As the difficult economic conditions over the past few years have continued to expose weaknesses in many international financial institutions, it is clear that a coordinated international approach to regulation has become more important than ever. Coordinated and consistent international regulatory standards, such as Basel III for banks, will become an essential foundation of global commerce. For insurers, the movement to adopt Solvency II (or equivalency under it) has become the key international regulatory initiative. The new Solvency II regime, scheduled to come into force as of January 2014, is aimed at better managing the risks and improving oversight of insurers, particularly through new capital requirements.1
Solvency II was adopted by the Council of the European Union and Parliament and with the support of the European Insurance and Occupational Pensions Authority (“EIOPA”) in November 2009. However, since then it has become an international movement. In an attempt to harmonize the global insurance market, Solvency II has established a mutual recognition/equivalency regime for countries outside of the European Economic Area (“EEA”). “Equivalency” allows subsidiaries or group entities within other countries to converge with EEA based group supervisors under Solvency II. The main benefit is the ability to align capital requirements. Numerous countries outside the EEA (including Bermuda, Switzerland and Japan) have either committed to adopting Solvency II or expressed interest in forming a transitional regime. The National Association of Insurance Commissioners (“NAIC”) in the U.S. is also currently considering its position and participation in it has not been ruled out.
A key issue for insurers operating in Canada is how the Office of the Superintendent of Financial Institutions (“OSFI”) will position Canada within the international regulatory movement of Solvency II. OSFI has not yet formally announced any intention to adopt Solvency II or to seek equivalency. It appears that OSFI has decided to defer adopting Solvency II and instead is continuing to develop its own similar, but not identical, regulatory system. As a result, Canada remains one of the few major jurisdictions that has not expressed a formal decision to adopt Solvency II or seek equivalency under it (Guernsey is the only country to formally reject Solvency II at this time).
OSFI has not actively publicized its position regarding Solvency II. Julie Dickson, the Superintendent of Financial Institutions, commented in a 2011 speech that although global harmonization is lacking within the insurance industry, Solvency II contains some uncertain elements. OSFI apparently still has some concerns regarding the approach that Solvency II takes to capital requirements as well as the overall supervisory framework.
Despite the significant costs associated with the transition to Solvency II, the pursuit of “equivalency” certification may soon become critical in order for jurisdictions to maintain a competitive advantage internationally and to ensure that they will be able to continue to attract new insurers and reinsurers to do business within their jurisdictions.
One of the hallmarks of OSFI’s insurance regulatory approach has been to require adequate capital to be maintained in Canada in order to protect Canadian policyholders by effectively creating a “ring fence” (using vested assets) from other foreign policyholders. The “ring fence” prohibits Canadian licensed foreign insurers from transferring assets outside of the country to pay the claims of non-Canadian policyholders without OSFI’s approval. This “ring fence” becomes especially important in the event that an insurer becomes insolvent. It is likely that as Solvency II is implemented and evolves, it will become more difficult for insurance regulators in any individual jurisdiction to require large capital deposits in order to protect their local policyholders.
OSFI has shown its willingness to go the route of internationalization with respect to Basel III (in order to protect the international competitive position of Canadian banks). It will be interesting to see whether OSFI is ultimately able to take a different approach with respect to insurance.
1) What is Solvency II?
Solvency II creates a principles based focus on policyholder protection through enhanced risk management, financial reporting and group supervision. Solvency II can be conceptualized as containing three pillars and a roof, in many ways similar to Basal III.
Pillar 1: Quantitative requirements
Pillar 1 of Solvency II sets out the main capital management criteria, including minimum capital requirements and a “prudent person” approach to investments. These are both significant changes that, together with additional group harmonization requirements, will influence the way insurance companies manage their capital. It is important to note that OSFI has also used a principles based approach to regulation for a number of years and that it already requires some, but not all, of the reforms provided by Solvency II.
A fundamental change under Solvency II is the option for companies to use internally developed market-based models to analyze their own solvency risk. In contrast, the previous Solvency I framework focused primarily on standard scenarios (which is what OSFI currently requires) to calculate required capital. Although companies will still face minimum capital requirements, the move is intended to bring more efficiency and competitiveness to the market by allowing insurers to more efficiently use their capital. Insurers often criticize capital models that are imposed by regulators as being arbitrary and not always appropriate for the types of business written by them.
It remains unclear whether OSFI will commit to the use of internal capital models. Although OSFI is currently working with the Insurance Bureau of Canada to develop an internal model framework, there is no immediate urgency to change the current standardized approach. According to a recent OSFI vision paper, the implementation of an internal model approach is scheduled to occur no earlier than 2015.
Pillar 2: Qualitative requirements
Pillar 2 addresses the more fundamental risk management issues through enhanced self governance and harmonized group supervision. The core component for insurers will be developing their own risk and solvency assessment (“ORSA”), which is designed to identify various internal controls necessary to ensure solvency requirements are met. For example, insurers will be required to provide a prospective analysis of potential catastrophic events and develop plans to maintain solvency. The process will act as both an internal assessment tool and external regulatory mechanism. OSFI employs a similar requirement to internal risk analysis through stress testing and forward looking analyses. Each year, all licensed insurers in Canada are required to have their Appointed Actuary prepare a Dynamic Capital Adequacy Test (“DCAT”) which tests the effects of various adverse scenarios (e.g. changes in interest rates and multiple large losses) on their capital levels.
