On February 11, 2022, the Office of the Superintendent of Financial Institutions Canada (OSFI) released the final versions of its much-anticipated Guideline B-3, Sound Reinsurance Practices and Procedures (Guideline B-3) and Guideline B-2, Property and Casualty Large Insurance Exposures and Investment Concentration (Guideline B-2). Both will be effective January 1, 2025, giving insurers and reinsurers almost three years to prepare to comply, as applicable. The Guidelines are well-written and clear, so rather than summarize them, let’s discuss some highlights and insights.
I. Guideline B-3
Guideline B-3 sets out OSFI’s expectations for effective reinsurance practices and procedures. It apples to all federally regulated insurers (FRIs) that are party to reinsurance cessions, retrocessions and, where applicable, to assumption reinsurance transactions. Such FRIs include life and property and casualty insurers and reinsurers, including domestic insurance companies and branches of foreign insurance companies authorized to carry on insurance business in Canada.
In reading Guideline B-3, it becomes very clear that OSFI has heightened its emphasis on certain of its expectations when it comes to FRIs’ monitoring risks related to their reinsurance arrangements. The following are notable:
Stress Testing
A renewed emphasis on stress testing reinsurance arrangements is clear. FRIs will be required to assess the adequacy and effectiveness of reinsurance arrangements regularly, which may involve stress testing to determine if the reinsurance arrangements mitigate exposures to acceptable levels adequately in accordance with the FRI’s appetite. To help ensure FRIs conduct such regular assessments, OSFI may require FRIs to provide the results of stress testing on its reinsurance program. This will mean more work for FRIs’ actuarial teams who will likely have to add such regular triangulation exercises to their already burgeoning workloads.
More (and More Frequent) Due Diligence on Reinsurers
OSFI expects FRIs to conduct more (and more frequent) in-depth due diligence on their reinsurer counterparties. This heightened standard is applicable to all of a FRI’s reinsurers equally, regardless of whether they are affiliated or not affiliated with the FRI. To be clear, OSFI expects an FRI to conduct the same in-depth due diligence (with the same frequency) on an affiliate to whom it cedes risks as it does on a new, unrelated reinsurer.
Specifically, OSFI expects FRIs to monitor and manage multiple factors that affect counterparty risk. They should consider all elements of risk associated with the counterparties, including implications of the legal and insolvency framework of the counterparty’s home jurisdiction and the terms and conditions of the relevant reinsurance agreement with the counterparty. FRIs should also consider all counterparties at an aggregate level for stress testing – a group of affiliated counterparties, for example. Moreover, the FRI is expected to assess its counterparties on both a “going concern” (the reinsurer will be in business for the foreseeable future) and a “gone concern” (the reinsurer is either already in a liquidation state or is likely to enter one in the near future) basis.
Practically, this means a FRI’s reinsurance risk manager may have to implement an expanded audit program that involves conducing regular due diligence on all of the FRI’s reinsurers, including affiliates. In some instances, the reinsurance risk manager may “report” (in a human resources sense) into one or more such affiliated reinsurers via a “dotted line” reporting structure. Notwithstanding this, it will be important for the FRI to demonstrate objectivity in its due diligence of such affiliated reinsurers.
Regular Senior Management Consideration
OSFI expects senior management to be more involved in, and have more regular oversight and discussion in respect of, the FRI’s reinsurance risk management policy (RRMP). For instance, OSFI expects FRIs to regularly report to senior management to confirm that its reinsurance risk management practices conform to Guideline B-3’s principles. Any deviation from such principles, and remediation measures recommended and taken to address these deviations, should be documented. This may mean ensuring the FRI’s RRMP is a regular and prominent formal item for discussion and debate at the FRI’s senior management meetings. Some FRIs will have to adapt to this more frequent attention given to its RRMP.
Cessions to Home Office
OSFI has placed heightened scrutiny on a foreign FRI’s cession(s) to its home office, going so far as to indicate that it will generally not recognize or grant capital credit to a foreign FRI for reinsurance when risks in Canada are ceded back to the foreign FRI’s home office through affiliated reinsurers. It remains to be seen how OSFI will reconcile this position against the efficiencies passed along to insureds as a result of a foreign FRI’s involvement in a global insurance group’s utilization of a centralized reinsurance clearinghouse model, for instance, where reinsurance is funneled through a small number of affiliated reinsurers established for that purpose.
Ceding Limits and Retaining Underwriting Expertise
OSFI has indicated that, in the normal course, an FRI should not cede 100%, or substantially all, of its insurance risks. At the same time, however, OSFI appreciates that certain fronting arrangements and cessions of substantially all of a particular business line may have a valid business purpose. Accordingly, Guideline B-3 does not prohibit FRIs from engaging in fronting arrangements or ceding substantially all of a business line, but instead focuses on those situations that can raise prudential concerns – which may include the following:
- Concerns with purely fronting insurers – those with no real substantial operations in Canada – who use their valid and subsisting Canadian insurance licenses to write insurance risks in Canada and then cede all, or substantially all, of those risks outside Canada.
- Concerns with underwriting expertise – when an FRI reinsures all, or substantially all, of its insurance risks, the underwriting expertise for such risks may not be maintained within the FRI. Rather, the FRI is relying entirely on underwriting expertise of its reinsurers. It will be interesting to see how OSFI reconciles this with the realities of a global insurance marketplace, where international insurance groups leverage – to Canadian insureds’ benefit – specialized underwriting expertise that exists outside of Canada within an affiliated reinsurer.
