Canadian regulator OSFI investigating offshore reinsurance

The Canadian insurance regulator, the Office of the Superintendent of Financial Institutions (OSFI), is investigating the use of offshore reinsurance as it seeks to ensure that insurance companies are able to meet their obligations to policyholders if they encounter stress.

Speaking at the 2015 Property and Casualty Insurance Industry Forum in Cambridge, Ontario on 4th June, Superintendent of the OFSI Jeremy Rudin explained that the regulator is assessing the scope and potential impacts that “recent changes in reinsurance practices” may have on Canada’s insurance industry.

The OFSI wants to ensure that the practice of entering into reinsurance agreements with unregistered (in Canada) offshore entities cannot impact insurers ability to pay claims when major losses or disasters occur.

The investigation seems to have been kicked off as the OFSI has noticed the increasing use of reinsurance as capital for insurers. This trend has been ongoing for years in reality, and in fact the bulk of the catastrophe reinsurance capacity in the world is now located offshore.

“We want to ensure that when the use of reinsurance serves as a substitute for capital, it is not used in a manner that leaves policyholders less protected,” Rudin explained in his speech.

He explained what it is that the regulator has noticed and has caught its interest, saying; “Recently we have noticed that some firms have been shifting toward a business model of insuring commercial risks in Canada and reinsuring a significant portion, or virtually all, of the risk offshore. Often, risks are ceded to unregistered affiliates, with little capital retention in Canada.”

He acknowledged that this has been a common practice for transferring large or catastrophic risks for some time, with offshore reinsurance markets providing the capacity, however the regulators concern is that the way this is achieved has changed and could put more risk on the country’s insurance industry.

“What we are seeing more recently seems to fall into a different category. It appears to be being used by insurers to increase policy limits and sizes without changing net risk retention. This means that exposures ceded are quite large. It also means that exposures are going up without a commensurate increase in the capital of the direct writer,” Rudin continued.

Now it has to be noted at this time that one of the reasons risk transfer works is that the cedant can offload risk to another party in its entirety, without having to hold additional capital. By paying a premium to transfer, or reinsurer, the risk the cedant can benefit from reducing its own exposure.

Rudin went on to explain the regulators concern; “Taken to extremes, this shifting business model introduces a very concentrated credit risk to policyholders. This raises prudential concerns given the possibility of distress in the unregistered reinsurer, whether affiliated or not.”

And then Rudin gets to the real issue that the regulator sees. That by reinsuring with unregistered entities in offshore domiciles Canadian insurers could find that the continuity is not there when they need it.

“History has shown that over-reliance on reinsurance can be dangerous if it is used as a means to “rent” capital to support rapid growth in insurance premiums. Reinsurance cover can evaporate when an insurer encounters stress, and this is usually happens when the company needs the reinsurance the most. This can leave the company in a struggle to renew its commitments. Ultimately, the company may be forced to quickly raise fresh capital to replace the disappearing reinsurance cover. And if it cannot raise that capital, it may fail,” he explained.

Playing devils advocate here, if the reinsurers were domiciled in Canada there would still be no guarantee that they would be there to support Canadian insurers in their times of need. Location is no guarantee of continuity of capital.

The OSFI has a guideline which looks at “reinsurance risk management practices such as the importance of diversification of reinsurers and robust, frequent credit evaluation of reinsurers.”

So in reality it may be that the OSFI has some concern about reinsurance companies that are protecting Canadian insurers for whom there is little information such as credit worthiness available.

It’s difficult to see how this could be targeted at insurance-linked securities (ILS) fund managers who provide collateralized reinsurance to Canadian insurance companies. The fully-collateralized nature of ILS capital products should perhaps negate the concerns about credit worthiness.

Although it should be noted that the OSFI has in the past expressed some concern about the motives of third-party reinsurance capital investors.

So the OSFI will assess the “prudential implications of new uses of reinsurance.” This is something that many other regulators around the world have been doing in recent years. It has perhaps been triggered by growing use of collateralized reinsurance, as well as the increasing number of offshore entities such as reinsurance sidecars and start-ups.

The regulator told the Canadian press that the aim is to ensure that the Canadian policyholder is protected. That’s a valid goal and it’s important to asses reinsurance capital quality in respect of this.

However, the reinsurance market is increasingly global, often offshore and in the coming years it is likely that Canadian insurers will look abroad for a growing proportion of the reinsurance capacity they need.

That’s the way the market has been going in recent years and other regulators have come to accept that. With the understanding that a globally diversified, combined reinsurance and capital market is the best source of the risk transfer capacity that insurers need.