Pillar 3: Prudential reporting and transparency
Pillar 3 further aligns the quantitative and qualitative aspects of Solvency II by requiring better disclosure of capital management, risk, and other governance elements. Similar to the Basel III framework, enhanced transparency is expected to encourage market discipline and to allow monitoring compliance. Insurers will be required to provide both an annual disclosure document to the public and a private report to the group supervisor. The disclosure will provide greater transparency on the financial condition of insurers by requiring the public to have access to their financial statements and material undertakings. Although OSFI similarly requires certain levels of private disclosure, public disclosure is not currently required in Canada. However, OSFI does provide access to some financial information regarding Canadian licensed insurers on its website.
2) Consolidated Group Supervision
Group insurance supervision is a new and important concept. It addresses the concern that large insurance groups may operated in a number of jurisdictions, all of which are able to regulate only their local operations. Currently, it is common that no one regulator is aware of all aspects of a company’s operations. Group supervision will allow one regulator to be appointed as the lead and to coordinate the activities of regulators in other jurisdictions.
In practice, each of the three Pillars will be connected by an overarching group supervisor. Previously, the specific rights and authorities of the group’s parent were not clearly defined. Solvency II attempts to consolidate the regulation of an entire group’s activities through a single supervisor that more clearly defines how each individual entity within the group shares information and to determine each entity’s respective capital requirements.
OSFI also appears to be interested in group supervision as a proactive measure to managing capital risk. During a speech last Summer, Julie Dickson confirmed that OSFI considers group supervision to be a very good idea since it allows insurance supervisors to have a full understanding of the risks in a financial group and to take steps to ensure group-wide risk management at the parent company level.
3) Implications for the Future
One of the main benefits of Solvency II for insurers is that it allows them to align their capital requirements by having the same set of capital requirements in all of the jurisdictions in which they operate. This harmonization will then allow for a more efficient use of capital.
It is likely that European insurers with Canadian branches will impose most or all Solvency II requirements on their Canadian subsidiaries. As a result, Solvency II will start to become more well known in Canada, regardless of whether is it formally recognized by OSFI.
OSFI’s approach to insurance regulation is principles based and is clearly similar to Solvency II in a number of respects. Since OSFI has adopted the International Association of Insurance Supervisors’ (“IAIS”) core principles and methodology, the two frameworks agree on similar reporting standards, disclosure and some quantitative aspects, such as a similar approach to minimum and target capital requirements.
OSFI is clearly committed to being part of the international insurance regulatory community and is an active member in the IAIS. In particular, OSFI is currently consulting with the IAIS to develop the ComFrame initiative. ComFrame (also known as Common Framework for the Supervision of Internationally Active Insurance Groups) was developed by the IAIS to harmonize group-wide supervision.
Developments such as Solvency II and ComFrame are clearly just the beginning of the international regulatory harmonization trend. The reality is that most large insurers and reinsurers now do business on a global basis. OSFI is not the lead regulator for most of these companies and must ultimately rely on the soundness of the head office regulation that is occurring.
The 2001 liquidation of Reliance Insurance Company provides a good illustration of this point. At the time that Reliance was put into liquidation by the Pennsylvania Department of Insurance (the head office regulator), the Canadian branch of Reliance was over capitalized and met all of OSFI’s requirements. However, it was still necessary for OSFI to take control of the Canadian branch and put it into liquidation due to solvency issues that occurred in the U.S. and outside of OSFI’s jurisdiction.
A number of potential consequences may arise if Canadian regulatory requirements are perceived as incompatible with Solvency II. The current Canadian capital requirements may simply make Canada too expensive a jurisdiction for many foreign insurers to do business in. Canada will likely be at a competitive disadvantage when it attempts to attract new insurers if they are required to comply with a different set of rules, as well as capital requirements, than all other jurisdictions in which they carry on business.
The main uncertainty that remains is the U.S. position. Given the size of the U.S. market and its ties to EEA insurers, a key determining factor may depend on whether the NAIC adopts some form of equivalency itself. It is likely that the approach taken by the NAIC in the U.S. will have a significant effect on OSFI’s position regarding international insurance regulation. A formal adoption of Solvency II in the U.S. would make it very difficult for OSFI not to adopt it as well.
Since OSFI appears to be in favour of many aspects of Solvency II, the apparent decision not to seek equivalency at this time is interesting. It appears that the real issue for OSFI may be a reluctance to give up full control regarding how insurers are regulated in Canada. Even if OSFI agreed totally with all of the current aspects of Solvency II, there is always a danger that it might disagree with future changes or amendments and be trapped into being required to implement them.
An approach in which Canada remains an island or fortress of “ring-fenced” regulatory capital with its own set of rules may provide better protection to Canadian policyholders in the short term, but may ultimately lead to a less competitive and more inefficient insurance market in which consumers have less choice and pay more for their insurance. In the long term, Canada may have no choice other than to adopt Solvency II in order to remain a competitive and relevant player in the international insurance community.
1. Acknowledgement: The research and preparation of this article was greatly assisted by Jared Puterman, a summar law student at Cassells Brock & Blackwell LLP.