On August 9, 2010, the Office of the Superintendent of Financial
Institutions (Canada) (OSFI), the Canadian federal prudential
insurance regulator, released for comment draft Guidance (the
Guidance) on the use of Reinsurance Security Agreements (RSAs). The
Guidance was accompanied by a letter (the Letter) that summarized
OSFI's rationale for discontinuing the previously utilized
mechanic of standard form reinsurance trust agreements (RTAs) and
outlined OSFI's new approach to RSAs. The Guidance, which is
open for comment until October 1, 2010, applies to all
federally-regulated insurers and reinsurers (each, a FRI) in
respect of reinsurance cessions and retrocessions with reinsurers
not licensed in Canada, and also outlines OSFI's expectations
of FRIs in connection with the RSA process. Once adopted, the
Guidance will significantly increase the administrative burden on
FRIs seeking to reinsure with unlicensed reinsurers and may, as a
result, significantly discourage the use of unlicensed
reinsurance.
This Insurance Law Update provides an overview of, and a commentary
on, the Guidance and Letter. OSFI has also simultaneously released
a draft Guideline on sound reinsurance practices and procedures.
Information regarding the draft Guideline can be found in Stikeman
Elliott's earlier
September 2010 Insurance Law Update.
Historical Background
The Letter advised that OSFI would no longer develop or be party
to standard form RTAs. Previously, OSFI had developed standard form
RTAs to which OSFI was a party and which FRIs were required to use
in order to be eligible for regulatory capital/asset credit in
respect of risks reinsured with unlicensed reinsurers.
OSFI's desire to change its role is understandable, as OSFI
practically does not have the expertise or resources to
continuously monitor and assess all applicable provincial
legislation. Nor, conceptually, should such drafting or monitoring
be OSFI's role or responsibility, and indeed, by comparison,
OSFI does not draft or become a party to commercial agreements
entered into by deposit-taking institutions it regulates.
In the Guidance, OSFI noted that its decision to discontinue use of
RTAs was supported by a number of factors, including the desire
to:
- require FRIs to better manage their own risks related to
unlicensed reinsurance;
- provide FRIs flexibility to create their own forms of security
agreements;
- as noted above, harmonize with the practice for other security
and collateral arrangements utilized by deposit-taking
institutions;
- recognize that the use of an appropriate standard form
agreement is a fact-specific determination and that the creation of
a first-ranking, perfected security interest depends on more than
just the form of the agreement;
- maintain access to Canadian courts; and
- as noted above, minimize OSFI's costs and responsibility associated with reviewing all applicable Canadian personal property legislation and securities transfer legislation (as would have been required in connection with the development of a standard form RSA).
New Approach
OSFI will now require FRIs to negotiate and enter into suitable
arrangements and take all necessary practical and operational
measures to create and maintain a valid, first-ranking security
interest in assets of an unlicensed reinsurer that are held in
Canada. Further, FRIs will be required to provide a legal opinion
addressed to the FRI and OSFI, and on which OSFI will be entitled
to rely, asserting that such an interest has been created in its
favour.
All agreements entered into after January 1, 2011 will be required
to comply with the new approach, although FRIs are encouraged to
migrate to the new regime as soon as possible. Practically, this
represents a very short timeline for compliance. In addition, and
importantly, OSFI expects that companies will replace all existing
agreements by January 1, 2012. That is also practically a very
short timeline for compliance with such a requirement and, as noted
below, may present significant commercial consequences for
FRIs.
In the Guidance, OSFI indicated that it will permit capital/asset
credit for reinsurance agreements in certain circumstances
including where the following criteria, among others, are
met:
- the assets of the unlicensed reinsurer are pledged to the FRI
pursuant to a security agreement made under provincial law;
- the pledged assets are held in Canada by a collateral agent,
which must be a Canadian financial institution not affiliated with
the unlicensed reinsurer;
- all relevant documentation is binding on the parties and
legally enforceable in all relevant jurisdictions;
- the FRI takes all necessary steps to create and maintain a
valid, first-ranking interest in the collateral;
- if the pledged assets are financial assets to which securities
transfer legislation applies, the collateral agent maintains
control of the assets on behalf of the FRI;
- the FRI provides OSFI with a legal opinion, addressed to the
FRI and OSFI and on which OSFI is entitled to rely, asserting that
a valid and enforceable first-ranking security interest in the
pledged assets has been created in its favour; and
- the credit quality of the reinsurer and the value of the collateral must not have a material positive correlation (for example, securities issued by the reinsurer or any related entity would provide little protection and would therefore be ineligible).
The legal opinion and accompanying RSA will be required to be
filed with the OSFI Securities Administration Unit.
OSFI expects FRIs to have a policy, approved by the board or a
committee of the board, requiring management to confirm to the
board/committee from time to time (but at least once every two
years) that a valid and enforceable first-ranking security interest
in the pledged assets continues to be created in the FRI's
favour, including where changes have been made to applicable
provincial/territorial personal property security legislation or
securities transfer legislation. It would appear that this
reconfirmation obligation will require FRIs to obtain reaffirmation
of existing opinions every two years, which will impose an
additional significant administrative burden and cost on FRIs. For
FRIs that are branches, OSFI expects that the Chief Agent will
ensure that the branch has an approved policy.
