OSFI Releases Reinsurance Framework Discussion Paper

The Office of the Superintendent of Financial Institutions (OSFI) released its Reinsurance Framework Discussion Paper (Discussion Paper) on June 8, which outlines a number of proposals designed to enhance and maintain an effective reinsurance framework applicable to federally regulated insurers (FRIs). The Discussion Paper is open for public comment until September 15.

What You Need To Know

• Through the Discussion Paper, OSFI is working to ensure its reinsurance framework remains appropriate and effective in light of the increasing reliance on reinsurance, and the emergence of new and evolving business models related to the use of reinsurance.
• Key proposals in the Discussion Paper aim to address risks associated with large exposures and concentration, particularly in the property and casualty (P&C) insurance sector.
• Other proposed changes to the reinsurance framework that would affect all FRIs are also included, such as enhancements to OSFI’s guidance on sound reinsurance practices and procedures, and changes to the administration of the statutory requirement to obtain the Superintendent’s approval to reinsure with an unregistered related party reinsurer.
• The Discussion Paper also references reinsurance related amendments that will be made to the next draft Minimum Capital Test (MCT) Guideline for federally regulated P&C insurers .

Maintaining the Effectiveness of OSFI’s Reinsurance Framework

Large Exposure and Concentrated Counterparty Risks

OSFI intends to revise Guideline B-3 Sound Reinsurance Practices and Procedures (Guideline B-3) to clarify and enhance expectations related to the prudent management of reinsurance risks. This will include an expectation that a FRI establish reasonable limits on its overall reinsurance exposure to any one reinsurance entity or group, particularly where the cedant FRI relies on its reinsurance programs to underwrite high-limit policies.

In addition, OSFI intends to introduce a rule related to the issuance of high-limit policies by P&C FRIs. Under the proposed rule, the maximum policy limit a P&C FRI could issue would depend upon its level of capital and excess collateral, as well as the diversity of its reinsurance counterparties.¹ The rule would be included in a revised Guideline B-2 Investment Concentration Limit for Property and Casualty Insurance Companies and would only apply to P&C FRIs that provide coverage directly to policyholders and to P&C FRI reinsurers in respect of direct business assumed by registered affiliates. OSFI is also considering the merits of developing a rule to address similar concerns with P&C FRI reinsurers.

The Capital Frameworks for Reinsurance

OSFI has identified a number of potential changes to the capital frameworks in respect of reinsurance.

Counterparty Credit Risk

In the MCT Guideline, a capital charge is applied to P&C FRIs that cede risks to unassociated FRIs. This capital charge is intended to address the risk that the assuming FRI will not honour its obligations. This capital charge does not, however, apply to P&C FRIs that cede risks to an associated FRI. OSFI is of the view that the risk that an associated FRI will not honour its obligations is the same as with an unassociated FRI. Therefore, OSFI plans to implement in the 2019 MCT Guideline a capital charge on P&C FRIs that cede risks to associated FRIs to account for counterparty credit risk. The proposed credit risk factors will be equal to those applied to unassociated FRIs.

Unregistered Associated Reinsurance Funds Withheld

The MCT Guideline prescribes the forms of collateral that can be used to reduce the margin required for unregistered reinsurance. One form of collateral is the amount of funds withheld by the cedant FRI to secure payment from the assuming reinsurer. For domestic P&C FRIs, OSFI imposes a restriction on funds withheld from reinsurers that are associates, and non-qualifying subsidiaries, by not recognizing the funds withheld payable as acceptable collateral. Foreign P&C FRIs are not subject to this same restriction, nor are life FRIs. Further to the reinsurance review, OSFI does not believe the differing treatment between domestic and foreign P&C FRIs is justified.

OSFI intends to remove the funds withheld restriction for domestic P&C FRIs and recognize the amount of funds held to secure payment from reinsurers that are associates and non-qualifying subsidiaries. Therefore, OSFI plans to allow a credit in the calculation of the margin required for risks ceded to unregistered associated reinsurers. However, conditions will be added to the MCT Guideline (and also to LICAT) effective January 1, 2019 in order to recognize funds withheld payables for cessions to both registered and unregistered associated and non-associated insurers.

MCT Guideline Margin Requirements for Unregistered Reinsurance

In the 2019 MCT Guideline—effective January 1, 2020—OSFI intends to increase the margin required for reinsurance ceded to an unregistered reinsurer from 15% to 20% in order for a FRI to obtain full capital/asset credit for that reinsurance. This level will more closely reflect the capital levels maintained by P&C FRIs to support insurance risk.

Financial Resources Supporting Earthquake Risk Exposures

Both domestic and foreign FRIs may include 10% of their consolidated/worldwide capital and surplus as an eligible financial resource to reduce the earthquake risk reserve. The concern that arises is that the portion of capital and surplus is used as an eligible financial resource to reduce the earthquake reserve, which reduces capital requirements, and then is also included as part of the FRI's capital available used to cover the overall capital requirement. There is potential double counting of the same financial resource.

