Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce

Issue 11 - Evidence - May 14, 2014

OTTAWA, Wednesday, May 14, 2014

The Standing Senate Committee on Banking, Trade and Commerce, met this day at 4:15 p.m. to examine the subject matter of those elements contained in Parts 2, 3 and 4 and Divisions 2, 3, 4, 8, 13, 14, 19, 22, 24 and 25 of Part 6 of Bill C-31, An Act to implement certain provisions of the budget tabled in Parliament on February 11, 2014, and other measures.

Senator Irving Gerstein (Chair) in the chair.


The Chair: Today is our fourth of five meetings as part of the pre-study of Bill C-31, An Act to implement certain provisions of the budget tabled in Parliament on February 11, 2014, and other measures.

We're going to start today with Part 6, Division 13, which amends the Bank Act to add regulation-making powers respecting a bank's activities in relation to derivatives and benchmarks.

Part 6, Division 13, can be found in tab F-13 in your briefing binder and at page 144 of the bill.

Two weeks ago, we heard from government officials on the topic, and today we are pleased to welcome representatives from the banking sector. First, we have, from the Canadian Bankers Association, Ms. Marina Mandal, Senior Legal Counsel; and from Scotiabank, Mr. Kenneth Thorlakson, Vice-President and Associate General Counsel.

Thank you to both of you for being here today. I will turn the floor over to Ms. Mandal first for her presentation, and then to Mr. Thorlakson.

Marina Mandal, Senior Legal Counsel, Canadian Bankers Association: Good afternoon. My name is Marina Mandal and I'm Senior Legal Counsel with the Canadian Bankers Association, the CBA. I'm joined today by Kenneth Thorlakson, Vice-President and Associate General Counsel with Scotiabank.

We're pleased to be here today at the committee's invitation to discuss Bill C-31, and in particular, Division 13 of Part 6, which contains provisions to amend the Bank Act to give the Department of Finance regulation-making authority over derivatives and financial benchmarks.

The Chair: Could I ask you to slow down just a little, because you may be rushing our interpreters.

Ms. Mandal: The CBA works on behalf of 60 domestic banks, foreign bank subsidiaries and foreign bank branches operating in Canada and its 275,000 employees.

In Budget 2014, the government announced its intention to amend the Bank Act to create an explicit regulation- making authority for banks regarding over-the-counter derivatives. The CBA strongly supports the proposed amendments to the Bank Act to make clear that the federal government has the authority to regulate OTC derivatives transactions where a bank is a counterparty.

Derivatives play a significant role in the economy by allowing businesses to manage and hedge risk. In the banking context, derivatives allow banks to manage their exposure to credit risk, which helps them expand their lending and investment capabilities.

Risk management is overseen, as you know, by the Office of the Superintendent of Financial Institutions as the bank's prudential regulator. OSFI has always been responsible for the oversight of bank derivatives activities, as part of its mandate to ensure the safety and soundness of Canadian banks. OSFI also has always had the ability to access data regarding derivatives transactions that Canadian banks enter into with foreign counterparts. In that sense, the derivatives businesses of Canadian banks have always been subject to oversight and regulation.

Transactions in OTC derivatives take place between highly sophisticated, well-capitalized corporations, including financial institutions. It is important to note that there is no retail market for OTC derivatives. Canada's five largest banks operate in these markets globally and they are the counterparties to over 95 per cent of OTC derivatives transactions that take place in Canada.

In 2009, the G20 countries committed to improving transparency and reducing systemic risk in the global OTC derivatives markets by requiring contracts to be traded on exchanges or electronic trading platforms, and cleared through central counterparties.

All derivatives trades were to be reported to trade repositories, to which regulators would have access, and non- centrally cleared derivatives trades would be subject to higher capital requirements. Since 2009, all major G20 jurisdictions have made significant progress in implementing regulatory reforms of OTC derivatives markets.

Also since 2009, OSFI has been working with a number of other Canadian regulators to develop a Canadian regulatory structure that will meet the G20 commitments.

Furthermore, in addition to other guidance provided to banks, we understand that OSFI will be issuing, in the near future, revised guidance for the banks' derivatives businesses. OSFI has also been working with the U.S. and other foreign regulators on harmonization of cross-border rules. This is necessary to ensure that the Canadian banks that transact in derivatives on a global basis are able to rely on Canadian rules rather than having to comply with multiple, often conflicting rules in various jurisdictions.

As you know, Division 13 of Part 6 in Bill C-31 also proposes amendments to the Bank Act that gives the federal government regulation-making authority in respect of banks' activities relating to financial benchmarks. Although the CBA did not advocate for this amendment, we have no concerns with it and the banking industry is looking forward to working with OSFI as it carries out its new mandate to oversee the settling of financial benchmarks in Canada.

We look forward to your questions.

The Chair: Mr. Thorlakson, did you have any opening comments you wish to make?

Kenneth Thorlakson, Vice-President and Associate General Counsel, Scotiabank: Thank you. It's a pleasure and an honour to be here. I don't have any introductory comments. I'm here as a member of Scotiabank and a representative of the Canadian banks that are very happy to support this legislation.

The Chair: Supportive of all of the comments Ms. Mandal made?

Mr. Thorlakson: Yes, absolutely.

Senator Black: Thank you to you both, and welcome.

If all of the presentations were so constructive and quick and supportive our work would be much easier. Thank you very much for that.

I hear you're very supportive of this legislation. My question to you both is: Would you have any suggestions to us for any areas that could be enhanced, improved, strengthened? Could we go further? Should we go further? This is an opportunity to give us some advice here.

Ms. Mandal: I'm happy to start and Mr. Thorlakson can supplement.

From my perspective, the way the derivatives process is defined in the proposed amendment is broad enough that it gives the federal government ample scope to introduce what needs to be introduced to keep us in line, and perhaps exceeding international standards.

Senator Black: Very well.

Mr. Thorlakson: I would echo that comment and say that this is an important step in the regulation of OTC derivatives and being involved in the international coordination of those efforts. What it will do is open the door and provide an opportunity for an explicit derivative regulation to be passed under the Bank Act to govern the banks' activities with OTC derivatives. That's helpful not only in terms of developing that regime in relation to derivatives, but also in demonstrating to international regulators and international counterparties when they look to Canada.

Ever since the financial crisis and the reforms that were put in place, regulators around the world are looking at each other's systems and regimes to be able to gauge the robustness and equivalence of those regimes, to the extent we have those in place. But by no means is this the last step. It's really the first step in terms of developing that within the Bank Act. In my view, there's no way to improve it other than to pass it in its present form and then proceed into that regulation-making power.

Senator Black: I have a further question. Is it your view that as the derivatives markets change — and one expects they will change through time — do the existing regulations or the power that's been granted here give the proper authorities the scope needed to adapt?

Mr. Thorlakson: Yes, I believe it does. If you look at the definition of the derivative, which takes up almost half of the amendment itself, it is very broad and all encompassing. But that is reflective of the fact that derivatives are a broad category of transactions and to the extent that the underlying reference assets that are referred to in that definition are also very broad, that will allow the regulators and the market to react to new types of transactions and to be able to include them, as opposed to excluding them, in a comprehensive and consistent international regime.


Senator Maltais: First, I would like to congratulate you on supporting our bill. It addresses a current and future situation.

I will speak on behalf of consumers. With respect to derivatives in the area of insurance, we know that banks and credit unions have been offering life insurance, home insurance, automobile insurance and mortgage insurance for many years.

The issue that results in most complaints is the lack of a firewall between the bank issuing the insurance policies and the client. There is no intermediary between the bank and the client.

When there is a conflict, the person ends up facing a large financial institution with a voice that is not as strong as the institution's.

In the future, could an arbitrator be involved in conflicts between the consumer and the financial institution issuing insurance policies? Have you already thought of that?


Ms. Mandal: I want to make sure I understand your question correctly. In terms of the interaction with a consumer that has a concern with the bank they're dealing with, there are a number of routes they can go. There's an internal complaints process, and each bank has a designated ombudsman internally to essentially mediate between the customer and the bank. If the customer is still concerned, they would be going outside. There are at this time two external complaint bodies. Again, it's impartial mediation of the dispute.

Does that answer your question?


Senator Maltais: Somewhat, but I would like you to be firmer. I did not know that each bank has an ombudsman. I do not think I am the only person not to know that. When you walk into a bank, you see a wide range of pamphlets telling you what services the bank offers. Could one be added to say that there is an ombudsman available in the event of conflicts?


Ms. Mandal: Unfortunately, the consumer relations aspect is not my area of specialty. One of my colleagues at the CBA deals with that. But we at the CBA can definitely follow up with you with more information. What I can say is I neglected to mention that in addition to the internal complaints process and the external complaint bodies, there's also the opportunity for the consumer to go to the Financial Consumer Agency of Canada with a complaint about how the bank has behaved towards the consumer. The right of the consumer to do that is in brochures that are placed in every bank branch on the website, and that's a legal requirement. It's a requirement under the Bank Act.

