Changes in financial regulation have left many Lloyd's players confused, says Raj Ahuja of EMB. The new regime can, however, be used to good effect to improve syndicates' capital positions.
The words "internal capital assessment" are guaranteed to generate groans from many a chief financial officer or compliance manager and nowhere more so than at Lloyd's. The change in regulatory regime may be causing their competitors in the company sector quite a few headaches, but at Lime Street they face a double dose. Not only must they adapt to a new type of risk-based regulation, they also have a new regulator, with the Financial Services Authority (FSA) taking over from the Corporation. There are many circles to be squared.
The internal capital assessment (ICA) lies at the heart of these reforms and, though no one has specifically said as much, it is likely to develop into the key tool for financial regulation at Lloyd's. It is also a new type of animal. Whereas previous financial supervision has either been market-wide or at the level of individual members, this one is designed for managing agencies and syndicates.
Right now, though, it is causing a great deal of uncertainty. The market is still waiting guidance on some pretty basic issues and, with reports that Lloyd's may require the initial ICAs to be delivered by the end of next month, it has become an urgent concern.
So, what is an ICA? Where does it fit into the overall scheme of things? What measures should syndicates and managing agencies be taking?
As the name suggests, an ICA is a form of self-certification, confirming that an insurer or reinsurer has enough capital to support the business it is writing and the other risks inherent in the business.
The list includes:
• Reserving risk on prior business
• Underwriting risk on planned business
• Attritional
• Large
• Catastrophe
• Reinsurance programmes
• Credit risk on reinsurance
• Asset risk
• Market/Credit risk
• Liquidity risk
• Operational risk
That answer, though, begs many questions. We are still awaiting guidance as to the criteria or methodologies to be employed or what would be regarded as a suitable level of risk tolerance. The situation leaves agents and syndicates to rely mainly on a series of FSA-produced documents, especially CP 190, CP 04/7 and CP 178, which are useful but offer only outline direction.
With the current level of information, therefore, ICAs may be pretty much what people want them to be potentially little more than a round of box ticking. For all that, we would urge agents and syndicates to embrace ICAs enthusiastically as more than simply an activity to satisfy the regulators. This is one piece of insurance regulation that should, in the long run, be beneficial to the industry.
Despite the short-term confusion, we have a pretty good idea of the direction in which the FSA is heading; it has repeatedly made clear that financial modelling lies at the heart of risk-based regulation. In particular, they favour stochastic models, which enable insurers to test their financial robustness in any number of possible scenarios taking into account such factors as exceptional loss experience across a wide range of lines, stock market failure and reinsurance default.
One issue that particularly concerns the regulators is the relationship between the different risks in the business. For example, the larger a catastrophe loss the greater the probability of reinsurer insolvency a factor that should be reflected in the risk assessment process.
The World Trade Centre disaster exposed the tendency of many practitioners to under-estimate how the interdependency between risks can cause aggregate losses to spiral. Without modelling, it is easy to overlook this type of relationship.
In practice, many smaller and medium-sized insurers will recoil at the prospect of going to these lengths. They may feel they are not geared up or resourced for such a modelling operation, which is arguably more appropriate for multinational concerns. That, though, is the whole point of getting to grips with the issues around ICAs now so that you are ready and able to cope when the demands escalate in future years.
There are, in any event, a number of less complicated alternatives to the full-scale modelling that the FSA would prefer. These would typically involve stress and scenario testing and/or the creation of much simpler, less ambitious models with limited objectives.
As well as being useful in their own right, they can become the platform for an expanded modelling programme at a later stage. With this experience behind you, going to the next level of sophistication will almost certainly prove easier and less time-consuming than you first thought. Hence the value of taking the ICA exercise seriously now when it is still in its infancy and relatively straightforward.
Above all, however, we would argue that any Lloyd's business will benefit from the disciplines of risk-based regulation. As well as assessing the company's underlying strength, the resulting information from stochastic models can help senior management make key strategic decisions.
It can lead to improvements in the following areas, among others:
• Capital adequacy and allocation
• Scenario testing
• Reinsurance purchasing
• Product and pricing strategy
• Security ratings
• Business expansion
• Mergers and acquisitions
A Lloyd's agent or syndicate can extract tangible business advantages from this type of information. Such data can be used, for example, to argue effectively for a reduced capital requirement, releasing additional resources for the underwriting team.
This is not a theoretical possibility; it is happening now. Just one example of how such analysis can aid any insurance or reinsurance business.
Embrace ICAs and the thinking behind them, and they will more than repay the effort.
This article appeared in Insurance Day in September 2004
