Vol. 145, No. 4 — February 16, 2011

Registration

SOR/2011-13 February 4, 2011

INSURANCE COMPANIES ACT

ARCHIVED — Regulations Repealing the Reinsurance (Canadian Companies) Regulations and the Reinsurance (Foreign Companies) Regulations

P.C. 2011-48 February 3, 2011

His Excellency the Governor General in Council, on the recommendation of the Minister of Finance, pursuant to sections 465 (see footnote a) and 596 (see footnote b) of the Insurance Companies Act (see footnote c), hereby makes the annexed Regulations Repealing the Reinsurance (Canadian Companies) Regulations and the Reinsurance (Foreign Companies) Regulations.

REGULATIONS REPEALING THE REINSURANCE (CANADIAN COMPANIES) REGULATIONS AND THE REINSURANCE (FOREIGN COMPANIES) REGULATIONS

REPEALS

1. The Reinsurance (Canadian Companies) Regulations (see footnote 1) are repealed.

2. The Reinsurance (Foreign Companies) Regulations (see footnote 2) are repealed.

COMING INTO FORCE

3. These Regulations come into force on June 30, 2011.

REGULATORY IMPACT
ANALYSIS STATEMENT

(This statement is not part of the Regulations.)

Executive summary

Issue

Reinsurance is one of the most important risk management tools available to insurers. Insurers can use reinsurance to reduce insurance risks and the volatility of financial results, stabilize solvency, make more efficient use of capital, better withstand catastrophic events (e.g. natural disasters), increase underwriting capacity and draw on reinsurers’ expertise. However, reinsurance also exposes insurers to other risks, including operational risks, legal risks, counterparty risks and liquidity risks. The combination of these risks makes reinsurance a complex matter, and inadequate reinsurance risk management practices and procedures can affect insurers’ financial soundness and reputation.

The nature of insurance and reinsurance operations, for both the property and casualty and life insurance sectors, has rapidly evolved in the past decade — it is more technologically advanced, increasingly segmented/niche and much more globally diversified — and, in response, insurance and reinsurance companies have since developed more sophisticated risk management programs.

The majority of the reinsurance capacity throughout the world is provided by a relatively small number of large global reinsurers. The Canadian reinsurance landscape reflects this trend and is comprised mostly of foreign-based companies, with the majority conducting business in Canada through a branch. In some instances, business activities are performed directly from abroad.

The Canadian regulatory regime for reinsurance currently includes both regulations and principles-based guidelines developed by the Office of the Superintendent of Financial Institutions (OSFI). On the regulations side, the Reinsurance (Canadian Companies) Regulations and the Reinsurance (Foreign Companies) Regulations (the “regulations”) impose, on federally regulated companies that insure risks, specific limits on their ability to cede risks/premiums.

These regulations state that non-life insurance companies (property and casualty insurance companies, referred to as “P&C” companies) cannot cede more than 75% of their gross premiums in total, and more than 25% of their gross premiums to unregistered reinsurers. The purpose of these prudential rules was to limit counterparty risk in the event reinsurance companies would not be able to meet claim obligations.

The regulations have not been subject to review or substantive reform since 1992. As a result, they have not kept up with industry innovations (multi-layered arrangements and sophisticated financial instruments, such as securitization) and lack in efficiency and flexibility. The rules are easily avoided, and in essence, can be qualified as obsolete as they no longer fulfill their prudential purpose.

Conversely, the guidance portion of the reinsurance regime has greatly improved since 1992. The regime developed and administered by OSFI is a reliance-based approach and has demonstrated, over the past years, its effectiveness in regulating financial institutions’ behaviour and practices. The guidance encompasses principles-based guidelines and a risk-based supervisory framework.

25% limit on risk ceded to unregistered reinsurers

Under the Regulations, a company that insures risks cannot cede more than 25% of its risks insured to unregistered reinsurers. This 25% limit was originally imposed on the P&C sector following an imprudent reliance on unregistered reinsurers, which was a contributing factor in the failure of many P&C insurers in the 1980s.

The limit was also intended to address concentration risk to unregistered (and potentially unenforceable) reinsurance. It served to mitigate the risk of relying on reinsurers operating in other jurisdictions, which may have supervisory and legal regimes that are substantially different from those in Canada.

The 25% limit is perhaps one of the most debated elements of the Canadian reinsurance regulatory framework for domestic players. Although the 25% limit has appeal from a prudential perspective, it does not provide the incentive for ceding companies to scrutinize their risks with respect to the financial condition/capacity of an unregistered reinsurer or other relevant factors (e.g. legal and insolvency framework of the jurisdiction in which the reinsurer is operating).