In terms of the internal ombudsman and the external complaints body, those are legal requirements, but I'm not sure if they're required to be posted. We can definitely follow up on that.


Senator Maltais: You argue very well, but consumers are borrowers, not arguers. We know that all these mechanisms exist, but the average consumer, who earns $50,000 or less a year, is not aware of all of this and does not necessarily have the time or the knowledge. If you did a little more advertising — and it would not cost much more — you could explain that there is someone who consumers could speak to in order to try to resolve the conflict instead of going before these organizations and sometimes before the courts.


The Chair: Thank you very much for the point.

Senator Hervieux-Payette: Regularly, we hear that there are billions of dollars of our financial institutions in Barbados and other foreign countries where the fiscal laws are certainly not as stringent as in Canada. I was wondering if OSFI was supervising the activities of our financial institutions in these countries.

Ms. Mandal: OSFI does supervise on a consolidated basis. Any Canadian bank that has a subsidiary in another jurisdiction, no matter what the jurisdiction is, would be under OSFI's oversight and regulation.

Senator Hervieux-Payette: Can I have more information from you, Mr. Thorlakson, about mainly your activities in the Americas? Your organization is very active. I've seen your installation in many countries. In this case, are you subject to both the country where you operate, like Mexico, Argentina and others, and also our own supervision in these countries?

Mr. Thorlakson: Thank you for the question. It is quite interesting, because it raises some of the issues that, although not directly related to derivatives, are part of the rationale behind this legislation. To the extent that we have foreign banking activities or foreign banking subsidiaries, we are subject to local regulatory oversight and we are also subject to comprehensive jurisdiction of OSFI of the bank and all of its consolidated subsidiaries, and we need to adhere fundamentally to the rules and requirements of our home jurisdiction.

Within that context, international bank regulators or other types of financial services regulators will look to cooperate or look to each other to determine and to be satisfied that, to the extent that certain activities take place in the home office as opposed to the local affiliate or the local branch, there's a mutual recognition.

Again, going back to the heart of this legislation, it's designed to be able to demonstrate, not to create a regulation- making authority around derivatives as something new, but to recognize and to demonstrate to international regulators that when they come to Canada to see if there's an equivalent regime in place, they know where to look.

Senator Hervieux-Payette: What's the process? Do you have to submit the structure of the new derivatives that you're putting in the market, which could be sold probably outside of Canada as well? Is it submitted here before it's being put on the market, or is it after the fact?

Mr. Thorlakson: Within each financial institution, under OSFI's risk management framework and oversight, one of the components is that, to the extent that you develop a new product, it has to undergo an internal review by a wide variety of stakeholders and to look at it from a financial aspect, from a market risk aspect, from a credit risk aspect, from a customer perspective. Those operations do take place internally to the extent that an institution would undertake a new type of derivative transaction.

Senator Hervieux-Payette: You are not replying to my question. I'm talking about OSFI. Do they see the new product? Do they understand the new product? Sometimes we have adventures with people being in the trade, and even the presidents of very large institutions do not understand the product that was put on the market.

Is there an exchange of information with the OSFI people?

Mr. Thorlakson: It's difficult for me to actually voice an opinion on the part of OSFI, but I can say that as a federally regulated institution, to the extent that we are undertaking new activities, we are under the guidance of and oversight from OSFI in terms of the controls and the safeguards that we fundamentally are required to maintain, and to the extent that we do not do that, then that would be an issue with the regulator.

Senator Hervieux-Payette: It's a higher level than before, now?

Ms. Mandal: Absolutely.

Senator Hervieux-Payette: It's a higher level of supervision than it was before, before the downfall in 2008 and 2009?

Mr. Thorlakson: Again, I would say that in relation to derivatives, there's more of an explicit focus on derivatives as being a type of transaction, but that is not to say that that didn't occur previously, that the types of risks that were present in derivatives have always been managed and subject to regulatory oversight and to an institution's own governance framework.


Senator Bellemare: I will continue along the same line of questioning. You answered briefly. However, I would like some clarification. Under this bill, the regulatory authority that would be given to the Office of the Superintendent of Financial Institutions would reduce the risks when it comes to derivatives.

If that regulatory provision had existed in 2007-08, would the asset-backed commercial papers have been identified as hazardous products?


Mr. Thorlakson: It's very difficult to respond to a hypothetical, because again I would emphasize the point that this regulating authority is not new; it's just more evident within the context of the Bank Act and the regulation being contemplated. You're relating back to specific events that emanated from the financial crisis, of which there were multiple causes. Although derivatives were a component of that, and the fact that international counterparties engaged in certain activities that were risky or were either not properly recognized in terms of measuring them, and then mitigating them through the use of collateral, there were aspects of that. I think the joint efforts of the international regulators and legislators to go comprehensively through the OTC derivatives market and to make sure that there is more transparency around what the risks are, where they're being transferred and how they're being collateralized or mitigated, I think the design of this is very much to try to prevent those same types of events from coalescing into a particular crisis, within a particular institution or a particular market.


Senator Bellemare: Suppose that regulation had been in force in 2007 and 2008. How would the movement of those derivatives been monitored? The derivatives did not come from banks in particular. However, some banks, including the National Bank, faced losses. What do you think would have happened? The current regulation is not specific enough to be able to imagine a scenario.


Mr. Thorlakson: Again, it's very difficult to answer a hypothetical question, but I think the intent of these reforms is to be better able to assess where the risk is going, because I think it's important to recognize that the derivative itself does not create risk; it does not give rise to risk so much as it transfers it from one counterparty to another, or it can concentrate or it can diffuse the risks. I think the intent of the international reforms is to make sure that where those risks are being transmitted inappropriately or concentrated within a particular institution — Lehman Brothers comes to mind — there would be an opportunity for their primary regulators, or even in cooperation, because if you think about Lehman, it failed in the U.S. and also failed in England, but to give the relevant regulators the opportunity to see how much risk is there, how much it wasn't mitigated, and then an opportunity to step in and save an institution as opposed to letting it fail. I think that very much is part of it.

The other part of the equation, of course, is, if that risk takes an institution too far, that ``too big to fail'' is deemed to be over, and then there are means by which you could resolve an institution without causing a catastrophic event that could have a knock-on effect among a variety of financial institutions.

Senator Moore: Thank you, witnesses, for being here. Ms. Mandal, in your remarks you said it's important to note that there is no retail market for the over-the-counter derivatives, yet after 2009 there was an effort to put in place a requirement that contracts for derivatives be traded on exchanges. Who trades in them?

Ms. Mandal: The trades are happening between say a bank and a very large corporation. I think Ken can give you a couple of concrete examples of that. It's not the traditional exchanges we have like the TSX or the New York Stock Exchange. It's a whole new facility, so in the U.S. they are called swap execution facilities. For clarity, the term used is ``exchange,'' but it's not open to retail investors to invest in.

Senator Moore: Do we have such a facility in Canada?

Mr. Thorlakson: No, we don't at this point. It's probably an overly expressive word to say a ``revolution,'' but there is certainly an evolution going on within the OTC derivatives market to the extent that the G20 reforms are requiring trading on trading facilities. There are exchanges, swap execution facilities, other trading platforms. Again, the goal is to increase transparency and to have some level of reporting. Actually they have a very high degree of reporting in real time as to the trades being conducted and the pricing of those trades. The participants in that market are overwhelmingly an institutional professional market, financial institutions, regulated brokers and dealers, large funds, pension funds. You can have a wide variety.

Senator Moore: Is there one exchange or facility that Canadian banks use? Is it in the U.S., is it in London?

Mr. Thorlakson: Right now there is a variety. There are a handful of six or seven that have been recognized and registered within the U.S., and there are also some trading platforms in the U.K. Between the European and the U.S. regulators, they have embarked on a journey to mutually recognize each trading platform, again on the basis that the international cooperation requires them to grant equivalents if they think that they're being run in a proper and effective manner. There are several.

Senator Moore: Who checks to make sure there is some substance behind these derivatives down the line? Who goes back to the beginning to make sure there was something there on which all of this trading is based?

Mr. Thorlakson: Fundamentally, that would rest with either institution that is a counter-party to the transaction. Depending on what it is, recognizing how broad a derivative can be — to the extent a risk is being transferred away or to an institution — it is incumbent on them to do a thorough analysis of the transaction and the counterparty you are dealing with. And to the extent that counterparty is transferring risk it acquired elsewhere, you would look to establish that through legal and other due diligence.

Senator Moore: Another part of this, and the wording here, is benchmarks. Explain to me, if you would, what are the benchmarks? Who determines them and how does that work in this whole derivatives market?

Ms. Mandal: I'm not sure that the intention behind introducing the financial benchmarks amendments was necessarily to tie it to the OTC derivatives amendments or the derivatives amendments.

Senator Moore: What were they for? It's mentioned here, and I don't know what it means. I want to know how it works, when would the Governor-in-Council step in and what would trigger that? This is complicated stuff, and I don't think the average citizen understands it. I struggle with it myself.

