Canadian regulator calls for more due diligence on reinsurers that use ILS

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The Canadian financial markets regulator, the Office of the Superintendent of Financial Institutions (OSFI), has called for ceding companies to perform a higher level of due diligence on reinsurance purchases involving ILS and alternative sources of capital.

The OSFI recently published a new Reinsurance Framework Discussion Paper (accessible here), which details changes that are being considered in the regulators current reinsurance framework and provides advice to federally regulated insurers (FRI’s).

The discussion paper features proposals related to the dangers associated with large exposures and risk concentration, particularly in the property and casualty (P&C) insurance sector, as well as potential adjustments to the capital framework for P&C insurers that the regulator is also considering.

Neville Henderson, Assistant Superintendent, Insurance Supervision Sector, explained what the regulators aims are with the discussion paper, “In light of the increasing reliance on reinsurance and the emergence of new and evolving business models related to the use of reinsurance, OSFI is working to ensure its reinsurance framework remains appropriate. This discussion paper is a key step in OSFI’s commitment to engage stakeholders, and all responses that will help maintain an effective regulatory approach to reinsurance will be carefully considered.”

Deep in the discussion paper is a section on insurance-linked securities (ILS), which the OFSI says has been driving an increasing number of queries to its door.

The Canadian financial regulator states, “A reinsurer that transfers the risks it assumes to investors, via ILS, may have a very different risk profile relative to a traditional reinsurer.”

A different risk profile is possible, however ILS is typically just a component of the overall reinsurance program these days and often on very similar terms to the rest of an reinsurers retrocession arrangements.

But the OSFI explains that it, “Expects a FRI to conduct a commensurately higher level of due diligence in respect of its reinsurance counterparty, and to carefully consider the unique risks associated with relying on a reinsurer that itself relies on non-traditional sources of funding.”

It’s an interesting suggestion, that more due diligence should be undertaken on reinsurers that use the capital markets as a source of retrocession.

It’s hard to think of many reinsurance firms around the globe which do not have an element of collateralized coverage within their retrocessional reinsurance programs, these days.

In fact, more reinsurers than ever are using the capital market investors for pure retrocession, via collateralized retro and ILS fund specialists, but additionally more than ever are also now utilising third-party capital as an augmentation tool for their own balance-sheet capacity, which makes it very hard to distinguish between the two.

It’s difficult to say exactly what the regulator is thinking here. But does it feel that ceding insurers that are federally regulated in Canada face higher risks from entering into reinsurance agreements with reinsurers that utilise ILS and alternative capital?

It’s particularly interesting given the fully collateralized nature of ILS and other alternative capital structures and solutions. When the biggest catastrophes or loss events strike, it’s just as likely that traditional retrocessionaires go belly up as capital markets backed retrocessionaires do.

However, there are unique differences and issues such as the potential for collateral trapping that could mean a retro provider has less capital available when a claim needs to be made than it did when the contract was entered into.

Although, again there is a risk associated with traditional retrocessionaires here as well, as there is no guarantee of their ability to recapitalise and they too face contracts being trapped, weighing on balance-sheet capacity.

The capital market model could actually be quicker to reload on capital, in some cases, especially those backed by major institutional investors, so there are positives to the non-traditional model that should also be considered.

There are also cost considerations and the fact that maintaining a diversified reinsurance program, without tapping reinsurers that themselves use ILS or alternative capital, could these days be a difficult thing to achieve. That would reduce the potential for Canadian insurers to diversify their risks outside of the borders of the country, potentially resulting in greater concentration risks.

Perhaps the issue should not be that more due diligence is required of a reinsurer taps the capital markets, as actually this means more scrutiny is required on virtually every major reinsurer in the world, under that view of the OSFI’s regulations.

Rather that full due diligence is required if you’re going to trust any re/insurer to be there when you need them, whether they are traditionally structured or a reinsurer leveraging multiple sources of capital.

The OSFI is inviting comments on its intention to revise its Sound Reinsurance Practices and Procedures guidelines to include these expectations for insurers that cede risks to reinsurers that utilise ILS or alternative capital.

Comments on the discussion paper can be emailed by September 15th 2018 to: [email protected]

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