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The Actuary The magazine of the Institute & Faculty of Actuaries

Solvency II: Lloyd's and the risk horizon

The introduction of Solvency II has resulted in the need for Lloyd’s to review how capital is managed within the market. On 31 October 2011, managing agents within the Lloyd’s 
market are required to provide the first 
formal submissions of an internal model Solvency Capital Requirement (SCR) in Europe. This will be a key milestone for the Solvency II programme at Lloyd’s.

Capital structure at Lloyd’s
The unique chain of security at Lloyd’s provides financial security to policyholders and capital efficiency for members. This capital structure and security is acknowledged by market participants and analysts as providing a significant advantage to operating at Lloyd’s. Capital efficiency is achieved through each member providing several capital funds (Funds at Lloyd’s), held in trust, and annual contributions to a mutual layer of capital to fund extreme downside risk (Central Fund). The Lloyd’s capital structure 
is also beneficial to policyholder security. 
The insolvency of a non-life insurance company results in a risk of default on all policyholder claims, however, in the case of Lloyd’s, many members may still be 
solvent when the Central Fund is insolvent. Hence, the average policyholder loss given default is lower at Lloyd’s than a comparable company for similar return period losses.

Figure 1 shows how losses flow through the Lloyd’s chain of security. The figure shows that, in the event of Central Fund insolvency, members in the market may still make profitable returns. This highlights the diversity of risks transacted through Lloyd’s, the geographical spread of these risks and the diversity of capital providers.

Figure 1

The level of mutuality within the market is managed to ensure Lloyd’s remains commercially attractive while providing policyholder protection. Lloyd’s considers the suitability of the overall level of Funds at Lloyd’s and the Central Fund on an annual basis. Funds at Lloyd’s are set through the member capital setting process which currently involves a review of each 
syndicate’s Individual Capital Assessment (ICA). An economic uplift (currently 35%) is applied by Lloyd’s to agreed ICAs in setting Funds at Lloyd’s at a level that provides a target credit rating (given the balance of several and mutual capital). One of the key roles of the member capital setting process is to help ensure each member derives a similar benefit from the Central Fund per unit of exposure. Hence, the equity of Funds at Lloyd’s, between members, plays a crucial role in capital management.

Risk horizon
The member capital setting process is currently based on syndicate ICAs, which are an ultimate assessment of risk. Since there will be no regulatory requirement to complete an ICA after the inception of Solvency II, Lloyd’s has reviewed the basis for member capital setting.

The ICA is calculated as the level of risk capital required to support the ultimate realisation of losses such that the probability of insolvency is less than 0.5%. Solvency II introduces an SCR risk measure defined as the potential decrease in the net asset value following a one-in-200-year event, over a 
one-year time horizon.

One of the key differences between an ICA and SCR is the risk horizon. The ICA measures the ultimate emergence of risk whereas the SCR considers risk over one year, with an allowance for the cost of funding future capital. Additionally, there is a difference in the treatment of future business.

For example, if we consider an SCR calculation as at 31 December 2011, a policy written at the end of December 2012 is 
likely to reduce an SCR whereas the ICA is likely to increase(1). If a new member entered Lloyd’s and supported a syndicate-only writing policies on 31 December 2012, 
the member would not be required to hold capital using the SCR basis. This highlights how an ultimate risk assessment may vary significantly from a one-year risk assessment for different classes. For example, property treaty policies typically incept early in the year, whereas aviation fleet policies tend to incept towards the end of the year.

As discussed, ensuring capital is held equitably between members plays a 
crucial part in member capital setting, 
so it is important to consider how the two calculations differ. For example, if one-year risk capital is always lower than ultimate risk capital by a fixed percentage, an increase to the economic uplift could result in no change to member capital. However, if the one-year and ultimate calculations vary significantly between classes, there will be winners and losers. Lloyd’s needs to consider the reasons for these movements before determining a solution that aligns the member capital setting process with the Lloyd’s business model and risk appetite.

Findings and critique
The level of risk emergence over one year compared to ultimate risk recognition 
can vary substantially between classes. 
Several methods have been developed over recent years for measuring reserve risk over a one-year time horizon and market studies are now available that show the difference in volatility emergence.

The Aon Benfield Insurance Risk Study for 2011 provides an assessment of the one-year and ultimate reserve volatility for major US classes of business based upon company size. The difference between classes of business can be significant. For example, for large companies (> $500m), the one-year and ultimate reserve volatility for product liability are 7.5% and 18.8%, whereas for homeowners, the respective volatilities are 10.5% and 12.2%. This means that for syndicates writing different classes of business, the impact of risk horizon on each member’s capital could be extremely significant.

One key complexity of the Solvency II regime can be traced back to the decision to follow a cost of capital approach to assess the risk margin. A simpler alternative would have been to apply a percentile-based risk margin — this is commonly used by (re)insurers 
for assessing the loading on top of the 
best estimate required to reach the fair 
value of liabilities under a Part VII transfer.