Mr. Thorlakson: I think it is best to look at the two components of the amendment independently. They coincide more in terms of timing than any direct relationship. It's a matter of demonstrating to international regulatory authorities that, to the extent that benchmarks are set in Canada or that Canadian banks participate in setting of a benchmark, a benchmark is a rate of interest or another rate or index that is used for purposes other than the pure transaction you're dealing with.

Senator Moore: It has nothing to do with derivatives.

Mr. Thorlakson: Only insofar as a derivative might make reference to a benchmark, but they are otherwise independent thoughts or concepts. The purpose of this is to better evidence OSFI's role and the federal government's role in terms of establishing or enhancing any existing practices in order to meet emerging international norms.

Senator Moore: What would be the circumstances that would get the attention of the Governor-in-Council and how would the Governor-in-Council act? What does this anticipate?

Ms. Mandal: I can address that. Part of the background to this is the International Organization of Securities Commissions last year issued best Principles for Financial Benchmarks. Regulators in Canada — the federal government as well as provincial regulators — took a closer look at the CDOR to ensure that —

Senator Moore: Can you explain what that is to people who may be listening because that is a key thing, too. Could you explain what a CDOR is?

Mr. Thorlakson: This gets into some arcane bank type issues, but the CDOR rate is an average rate that is based upon an effective yield or effective rate of interest that is determined by reference to a banking negotiable instrument referred to as a banker's acceptance, which is a customized form of cheque. The CDOR rate is essentially a means to get a common reference rate to reflect, on each day, what that CDOR rate would be so it can be used.

Senator Moore: Between all of our charter banks.

Mr. Thorlakson: Precisely.

Ms. Mandal: Last summer that was introduced by IOSCO and that filters down. After the financial crisis, in all areas — capital, risk, liquidity — there has been a massive amount of regulation coming forth from international bodies, like the Basel Committee and IOSCO, influenced by what the Financial Stability Board has recommended, and by reports that keep going back to the G20 and being iterated through back to domestic regulators that are working with their counterparts internationally.

Our understanding is the government wants to have the ability in the Bank Act, because it is set by banks, to come in and regulate that to the extent they need to. Earlier this year the oversight and regulation was handed over to OSFI to look at the governance and risk controls around the setting of financial benchmarks generally, the most common one in Canada is CDOR. So it's one of the tools in the government's tool box to ensure that Canada is going to keep in step — if we are out of step — and that scrutiny is ongoing. CDOR has been looked at and they haven't found any problems with it, but to ensure that we keep in step with international standards or exceed them.

Senator Ringuette: What would be the Canadian market for derivatives between the Canadian financial institutions on a yearly basis? What is the average? Last year what was the dollar amount of swap between Canadian financial institutions?

Mr. Thorlakson: I don't have that number in particular. I think —

Senator Ringuette: Ballpark, one or two billion?

Mr. Thorlakson: The best way to reference it is that most estimates of the global derivatives market puts it at somewhere between $600 and $700 trillion by notional amount.

Again, the estimates that the Canadian banks have looked at anticipate that Canadian banks have about 2 per cent of that global market. I'm not in a position to do the math on that, but I can tell you it's a very large number and a very significant activity.

Senator Ringuette: But that's on the international market. In regard to our internal market, do you, a financial institution with the big Canadian corporation, swap derivatives? And at what dollar amount, roughly?

Mr. Thorlakson: Again, I don't have the dollar amount. I think those numbers might be a rough proxy for the amount. Perhaps through the CBA we could get back to you with a better number estimate of the value of those transactions.

Senator Ringuette: Essentially, that is, from my perspective, the priority market in regard to the supervisory role of OSFI.

Mr. Thorlakson: It certainly is a fundamental part of OSFI's regulatory oversight. But getting back to even the earlier discussion and questions around OSFI's role, they regulate the banks' global activities, including the global derivatives activities. The derivatives are borderless. It's very important that we, a Canadian bank, be in a position to provide derivative transaction financial services to our Canadian corporate client base or institutional client base, but by no means is that the end of the story. Often, if we are taking on a risk from a client, we will be looking to off-load or hedge that risk and, by and large, that will happen internationally.

You can't look at a piece of the market in isolation. The extent of the regulatory reforms are all designed to make sure that everybody develops regulations that are compatible and mutually respective of each other's jurisdiction.

Senator Ringuette: But you have to understand that, as you say, the Canadian portion of the world swap derivative market is 2 per cent of trillions of dollars. That is very important. It is important that we understand to what extent Canadians are at risk and to what extent OSFI will be able to routinely supervise what is happening with that financial product.

I have another question. Scotiabank, as my colleague has indicated earlier, has branches in different countries, mostly in central and Latin America and in the U.S. big time. Would you swap derivatives with a subsidiary in another country?

Mr. Thorlakson: A subsidiary of the bank?

Senator Ringuette: Yes.

Mr. Thorlakson: In certain cases, yes, we would, and that might be for a variety of reasons in terms of risk management.

In answer to your earlier question, again, the derivatives market is borderless, so to the extent that risks can occur or be shifted within an organization in other jurisdictions or with other institutions in other jurisdictions, it's very important that it be done on a compatible basis, so that those risks, to the extent that they have a knock-on effect in another jurisdiction, are understood.

The other outgrowth of the OTC derivatives reform is to create a much better dialogue among all the regulators with specific reference to the OTC derivatives market.

Senator Ringuette: But we don't have an internal Canadian institution that oversees these swaps in regard to the in- and-out — the flow — an institution like a securities market.

Mr. Thorlakson: With respect, I would disagree with that comment. The heart of this legislative amendment is to recognize that the banks engaging in derivatives activities to the extent that it can involve the risks you are referring to — risks that can go beyond an individual default and create a systemic risk that could bring down an institution — that is really the pith and substance of why this legislation is being brought forward — or recognizing what the risks are in relation to those activities. To the extent that there is oversight around that — because, at the end of the day, if any of those risks did proceed past that individual impact to a more collective one or institution-wide impact and it did threaten an institution — and maybe that is our counterparty and maybe if that counterparty fails, there is a greater risk that the default occurrence of that failure is going to have an ongoing knock-on effect and give rise to a systemic risk event.

Those risks need to be measured, monitored and looked at by someone who really understands where all the risks come home. For the Canadian banks, it comes home to the home office. We would look to the federal regulatory authorities to deal with something to the extent that it got beyond what could be managed within the organization.

Ms. Mandal: I want to add to that. This might have been a bit of a misunderstanding. When I said earlier that there is no exchange or central trading platform in Canada, that doesn't mean that Canadian banks aren't going to be trading on Canadian exchange. They will be centrally trading. The Canadian authorities will have access to that. OSFI already has access to information about any derivatives transaction, the right to access any derivatives transaction a Canadian bank does anywhere in the world, not just Scotiabank Canada but any of its subsidiaries, whether it is in Chile or London.

To be clear, as 2 per cent of the world market, I would think it doesn't seem feasible to build a standalone platform in Canada, which is why there is a bit of reliance in the U.S. and the U.K.

The other point I wanted to address is that, to some extent, the introduction of this amendment — we don't see it as controversial because it formalizes what OSFI's done since derivatives business started. So there is OSFI guidance on best practices on derivative businesses. It already has to follow and comply with the risks inherent in a derivatives product — market risk, credit risk, legal risk — are already overseen by the Canadian regulatory. The business hasn't been operating in a vacuum.

Senator Ringuette: To what extent would OSFI be able to evaluate the inherent risk of a derivative?

Mr. Thorlakson: Again, I think within the context of OSFI's risk management framework, the primary expectation is that the institution gets it right in the first instance, but all of that is subject to their governance standards and their risk management oversight. To the extent there are cross-border activities, one of the other effects of the global reaction to the financial crisis is that there is a much more active dialogue among a variety of international regulators, not just bank regulators but, for example, the CFTC, which acquired a tremendous amount of really new jurisdiction within the United States to be the primary regulator of the OTC derivatives market.

There is a high degree of cooperation and, if I might add, mutual recognition in terms of who is responsible to fundamentally get their risks right and, if they do, will that be recognized by the other jurisdiction. As an example of that, I think last December, the CFTC recognized fundamentally that OSFI's risk management framework, based on the federal legislative regime and the rules around risk management, compliance, measuring and monitoring those risks, were generally equivalent — I think the words were ``generally identical'' — to the CFTC regime. There is a dialogue not only among those two regulators but among all international regulators to make sure there is a coordinated approach to the extent that there are, as I said, risks that are transferred from one border to the next.

The Chair: You've referred in your comments to parents, to subs, to domestics and international. You're very supportive of the amendments. Is there any recommendation you would make to our committee as to exposures that have not been covered that we might want to consider?

Mr. Thorlakson: Again, having been at this for many years, I can't think of an improvement to make to the legislative wording itself.