Further, because registered reinsurers are not themselves subject to the 25% limit, it does not necessarily act as an absolute bar to companies gaining exposure to additional unregistered reinsurance.

It has also been argued that the 25% limit on unregistered reinsurance is inconsistent with the international nature of reinsurance business, and constrains some insurers from appropriately managing their risks through diversification and from having full access to very strong reinsurers. As well, a premiums-based limit may not be appropriate in all circumstances, as it is not necessarily calibrated to the level of risk underwritten in the reinsurance policy.

75% fronting limit

According to the regulations, a P&C insurer cannot cede more than 75% of its gross premiums in any given year. This type of operation can involve writing a risk for another insurance company that is not licensed in Canada (i.e. fronting) or ceding portions of a risk to a reinsurer because the risk does not fit in the underwriting portfolio.

This 75% “fronting” limit was implemented on the basis that where a direct writer’s capital is not exposed to loss, it has little incentive to carefully underwrite business. This risk can be amplified as insurers receive commissions on business reinsured. Some insurers have, in the past, been inclined to write large volumes of business and to charge lower premiums to attract more business. Due to poor underwriting, some reinsurers have not honoured their obligations. In certain cases, they have claimed fraud or misrepresentation by the insurer.

This prudential limit, which is essentially intended to mitigate moral hazard, may not be effective as certain lines of business may be fully fronted if they represent less than 75% of total premiums. Some insurers may front lines for unregistered reinsurers for cost-efficiency purposes, as the latter do not have to set up a subsidiary or branch in Canada. While the fronting limit applicable to the ceding company as a whole may be met, poor underwriting could nevertheless occur for fronted lines.

In other cases, insurance companies can cede a portion (or even the totality) of the risk to a reinsurer because that risk does not fit the direct insurer’s underwriting profile or the direct writer does not have the requisite expertise but it seeks to underwrite the business for purely marketing/relationship purposes. This specific practice of ceding business, currently captured by the 75% fronting limit, is quite common in the industry and may be acceptable from a prudential supervisory perspective.

In fact, as long as the insurance company (or reinsurer) is diligent through prudent underwriting practices and procedures, is cognizant of the associated risks involved with its business, and is maintaining sufficient regulatory capital to account for those risks, then the amount of the business that is ceded, in effect, becomes less of an important metric from a prudential perspective.

It is anticipated that by eliminating the 75% limit, insurance companies will potentially abandon complicated (and costly) reinsurance arrangements between affiliated financial institutions, and will be encouraged to pursue simplified pooling arrangements that, in fact, may reduce the risk to individual financial institutions — a positive result from a supervisory perspective.

Although this limit prevents P&C insurance companies from operating solely as fronting entities, again, it does not provide the incentive for ceding companies to scrutinize the risks associated with underwriting the business. Further, the limit can be bypassed entirely using other risk transfer methods (e.g. securitization, hedges such as catastrophe bonds).

Objectives

Changes to the existing framework have been developed with the following objectives in mind:

• ensuring “neutrality” between registered and unregistered reinsurance, recognizing that reinsurance is at its very core a diversified international business and that most reinsurers operating in Canada are foreign-based;
• creating greater equity and consistency with respect to treatment (and more specifically, capital) of the P&C insurance sector with other sectors (particularly life) in regards to similar risks; and
• bolstering OSFI guidance on reinsurance governance, particularly in respect of sound reinsurance practices and procedures (as part of enterprise-wide risk management), with a particular focus on the enforceability of reinsurance contracts.

Description

The following regulations will be repealed, effective June 30, 2011:

• Reinsurance (Canadian Companies) Regulations, SOR/92-298; and
• Reinsurance (Foreign Companies) Regulations, SOR/92-302.

Regulatory and non-regulatory options considered

Considering the business environment (domestic and foreign) in which reinsurance companies operate, OSFI believes that a regulatory amendment to the current Regulations (i.e. increase or decrease of limits) would lack the flexibility to adapt to new practices and capture new types of operations in a timely manner. This would equate to, once again, having a regulatory instrument that would quickly become antiquated.

As mentioned previously, OSFI has developed a reinsurance framework which is composed of principles-based guidelines used to govern industry activities and behaviors. These instruments provide OSFI with the ability to adapt more quickly to changing industry practices while providing a recognized reliance-based approach to which industry adheres to.

