INSURANCE FORMULA CHIEF FINANCIAL OFFICERS - IDA MEMBER FIRMS PANEL AUDITORS - IDA JURISDICTION FIRMS. June 12, 1995 C-84

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1 TO: CHIEF FINANCIAL OFFICERS - IDA MEMBER FIRMS PANEL AUDITORS - IDA JURISDICTION FIRMS June 12, 1995 C-84 INSURANCE FORMULA This summary is designed to highlight the background and application of the insurance formula rules pursuant to IDA by-law 17.4 and Regulation What is the purpose of an insurance requirement? The purpose of a Member firm having insurance coverage is to effectively protect the firm and the industry against the loss of property resulting from dishonest and fraudulent acts. This insurance should protect not only the capital of the firm but the clients' assets it administers. For example, in the event of a loss of certificates that have been misplaced, stolen or destroyed, an insurance policy would allow the firm to claim for the loss amount or obtain a "lost bond certificate" in order to continue normal trading activity in that security. Insurance protects the firm against dishonest acts of employees, whether such acts involve the physical theft of securities or do not involve securities such as trading losses or misappropriation of monies. It should be noted that to have an insurance claim under "fidelity losses", there must be manifest intent of financial or potential gain on the part of the employee. A sound system of internal control is unquestionably one of the best ways to prevent losses from occurring. Insurance companies assess the degree of operating risk and loss exposure of Member firms. The existence of adequate internal controls of a Member and past loss experiences bear a direct relationship to the level of coverage an insurer will provide and the cost of such a policy. 2. What is an acceptable form of insurance policy for a Member firm? The operation of a securities firm is unique from other financial industry sectors. On this basis, the insurance industry has developed a specific insurance policy with standard clause coverage and wording that is specific to a securities firm. The standard form of insurance policy applicable to securities dealers is referred to as a "Financial Institution Bond (FIB) Form No. 14". This standard document eliminates any misunderstandings as to the terms and limits of coverage of the insurance policy obtained from any insurer by a Member firm. The standard clause coverage contained in the FIB Form 14 document complies with the minimum insurance requirements as

2 prescribed in IDA Regulation What are the SRO requirements as to the extent of insurance coverage required? The minimum insurance clause coverage requirements to be obtained by all Member firms pursuant to IDA Regulation 400 are included in a standard FIB form 14 policy. As a minimum it must include the following clause coverage (refer to Regulation for details): Clause (A) - Fidelity - Any loss occurring through any dishonest or fraudulent act of any employee(s) of the firm. Clause (B) - On Premises - Any loss of money or securities occurring through robbery, mysterious disappearance or destruction of securities while within any of the firm s offices, or safe deposit box locations. Clause (C) - In Transit - Any loss of money or securities occurring through robbery, mysterious disappearance or destruction, while in transit in the custody of any employee or any person acting as messenger for the firm, as in the case of an armoured motor vehicle company. Clause (D) - Forgery and Alterations - Any loss through forgery or alteration of any cheques, drafts, promissory notes or other written instructions to pay sums in money. Clause (E) - Securities - Any loss through having purchased or acquired, sold or delivered, or extended credit or acted upon securities or other written instructions which prove to have been forged or counterfeited. In addition, Member firms must also carry mail insurance against loss arising from any out-going shipments of money or securities, negotiable or non-negotiable, by first class mail, registered mail, registered air mail, express or air express, such insurance to provide 100 percent cover. 4. What are the SRO requirements for the amount of insurance to be carried by Member firms? All Member firms are required to maintain a level of insurance as prescribed by an insurance formula. On December 1, 1994 a new insurance formula was introduced that moved away from the traditional method of calculating insurance requirements based on the valuation of securities held by Member firms. The guiding principle established in the development of the new formula was to determine the level of insurance given the assets under administration by Member firms. The formula developed was intended to be simple to calculate and in no way discourage the industry's move to the immobilization of securities held at book based depositories. The formula employs two benchmark criteria in the determination of minimum insurance requirement for Member firms. They are client net equity and total allowable assets. These two criteria are designed to take into account any combination of a Member firm's business activities. The required amount of insurance to be carried by any Member firm is based on the greater of total client net equity and total allowable assets. Total allowable assets are defined in Schedule A of the JRFQ&R. The amount of insurance required is based on applying a rate of 1% to the predetermined benchmark amount. The minimum insurance required is $500,000 and for introducing brokers, $200,000. The maximum insurance required is $25 million.

