In 2008, the Office of the Superintendent of Financial Institutions (“OSFI”) launched a comprehensive policy review of its regulatory and supervisory approach to the regulation of reinsurance in Canada. As a result of this review, OSFI concluded that it was necessary to update its reinsurance governance framework. It was announced that this update would include the repeal of the Reinsurance Regulations, eliminating the 25% unlicensed reinsurance limit and the 75% licensed reinsurance limit. The 25% limit was significant since it prohibited a Canadian licensed insurer from ceding more than 25% of it’s gross written premiums to unlicensed reinsurers.
OSFI also announced that it would make changes to the form of security arrangement required for a Canadian cedant to be able to take credit for unlicensed reinsurance. Under the current form of security arrangement, an unlicensed reinsurer trust account under the control of OSFI must be established. The new form of security arrangement will involve a Reinsurance Security Agreement that OSFI will not be a party to.
On December 24, 2010, OSFI released: (1) Guideline B-3 Sound Reinsurance Practices and Procedures (“Guideline B-3”) and (2) Guidance for Reinsurance Security Agreements (“Guidance RSA”). Guideline B-3 and Guidance RSA apply to all federally regulated insurers (including life insurers and property and casualty insurers, domestic insurers and foreign insurers in respect of their insurance business in Canada), registered reinsurers and fraternal benefit societies (collectively, “FRIs”), that are party to reinsurance transactions.
PART I: Implementation
Guideline B-3
- OSFI encourages each FRI to implement the principles and expectations of Guideline B-3 as soon as practically possible. OSFI expects that each FRI will adopt, secure approval of the FRI’s board of directors (the “Board”), and implement a sound and comprehensive reinsurance risk management policy (“RRMP”) by July 1, 2011.
Part II: Guideline B-3
OSFI sets out in Guideline B-3 its key reinsurance principles, which are intended to provide guidance to insurers and reinsurers in developing an approach to managing reinsurance risks.
1. An FRI should have a sound and comprehensive reinsurance risk management policy subject to oversight by the FRI’s Board of Directors and implementation by senior management.
OSFI now requires FRIs to implement a reinsurance risk management policy (“RRMP”). The RRMP will provide a set of guidelines and rules with respect to how the FRI will use reinsurance. FRIs are required to implement an RRMP by July 1, 2011 and the RRMP must be approved by the FRI’s Board.
2. An FRI should perform a sufficient level of due diligence on its reinsurance counterparties on an on-going basis to ensure that the FRI is aware of its counterparty risk and is able to asses and manage such risk.
- OSFI clarified that the level of due diligence required of any reinsurance counterparty should be commensurate with its level of exposure to that counterparty. The level of due diligence should not be any less thorough if the counterparty is a related party of the FRI.
- OSFI continued to reiterate that when an FRI is conducting this due diligence, it should not generally rely solely on third parties, including rating agency assessments, or broker analysis and assessments. An FRI is expected, to an extent proportional to the importance of such counterparty, to conduct its own due diligence on the financial strength and capabilities of all reinsurance counterparties.
3. The terms and conditions of the reinsurance contract should provide clarity and certainty on reinsurance coverage.
- OSFI acknowledges that there may be situations where it is necessary and appropriate for an FRI to enter into a supplemental or subordinated reinsurance contract, a side letter or other type of arrangement that is ancillary to and form part of the main reinsurance contract. In addition to ensuring that such arrangements meet the requirements of Guideline B-3, the FRI is expected to be transparent with its stakeholders regarding these arrangements, reflect the arrangements in its financial statements and ensure that these ancillary arrangements do not adversely impact the terms and conditions of the original reinsurance contract to the detriment of policyholders.
4. A ceding FRI should not be adversely affected by the terms and conditions of a reinsurance contract.
- This key principle has been revised to provide that a ceding FRI should not be adversely affected by the terms and conditions of a reinsurance contract.
- OSFI expects all contracts related to reinsurance coverage expressly provide a choice of forum, a choice of law and the appointment of agents for service of legal processes. Although OSFI prefers that reinsurance contracts and any disputes arising from such contracts are subject to the laws and courts of a Canadian province, an FRI is permitted to select the laws and courts of another jurisdiction.
- OSFI continues to expressly state that all reinsurance contracts should include an insolvency clause so that funds will be available to cover policyholder claims in the event of a cedant’s or reinsurer’s insolvency. In particular, the insolvency clause should ensure that the reinsurer is required to continue to make full payments to an insolvent cedant without any reduction resulting solely from the cedant’s insolvency. Such a clause provides greater certainty that reinsurance receivables remain within the overall general estate of the insolvent ceding company, or as part of the assets in Canada of a foreign insurance company as defined under the Winding-Up and Restructuring Act (Canada) and the Insurance Companies Act (Canada), rather than being allocated toward the payment of specific claims of creditors or policyholders.