The philosophy underlying the risk margin 
is that, following a one-in-200-year event, 
an insurer’s risk-bearing capital will have been depleted by an amount equal to the initial SCR. If the remaining available capital is less than the point in time minimum capital requirement, it will be necessary to cease business and transfer the liabilities to a 
third party.

The key question is what size loading on top of the best estimate of the liabilities will the third party require in order to accept the transfer? Under the cost of capital approach, the third party would quantify the level of risk-bearing capital it will be required to 
hold in each future year over the lifetime of the liabilities and assess the discounted 
cost of raising this additional capital. 

While this approach is correct from a financial economic standpoint, it creates serious challenges for implementation due to the difficulty in defining the risk margin in terms of future SCRs, since the definition of the SCR already includes the potential change in risk margin during the year. While a number of simplifications have been developed to resolve this apparent circularity(2), they vary in terms of conservativeness and complexity.

As illustrated in the article on Risk Margins in The Actuary, December 2006, the difference between the exact computation of the risk margin compared to the ‘proportional’ simplification can be non-trivial for certain classes of business. In Figure 2, we provide a simplified view of the liability paths that contribute towards the initial SCR and 
risk margin under the cost of capital 
methodology to illustrate the conditional nature of the calculation.

Figure 2

In order to compare the overall relative conservativeness of the ICAS and Solvency II regime, it is necessary to consider the total resource requirements — the sum of technical provisions and required capital. Some of the key differences between the two regimes can be characterised as:

• The impact of risk horizon on the level of assessed risk capital
• Discounting effect in assessing technical provisions
• Inclusion of a risk margin in the technical provisions. The risk margin may compensate for the effect of discounting, but the net impact will depend on the riskiness and duration of the liabilities.

There are also differences in what is allowed to count towards available capital, which can also have a substantial impact on the assessed level of regulatory solvency (while the true economic position is unchanged). The overall balance of the above factors will vary considerably between syndicates, depending on the mix of business.

1 SCR is reduced by the economic value of the policy less the cost of funding future capital. This is typically positive for business written to a profitable target

2 It is not actually circularity, since the problem is path dependent and future SCRs are calculated conditional on the historical path of reserve development. However, this exact risk margin calculation can require nested Monte Carlo simulation which is undesirable, and the majority of undertakings are pursuing simplified approaches in their Solvency II internal models.


Member capital setting under Solvency II
The SCR basis may be considered economically more efficient than an ultimate risk assessment for managing capital needs. The SCR assumes future capital will be raised as risk is expected to emerge, whereas an ultimate assessment requires risk to be collateralised immediately. For Lloyd’s, use of the SCR would assume members continue to have access to, and provide capital to support liabilities until full risk emergence.

A change to this philosophy would result in the risk of members not replenishing capital as required, and posing greater 
Central Fund risk. In other words, if the economic uplift remained unchanged, additional resources would be required for the Central Fund to maintain the targeted credit rating and existing level of policyholder security (that is, to change the level of mutuality within the market).

The shift in capital from Funds at 
Lloyd’s to the Central Fund would benefit long-tail writers where the risk emerges slowly. Long-tail writers would derive 
greater benefit from the Central Fund, as Central Fund contributions are provided by members based on a percentage of premium. This would also allow members to take a ‘bet’ on risks with slow emergence, for example:

• Write a policy with slow risk emergence and therefore low initial capital requirements
• If the risk emerges favourably, continue to meet capital requirements and benefit from the profits
• If the risk emerges unfavourably, do not replenish capital and cap your loss.

The same issue also exists if Lloyd’s were to increase the economic uplift to preserve Funds at Lloyd’s at its current level. This would result in a shift in capital held, within Funds at Lloyd’s, from long-tail writers to short-tail writers who would become overcapitalised.

For these reasons and after consultation with the Lloyd’s Market Association, 
Lloyd’s decided to continue setting member capital using an ultimate risk horizon. 
Capital will be determined using the 
Solvency II balance sheet as a starting point. An ultimate calculation is more in line with setting member capital on an underwriting year basis and will exclude exposures relating to any underwriting year beyond the new business period (for instance, exposures related to unincepted legal obligations at the year-end balance sheet). This capital requirement will be uplifted to ensure the total resource requirements remain similar to is the level currently held.

Figure 3 shows the moving parts of the total resource requirements from the current basis to what may occur under Solvency II in the Lloyd’s market. Lloyd’s argues that this approach maintains a capital structure that is commercially attractive, that continues to provide strong policyholder protection, while also adapting the capital setting process to be in line with market developments.

Figure 3


Harjit SainiGareth HaslipHarjit Saini (left) is a manager in the market reserving and capital department at Lloyd’s of London, and Gareth Haslip is head of Aon Benfield’s risk and capital strategy team for EMEA. The views expressed in this article are the authors’ and may not represent the views of their prospective employers