3 The amount of insurance calculated above must be maintained for each of the clause requirements set out in paragraph (3) of this Bulletin. However, in respect to Clause (C) coverage, the amount is subject to dollar for dollar coverage based on the value of securities transported by the firm at any point in time. Furthermore, the minimum insurance required for any Member firm must consist of maintaining a policy with at least a double aggregate limit or a full reinstatement provision as will be explained later. 5. How is Client Net Equity Calculated? For purposes of IDA Regulation 400, Client Net Equity ("CNE") is defined as follows: The aggregate of net equity for each customer determined as the total value of cash and securities owed to the customer by the Member less the total value of cash and securities owed by the customer to the Member. The CNE requires that net equity be determined on a client by client basis. Net amounts owed to clients (including securities), on a client by client basis, should be aggregated in total for purposes of this calculation. In situations where there are amounts owed by clients (on a client by client basis) such amounts should not be netted in the determination of the total CNE balance owed to clients by the firm. Accounts included in the CNE calculation consist of individual client accounts: i) on a combined basis - cash, margin, short sale, options, futures, foreign currency and Quebec Stock Savings Plans accounts, and ii) accounts such as RRSP, RRIF, RESP, Joint Accounts, and Guarantee-Guarantor Accounts which are not combined with other accounts and should be treated as separate accounts. The CNE calculation also includes Broker-Dealer balances, Repos, Loan Post, Broker Syndicate Accounts and Balances with affiliates, calculated on a combined basis with the same counterparty. The following table illustrates the client net equity calculation: Client Account Type Net Debit Balance (owing from client) [Debit cash balance + value of securities sold short - value of securities held long] > 0 Net (Credit) Balance (owing to client) [Credit cash balance - value of securities sold short + value of securities held long] < 0 Client Net Equity (owing to clients on a client by client basis) - in absolute dollars Client A Cash $10,000 $0 Client B Cash ($20,000) $20,000 Client C C.O.D ($500) $500 Client D Client D Margin Cash $2,000 ($5,000) $3,000 Client E Margin $5,000 ($2,000) $0

4 Client E Client F Client F Cash Margin RRSP $1,000 ($4,000) $4,000 Aggregate Client Net Equity $27, How often does the client net equity and total allowable asset calculation need to be performed? For Member firms that carry the maximum amount of insurance of $25 million for any kind of coverage, the CNE calculation for such coverage need only be performed at least quarterly for purposes of regulatory reporting. This includes the filing of Schedule 10 of the year-end Joint Regulatory Financial Questionnaire and Report ("JRFQ&R") in addition to the filing of the Schedule with the Quarterly Operations Questionnaires ("QOQ"). (See Attachment I). For Member firms that do not carry the maximum amount of insurance for any kind of coverage, in order to comply with SRO by-laws of maintaining the required minimum amount of insurance as prescribed by Regulation at all times, the insurance calculation should be performed at least monthly or more often depending on the amount of insurance carried by the firm relative to the minimum otherwise required, and more frequently as is warranted due to changes in the volume or type of business conducted by the firm. In addition to the level of insurance prescribed by the regulatory insurance formula, Member firms should take into account any additional amounts and type of insurance coverage in the corporate governance activities of the firm as a whole. 7. How does the new client equity calculation effect Member firms who have introducing or servicing arrangements? For Introducing Broker members, the component of the insurance formula dealing with client net equity is effectively covered by the Carrying Broker. Clients of the Introducing Broker are fully disclosed and consent to the arrangement that their accounts are carried on the books of the Carrying Broker. As a result, the client assets are the direct responsibility of the Carrying Broker and the Carrying Broker is required to include these client assets in its own insurance calculations. The Introducing Broker is still required to calculate the other component of the insurance formula based on total allowable assets and maintain at least the minimum amount of insurance required for Introducing Brokers in the amount of $200,000. In the case of servicing arrangements, whereby a "Servicor" firm offers accounting, settlement and/or custodial services to the "Servicee" firm, this arrangement is not disclosed to the clients of the Servicee. The Servicee is held accountable directly to its own clients in the event of any loss of client assets. For example, to the extent that the Servicee provides instructions to the Servicor as to the settlement of client trades or movement of client monies, any fraudulent act perpetrated by an employee the Servicee firm or otherwise that results in a loss of client assets, is the responsibility of the Servicee and must thereby carry insurance accordingly. The Servicor is also required to provide insurance on the Servicee's client assets under its custody to protect against other aspects of loss such as theft or mysterious disappearance