There's a variety of definitions of ``derivative.'' Given that it is an evolving type of definition, we've struggled on occasion with: Is it broad enough? Is it too narrow? Will it capture, as some of these questions, new and evolving products? They didn't consult me on the drafting, but I'm happy to say that I'm delighted by it because I think it will enable that kind of reaction. Again, there's a reference to over-the-counter derivatives as a modifier. The important thing to recognize out of the crisis is that the market is evolving. Originally, these were bilaterally negotiated, private contracts between two parties. Increasingly, as we're seeing with trading, clearing and reporting, it's becoming a more open and transparent market — less over-the-counter and with more elements of an exchanged-traded environment. Again, it's important that it not be seen as a restriction or a qualifier in the amendment. It's broad enough to capture these types of transactions and risks, regardless of where they land.

Senator Moore: Further to Senator Ringuette's question about the value internationally, and I know these are not exact numbers, but if Canada's share of the market is $12 trillion to $14 trillion, being 2 per cent of the $600 trillion to $700 trillion, what is that? Are those derivatives that our banks have issued or that have been issued by other parties and that they're holding, or is it a combination of those things?

Mr. Thorlakson: It is a combination of those things. Often, because they're so variable with so many different kinds of transactions, the one common element to derivatives is a term that's become a term of art in the derivative markets: a notional amount. For example, if you and I do an interest rate swap where I agree to pay you the floating rate on a particular principal amount and you agree to pay me a fixed rate in exchange, and say we set that dollar amount at $50 million Canadian, that's the notional amount. That money doesn't change hands on day one. That's just the denominator to determine the cash flows or the future payment obligations will be determined by reference. When we say there are $700 trillion in derivatives, it's not that that money is moving around the globe day to day. It's a matter of it being the common element reflecting the total value at risk.

Senator Moore: I understand that. But what would be, in our discussion here, the exposure of the Canadian banks? Would it be $12 trillion to $14 trillion? It's not. What's the lesser sum? What is it?

Mr. Thorlakson: From the perspective of expertise, being a lawyer, I'm not the person to deal with the questions of numbers. Increasingly, there are disclosures as part of each bank's public disclosure in terms of the risks associated with derivatives. There are emerging best practices in terms of the capital, the market risk elements and the value at risk. I would defer —

Senator Moore: OSFI keeps an eye on that, in any event.

Mr. Thorlakson: Absolutely. It's one of the key components.

Senator Moore: One final thing. I didn't get an answer before.

You think this bill, combined with these amendments, is really good and gives us the oversight and the transparency we need. What would trigger the Governor-in-Council to exercise these powers? What kind of event would have to happen? Would the Governor-in-Council be asked to do that by OSFI or does somebody in Finance watch that? What event would cause the government to step in and regulate the banks in this activity?

Mr. Thorlakson: Again, it's the government's decision as to how best to organize that.

Senator Moore: I want some idea as to why we're doing this.

Mr. Thorlakson: I would anticipate from here, if this bill is enacted, the regulation-making authority is not going to be in the form of an intervention upon the occurrence of a crisis. It is more a means to establish a framework for best practices, for requirements around clearing, for example. Previously, in a bilateral market, if you and I had that risk on that interest rate swap, then that was a risk that you and I had, and if you happen to fail — more likely I would fail — then you would be at risk to the extent I owed you money on that swap. Centrally clearing it tends to lower the risk because the large numbers will determine the net risk among all the counterparties and in a perfect world should get closer to zero and collateralize it.

Within the context of this guideline, we expect to see a regulation setting out the framework by which Canadian banks are mandated to clear certain products in terms of making the road safe in anticipation or in advance of the next crisis that might come down the road, as opposed to reacting to it.

Ms. Mandal: If I could add to that as well, I feel that there's a suggestion in the question that the Governor-in- Council would step in in an emergency situation. That's really not how we view it, and it's not where the government is coming from. I absolutely agree with what Ken said. To supplement, there are the G20 commitments and flowing from that a lot of work is going on internationally from standard-setting boards, like the FSB and reporting back to the G20 on how well progress has been made towards full implementation of the reforms. For that reason, because we're looking to meet or exceed international standards, the Canadian regulatory system, and also to get what Ken referred to before, the recognition of equivalents, so we avoid our banks having to comply with multiple rules in various jurisdictions. For those two reasons, whether it comes from Finance or OSFI, the suggestion might be put to have regulations introduced that keep pace internationally.

Again, it's very much an international effort. To the extent that there is any gap in the Canadian system relative to the EU or the U.S., just as two examples, we would be looking to fulfill that.

Senator Ringuette: We understand the 2 per cent on average that you have in the global market currently. What was the percentage of those derivatives between 2007 and 2009?

Mr. Thorlakson: I don't have that number offhand. I know that the number has been fairly consistent, dating back to 2010 and 2011, when the organizations involved in the derivatives market in Canada assembled those statistics. I can't speak to what it was at the time.

Senator Ringuette: Which organization is involved in Canada?

Mr. Thorlakson: There's a variety of industry associations. There's a committee involving what's known as the sell side and the buy side. The sell side is typically the banks: The Canadian Market Infrastructure Committee. The committee is engaged in participating in the regulator's efforts federally and provincially in developing an oversight regime.

Senator Ringuette: Is that committee within the Canadian Bankers Association?

Ms. Mandal: It's a separate committee.

Mr. Thorlakson: It has representation more broadly than the banks have. It includes other counterparties that would participate in the derivatives market in Canada.

Senator Ringuette: In order to have an answer on the situation and the loss that happened during those years within Canada, we would have to ask that committee?

Ms. Mandal: Yes. Speaking for the CBA, we can definitely look into it. I assume that is tracked somewhere; so we can try to find that information.

Senator Ringuette: It would be appreciated if you could find it for us.

Ms. Mandal: I've made a note of it.

The Chair: We'll see that it's distributed to members of the committee.

Derivatives and benchmarks are complicated areas. We greatly appreciate the time you've taken to shed some light and help us with our deliberations. We thank you very much.

In our second hour, we are focusing on Part 6, Division 14, which amends the Insurance Companies Act to broaden the Governor-in-Council's authority to make regulations respecting the conversion of a mutual company into a company with common shares.

Part 6, Division 14 can be found at tab F14 in your briefing binder, and at page 145 of the bill.

Two weeks ago, the committee heard from the government officials and today we are pleased to welcome representatives from the insurance sector.

From the Insurance Brokers Association of Canada, Mr. Steve Masnyk, who is becoming a regular in front of our committee. He's the manager of public affairs. He appeared last Wednesday in regard to our study of the amendments of the Proceeds of Crime (Money Laundering) and Terrorist Financing Act. We welcome you back, Mr. Masnyk.

From the Canadian Association of Mutual Insurance Companies, Mr. Normand Lafrenière, President; from The Co-operators, Frank Lowery, Senior Vice-President, General Counsel and Secretary; and from Economical Insurance, Ms. Karen Gavan, President and CEO.

We thank you all for being here today.

I will turn the floor over to Mr. Masnyk first, to be followed across the front of the room. You have approximately five minutes to make your opening statements. We want to leave enough time for questions. Mr. Masnyk, the floor is yours.

Steve Masnyk, Manager, Public Affairs, Insurance Brokers Association of Canada: Thank you and good afternoon. The Insurance Brokers Association of Canada is the national voice of over 35,000 property and casualty insurance brokers and an advocate for insurance consumers. IBAC represents their interests to the Government of Canada.

IBAC and its members have a considerable stake in the legislation and regulations governing the process of demutualization of P&C insurance mutuals. Insurance brokers sell Canadians policies from private insurers, mutual insurers and government insurers.

As an intermediary for all three types of insurers, brokers have a well-established grasp of how consumers fare in the marketplace with the choice of these three types of manufacturers.

Mutuals represent about one of every four policies sold in Canada. They represent a very important part of the insurance market Canadians count on. Mutuals have a long history of high-quality, low-cost continuity of service. This continuity in service is partly explained by the fact that the mandate of mutual insurers is to pool the risk of the many, not principally to earn a profit by providing financial services. That is to say, for non-mutual insurers, profit is the primary objective, whereas it is incidental to mutual P&C insurers.

Common industry knowledge is that mutual P&C insurers have a higher rate of underwriting losses than their non- mutual competitors. Mutuals have been able to do so in part because they have built up over generations, through the participation of all policyholders, significant investment portfolios and thus have been able to subsidize their policy underwriting to the financial benefit of their communities.

Moreover, the mutual structure allows P&C insurers to operate by and for their constituents, i.e., protecting their assets, and they therefore do not have the need to generate profit for shareholders.

As outlined above, mutual P&C insurers have both in conception and execution a different mandate from their non- mutual counterparts. Hence, in our view, the regulation of the demutualization of P&C insurers ought to be primarily concerned with maintaining the broad public policy objective of preserving and enhancing the quality, cost and continuity of financial services primarily, but not exclusively, outside of major urban areas.

It is further our view that the mutual form of organization is, generally, well-suited to meeting this policy objective. However, where demutualization may be warranted, we would like to see those companies proposing demutualization make a credible commitment to undertake the following: First, provide a clear rationale as to why the transformation into a publicly held company is preferable; second, provide demonstrable proof that the existing tools available to mutual insurers, such as amalgamations with other mutual insurers or raising capital via outside loans, et cetera, is not sufficient to meet their current requirements; and third, provide a clear indication of how the newly transformed mutual will provide the same level of quality, cost and continuity to the same diversity of constituents.