OSFI expects that the RSA will, at a minimum:
- include a reference to the applicable statute pursuant to which
the RSA is made;
- provide that the pledged assets shall be held in the province
pursuant to which the RSA has been made;
- provide that the collateral agent will, in respect of the
pledge, act solely as agent for the FRI and not as agent for the
reinsurer (which, we note, does not reflect the current securities
transfer legislation in respect of securities in the possession of
a securities intermediary);
- provide that the pledged assets will be held by the collateral
agent in one or more accounts identified in its records as separate
and distinct from other accounts of the collateral agent; and
- provide that the reinsurer agrees to deliver to, and maintain with, the collateral agent as collateral under the RSA, assets having a market value at all times at least equal to a specific amount or to an amount determined by formula.
OSFI expects the legal opinion to include:
- an assertion that the security interest in the pledged assets
is valid and enforceable against all other creditors of the
unlicensed reinsurer, including in the event of insolvency;
- a reference to the applicable provincial statute pursuant to
which the arrangement is made;
- a statement as to the validity and enforceability of the
security interest in the context of the applicable rules governing
conflicts of laws; and
- an assertion that a first-ranking priority is created by such security interest.
OSFI will continue to require ceding companies to obtain OSFI
approval (i) for the removal of pledged assets; (ii) to obtain
credit for assets that are not listed on Schedule A to the
Guidance; (iii) or for any transaction involving foreign currency
assets. The ceding company may, without OSFI's prior written
approval, accept a pledge of assets listed in Schedule A, and allow
the reinsurer to withdraw any asset if the asset withdrawn is
replaced either prior to or simultaneously with an asset listed in
Schedule A, the market value of which on the date of the
replacement is, and is certified by the ceding company to OSFI to
be, at least equal to the market value of the asset withdrawn. If
an asset is to be replaced with an asset not on Schedule A, it will
require OSFI approval. Schedule A assets are limited to bonds,
debentures and other evidences of indebtedness of Canadian
governmental entities and Canadian companies holding a minimum
rating, potentially A-, from a nationally recognized rating agency,
as well as common and preferred shares traded on a recognized stock
exchange in Canada.
Commentary
As noted above, the new approach is commendable in the sense
that it gets OSFI out of the business of drafting or being a party
to commercial contracts, and to that extent is consistent with the
approach taken to the deposit-taking sector.
However, the abandoning of the use of a standard form agreement
will impose substantial new burdens on FRIs seeking to utilize
unlicensed reinsurers, as FRIs will now be required to negotiate
the forms of (i) RSAs having regard to both the applicable
provincial law and the laws of the jurisdiction of the unlicensed
reinsurer, (ii) related opinions under applicable provincial law
and (iii) appropriately (although not expressly required by the
Guidance), related opinions under the laws of the jurisdiction of
the unlicensed reinsurer. Further, FRIs will face the uncertainty
of whether OSFI, upon a review of an FRI's RSA and related
opinions, would challenge the form/acceptability of the RSA and
related opinions and deny capital/asset credit on that basis.
Consequently, the new regime may significantly discourage the use
of unlicensed reinsurers, as the increased internal and external
costs may make many such arrangements uneconomical. Practically,
FRIs may wish to attempt, including through their industry
associations, to settle a number of standard form RSAs and related
opinions for use in connection with the small number of domiciles
of the leading unlicensed reinsurers.
Although the Letter and Guidance take a principles-based approach
and are intended to provide FRIs with increased flexibility,
certain requirements under the Guidance are actually quite
prescriptive and, further, are inconsistent with the approach taken
for banks in respect of collateral for derivatives. It is not clear
why it is necessary that RSAs be made under provincial law, that
the pledged assets be held in Canada or that the collateral agent
be a Canadian financial institution, as none of those requirements
apply to banks in the context of derivatives. With respect to the
requirement for legal opinions from a number of jurisdictions, over
time hopefully it will be possible for FRIs, including through
their industry associations, to collectively develop and rely on
general advice and opinions such as those published by the
International Swap Dealers Association in respect of swaps in
relation to various jurisdictions.
While OSFI obviously has an interest in the quality of the
collateral pledged, it could address this issue directly rather
than by imposing constraints relating to the form and jurisdiction
of the pledge. In general, security arrangements are more flexible
and allow for the taking of the security in other jurisdictions. As
in the case of deposit-taking institutions, the onus should
reasonably be on the FRI to satisfy itself that it has taken all
appropriate steps and obtained all necessary documentation under
applicable foreign law. As a result of recent developments under
Canadian and foreign law, it has become much easier to obtain valid
and perfected security in certain foreign jurisdictions.
The lack of any grandfathering of existing RTAs will require FRIs
to obtain the cooperation of their unlicensed reinsurers in order
to replace existing RTAs with new RSAs. This will impose a
significant commercial risk on FRIs, as they will be forced to
reopen negotiations and face the prospect of being forced to agree
to less favourable terms than at present.
Further, certain of the quite prescriptive requirements with
respect to the required legal opinions are not consistent with
market practice, may likely make compliance difficult. In
particular, opinions are typically subject to standard assumptions
and exceptions with respect to priority, and to a qualification
with respect to enforceability under insolvency laws, all of which
OSFI will ideally appreciate and accept, consistent with current
market practice.
Lastly, it is not yet clear whether OSFI's RSA mechanic and
form will be acceptable to any provincial insurance regulators
asserting co-jurisdiction over capital/asset levels supporting
risks located in their provinces and written by federally-licensed
insurers also licensed and carrying on business in the applicable
province (or, conversely, whether any required provincial
mechanism/agreements will be satisfactory to OSFI), although we
understand that discussions are to occur in that connection.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.