5 of client securities in its custody. The minimum insurance requirement for both a Servicor and Servicee firm is $500, What reporting method is used in calculating the insurance requirement? Member firms are permitted to choose between settlement date or trade date client accounting in computing Client Net Equity ("CNE") as long as the computation is performed on a consistent basis. However, for purposes of determining the total allowable assets of a firm, trade date basis of accounting must be used. This is consistent with the method of reporting by Member firms on Statement A of the JRFQ&R. 9. What does it mean to have a double aggregate limit versus a provision for full reinstatement policy? As required under IDA Regulation 400.5(b), Member firms are required to maintain a Financial Institution Bond Form 14 ("FIB Form 14") policy with, at least a double aggregate limit or a provision for full reinstatement. Most insurers in the past few years have adopted aggregate limit policies. Aggregate limits are defined in the context of both the bond coverage and the number of value of losses which occur during the applicable coverage period. The following is a description of the various alternatives of insurance coverage available: (i) No Aggregate There is a limit per loss based on the bond coverage with no limit as to the number of claims or losses which occur during the applicable coverage period. (ii) Single Aggregate The amount of the bond coverage is reduced by losses as they occur during the applicable coverage period. (iii) Double Aggregate In this type of policy limit, after the first loss occurs, the bond coverage does not change; the coverage is reduced after the second loss occurs. One large loss could result in the policy being exhausted, exposing the firm to further uninsured losses, or more probably, to difficulties and extra costs to purchase new coverage in order to be in compliance with regulations. In the case of no aggregate limit, depending on the magnitude of any loss claim and the relationship between an insurer and the firm, it is probable that the insurer may exercise its right and provide notice of cancellation of coverage to the firm after a very large loss claim. In both cases, the firm will have to obtain insurance coverage as required. The following table illustrates what happens to the remaining bond coverage as losses occur during a single coverage period under various aggregate limit policies: No Aggregate Single Aggregate Double Aggregate Current Policy Coverage $25 million $25 million $25 million 1st $10 million loss claim $25 million $15 million $25 million