Turning to the question of what is the relationship between policyholders and the mutual itself. First, unlike mutual life insurance companies, there is no direct connection between present constituents, i.e., the policyholders, and the assets of the mutual. The constituents of P&C mutual insurers subscribe to their policies on an annual basis and once their policy expires, so too does their membership in the mutual.

Second, and flowing from the first, is that the assets of a mutual are essentially community assets built up over the generations of those living in the community.

Third, as such, present policyholders have no more right to claim the assets of the mutual than past policyholders or the other way, present and past policyholders both have their participation built up, through capital, the ability of the mutual to be able to offer this ``protection,'' this insurance, in essence, the sole purpose for the mutual's existence.

In light of the above three points, it should be clear that it is conceptually difficult, if not impossible, to determine a clear line of property rights flowing from policyholders to P&C mutual's assets.

Given the above, we believe that voting on demutualization should be open to all constituents, i.e., all those who presently and in the past hold or have held a policy, quite apart from whether they are deemed to be members with voting rights with respect to the normal governance of the mutual.

Demutualization is an extraordinary measure and thus deserves extraordinary scrutiny by a broader range of members than is customary in the constitution of mutual insurers. In short, those considering demutualization should be required by law or regulation to subscribe to a one-policy, one-vote model for the purposes of demutualization. On the proposed legislative changes at hand, specifically the changes to the ICA, Insurance Companies Act, we are supportive of the goal in giving the Governor-in-Council a clear mandate in establishing a framework for any possible demutualization.

This legislative framework set out in the budget is sound; however, the devil will be in the details during the drafting of the regulations, which I hope this committee will have some input into down the road.

Thank you, Mr. Chair.

Normand Lafrenière, President, Canadian Association of Mutual Insurance Companies: Thank you for deciding to hold public hearings on Bill C-31, and I thank you for inviting me to appear before this committee.

The Canadian Association of Mutual Insurance Companies is a trade association of property and casualty mutual insurers. There are currently 91 companies who are members of CAMIC. They have a collective premium volume of $5.3 billion, or 12.7 per cent of the Canadian private sector property and casualty insurance market.

Canadian property and casualty mutual insurers were formed between 100 and 175 years ago, mostly by farmers, as they were unable to find insurance or could not find insurance at a fair price. In fact, a large number of our member companies are older than this country. Since their formation, the policyholders of these companies, called ``mutual policyholders,'' have controlled the development of their company.

Every year, when a profit is generated, the members' elected board of directors decides if that profit will be reimbursed as a ``premium refund'' or put into the surplus of the company to ensure its survival and growth over future generations. The surplus enjoyed by mutual insurers today is the accumulation of these allocations of profits to surplus.


Three years ago, a property and casualty mutual insurance company, Economical Mutual Insurance Company, asked the then Minister of Finance to develop demutualization rules for property and casualty mutual insurers, rules that it could then use to demutualize Economical.

Through what CAMIC believes were improper manoeuvers, the company has constantly reduced the number of its mutual policyholders (to whom only the company has given the right to vote), so much so that the company now has about 940 mutual policyholders out of a total of more than one million policyholders.

Should the company demutualize, it is fair to assume that the surplus of the company would be divided between the current cohorts of mutual policyholders even though the surplus was accumulated with the contribution of all policyholders since the beginning of the company — over the last 140 years or so.

While CAMIC prefers an environment with no demutualization rules, the Minister of Finance announced in the June 2011 budget that demutualization rules would be put in place for property and casualty mutual insurance companies. That commitment was reinstated in the February 2014 budget.


In Division 14 of Part 6 of Bill C-31, An Act to implement certain provisions of the budget tabled in Parliament on February 11, 2014, and other measures, the Minister of Finance introduces proposed changes to the Insurance Companies Act to provide a framework under which the demutualization regulations for property and casualty mutual insurers will be developed.

The Canadian Association of Mutual Insurance Companies strongly believes that the proposed legislative change has three major shortcomings:

First, it does not require that all policyholders of a mutual insurance company, whether considered mutual policyholders or not, have the right to vote on a demutualization proposal, and any proposal should be subject to supermajority quorum and approval thresholds.

Second, it does not recognize that the surplus of a mutual insurance company, built over many generations, is a ``common good'' that is ``indivisible.'' It is repugnant that current policyholders may receive this surplus directly or indirectly that they have not earned.

Third, it opens the possibility of deferring issues to the courts to address issues that should be solved by elected officials who are required to put in place proper public policy through legislation and make decisions in the public interest.

Through this submission, CAMIC respectfully asks the Standing Senate Committee on Banking, Trade and Commerce to modify Division 14 of Part 6 of Bill C-31 to correct the shortcomings highlighted in this submission.

Alternatively, Division 14 could be taken out of Bill C-31 and be considered in separate legislation.

Thank you for your attention.

The Chair: Thank you very much.

Frank Lowery, Senior Vice President, General Counsel and Secretary, The Co-operators: My understanding from the clerk is that the submission wasn't translated into French.

The Chair: I just learned this. Would you indicate to the committee the situation?

Barbara Reynolds, Clerk of the Committee: There was a presentation that came in English, and I apologize to the committee; I did not forward it to Translation. So I have only English copies. I offer my sincere apologies to the committee.

The Chair: Thank you.

Mr. Lowery, our apologies.

Mr. Lowery: Mr. Chairman and members of the committee, I'm pleased to have the opportunity to participate in this round-table discussion on behalf of The Co-operators Group Limited.

By way of background, The Co-operators Group Limited is a Canadian-owned cooperative. Our 42 member owners include Canadian cooperatives, representative farm organizations and credit union centrals. We were founded in 1945 and have grown into one of the largest financial cooperatives in the country. Through our group of companies, The Co-operators provides a broad range of insurance and financial services to Canadians and their communities.

Although The Co-operators itself is not a mutual insurance company, we are founded on similar principles to mutuals. Cooperatives and mutuals work together because of this common set of principles. We are a member of the Canadian Association of Mutual Insurance Companies, CAMIC, as well as ICMIF, the International Cooperative and Mutual Insurance Federation based in the United Kingdom.

Like a mutual, The Co-operators was founded to meet the insurance needs of Canadian farmers, which at that time were not being met satisfactorily by the market.

Just as mutual insurers have a long-term focus and commitment to their communities and a desire to use their profits for the benefit of their mutual policyholders, The Co-operators has a similar focus on cooperative principles and using our profits for the benefit of our members as well as the communities which we serve. It is for this reason that The Co-operators is most interested in the ongoing consultation process surrounding the proposed regime for the demutualization of mutual property and casualty insurers.

In our 2011 submission to the Minister of Finance, we expressed support for the position of CAMIC that a small minority of policyholders, board members, senior management, brokers and professional consultants should not receive windfall benefits from the demutualization of a property and casualty mutual insurance company.

We believe that in a conversion or a demutualization process, all policyholders should be treated in the same manner with respect to the right to vote and their right to receive a portion of the mutual company's surplus.

Further, we believe that no policyholder should receive a portion of the surplus, or other consideration, greater than the value of that policyholder's actuarially demonstrated contribution to the company's surplus over time, with any remaining balance being retained in some manner to support the mutual insurance industry or mutualist goals. This is CAMIC's position, and we support it.

This is a thought, I think, for the committee: If there is a pattern of privatization on the property and casualty side, similar to what happened on the life side a decade or so ago, there would likely be consolidation, and the capital supporting risks in rural regions may be shifted to more profitable urban markets or even outside of Canada.

In a hard market, this could result in a lack of availability of products for risks in rural communities, which is exactly the issue and the reason for the creation of mutual companies a century ago. We must learn from this proud history.

Mutual property and casualty insurance companies proposing to change their form should be legally required to demonstrate to the satisfaction of the Minister of Finance and the Governor-in-Council that all reasonable alternatives to demutualization have been considered, including the possibility of a merger with other mutuals or a combination with other mutuals, cooperatives and like-minded and structured organizations, and that demutualization would serve the best interests of all policyholders irrespective of the right to vote. In demonstrating this, a converting company would also need to show that it has considered other alternatives that do not require demutualization.

However, we think it should be noted that however fair and equitable regulations for the demutualization of Canadian P&C mutuals are, we don't think that is enough, just having good regulations. We also encourage the government to enact legislation that would enable mutual and like-minded organizations like cooperatives and fraternal benefit associations to be organized in a manner that would preserve the character of the existing mutual company without the need to demutualize and to distribute the surplus.

A mutual benefits organization — and no such thing exists in this context, at this point; it's really a name we've given it for the sake of having a name — could be composed of any number of mutuals, cooperatives, fraternal benefits and like-minded and structured organizations that saw fit to come together. A similar approach was followed several years ago in the United Kingdom and was called the Butterfill Act. We spoke about that, several years ago, to the House of Commons. We urged the government to consider a similar approach as an alternative to demutualization in the Canadian marketplace. In conclusion, The Co-operators would like to thank the committee for the opportunity to participate in this round table discussion and provide our unique perspective as a cooperative. We are a cooperative as well as an insurer and share many of the founding values and long-term goals of the mutual property and casualty insurance sector.