Consequently, OSFI will move this part of the reinsurance framework (prudential limits) from a rules-based to a principles-based approach. OSFI firmly believes in the efficiency of this approach and its capability to provide a clear line of conduct for companies that insure risks.

Benefits and costs

Benefits associated with the repeal of the regulations are the following:

(1) improved ability for OSFI to address to new industry practices through the reliance on OSFI’s principles-based reinsurance framework;

(2) improved industry practices will allow simplified reinsurance transactions and contractual agreements for the industry, which will translate into greater transparency in reinsurance transactions, thus facilitating supervisory efforts;

(3) improved alignment with global business practices will facilitate international transactions and make federally regulated companies more competitive; and

(4) enhanced guidance will provide more clarity to industry on OSFI expectations pertaining to reinsurance arrangements, which will produce more effective and efficient supervisory efforts.

The repeal of the regulations itself will not cause the incurrence of any costs. Nonetheless, OSFI proceeded to evaluate the potential impact of the considered enhancements to its existing framework and concluded the cost will be immaterial for both OSFI and industry. OSFI is of the view that any change to its supervisory role brought about by proposed enhancements to the framework will be addressed through reallocation of staff, which will abide by the current budget restrictions in force.

Rationale

Considering that the regulations no longer play the prudential role they initially intended and that existing OSFI regulatory and supervisory instruments currently in place successfully encourage prudent underwriting and sound risk control standards, the regulations will be repealed.

Due to the existing guidance framework which encourages sound governance and risk control standards, OSFI believes that repealing the reinsurance limits will create a more prudent and responsible business environment where insurance companies will be encouraged to proceed with more transparency and caution with their reinsurance transactions.

The repeal also provides an opportunity for OSFI to address any shortcomings of the existing reinsurance regime which will improve the existing framework and enhance industry’s understanding of OSFI’s expectations. In turn, this will positively impact the efficiency and effectiveness of our supervisory efforts.

Consultation

In December 2008, OSFI conducted a comprehensive industry consultation on its regulatory and supervisory approach to reinsurance. The purpose of the consultation was to receive feedback on the overall policy direction of reinsurance regulation (which included the regulations) and supervision in Canada. To address the submissions received from industry through the consultation process, OSFI prepared and communicated a response paper which outlines impending reforms to the reinsurance regulatory and supervisory framework (e.g. repeal of regulations and review of certain guidelines). The response paper confirmed that submissions received from industry had been generally positive pertaining to the repeal of the regulations.

The guidance review discussed previously has also been subject to industry consultation.

The Regulations Repealing the Reinsurance (Canadian Companies) Regulations and the Reinsurance (Foreign Companies) Regulations was pre-published in the Canada Gazette, Part I, on October 30, 2010, providing an official consultation period of 15 days, during which time only one comment, in favour of the repeal of the regulations, was received.

Implementation, enforcement and service standards

Considering guidance on sound reinsurance practices and procedures is already in place, the regulations’ repeal need not be dependent on any other implementation. This said, OSFI is also working to conclude the guidance review it has initiated so it may be available to industry prior to the repeal of the regulations. This revised guidance will set higher reinsurance standards for insurance companies.

After the repeal of the regulations, reinsurance strategies, programs, processes and contracts will be subject to significantly greater scrutiny by OSFI’s supervision arm, which may take enforcement actions if a company does not act in the best interest of policyholders. OSFI’s enforcement authority is enabled by both the Office of the Superintendent of Financial Institutions Act and Part XV of the Insurance Companies Act.

Performance measurement and evaluation

Considering this regulatory amendment is for the repeal of Regulations, there will be no follow-up performance measures on the repeal itself. However, OSFI’s reinsurance and supervisory framework are subject to periodic reviews.

These periodic reviews of essential components of the reinsurance guidance and supervisory framework are performed in a manner that captures changing industry practices, thus ensuring that OSFI enforcement is commensurate with industry risks.

Contact

Philipe-A. Sarrazin
Managing Director
Legislation and Policy Initiatives
Office of the Superintendent of Financial Institutions
255 Albert Street
Ottawa, Ontario
K1A 0H2
Telephone: 613-991-0378
Fax: 613-998-6716
Email: philipe.sarrazin@osfi-bsif.gc.ca

Footnote a
S.C. 2007, c. 6, s. 226

Footnote b
S.C. 2007, c. 6, s. 277

Footnote c
S.C. 1991, c. 47

Footnote 1
SOR/92-298; SOR/2009-296

Footnote 2
SOR/92-302; SOR/2009-296