How to survive the next systemic crisis at Lloyd’s

In May 2018, Vario held its second annual ILS panel discussion, co-hosted with the LMA.

The panellists were Michael Wade (Lloyd’s market veteran and currently Chairman of TigerRisk Capital Markets & Advisory in the UK), Rob Cannon (special counsel and ILS specialist at Cadwalader Wickersham & Taft), John Parry (Lloyd’s CFO who had recently announced his departure from Lloyd’s) and Michael Watson (Chairman of Canopius and a partner at Vario Partners).

Discussion focused around how Lloyd’s and London could adapt to ILS and add their unique value to investor propositions. John Parry relayed that Lloyd’s itself was looking at potential ILS solutions to augment its central assets backing policyholders, although this work was at a very early stage. Following the recent announcement that Lloyd’s CEO, Dame Inga Beale, was also to leave the market, it remains to be seen whether any progress will be made in this area before the yet-to-be-appointed senior management are comfortably in place.

Despite this, we ran some of our own analyses, using our own proprietary Lloyd’s model, to look at options for Lloyd’s Central Fund to utilise ILS structures.

We used our proprietary “outside-in” Lloyd’s model to conduct an in-depth study of the market’s historical and prospective underwriting results. Our model uses publicly available information, built up from individual syndicate’s published information by lines of business, and replicates the behaviour of the Lloyd’s market as a whole. These curves and the dependencies between them enable us to model distributions of outcomes for individual syndicates as well as for the market as a whole. Using the 2017 actual results and comparing them with the ab initio market curve, the adverse loss ratio incurred during 2017 was modelled to equate to a return period of around 10 years. Vario’s estimates of each syndicate’s portfolio level exceedance probability curve for 2018, along with the aggregated curve for the Lloyd’s market as a whole, is shown in Figure 1.

What might this mean for Lloyd’s central assets?

Overlaying our current market curve with our estimates for individual syndicate’s FaL enables us to model potential impacts to Lloyd’s central assets as the market’s aggregate loss ratio changes. The scatter plot in Figure 2 shows the modelled Central Fund earmarking from Vario’s syndicate level model against the modelled Lloyd’s aggregate calendar year loss ratio. Additionally, the historical Central Fund earmarking as a percentage of that year end’s Central Fund assets are shown as large red dots (data sourced from the Society’s annual reports since 1997, i.e post Reconstruction and Renewal). Each small white dot represents one of the 500k simulation of the model’s output.

According to the model, the aggregated Lloyd’s market 1 in 200 net calendar year loss ratio is in the range of 100% - 110%, i.e. a combined ratio of 140% - 150%, figures last seen in 2001. Figure 2 shows a clustering of scenarios with relatively low impact on the Central Fund, up to an aggregated market loss ratio of c.100%. This is entirely plausible as under Lloyd’s rules each syndicate is capitalized 35% above its own 1 in 200 year capital requirement. But, as the market loss ratio transitions pass 100%, the clustering disperses and the probability of significant impairment of the Central Fund increases materially – almost as a cliff edge. Again, this is logical as syndicates’ internal models are all calibrated to the same 1 in 200 confidence level and this coincides with a significant probability that syndicates exhaust their FaL. This means that following a loss year of this magnitude, the market would not just need to recapitalise, it may need to reconstitute with new forms of businesses or an overall new operating model. This would inevitably introduce a delay before the new businesses could underwrite, which could be detrimental to Lloyd’s future wellbeing. In addition, Lloyd’s is likely to be under rating agency pressure, even when only a fraction of the Central Fund has been eroded or earmarked.

What part might ILS play for Lloyd’s?

At the LMA and Vario Partners panel discussion, John Parry mentioned that the market was looking into protecting or enhancing Lloyd’s central assets including exploring some form of ILS risk transfer, but that it was early in the project and no decisions had been made. Risk transfer into the reinsurance market holds painful memories for many who remember the previous Lloyd’s Central Fund reinsurance policy, so the current caution is understandable.

Based on the above analysis, using ILS to reinsure market risk at or above the market’s 1 in 200 point looks rather like shutting the stable door after the horse has bolted. If the effect of market’s approach to syndicate level capital is for syndicates to exhaust FaL roughly simultaneously, then enhancing central assets at this level of loss would be too late to be relevant to the profitable continuation of the market, unless the major participants, most of whom have substantial non-Lloyd’s franchises, choose to reload within Lloyd’s to the same level as currently.

To help accelerate Lloyd’s advantage post-event, which has traditionally been when Lloyd’s has prospered, any ILS solution should either augment syndicate capital (notwithstanding potential allocation issues between members depending upon how such augmentation took place) or bolster central assets in such a way as to relieve syndicate capital, triggered before the 1 in 200 point is reached. The above analysis suggests that such a use of ILS could materially improve Lloyd’s position following a less than 1 in 200 event (subject to structure). Furthermore, this additional capital injection at such a crucial time would also help to mitigate against any potential rating agency downgrades.