Lloyd’s syndicates have invested heavily in developing the capital models required by the regulators - and it is now pay-back time. These investments should be providing significant and wide-ranging benefits. If not, they will become a burden that the market can ill afford, argues Jonathan Broughton of EMB.
Of all the recent changes in the way Lloyd’s manages its capital, by far the most important has been the introduction of the ICAs (Individual Capital Assessments). They have been a requirement since 2005, a key feature being the capital models that lie at their heart.
At the time there were two camps among syndicates, as indeed there still are:
1. “We should have been doing this anyway; it makes business sense. Let’s do a thorough job and get a competitive advantage.”
2. “Another expensive regulatory burden. Let’s do the minimum in order to tick the box.”
We argued that syndicates should respond positively to the new regulatory imperative. It had the potential to give Lloyd’s a significant edge against its European competitors and against Bermuda – but only if the market took the opportunity.
The difference in business benefits obtained from a good ICA model compared to a poor one is huge. Good models require a powerful platform, allowing your existing business and future plans to be easily assessed in a robust, flexible and scalable manner. As important, they require detailed internal mechanics to be built to properly reflect your business.
The recent exceptional market environment means you do not have to be capital-efficient to have made big profits or to enjoy a healthy capital position. However, the coincidence of high rates and low loss experience is a rare and short-lived occurrence.
Those in camp two will eventually find their views become a self-fulfilling prophecy. Money invested in a poor model is wasted, except in narrow regulatory terms. Unless a model gets above a certain quality threshold, it is next to useless. They will indeed have created an expensive regulatory burden with little or no business benefit.
For this reason – and with apologies to those who know already – it is worth briefly reiterating that the main benefit of creating an ICA model should be competitive advantage, not regulatory compliance. Indeed, those in camp one will probably have more than recouped their investment already. Some of the advantages that they should now be experiencing include:
• Transparent. documented and realistic risk appetite;
• Informed strategic decisions, especially about growth;
• Improved reinsurance strategy;
• Improved investment strategy;
• Positive discussions with the regulator.
Before looking at these business uses, let’s now consider the essential features of a good capital model.
Transparent inputs and outputs – detailed, yet simple to understand
Just because the work that goes into a typical capital model is complex, there is no excuse for it to become a black box that hardly anyone understands.
The inputs should be structured in a simple way so that they can be reviewed easily. Outputs should be standardised and clearly laid out so that the Board and senior managers can easily see and understand the key information.
Reports should be generated not just at syndicate level, but also at a corporate member or underwriting agency level where relevant. This will make it easier to report to other interested parties such as investors.
Clear and easily understood outputs will also strengthen management’s hand when talking to the regulator, aiding positive discussions about setting capital requirements.
Run quickly – be flexible
Another critical requirement is to be fast and flexible. There is always a trade-off between ever more detailed modelling and speed. To be usable by the senior management on a regular basis, the model needs to have sufficient speed. 50,000 simulations in about two hours for a given set of assumptions is probably a minimum for a “quick and dirty” what-if run of the model. Larger numbers of simulations can be run once a particular set of assumptions has been agreed.
In order to achieve this, it is essential to have powerful kit, both hardware and software. Money saved on inferior hardware and software will quickly be lost on wasted hours, never mind frustrated staff.
Armed with quality, informative, simple-to-understand outputs that can be generated quickly on different scenarios, the senior team can really make use of their model. So what should a Board be getting back now from their investment?
Transparent, realistic risk appetite
As a start point, the capital model will help the Board to define its risk appetite statement and verify that it is consistent with its views of the underlying business. This risk appetite statement is fundamental to the syndicate’s financial objectives, providing the link between capital, risk and profit. It allows decisions to be made that maximise expected returns for a given level of risk.
For example, they often include a planned percentage return on capital over the cycle. Taking a view on the cycle, the capital model used for the ICA should be able to determine what percentage return is consistent with this.
Similarly, many risk appetite statements include a percentage tolerance for a loss in a year and a percentage tolerance for missing the plan by a given amount. An important issue is that capital models look to the ultimate, whereas risk appetite statements generally refer to next year’s profit and loss statement. It is important, therefore, that models produce consistent information on both ultimate and next year bases.
Many syndicates have a risk appetite statement, but how many are really consistent with and tested against their capital model? Are many risk appetite statements just aspirational?
Help inform strategic decisions
Probably the most obvious use of a well-constructed capital model is to assist in making strategic decisions and to support disciplined underwriting. For example, if a syndicate is considering growth through writing a new class of business, this should be evaluated, amongst other things, on how it fits in with the financial objectives of the syndicate – is it consistent with the risk appetite? The model will also help inform about the capital diversification benefits within your business.
Another example is that, in the current softening market, the model should be used to help decide what strategy to adopt for each class. A number of managing agencies have planned for materially lower capacity in 2008, in all likelihood as a result of such a strategic review involving their capital model.
Improved reinsurance strategy
Capital models should look at each outwards reinsurance contract separately.
The average syndicate spends a huge amount of money each year on outwards reinsurance protection. Given that it provides the senior management’s best view of the distribution of possible gross outcomes, the capital model should be central to the reinsurance spending decisions.
There are a number of theoretical reinsurance programmes that are likely to satisfy your risk appetite criteria. What-if analyses can be run through the model to explore features such as aggregate deductibles, cross class contracts and numbers of reinstatements. This can include consideration of alternative approaches, including side cars.
In reality only a limited number of options will be available. The model should be used to look at the actual contracts being purchased by the reinsurance manager. By having a view on what the reinsurance premium should be, and based on your understanding of the gross loss distribution going to it, you can evaluate whether or not the offer is good value. The model may inform you where the cost of reinsurance appears overly excessive from which you can make better informed decisions about reinsurance spend. Contracts with large aggregate deductibles or high retentions may appear cheap, yet offer material capital savings, greatly aiding the target return on capital.
It is incredible that these amounts of money are being spent on reinsurance in some cases without proper consideration of capital implications. There will probably be many deals struck during the coming renewal season where at least one party does not truly understand their needs.
Inform investment strategy
The capital model will produce a distribution of future net liability cash flows. This is critical information when forming an investment strategy.
Again the capital model can be used to help decide on an investment strategy that maximises expected returns for a given level of risk appetite. For example, does a portfolio of corporate bonds provide a better fit than gilts – does this lead to greater expected returns for acceptable extra risk?
A two-tier market
The ICA regime has already helped Lloyd’s to gain an edge on overseas competitors. The recent decision to delay Solvency 2 provides an opportunity to prolong that advantage.
Insurance and reinsurance will always be risky businesses and prone to potential losses in exceptional years. However, a syndicate that makes better decisions about reinsurance buying and underwriting strategy as a result of exploiting its capital model, whilst perhaps also squeezing an extra 0.25% out of investments, may find it makes all the difference between profit and loss in a difficult market.
Unfortunately, some syndicates have not got the message and so the market as a whole will not gain the full benefit. As more challenging conditions return, then the advantages of first class capital modelling will become fully apparent.
This article first appeared in Insurance Insider (www.theinsider.co.uk)