OSFI is reviewing the appropriateness of the 10% of consolidated/worldwide capital and surplus as eligible earthquake financial resources for domestic and foreign FRIs. OSFI will complete a review of the issue and determine its position at a later date.

Reinsurance Concentration Risk

OSFI has observed that some FRIs have material reinsurance programs with a single or only a few reinsurers, or a few groups of related reinsurers, which raises the risk of an adverse impact on the financial position of the cedant FRI should one of its reinsurance counterparties encounter financial difficulty. OSFI is considering introducing a concentration risk charge/limit on reinsurance assets in a future update of the capital guidelines. OSFI has not completed its review and is raising the matter with the industry for comments.

Clarifications to Guideline B-3 and Other Potential Reinsurance Framework Adjustments

Worldwide Treaties and Flow of Reinsurance Funds

OSFI intends to amend Guideline B-3 to clarify its expectation that worldwide reinsurance treaties should only be granted credit in the determination of target operating capital levels if the reinsurance payments flow directly to the FRI in Canada. OSFI is also considering providing more detailed guidance regarding its expectations for worldwide treaties that reinsure FRIs, and collecting more information from FRIs to identify when such treaties are used.

Significant Quota Share Treaties

A number of FRIs have implemented increasingly significant quota share treaties in recent years. Over reliance by FRIs on quota share reinsurance is a concern for OSFI. OSFI is also of the view that FRIs should avoid unduly relying upon a single reinsurer or reinsurance group when reinsuring a significant activity of the FRI.

OSFI invites views on its intention to strengthen Guideline B-3 with respect to the management of the risks related to significant quota share treaties, and the expectation that FRIs not cede substantially all of their risks. In particular, OSFI is seeking views on the concept of "substantially all of [an insurer's] risks" and how this concept could be expressed in a more objective manner.

Fronting Arrangements

The term "fronting" in the context of this reinsurance review refers to the practice of insuring a risk and then reinsuring 100% of that risk with another insurer. OSFI expects FRIs have sufficient knowledge and expertise when entering into fronting arrangements that expose the FRI to material risks, or that represent a material portion of the FRI's insurance business in Canada.

OSFI plans to include an expectation in Guideline B-3 for FRIs to take reasonable measures to satisfy themselves that legal risks related to contract wording in respect of reinsurance arrangements with captive unregistered unrelated foreign insurers are appropriately managed. OSFI also intends to apply other relevant reinsurance measures identified in the Discussion Paper to fronting arrangements (e.g., large exposures).

Foreign FRIs Ceding Risks Back to the Home Office

OSFI has observed situations where foreign FRIs cede risks insured in Canada to an unregistered affiliated reinsurer, which then retrocedes the risks back to the home office of the FRIs. These foreign FRIs then generally recognize this reinsurance arrangement for the purposes of determining their required vested assets, even though the economic reality of these arrangements is that the FRIs retain insurance risk originally ceded to the unregistered affiliate. When a loss occurs in Canada, reinsurance proceeds flow from the FRI's foreign accounts, to the FRI's affiliated reinsurer in the first instance, before flowing to the FRI's branch in Canada. This practice has been undertaken by both life and P&C FRIs.

OSFI continues to review this issue and is raising the matter in this paper, along with possible solutions, to seek views from the industry. One measure under consideration is to deny credit to a foreign FRI for the risks that are ultimately retroceded, exclusively through entities within the FRI's group, back to the FRI in its home jurisdiction. Alternatively, OSFI may require that additional collateral be maintained in Canada to mitigate the concerns related to the reduction of assets in Canada that result from such arrangements.

Legislative Approvals for Reinsurance with Related Parties

OSFI plans to request additional information when a FRI requests the Superintendent's approval to cause itself to be reinsured by an unregistered related party insurer. In addition, OSFI plans to expand the scope of the information to be submitted annually in respect of such reinsurance relationships (for both existing and prospective related party reinsurance arrangements). In this regard, OSFI would generally only recommend the Superintendent grant an approval where both the related party reinsurer and the group to which it belongs appear to be in sound financial condition. Conversely, OSFI may recommend the Superintendent revoke an approval if it is subsequently determined that either the related party reinsurer, or the group to which it belongs, no longer appear to be in sound financial condition.

Insurance Linked Securities

Insurance Linked Securities (ILS) are financial instruments used by insurers to transfer insurance risks to capital markets. They may include, among other things, catastrophe bonds, swaps, industry loss warranties, derivatives contracts and sidecars. OSFI invites comments on its intention to revise Guideline B-3 to include its expectations for FRIs that cede risks to reinsurers that rely upon ILS.

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¹ Annex I to the Discussion Paper contains details about the proposed rule.

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