- Reinsurance contracts should not contain terms or conditions that limit a troubled or insolvent cedant’s ability to enforce the contractual obligations of a reinsurer or that may adversely affect the treatment of any claims in respect of the cedant’s policyholders. Reinsurers and cedants should pay “particular attention” to the “appropriate” use of off-set or cut-through clauses, the structure of “funds withheld arrangements” and such other types of terms or conditions that may frustrate the scheme or priorities under the Winding-Up and Restructuring Act (Canada).
- If a reinsurance contract provides for a “funds withheld arrangement,” such reinsurance contract must clearly provide that, in the event of the cedant’s or reinsurer’s insolvency, the funds withheld, less any surplus due back to the reinsurer, must form part of the property of the cedant’s general estate, or part of the assets in Canada of a foreign insurance company as defined under the Winding-Up and Restructuring Act (Canada) and the Insurance Companies Act (Canada).
5. Annual Reinsurance Declaration
- A senior officer of an FRI must make an annual reinsurance declaration confirming that the FRI’s reinsurance risk management practices and procedures meet Guideline B-3’s standards, except as specifically set out in the declaration. The declaration should also include an attestation that the FRI’s reinsurance arrangements effect a risk transfer and they are accounted for in the appropriate manner.
PART III: Guidance RSA
The Guidance RSA sets out OSFI’s minimum standards with respect to collateral secured through the establishment of a Reinsurance Security Agreement as follows:
Valid and Enforceable Security Interest
- A capital/asset credit in respect of unregistered reinsurance is allowed where a ceding FRI obtains and maintains a valid and enforceable security interest in collateral held in Canada supporting reinsurance ceded to an unregistered reinsurer that has priority over any other security interest in such collateral.
- A legal opinion must be obtained by the ceding FRI confirming that a valid and enforceable security interest (one that has priority over any other security interests of creditors in the pledged assets) has been or will be created in the ceding FRI’s favour (subject to customary and appropriate qualifications). OSFI must be able to rely on the opinion and a copy of the RSA must be filed with OSFI within 15 days of the ceding FRI obtaining the opinion.
- Where a new type of asset not already covered by the legal opinion is approved by a ceding FRI, OSFI expects the ceding FRI will obtain an additional legal opinion asserting that, with respect to the new type of asset, a valid and enforceable security interest has been or will be created in the ceding FRI’s favour.
- OSFI has eliminated the list of acceptable assets to be pledged (Schedule A to the Draft Guidelines) and will not be providing such a scheduled list of approved assets to be pledged, but will expect the ceding FRI to exercise a prudent person standard when determining the types of assets it will accept as pledged assets.
PART IV: Practical Considerations
- If a ceding FRI does not comply strictly to the principles of Guideline B-3 when structuring its RRMP or negotiating reinsurance contracts, OSFI, on a case by case basis, may not grant a capital/asset credit for the reinsurance arrangement or may, commensurate with risk, use its discretionary authority to adjust the FRI’s capital asset requirement or target solvency ratios.
- As OSFI is not a party to the RSA, ceding FRIs and their reinsurance counterparty do not need to obtain approval from their designated Relationship Manager (or such other person as required by OSFI) for the withdrawal of pledged assets or for any transaction involving foreign currency assets. A ceding company should negotiate in its RSA the terms and conditions of an investment policy relating to the pledged assets.
PART V: Summary
The changes regarding the regulation of reinsurance in Canada can be summarized as follows:
- The new rules allow for greater use of unlicensed reinsurance since the 25% limit will be replaced on July 1, 2011
- Fronting arrangements are still permitted
- A new form of Reinsurance Security Agreement must be used to replace the current Unlicensed Reinsurer Trust Agreement in order for a Canadian cedant to be able to take credit for unlicensed reinsurance
- A legal opinion that OSFI can rely on will now be required in order to confirm that a perfected first charge security interest has been created in favour of the Canadian cedent with respect to the assets being held as security.
Many cedants and unlicensed reinsurers have expressed concerns about the new rules and the uncertainty regarding them. It is our expectation that once the new forms of reinsurance security agreement and legal opinions have become standardized, these new arrangements will be relatively easy to implement.
Although OSFI has introduced a significantly different set of rules regarding the form of agreement and arrangements necessary in order for a cedant to be able to take credit for unlicensed reinsurance, it is unlikely that that they will result in fundamental changes regarding how unlicensed reinsurance is used in Canada.