Karen Gavan, President and CEO, Economical Insurance: On behalf of Economical Insurance, I welcome the opportunity to speak to you about property casualty insurance companies. I was invited to comment on Bill C-31, but that's a rather technical bill. So I'm going to focus on what the enabling legislation will allow and what demutualization means to Economical and our industry as a whole. I'm going to address why demutualization is right for Economical, how demutualization will benefit the insurance industry, Canada's financial system and all Canadians and the need for workable regulations that allow mutual P&C companies the option to demutualize.

Over the past three years, the Department of Finance has engaged in an extensive consultation process with a broad range of stakeholders, including those appearing before you today. Finance's stated objectives have included the fair and equitable treatment of all policy holders and the creation of an orderly and transparent process that is not overly complex, time-consuming or costly to undertake. We fully embrace those objectives and strongly believe that, through demutualization, Economical will become a Canadian leader.

Economical has a long history and a proud tradition. From our regional roots in southwestern Ontario, we have grown to offer a range of insurance products to consumers and businesses across Canada and are proud to stand among the top 10 companies in our industry.

But we are competing in a market that has changed profoundly over the last decade. Because our business is national in scope and substantially more diverse than most other mutuals, we compete against large and growing stock companies and the Canadian operations of even larger insurance multinationals. These companies have access to capital markets to raise funds for growth, and, increasingly, they have been deploying that capital to drive industry consolidation.

In our industry, the big are getting bigger. When Economical began to pursue demutualization in 2010, the top 5 insurers held 37 per cent market share. In only three years that's grown to 47 per cent. The larger companies are acquiring smaller competitors and gaining market share and economies of scale. Over the last three years, there have been six major transactions affecting 12 per cent of total industry premiums.

As a mutual company, without access to capital, we could not have done any of these transactions. Mutual companies are expected to maintain higher levels of capital than our stock competitors, and that means we're not competing on a level playing field. From Economical's perspective, a successful demutualization is critical to levelling that playing field and unlocking our long-term potential.

Demutualization will allow us to overcome the limitations inherent in the mutual structure, first, by improving our financial stability and flexibility. Mutual companies do not have access to capital markets when they need it, such as to recover from severe catastrophe-related insurance claims or extreme market events. With the impact of climate change, unpredictable, severe weather events are becoming the norm. As a result, insurers must have larger and more flexible capital bases and a broader base to spread risk that comes from scale in order to effectively manage the frequency and severity of claims.

Second, it permits us to make investments required to remain competitive. Sophisticated systems, comprehensive data analytics and ongoing technological innovation are quickly becoming the minimum requirements for leadership in our industry. Those who are unable to make those investments risk becoming marginalized. Finally, it positions Economical for industry consolidation. We cannot achieve our vision of being a leading national P&C insurer through our organic growth alone or even through the absorption of other mutual companies. In order to participate meaningfully in industry consolidation, we would need to be able to issue shares to raise acquisition funding or to deploy as acquisition currency.

Regulations do exist for mutual life companies to demutualize, and they were used by a number of companies in the late 1990s. The result was larger, stronger, more internationally competitive life insurance companies that served more consumers, employed more people and added significantly to the Canadian economy.

Those who choose to demutualize should have a clear and workable path to act on their decision. Those who choose not to demutualize should be allowed to make that choice so that they can continue to serve their communities as they have in the past. Just because there are regulations does not mean that all companies will choose to demutualize. In fact, the life company regulations have existed for over 14 years, and there remain mutual life insurance companies operating today.

It's important to remember that the demutualization framework needs to be workable, since any regulatory process can only achieve its objectives if it can be implemented. We believe that the interests of Economical and the industry are best served by regulations that permit demutualization to be implemented effectively, without excessive delay, cost or undue risk of protracted litigation.

The Chair: Thank you very much. I extend my compliments to our witnesses; they all stayed within their time frame. I have a very lengthy list of questioners, so I will do the same with our committee members.

Senator Hervieux-Payette: My first question is for Mr. Masnyk. So you are ready to come before us once the regulations are tabled, and we should examine them to ensure that they are properly protecting the policy holders, which is new? I have to tell you that, to have this committee examine regulations, would be, I think, almost a world premiere. You make that suggestion. I would like to inform you that we don't usually examine regulations. But you would feel comfortable that the guidelines to go ahead with this demutualization would be seen by parliamentarians?

Mr. Masnyk: I think so, yes.


Senator Hervieux-Payette: Mr. Lafrenière, I refer you to the three clauses at the end — the first and last paragraphs. The first paragraph reads as follows, ``it does not require that all policyholders of a mutual insurance company, be they considered `mutual policyholders' or not, have the right to vote. . .''

What makes you say that it will work like that? Is it because there is a vacuum when it comes to rules or regulations, and you think there are precedents that ensured that everyone holding an insurance policy did not have the same rights? Where does that idea come from?

Mr. Lafrenière: There are currently four companies — under federal jurisdiction — whose policyholders do not all have voting rights. Therefore, the situation we are looking at, like the situation of the Economical company, is elsewhere. We fear that these limited people who have right to vote, under the regulations, are dividing the surplus of the company that was built with the help of all policyholders from the time the company began. The fear is that it will give them ownership rights to that company. And all of these companies are over 100 years old.

Senator Hervieux-Payette: So, you do not really want all this to end up before the courts in the next 10 years.

Mr. Lafrenière: Absolutely not. Moreover, we cannot see how we can protect these people before the courts when they are not included in the legislation as having voting rights when demutualization occurs.

Senator Hervieux-Payette: So if I have understood correctly, among the current and former policyholders — and earlier we talked about 175 years, and we cannot dig up the dead — who should have the right to vote?

Mr. Lafrenière: All the current policyholders, but all policyholders. Obviously, we cannot dig up the dead, but all current policyholders should have the right to vote, and not just those with the ``mutual policy'' notation, in the case of those who have identified differences between mutual policies and non-mutual policies.

By the way, of the 91 members, all the others — aside from the three who have mutual policies different from all the policies — count 100 per cent of their members as having mutual policies.


Senator Hervieux-Payette: Do I understand that The Co-operators is a group of mutual companies that are regrouped under The Co-operators?

Mr. Lowery: No, under Canadian insurance law you cannot incorporate a co-operative insurance company. It is just not permitted, so with The Co-operators, the ownership is co-operative. There's actually an entity — The Co-operators Group Limited — which is a co-operative under the Canada Cooperatives Act. So it's constituted like any other, one- member one-vote, based on the International Co-operative Alliance principles. It owns the subsidiary insurance companies, which are stock companies, but we try to operate the organization holistically.

To give you an example under the Insurance Companies Act, when a financial institution gets $2 billion in capital you're required to distribute 35 per cent of your shares publicly. We sought a legislative amendment, which we succeeded in getting through Parliament, and sought an exemption because in a co-operative it's not consistent with our values to have basically equity-minded shareholders — people looking for speculative gain — and then you have the other 65 per cent, which is owned by a group based on concern for community co-operative education, reinvestment in co-operative economic development. So we were granted that particular exemption and so long as those insurance companies are owned by The Co-operators, we have that exemption for our general insurance company.

Senator Hervieux-Payette: Do I understand you endorse the position of the Insurance Brokers Association of Canada?

Mr. Lowery: Absolutely, in every respect. I endorse the idea the regulations are the most important part of this issue. The bit in the budget bill is interesting because it's giving power, but the truth is it's the regulations that are the detail.

If I were to look at the life conversion regulations, those were done in a different context with respect to companies that had wide bases of support in terms of policyholders who participated in the vote and also with respect to products whereas — I think Mr. Masnyk made the observation — in a life company there are a lot of deposit types, savings types products. One could actually tie the underlying asset value to the contributors to the capital.

On the P&C side these are one-year policies, most of which on an actuarial basis have made an insignificant contribution to the underlying equity of an organization. I totally endorse that. If you are prepared to have us again, I would love to talk about the regulations because we proposed some changes to them the last time around.

Senator Black: Thank you all for being here. I'm hoping that you can help me understand the fundamental issue that you have tabled and over which there is some legitimate disagreement. Do I understand correctly that demutualization is an option that companies could pursue or not, as they choose? Would that be accurate?

Ms. Gavan: Yes, the Insurance Companies Act currently says companies can choose to demutualize.

Senator Black: And you would all agree that it's an option? So if it's an option, an option obviously entails that you don't have to take the option. If your mutual company elected to maintain that status for good and proper reasons — and you have indicated some of them, Mr. Lowery, including service to rural communities — you would simply not elect to take this step; is that not correct?

