensure that reinsurance contracts contain an insolvency clause and should not contain other terms and conditions that limit, rather than enhance, a troubled or insolvent cedant's ability to enforce the agreement. (For example, off-set and cut-through clauses may allow certain creditors or policyholders to obtain preferential treatment over the statutory claims on the assets of the insolvent cedant pursuant to the Winding-up and Restructuring Act (Canada)). Consequently, ceding companies will need to fully and carefully consider the appropriateness, in each circumstance, of including such types of clauses.
If the reinsurance contract provides for a funds withheld arrangement, the FRI should ensure that the terms of the arrangements convey continuous control of the funds to the FRI and result in the funds forming part of the FRI's general estate.
Finally, and potentially contrary to common practice, OSFI expects that all contracts related to reinsurance coverage be subject to Canadian laws or the laws of another jurisdiction acceptable to OSFI (after receiving a submission from the FRI's counsel as to why the choice of foreign law would not disadvantage the FRI), that any dispute should be subject to the non-exclusive jurisdiction of Canadian courts and that any foreign counterparty has taken steps to ensure that legal process may be served against it in Canada.
Draft Guideline - Administrative Matters
In connection with the adoption of the Guideline, OSFI has indicated that a FRI will be required to maintain and provide to OSFI, upon request, its RRMP and a complete description of all its reinsurance arrangements, including levels of reinsurance, the due diligence performed on counterparties and the proportion of registered versus unregistered cessions. An entity is to promptly inform OSFI if it makes a material change to its RRMP or if it anticipates that a problem is likely to arise, or has arisen, under its reinsurance arrangements that may affect its, or its reinsurer's, current or future capacity to meet its obligations. The FRI should implement plans to address any such problems, and should advise OSFI accordingly.
With respect to capital, if a FRI fails to meet the principles set out in the Guideline, on a case-by-case basis OSFI may not grant regulatory capital/asset credit for the reinsurance arrangement, or may, commensurate with the risks, use OSFI's discretionary authority under the Act to adjust the FRI's capital/asset requirements or target solvency ratios in order to compensate for the applicable reinsurance arrangement. Further, federally-approved provincial/territorial reinsurers may lose OSFI recognition for certain purposes under the Act if they fail to meet the expectations set out in the Guideline.
The Guideline imposes a further reporting requirement in that a senior officer of the FRI will be required to make an annual reinsurance declaration to the board to confirm that the FRI's reinsurance risk management practices and procedures meet the standards set out in the Guideline, except as otherwise disclosed in the declaration. Further, the declaration is to include an attestation that the reinsurance arrangements convey a true transfer of risk, that the reinsurance arrangements are properly documented and binding on the reinsurer and that all reinsurance arrangements with related parties are on terms and conditions at least as favourable to the FRI as market terms and conditions. Where a deviation from the Guideline has taken place during the course of the year, the extent and the proposed plan to remedy the deviation should also be disclosed in full to the Board and to OSFI.