Lloyd's of London members are facing potentially disruptive changes to how they fund underwriting at the insurance market, yet its underwriting representatives say Lloyd's is well prepared for the change, partly thanks to a dispensation the market has provided for smaller members.
Members provide the underwriting capital at Lloyd's. They can be either wealthy individuals, known as Names, or companies. Syndicates, which carry out the underwriting, can be backed by several members, though syndicates belonging to big-name global insurers or reinsurers tend to just have one member backing them.
Lloyd's is looking to limit how much of the members' funds supporting underwriting is made up of so-called Tier 2 capital, that is, supplementary capital such as subordinated debt. For Lloyd's members, this mainly consists of bank letters of credit, or LOCs.
The capital members provide as security to support their Lloyd's underwriting business is called funds at Lloyd's, or FAL. These stood at £22.3 billion on June 30, 2017, with the LOCs and bank-guarantees portion totaling £9.4 billion.
Lloyd's currently allows LOCs and other Tier 2 capital to make up 100% of each member's FAL. The problem is that under Europe's Solvency II insurance capital rules, Tier 2 and Tier 3 assets can make up only 50% of the solvency capital at any company covered by the rules. So, any Tier 2 and Tier 3 assets Lloyd's has over the 50% threshold cannot count toward coverage of its marketwide solvency capital requirement, or SCR, which is the baseline capital standard for normal operation under Solvency II.
A challenge for some Lloyd's members
On June 30, 2017, £1.18 billion of Lloyd's solvency capital — including £1.14 billion worth of LOCs — was not eligible to count toward its marketwide SCR. However, this was an improvement on the £1.93 billion that was disallowed as of Dec. 31, 2016, of which £1.89 billion was LOCs.
Although the capital held by Lloyd's still comfortably covers its marketwide SCR — its coverage ratio was 147% on June 30, 2017 — the insurance market still wants to take action.
"At 31 December 2016, Tier 2 capital in members' FAL generated a solvency disallowance of £1.9 billion and resulted in the Lloyd's marketwide solvency ratio being diminished," it wrote in a market bulletin dated Aug. 10, 2017. "We need to manage the Lloyd's marketwide solvency ratio over time whilst continuing to allow members the flexibility to use Tier 2 capital as FAL."
Lloyd's said in the bulletin that from the Dec. 1, 2018 coming-into-line date — one of two occasions each year when members ensure their capital is aligned to their underwriting ambitions — Tier 2 capital would be limited to 90% of the capital required, which is determined by the economic capital assessment, or ECA. This ratio will fall to 80% in 2019 and 75% in 2020. In addition, members will have to fund their share of any syndicate solvency deficits with Tier 1 capital. Solvency deficits incurred between July 1, 2017, and Dec. 31, 2017, will have to be covered by the mid-year coming-into-line date of June 30, while any deficits incurred before July 1, 2017, will have to be funded by the full-year deadline on Dec. 1, 2018.
This could present a challenge for some Lloyd's members and their banks. Lloyds Banking Group Plc is one of the providers of funds at Lloyd's, and its global head of insurance, Bill Cooper, said some of the larger firms use LOCs for their entire regulatory capital requirement.
He noted that an alternative to LOCs is simply providing a loan. "This is appropriate for some. But the LOCs are quite capital-efficient for banks. They are better [for banks] because we don't have to fund them, whereas we do [have to fund] a loan, so it is slightly more expensive for firms to take the loan route. We are in the early days of this, but we are going to see some changes there."
He added: "It is more complex for firms in the market, particularly if they are new to Lloyd's of London."
Iain French, relationship director in the insurance team at Barclays Plc, said Lloyd's syndicates backed by capital from Names could be hit hardest by the change, adding that switching to loans from LOCs may be unpalatable.
"[A loan is] not attractive to a lot of Names because an LOC is cheaper and you don't have the LIBOR and base-rate costs associated with it," he said.
Adequate response
Lloyd's members already had a taste of things to come when they had to replenish capital in the wake of the heavy 2017 catastrophe losses. In a joint email to the market on Dec. 19, 2017, Lloyd's Chairman Bruce Carnegie-Brown and CEO Inga Beale revealed that Lloyd's backers had pumped in about £3 billion of additional capital to restore levels to where they had been before the catastrophes in the third quarter of that year. Lloyd's required the fresh funds to be Tier 1.
Fortunately, the process was not as painful as it could have been for smaller members because Lloyd's granted a dispensation for those who needed to put up less than £5 million of capital as determined by the ECA.
Ken Curtis, CFO of the Lloyd's Market Association, a trade body representing Lloyd's underwriters, said: "The need following the losses for those who had to recapitalize with Tier 1 assets rather than LOCs probably did catch a few on the hop, but having given them dispensation, everybody coped adequately."
The dispensation is also expected to apply going forward, meaning that members who have to put up less than £5 million according to their ECA at future coming-into-line dates will continue to be able to fund this fully through Tier 2 capital.
"I think Lloyd's gave sufficient notice, and it has been dealt with adequately" Curtis said. "There was a little hiccup about what they were going to do with small members, and Lloyd's gave a dispensation, so those who might have been inconvenienced haven't been."