Mr. Lowery: I think that's true, but you need to look at what is happening in context. It isn't always that a mutual insurance company chooses to demutualize. It's that there are a number of other interested parties who create an environment wherein the mutual insurance company will demutualize. For example, there are law firms, other groups who basically will advertise, try to find interested people who will lead, like policyholders, and try to get a vote to demutualize. They often refer to this as ``unlocking'' value. The real dispute here today, I think, is not a question of whether or not you can unlock value; of course you can, and these regulations will permit it. The real issue is: Should the value built up over time by mutuals policyholders, on the basis of a certain set of values, be unlocked for a small group? That's the underlying issue.

Senator Black: I understand that to be your point of view. But certainly another argument could be that the mutual company could be more effective in its communications with its owners to allow people to say no. Would that not be another point of view?

Mr. Lowery: Yes, of course.

Mr. Lafrenière: Could I comment on that?

Senator Black: Of course.

Mr. Lafrenière: Our fear is that the surplus, which has been built over 275 years, is attractive to some people to leave with, and we don't want to create an environment where it is an encouragement to demutualize companies and find ourselves with stock companies. It is an encouragement to leave with the money surplus built over many generations by all the policyholders when in fact some companies only have a very small portion of all their policyholders with a voting right, and these are the people who feel they own the company and that surplus.

Senator Ringuette: First, chair, I don't think I'm in conflict, but I know my home is insured with Economical, just so everyone will know.

I certainly understand what you're saying. For the mutual insurance and cooperative movement, what would be the Canadian market that you would have in regard to insurance?

Mr. Masnyk: It's about 25 per cent of market.

Senator Ringuette: Economical would be included in that 25 per cent currently?

Ms. Gavan: I don't know if he includes us because we've never been members of CAMIC.

Mr. Lowery: The question was the mutual marketplace and I think the answer is that it would be included, not members of CAMIC.

Mr. Lafrenière: Members of CAMIC have 12.7 per cent of the private sector market, and that excludes some of the mutuals that are not members of CAMIC.

Senator Ringuette: Ms. Gavan, we have been told that in the last three years your mutual policyholders have gone from 1 million to 940. That is quite a drop.

Ms. Gavan: That is not correct.

Senator Ringuette: Could you correct it?

Ms. Gavan: Economical Insurance started out as a mutual and then became what's called a cash mutual. Over 100 years ago we began issuing both non-mutual policies as well as mutual policies. Over time, particularly in the 1970s, the number of mutual policyholders had dwindled down to only about 130, because the company was having difficulty, through its brokers, selling the mutual policy. The company made tremendous efforts to build that up in the 1980s, but it remained an unattractive product at the time. The Ontario Insurance Act required that we could only issue mutual policies if the policyholder was willing to sign what was called a premium note. This was a capital call; the board of directors could call upon those policyholders who signed that for up to three times their annual premium. The brokers had great difficulty selling that product. Many members of IBAC have told me directly how difficult it was to sell those policies.

By the time we put the moratorium on new issues when we started looking at demutualization in 2010, we were at about 940.

Senator Ringuette: Of mutual policies?

Ms. Gavan: Of mutual policies. Economical Insurance Group —

Senator Ringuette: How many non-mutual policies do you have?

Ms. Gavan: We have a number of wholly-owned stock subsidiaries. When Mr. Lafrenière mentioned over 1 million, it includes our stock subsidiaries not in the mutual company. Policyholders of the mutual company are about 800,000.

Senator Ringuette: What are these stock subsidiaries you're talking about?

Ms. Gavan: Over the past 50 or 60 years, we rescued a number of mutuals that got into difficulty. They were demutualized in various forms, and they were all in financial difficulty. Those were converted into stock companies. Much of the business ended up in Economical, but we used those converted legal entities for certain different lines of business, because we can't write group insurance through the same entity as our direct, normal policies or non- standard business. That's due to provincial regulation.

Senator Ringuette: I'm still trying to figure out that you hold stock in many demutualized — how many would that be?

Ms. Gavan: Four.

Mr. Lowery: Could I help with this question? In the insurance industry, insurance companies are restricted as to what businesses you can run within a particular type of insurance company. Putting aside the issue of mutuality or non-mutuality, most companies have a group of different companies and the reason is because you can only do particular lines in a particular type of company; you can't compete against yourself with respect to the same product. Economical has a structure like that, and that's below the main structure.

I think the answer to your question was that in the mutual company, there are 800,000 policyholders and 1,000 mutualist policyholders. That's really the key number in the context of this discussion.

Senator Ringuette: Thank you for that. I still believe, and I still agree, that the proof is going to be in the rules in order to protect over many generations — and still current generation — to protect them in regard to whatever or whoever might want to demutualize.


Senator Bellemare: This case bothers me very much. We are hearing that mutuals can demutualize or that it is possible for them to do so. That happens with life insurance, anyway. Furthermore, the way the various stakeholders have presented the matter at issue in Bill C-31 gives me the impression that the clauses in Bill C-31 were to address the case of one mutual company: Economical. I would like to hear your comments on that. If that is the case, I have a lot of trouble with that, with amending a bill for a single company. That is my take on it so far, based on the way you have developed your arguments. Can you show me that this is not the case and that it is for the good of everybody?

Mr. Lafrenière: It is for everybody. Regulations for the demutualization of life insurance companies are in force; the Insurance Companies Act covers both life insurers and general insurers. Regulations have been established for life insurance only — we saw this in the late 1990s — and they had an impact. The life insurance market share of mutual insurance companies dropped from over 50 per cent to less than five per cent in two or three years. We are now implementing draft legislation for general insurance. We told the minister that we did not want regulations for demutualization. However, three years ago, a company expressed an interest in demutualizing, and the Minister of Finance said that if there was now an interest in demutualization, he would draft demutualization regulations. Now, on our side, we are saying that surpluses have been made; in general insurance, we are talking about companies that have been around for a very long time, for as long as 175 years. A surplus was made by each generation and there is a lot of interest in getting this money. However, it needs to be done properly. The surplus does not belong to the current cohort of policyholders; it belongs to all policyholders from past generations. We think it is a collective asset that belongs to the community and is indivisible. That is the big question when it comes to demutualization. If there is no personal interest in taking the money that is there, I guarantee you that there will not be demutualization. The main interest is the money that is there.

Senator Bellemare: That leads me to my second question: in this case, how much surplus has Economical accumulated?

Mr. Lafrenière: The best person to answer that question is right there.


Ms. Gavan: At the time we announced our intention to demutualize our capital and surplus, our total equity at that time was about $1.2 billion. We've been very successful over the last three years, and our current equity is approximately $1.6 billion.

Senator Moore: Ms. Gavan, you said there was an Ontario law that put in place a new category called a mutual policyholder; is that right?

Ms. Gavan: No, the Ontario Insurance Act, up until the early 2000s, had a requirement that to issue a mutual policy in Ontario you had to have what was called a premium note, which was a legal liability, to pay up to three years of annual premium. Because we were organized under that statute, we had that embedded in the company's bylaws that we could not eliminate that premium note.

Senator Moore: When did this come in?

Ms. Gavan: As far back in the history books as I could go.

Senator Moore: This Ontario legislation?

Ms. Gavan: Yes. We've been issuing cash policies for over 100 years.

Senator Moore: So of all the people who have held insurance policies at that time issued by Economical Mutual, only a handful of them agreed to this new vehicle? I don't understand that. Was every policyholder given the opportunity? I don't understand how that unfolded. What was the process?

Ms. Gavan: No, a mutual policy could only be offered on certain classes of business, according to the Ontario Insurance Act: for five, livestock and weather risks, I believe it was. So we couldn't offer mutual policies broadly. We don't sell policies directly; we sell through independent distribution.

Senator Moore: Through brokers.

Ms. Gavan: Through brokers. They expressed great difficulty in trying to sell the mutual policies because of this additional requirement — the signing of this premium note.

Senator Moore: So of all the insurance policies and holders you had out there, it only came down to a couple hundred? Now it's 940. What happened to all the other policyholders? Did they all go away?

Ms. Gavan: No, we have in the legal entity of Economical Mutual, we have over 800,000 now. But they are not mutual policies, which attract the right to vote, according to the company bylaws.

Senator Moore: When that happened, do all of the policyholders have an opportunity to vote in that decision? They're in a mutual company. Did they all have a vote, and did they all decide that there will be a new class of policyholder here and only they would get a vote and participate in the distribution down the road? How did that happen?

Ms. Gavan: These have been in the bylaws for over a hundred years. I can't answer how it came about.

Senator Moore: It's pretty fundamental.

Mr. Lowery: I'd like to comment on the concept. I don't know how many of you knew Claude Gingras, but he was the general counsel of Mutual Life before it demutualized. He was a mutualist expert. He was a lawyer. He ultimately went and worked for the Department of Finance after he left Mutual Life when it demutualized.

The concept of a mutualist organization is it's owned by the policyholders. Basically, it's almost like co-insurance. These people are in local communities. They're really almost self-insuring. The concept of a premium note was the idea if you want to be a participant in this company, you may be called upon to give additional capital. It's almost like a modified Lloyd's scheme except it is not as extensive as that. It is a limited liability, but it is a potential liability if you get a call. The more relevant question is how many people ever had a call on the premium notes and were the premium notes offered and when was it stopped.