6 2nd $10 million loss claim $25 million $5 million $15 million 3rd $10 million loss claim $25 million $0 million $5 million In comparison, a provision for full reinstatement involves having any diminished coverage fully reinstated. As such, it results in principally the same coverage as a double aggregate limit policy. However, to accomplish equality between the two options, the provision for full reinstatement should be required at least once. For purposes of complying with the insurance regulations, any policy specifying a single aggregate limit does not meet with the minimum insurance requirements. 10. What is the purpose of the Notice of Termination Rider requirement under Regulation 400.3(a)? In the event that the insurance underwriter terminates the Member's policy, IDA Regulation 400.3(a) requires that each FIB Form 14 policy carried by a Member firm shall contain a "rider" that requires, in cases other than those specified, such as the termination of the bond on the expiry of the coverage period (see Attachment II), the underwriter to notify the Director of Compliance of the IDA at least 30 days prior to the termination or cancellation of the bond. This notice enables the regulators to become aware and act upon any possible breach of Canadian Investor Protection Fund ("CIPF") minimum standards and SRO regulations as they relate to every Member firm maintaining the required amount of insurance as prescribed by regulation. Attachment II of this Bulletin sets out wording for a standard termination rider developed by insurance underwriters that meets the requirements set out in Regulation 400.3(a). 11. What are the minimum IDA requirements under a Global FIB Insurance Policy? Global insurance policies involve the Member firm becoming a named insured under a blanket insurance policy obtained by a parent company on its behalf or its subsidiaries/affiliates. In order to ensure that the same standard of insurance requirements are embodied under a global insurance policy, the SROs developed the following conditions that must be met: (a) the Member must have the right to claim directly against the insurer in respect of any losses, and any payment required must be made directly to the Member. (b) the individual or aggregate limits under the global policy may only be affected by the claims made on behalf of the following: (i) the Member (ii) any of the Members subsidiaries whose financial results are consolidated with those of the Member (iii) a holding company of the Member provided that the holding company does not carry on any business or own any investments other than its interest in the Member For example, if the global policy is for $25 million and the Member has a $15 million claim and another subsidiary of the parent under the global policy has a

7 claim outstanding for $20 million, the Members claim would not be affected by the claim of the subsidiary if it is a named insured under the policy. This is referred to as a separate aggregate limit coverage for the Member. (c) the policy must otherwise comply with the requirements of the SRO s and contain the minimum clause coverage and wording contained in a standard FIB Form 14 policy. 12. Who is qualified to be an acceptable Insurance Carrier? To be an acceptable insurance carrier pursuant to the regulations, the insurer must be either (i) an insurer registered or licensed under the laws of Canada or any province of Canada or (ii) any foreign insurer approved by the Director of Compliance. The foreign insurer is required to have a minimum net worth of $75 million on the last audited balance sheet and the Director of Compliance is satisfied that the insurer is subject to supervision by regulatory authorities in the jurisdiction of incorporation of the insurer which is substantially similar to the supervision of insurance companies in Canada. 13. What action must be taken in the event of incurring an insurance deficiency? Member firms are allowed two months to correct any insurance deficiency to the extent that the amount of the deficiency is less than 10% of the actual insurance requirements for the member. Any Member experiencing an insurance deficiency in excess of 10% of its actual coverage requirements must immediately report the deficiency to the SRO and take correcting action within 10 business days. 14. What is the Member firm s responsibility to report loss claims? In addition to reporting any loss at the time of discovery to the Member s insurer, pursuant to By-law 17.6 Every Member shall give the Director of Compliance written notice, with all available particulars, of any claim (other than client losses relating to lost document bonds) reported in writing by the Member to its insurers or their authorized representatives arising under the Financial Institution Bond or Bonds which such Member is required to effect and keep in force under Regulation Such notice will be given within two business days of the Member so reporting to the insurer or its authorized representative. 15. What are the prescribed minimum internal control requirements in respect to Insurance? The SROs have developed new Internal Control Policy Statements that prescribe requirements for and provide guidance on compliance with new IDA Regulation in which Members must "establish and maintain adequate internal controls". In a series of Policy Statements, "Internal Control Policy Statement No. 3" deals with internal controls for Insurance. This policy sets out specific control objectives and minimum required policies and procedures that a Member must maintain in order to comply with the regulatory insurance requirements (See Attachment III). 16. Are there additional coverage or enhancements available to the standard FIB Form 14 insurance policy? Attachment IV lists a brief description of additional enhancements which Members should be aware of and should strongly consider when negotiating policies with their insurance brokers. While theses enhancements to the policy are not currently mandatory requirements pursuant to SRO Regulations, the FAS Insurance Subcommittee is

8 reviewing these enhancements with a view to adding them as minimum requirements for insurance. Questions regarding this notice may be directed to Louis P. Piergeti, Director of Compliance at (416) PLEASE DISTRIBUTE TO ALL INTERESTED PARTIES IN YOUR FIRM

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