New Required Insolvency Clauses
OSFI expects FRIs to include the following clauses in reinsurance agreements under which they cede risks, as applicable:
- In reinsurance agreements with non-affiliated reinsurers – an insolvency clause stipulating that, in the event of the FRI’s insolvency, all reinsurance receivables are paid directly to the FRI in Canada or to a person acting for, or on behalf of, the FRI in Canada.
- In reinsurance agreements with affiliated reinsurers – an insolvency clause stipulating that all reinsurance receivables are paid directly to the FRI in Canada or to a person acting for, or on behalf of, the FRI in Canada.
OSFI has made it very clear that it may not grant capital credit for reinsurance or may adjust capital requirements or target solvency ratios where a FRI’s reinsurance program or a particular reinsurance contract does not adhere to the principles set out in Guideline B-3. Moreover, federally-approved provincial and territorial reinsurers may lose their approved status with OSFI if they fail to meet Guideline B-3’s principles.
II. Guideline B-2
Guideline B-2 sets out OSFI’s expectations related to large insurance exposures; that is, losses a property and casualty FRI could suffer from a single large insurance exposure and the sudden failure of an individual unregistered insurance counterparty. It also sets out OSFI’s expectations related to investment concentration. References to “FRI” in this section II are references to property and casualty FRIs.
Gross Underwriting Limit Policy
Perhaps the most significant aspect of Guideline B-2 is the shift to a maximum loss from a single risk exposure, rather than the 2018 proposal with respect to aggregate simultaneous maximum losses from an FRI’s three largest exposures. Under this new Guideline B-2, OSFI expects an FRI to maintain a gross underwriting limit policy (a GUWP) that is consistent with the FRI’s risk appetite framework and reflects all of the following:
- It should define what constitutes a “Single Insurance Exposure” by class of insurance, as appropriate. An FRI could aggregate insurance exposures across multiple coverages and/or classes of insurance.
- It should establish limits by class of insurance for the level of gross insurance risk that the FRI is willing to accept in respect of a maximum loss related to a Single Insurance Exposure.
- An FRI’s senior management should review it at least annually. While OSFI expects senior management to review the GUWP at least annually, to demonstrate heightened prudence, an FRI may wish to incorporate a discussion of the GUWP as a regular agenda item for senior management meetings.
With respect to certain classes of insurance set out below, OSFI expects the FRI to consider the following when determining a Single Insurance Exposure:
| Property | The aggregated insurance exposures on in-force policies at a single location, including any exposures subject to the location. |
| Credit | The aggregated insurance exposures on in-force policies to any one single buyer or group of connected buyers. |
| Surety | The aggregated insurance exposures on in-force bonds to any one single contractor or group of connected contractors. |
| Title | The aggregated insurance exposures on in-force policies related to the legal title for a single location. |
OSFI expects FRIs to provide, upon request, all information with respect to its large Single Insurance Exposure. What is more, OSFI may use its discretion to advise an FRI to use specific criteria or an approach to determine and measure its maximum loss on a Single Insurance Exposure.
Insurance Limit Exposure
When considering an FRI’s direct business and assumed cessions from an affiliated entity that is a direct insurer of such risks, at no time should the FRI’s net retention, plus its largest net counterparty unregistered reinsurance exposure, due to the occurrence of a maximum loss on a Single Insurance Exposure, exceed the following limits:
| Insurance Companies | i. 100 percent of Total Capital Available1 where any entity in the P&C FRI’s control chain is a) a widely held company, and/or b) a regulated financial institution;
ii. 25 per cent of Total Capital Available otherwise. |
| Foreign Branches | 100 percent of Net Assets Available2 of the foreign branch |
Investment Concentration Limits
An FRI’s aggregate market value of investments3 in any one entity or group of affiliated companies should not exceed five percent of the FRI’s assets (for domestic FRIs) and five percent of the FRI’s assets in Canada (for foreign FRIs).
Conclusions
Canada’s insurance industry has been waiting for the new Guideline B-3 and Guideline B-2 for some time with anticipation, after years of effective public consultation. With these new Guidelines, it is clear that OSFI has attempted to strike a balance between ensuring safeguards are in place to address its concerns over reinsurance concentration limits, large cessions to a FRI’s home office, and effective and continued due diligence on reinsurance counterparties against the need to maintain effective principles-based regulation of Canada’s insurance industry in a way that allows continued innovation and an ability to leverage international efficiencies. When these Guidelines take effect in 2025, it will be 15 years after their last update in 2010. 15 years is a long time in an ever-evolving and rapidly-growing industry. We will see how these new Guidelines will age with market developments in the years after 2025 and whether they will need to be updated much sooner as a result.
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1 The consolidated total available capital of a company as defined for the purpose of calculating the Minimum Capital Test (MCT) / Mortgage Insurer Capital Adequacy Test (MICAT).
2 The net assets available as defined for the purposes of calculating the Branch Adequacy of Assets Test (BAAT).
3 An asset or item acquired with the goal of generating income or appreciation, excluding loans to, and loans guaranteed or securities issued or guaranteed by the Government of Canada, a Canadian province or a member jurisdiction of the Organisation for Economic Co-operation and Development (OECD).