Senator Moore: That's what I want to know. The hundreds or thousands of shareholders, did they all get a chance to do this?

Mr. Lafrenière: I'd like to bring you back into history, if I can.

The Chair: Please continue very briefly on this subject.

Mr. Lafrenière: I'd like to bring you back a little more into history, if I can. When we talk about the 100 and 150 years ago, those mutuals were charging the premium at the end of the year, as opposed to the beginning of the year. The reason for this is they were just starting the companies. They didn't have any surplus. They were poor. Farmers were poor and they were creating their own companies. At the end of the year, they knew exactly how much they owed to the company in order to pay for all the losses and the administration of the company in the course of the year.

Now came a time where they were in competition with stock companies, from England mostly. When that happened, they said that we'd like to pay the premium at the beginning of the year and know how much we owe to the company, as opposed to only knowing it at the end of the year.

Also, at the time of the Depression, as you can imagine, we were going to see our policyholders and we were trying to get the money and it was impossible because they didn't have any money to pay us. Some companies went bankrupt.

We went from charging at the end of the year to charging at the beginning of the year, charging a little more in order to build surplus and not having to go back to our policyholders.

The regulators were the ones saying at the time you don't have any surplus, or barely any surplus. Okay, you can charge at the beginning of the year, but I want you to have the possibility of returning to your policyholders at the end of the year if you don't have enough money to pay for the losses and everything. That's how we came up with those premium notes.

Later on in the process, we started to have the companies banding together and saying that we will create guaranteed funds. With the guaranteed funds, if one company goes bankrupt, we will not save the company but we will save the policyholders of that company. We will leave everybody intact at the end of the day.

A group of companies together, we say that we will protect each other and then the regulators said: Okay, now we can get rid of your premium note system, because it doesn't have any raison d'être to remain in place. There is a group that will protect the policyholder, in fact, not the companies.

The Chair: We have to conclude. I do have a number of questioners.


Senator Maltais: It is important to understand that mutual companies have two kinds of policy. There are insured policies and regular policies. We must not mince words. You may have a few hundred insured policyholders and 800,000 or 900,000 other policyholders.

Mutualization, the deposit notes, were aimed at capitalizing the company. It was paid over three years to capitalize the company. Does an insurance company like Economical engage in reinsurance?


Ms. Gavan: We purchase reinsurance to protect ourselves in the event of large losses or catastrophic events, so that we only retain a certain amount of risk within the company.


Senator Maltais: What prevents you from accessing capital, from merging or seeking associates to maintain the strength of your mutual?


Ms. Gavan: When the special committee of our board of directors looked at the option to demutualize, they looked at various hybrid scenarios where you raise a little bit of capital in the market, similar to what The Co-operators have done, but it cannot make a substantive difference.


Senator Maltais: If you demutualize, you would become a limited company. Would you commit to ensuring that all shareholders, regardless of the policy type, would be holders of the capital that remains, as has been done with life insurance companies?


Ms. Gavan: It is our intent that, when we demutualize, we remain an independent, Canadian-owned company with Canadian shareholders.


Senator Maltais: That is not my question. If you demutualize, would you commit now to having the 800,000 or one million members become shareholders for the value of the publicly-traded company?


Ms. Gavan: It has been very clear in our consultation with the Department of Finance, they have signalled very clearly that there is going to be broader sharing than just the mutual policies, and that they're looking out for the interests of all policyholders.

The Chair: The answer that you're given, it may not be what you want to hear.

Ms. Gavan: I'm not responsible for developing the regulations by which we demutualize. The Department of Finance has gone through a consultation process. They have indicated clearly to us that there's going to be broader sharing of the benefits to policyholders.


Senator Maltais: The problem is that you are interested in the jackpot.


Senator Tkachuk: My question is a follow-up to Senator Black's question on the right of previous policyholders, which I don't quite understand. I have property and casualty insurance from Sask Mutual. I quit buying. I go to SGI. Sask Mutual demutualizes, and it wants to become a public company. Why should I have anything to say about that as a previous owner, as a previous shareholder?

Mr. Lafrenière: You most likely would not. We cannot go back, unfortunately, to our previous generations and say: What do you think about demutualization? However, what we can say to past generations is to say you have helped build the surplus of that company. You probably did yourself when you were a member of that company.

That surplus should not be owned by the current cohort of policyholders who would benefit from what has been accumulated by past generations. That money should not be yours — you the current cohort of policyholders — it should be owned by the community; it should be indivisible. This is what we're saying. A company may demutualize if it so wishes, but it should not go with that surplus built by past generations for the future generations of that company.

Senator Tkachuk: I don't understand that, but there's no expectation by me that once I leave one insurance company to go to another insurance company that at some future date 25 years from now, I have contributed so much to that company. Isn't one of the benefits of shares in a public company that I can give them to my kids, and they can benefit from my investment? I can't do that with an insurance company.

Mr. Lafrenière: Absolutely, but if you follow me on that, when you purchase the shares, you pay for the shares.

Senator Tkachuk: Of course. That's how I'm paying for the insurance.

Mr. Lafrenière: That's different. When you're buying the insurance from the mutual company, you're buying protection for the year. You're also contributing — you may not because you may have losses in that year — to the surplus of that company. That company's surplus has been built over many generations. Never was there a sale of shares of that company. You purchased shares. You paid for the past generations of that share when you purchased it.

Senator Tkachuk: As far as I know, I purchased insurance. I'd like to ask Mr. Lowery a question.

The wheat pool privatized and became Viterra. I'm no longer a member of the wheat pool and haven't been for 20 or more years. Did they consult me even though I hadn't been a member of the wheat pool for 20 years about getting a benefit out of those? Was it just the present members of the wheat pool that benefited? I think it was.

Mr. Lowery: That's absolutely right. The wheat pool was a cooperative. The wheat pool benefited all its members with a mutual company where you have a small cohort, the ``mutualist policyholders.'' The vast majority, about 99 per cent, are not the mutualist policyholders, but both have contributed the same amount to the company. That's not a parallel to the wheat pool. In the case of the wheat pool, they exchanged shares of the publicly traded company for the membership shares or co-op shares that the members had before, but it was to all members. It wasn't to a small group.

Senator Tkachuk: I know, but my contribution beforehand wasn't recognized.

Mr. Lowery: You're absolutely right, but I think we're talking about two different issues here. One issue is where you have a membership base. Even if it were the case that a mutual company today said, and often that generally was the case, that all policyholders basically participated, I think that would be less egregious than what's being proposed under the current rules.

The Chair: Ms. Gavan has a comment.

Senator Tkachuk: I have one more question after she's done, but just a tiny one.

Ms. Gavan: I wanted to reiterate that the Department of Finance has given a strong indication that it is broader sharing, so it's not, as Mr. Lowery is saying, just a small group that is going to share. The benefits will be shared more broadly. That's the indication we've been given by the Department of Finance. We are not privy to the regulations, but that's the indication we've been given. We've been communicating that to our stakeholders.

The Chair: Senator Tkachuk, your quick question.

Senator Tkachuk: I bought life insurance for my two kids. The life insurance was purchased from a mutual, which demutualized.

The Chair: The question, please.

Senator Tkachuk: This is the question. I get this letter, and I receive a whole bunch of shares to the company. I was a really happy policyholder, and I still had the insurance — well, my kids still had the insurance. I had the cash and all these shares, which I never had before. Isn't that what will happen to the people who own insurance in that company? I'm asking. I don't know.

Mr. Lafrenière: In the case of life insurance companies, the sharing was very broad. That's not the case we have in point today.

Senator Hervieux-Payette: Only 1 per cent is in the small group of nearly a million. Who are these people? Are they employees, past employees, brokers, past brokers? Who are they? We'd like to know why there is a difference. Do they pay the same rate for their policy? For the same coverage, do they pay the same rate?

Ms. Gavan: The policies are fairly widely distributed. They tend to be older people spread broadly around southwestern Ontario. They are people who tended to have a community of interest with Economical. The number of directors, managers and employees with policies is a minority in the total. In fact, the number of current managers and directors who have policies is the minority of those on our executive team.

It was sold to local business people who had their personal insurance with Economical. This was only available on the principal residence, not on auto or business insurance. It was only on the principal residence. There were tight underwriting quality standards because we had to ensure that people would be able to pay the premium note if it had been called on. It was distributed through our brokers.

Senator Hervieux-Payette: Can one person have more than one mutual policy? Do you have more than one mutual policy?

Ms. Gavan: No one can have more than one because you can only have one principal residence.

The Chair: You're on a touchy subject for the Senate at the moment when discussing principal residence.

I'd like to say that it's been a while since we've had such a stimulating and spirited discussion by any panel. I extend my compliments to each of you for presenting your views. I know I express the views of every member of the committee in giving you our appreciation for appearing before us today. Thank you very much. This meeting is concluded.

(The committee adjourned.)