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Royal & Sun Alliance Submission in Response to Finance Canada's 2006 Review of Financial Sector Legislation:

June 1, 2005

Gerry Salembier
Director, Financial Institutions Division
Financial Sector Policy Branch
Department of Finance
L'Esplanade Laurier
20th Floor, East Tower
140 O'Connor Street
Ottawa, Canada
K1A 0G5

Dear Mr. Salembier,

I am pleased to provide you with comments on the Government's consultation paper, An Effective and Efficient Legislative Framework for the Canadian Financial Services Sector.

Improved Access to Global Reinsurance Markets

Securing reinsurance protection against larger risks or the potential accumulation of smaller risks due to natural disasters is a vital requirement for insurance companies. The global reinsurance market includes many large international companies with substantial capital, a global spread of risk, and sophisticated underwriting capability. It has responded well to major catastrophes such as the World Trade Centre, Florida hurricanes, earthquakes and tsunamis. At present, Canadian insurers seeking to access global reinsurance markets face numerous legislative and regulatory impediments in doing so – impediments which do not apply to reinsurance placed with Canadian reinsurance companies or branches. Section 6 of the Reinsurance (Canadian Companies) Regulations (the "Reinsurance Regulation") made pursuant to the Insurance Companies Act (the "ICA") prohibits companies reinsuring more than 25% of their premiums with foreign reinsurers (i.e. non-approved insurers). In addition, the capital regulations imposed by OSFI provide virtually full recognition for reinsurance placed with domestically regulated reinsurers but no recognition for reinsurance placed with foreign reinsurers – representing a punitive disadvantage on insurers seeking to place reinsurance outside Canada. The result of these restrictions is to essentially compel Canadian insurers to obtain most of their reinsurance with Canadian reinsurance companies, effectively preventing them from seeking out the strongest, most stable and cost effective reinsurance arrangements available globally. This situation inhibits competition, potentially increases the costs and reduces the availability of reinsurance. This is not simply an issue for the Canadian insurance industry. The cost and availability of reinsurance to Canadian insurers directly impacts the cost and extent of insurance protection they can provide to Canadian consumers and businesses. More seriously still, these restrictions potentially represent a systemic risk to the Canadian economy. The Canadian reinsurance sector is relatively small. The largest domestic reinsurer has a capital base of less than $400 million and the entire sector has capital of less than $2 billion – a small fraction of the potential cost of a major natural disaster. While it is true that the major Canadian reinsurers have very substantial foreign parents which would be expected to provide capital support in the event it were required, there is no legal requirement for them to do so. (Some of the Canadian reinsurers operate as branches rather than subsidiaries of the foreign parent. In this situation, there would be a legal obligation on the foreign parent to honour Canadian claims.) The reality is that even the largest Canadian reinsurers have nowhere near the capital base, breadth or stability of the larger global reinsurers. Effectively compelling Canadian insurers to place their reinsurance with domestic companies represents an increased risk that Canadian insurers would be unable to meet their obligations due to their inability to recover on their reinsurance arrangements.

We recommend that the ICA, the regulations thereto and the OSFI guidelines be amended to allow Canadian insurers with unfettered access to the global reinsurance markets. In an era where capital and risk transfer flows freely around the globe, the current restrictions are out-dated and detrimental – both to the Canadian insurance industry and to the availability and cost of insurance to Canadian businesses generally. Canadian banks seeking to transfer risk do not face comparable restrictions and we are not aware of similar restrictions in any other major industrialized country.

We do acknowledge the critical importance of ensuring that reinsurance is placed with financially strong and stable companies. Accordingly, we recommend that OSFI require that reinsurance be placed only with global reinsurers that meet a prescribed minimum credit rating. Investment risk is a close analogy and we note that the legislation and capital guidelines do not restrict investments in foreign entities. Instead, the capital guidelines relate the amount of capital to the credit rating of the company in which the investment is made. This is a reasonable and effective approach and has worked well in inducing insurers to maintain a high quality investment portfolio.

Use of Subordinated Debt to Meet Capital Requirements

While OSFI's capital guidelines permit the inclusion of subordinated debt as part of regulatory capital, Section 476 of the ICA currently restricts insurers from borrowing amounts in excess of 2% of total assets. Given typical asset/capital leverage of 3:1, the 2% limitation would represent 6% of capital and is, accordingly, too low a limit to be meaningful. By contrast Canadian banks and life companies are allowed to issue and utilize subordinated debt to meet a significant proportion of their capital requirements and virtually all of the major banks and lifecos do so.

IBC studies have indicated that the capital requirements applicable to Canadian P&C companies are higher than those of most other major industrialized countries. While higher capital requirements represent increased financial security, they also put upwards pressure on pricing as insurers need to make a return on the capital invested. This adversely affects Canadian consumers and businesses. This result is compounded by the inability to use subordinated debt for any portion of the capital requirements. Permitting the use of subordinated debt would allow insurers to substitute debt for equity which could partially mitigate the impact on pricing of the higher Canadian capital requirements.

Accordingly, we recommend that insurers be allowed to borrow up to 15% of their assets subject to the condition that this debt is subordinate to obligations to policyholders (which would be the case under existing legislation). The recommendation of 15% reflects the fact that the ratio of assets to capital for insurers would generally range from 3:1 to 4:1. At 3:1, 15% of assets would equate to 45% of capital which we feel is an appropriate maximum.

Elimination of Pooling Restrictions

The Reinsurance Regulation generally prohibits companies from establishing pooling arrangements. These are arrangements under which risks written by an individual company are pooled throughout a corporate group.

In most situations, pooling arrangements are desirable in that they spread risks over a broader base which tends to reduce volatility and the risk of failure by any individual member of the pool. The economic result is no different than had the companies within the pool been a single legal entity. Many insurers in Canada undertake their business through multiple legal entities to provide distinct branding and greater rating flexibility. While a corporate group may be large, the individual companies may be relatively small and thus more vulnerable to unexpected or abnormal market conditions. Pooling the results is desirable in that it spreads the risks and reduces the vulnerability of the smaller companies.

We believe that pooling arrangements should be permitted subject to OSFI's approval. Accordingly, we recommend that the restrictions on pooling currently within the ICA and the regulations thereto be eliminated.

We thank you for the opportunity to provide you with our comments and I would be happy to discuss the foregoing points with you.

Yours very truly,

J. Philip Wilson
Vice President Finance