Capital efficiency: Maintaining Lloyd's advantage

This article follows on from the joint events organised by the LMA and Vario Partners during the past 18 months. If you have any observations or feedback on this paper, or on ILS more generally, please feel free to contact Markus Gesmann (Vario) or Gary Budinger (LMA).

Lloyd’s was always a very capital efficient market for specialty risks. When the market comprised unlimited liability Names, individual members benefited from diversification across syndicates and the mutual Central Fund layer. Additionally, Funds at Lloyd’s requirements could be met by Letters of Credit. Syndicates benefited from Lloyd’s brand, rating, licences and marketplace.

The Lloyd’s marketplace has changed fundamentally over the last 25 years with the introduction of corporate capital. Many syndicates are now aligned to international insurance groups, and Lloyd’s is only one of their platforms to accept insurance risk.

Speciality risk still comes to Lloyd’s, the brand matters to many clients, e.g. Greek shipowners will accept no other rated paper, but the rating and licensing network might be not such a big factor for the larger market players than for the traditional non-aligned syndicates.

What about capital efficiency?

This used to be one of the biggest pull factors. Capital requirements for syndicates in the market were much lower than on a standalone basis, and the use of letters of credit (LoCs) made it even more efficient, particularly when they could make up 100% of Funds at Lloyd’s.

This permitted members to make multiple uses of pledged capital. It facilitated the same member capital to generate up to three separate revenue streams: underlying investment return on the asset itself, the return generated on the insurance float accumulated and lastly the potential to generate an underwriting profit.

However, LoCs can only contribute to 50% of FaL from 1 December 2020. Furthermore, dispensations Lloyd’s has had with regulators around the world in respect of funding losses are under increasing pressure.

As disclosed at the Monte-Carlo Rendezvous in September, rating agents are beginning to acknowledge capital efficiency as a key discriminator in their assessment of Financial Strength Ratings. See also the S&P 2018 Global Highlights Report, where they analysed how the leaders are breaking away from the pack. This stands to reason as the more efficient the capital, the greater the insurer’s ability to weather the storm of a soft market.

Lloyd’s remains a capital efficient place to do business, but the complexity of entering and leaving Lloyd’s, particularly with regard to capital, the erosion of regulatory benefits such as LoCs and global moves to gross funding of losses all put pressure on the marketplace to remain innovative in the way it capitalises risk.

How ILS can help Lloyd’s syndicates maintain capital efficiency

Disclaimer: The following section is an opinion of Vario Global Capital Ltd. The views expressed here are those of Vario Global Capital Ltd. only and not the LMA. Content is provided “as is”, with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.

The recent LMA survey showed that market participants viewed an increasing ILS profile in London under the new PRA ILS regulations as both desirable and inevitable. Given the increasing capital requirements and the change in eligibility of LoCs at Lloyd’s, ILS can provide a potential way out of the increasing costs of capital. Indeed, “renting” risk capital through reinsuring with capital markets investors, instead of holding ever more equity, can be a smart and capital efficient approach to capitalising risk.

Is UK ILS only for the bigger players?

The first Catastrophe bond issued under this new UK legislation was a $300m cat bond, Atlas Capital 2018 PLC, sponsored by SCOR in May 2018. The success and scale of this transaction also highlights a key difficulty with issuing ILS in London; costs.

ILS issuance in London is likely to be expensive. Legal costs, special advisers, arrangement fees and other agents will likely cost more than $500k per transaction. Hence, most transactions will be most likely in excess of $100m, which will rule it out as uneconomic for a significant number of London Market businesses.

A cost-effective approach: ILW

A more cost-effective approach could be through parametric ILS purchasing. Here, rather than an insurer using its own reported figures as the basis for determining whether the contract has been triggered, and the capital markets investors have lost their capital, an industry or physical index or parameter is used instead. Indeed, there is already a huge market in Industry Loss Warranties; these are typically based around adjudications on insured loss quantum by Property Claims Service (PCS) in the US or Perils in Europe for individual major natural catastrophes, or on an independent assessment of the intensity of a storm or earthquake.

These products have become mainstream because they have been able to bridge the gap between insurers’ and investors’ understanding of risk in a highly cost-effective way. Basing reinsurance contract wordings on natural catastrophes exceeding specified thresholds gives investors a much clearer line of sight on the risk they are running, with independent data available for risk quantification — they, like everyone else, have access to historical natural catastrophe information upon which to base their decisions. This is a far more scalable approach than the individual, indemnity-based approach of an insurer’s own ILS bond issuance, and the costs reflect this.

Expanding from Nat-Cat to all risk covers

However, up to now, the main constraint has been the relatively narrow product range that parametric ILS offers, reflecting a similar range of perils covered by wider ILS bond issuance. We believe that new products introduced in this space are a perfect example of where the London Market can add value and make its mark on global ILS issuance.

In our previous article in June this year, we examined how Lloyd’s might employ a simple but very different approach to ILS issuance to enhance the Central Fund at a time when its members were still able to deploy capital successfully. This was as an alternative to merely adding more subordinated debt within Lloyd’s Central Assets, which just provides policyholder protection funds when the market’s own resources have been completely exhausted.

From ILW to LLW

The basic premise of the June article was that Lloyd’s could issue its own parametric ILS bond, with the parameter being Lloyd’s own published calendar year loss ratio. There is a significant amount of data in the public domain enabling potential investors to form a view of the probability of this number breaching specific predefined thresholds, see chart below.

Lloyd’s historical loss ratio 1948 – 2017

We believe that the case for Lloyd’s issuing such ILS centrally is evident. Furthermore, individual syndicates can effectively gain the protection of a Lloyd’s ILS themselves; by buying collateralised parametric ILW reinsurance from any of the existing ILS funds providing such cover using the Lloyd’s market data to parameterise the cover.

ILW protection of Lloyd’s syndicates

Why would a syndicate want to buy this? Doesn’t it have its own bespoke reinsurance programme?

Well, the key benefit of an ILS product based on Lloyd’s published calendar year loss ratio is that it simply doesn’t matter what claims have emerged from which classes of business; if the trigger has been reached, then the collateralised reinsurer will pay the reinsurance recovery due. This may be of particular interest to cover those classes where reinsurance is restricted, or for additional sideways cover for multiple events. In effect, the syndicate is acquiring a form of Stop Loss protection based on a parametric trigger. This is a product currently being marketed in Lloyd’s by Lockton Re.

But won’t this just be an additional cost? And what about basis risk?

Our VarioQuant model can show the basis risk of such an ILS product to each individual syndicate, as follows:

This chart shows that, for a typical Lloyd’s syndicate writing a broad mix of property, casualty and reinsurance risk, at the syndicate’s 1-in-200-year (SCR) loss, there is a recovery from a Lloyd’s calendar year loss ratio ILS ranging from [40% to 80%] of the limit, depending upon return period purchased. The difference between this and 100% is, in effect, the basis risk attaching to the parametric nature of this reinsurance. Indeed, Lloyd’s have given capital credit for parametric CAT ILS reinsurance on this basis and will similarly support these products.

Who said Lloyd’s couldn’t be innovative?