It’s common knowledge that the Lloyd’s market has been looking seriously at how an insurance-linked security (ILS) or catastrophe bond structure could assist the market by supporting its capital and profitability, but it is vital any Lloyd’s ILS solution supports syndicate capital, according to Vario Global Capital Ltd.
Vario Global Capital Ltd., a specialist ILS focused insurance analysis and modelling firm, believes that any ILS solution for the Lloyd’s of London market needs to be carefully targeted to ensure it elevates syndicate profitability.
Hence a catch-all approach to just hedging the Lloyd’s markets losses may not be as successful as an approach that finds a way that the capital of every Lloyd’s syndicate can either be augmented or relieved.
By analysing the performance of Lloyd’s syndicate and the wider Lloyd’s market central fund asset base, Vario found that the introduction of an ILS instrument that attaches below a market-wide 1-in-200 year loss event “could provide the flexibility to allow syndicates to expand and take advantage of positive post event developments.”
Vario said that the Lloyd’s market needs to be able to flourish post event and that simply providing ILS tools that attach above a 1-in-200 year loss will not help the market maintain profitability, as by the time a 200 year loss comes along many of the Lloyd’s market syndicates are already well over 100% in terms of loss ratios.
Hence an ILS solution for Lloyd’s of London needs to consider covering losses further down, at a return period below 1-in-200, in order to provide the best support for syndicates capital levels and to ensure capital is injected at just the right time to foster market recovery and its ability to capitalise on post-loss event opportunities.
By creating a curve of the Lloyd’s markets current underwriting performance and results along with Vario’s estimates for individual syndicate’s Funds at Lloyd’s, the company was able to model potential impacts to Lloyd’s central fund assets as the market’s aggregate loss ratio changes.
Vario found that for an aggregated Lloyd’s market 1-in-200 net calendar year the market’s loss ratio is in the range of 100% – 110%, which implies a combined ratio of between 140% – 150%.
So at this level the syndicates are in the majority facing losses and unprofitability, making the 1-in-200 year marker too high up for an ILS solution to kick-in.
Additionally, Vario’s modelled results show that as the Lloyd’s market loss ratio passes 100%, the probability of significant losses being suffered by the Central Fund increases dramatically, in fact Vario suggests this almost falls off a “cliff edge.”
The reason is that the 1-in-200 year market loss coincides with where many syndicates begin to exhaust their funds at Lloyd’s, which means that after a loss year of this magnitude Lloyd’s and its syndicates do not just need to recapitalise, but rather they need to “reconstitute with new forms of businesses or an overall new operating model,” Vario explains.
As a result this could delay and impair syndicates ability to trade forwards effectively and take advantage of post-loss pricing conditions, which could hurt Lloyd’s as a whole and also raise the spectre of rating agency pressure for the market.
Because of this, Vario concludes, “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 syndicate capital and funds at Lloyd’s are exhausting around the 200 year loss for the market, then enhancing central assets at this level is, “Too late to be relevant to the profitable continuation of the market.”
Vario notes that Lloyd’s has traditionally prospered post-event and major market wide losses, hence any ILS solution designed to support the Lloyd’s of London insurance and reinsurance market needs to attach at the right time to support syndicates ability to trade forwards and the market’s ability to respond quickly.
“Any ILS solution should either augment syndicate capital or bolster central assets in such a way as to relieve syndicate capital,” Vario states, adding that this means a Lloyd’s market ILS cover needs to trigger before the 1-in-200 year aggregate loss occurs.
Vario concludes that its 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.”
Lloyd’s pre-deal road show of ILS options received a significant amount of feedback from the ILS investors and ILS funds that Lloyd’s execs met with and this analysis from Vario will also help the market in taking any further steps into the capital markets and ILS arena.
The core tenets that Vario lays out are sound, in that Lloyd’s should leverage the ILS market to not just share in its returns and losses, but to support the market’s recovery from loss events and ensure that its syndicates have the capital they need to trade forwards and take advantage of post-event pricing, at the time when they need it most.
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