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22 November 2021 | 5-minute read
Insurers’ capital and business strategy are tightly interwoven and interconnected. An efficient capital-to-premium ratio is a traditional advantage for those operating in Lloyd’s, but managing agents face capital constraints which competitors outside the market do not. The Lloyd’s Market Association, in its first Market Insights report produced with Aon’s UK Capital Advisory Department, reveals the links between capital and strategy which are shaping current decisions in the market’s C-suites.
The enquiry is timely. It has never been more important for CFOs to maintain clear and constant sight of the capital implications of syndicate business plans. Their skills at influencing their managing agents’ strategic decision-making are critical. Three developments highlight the challenges:
- integration of internal models into capital and strategy decisions
- importance of earnings volatility management
- increasing management interest in reserve exposure and capital allocations.
We questioned 28 agents representing 75% of the market’s 2021 capacity about these issues, then conducted 23 follow-up interviews. The result is a deep dive into the evolving role of the Lloyd’s CFO in capital and strategy.
We found that the average capital-planning horizon for survey respondents is a surprisingly short two years. As expected, the biggest driver of planning was an intended change in underwriting capacity. It is the primary or secondary consideration for 82% of respondents (with 87% overall planning to increase capacity). Reduction of excess capital was the primary or secondary consideration for 36%, and a change of capital mix for 32%. Shifting business between entities was the primary driver for 11%.
These numbers clearly reflect the current business environment, where buoyant rates encourage increased capacity. Some agents are shifting business out of Lloyd’s (in part due to Brexit), but it is clear that the post-Covid market is resilient and robust, with only very limited capital adjustment targeted at balance-sheet repair.
Capital requirements and supply
In reflection of the abundance of capital and the ownership of many responding agents by large insurance groups (91%), capital availability is a minor concern at Lloyd’s. Overall, only about half the respondents’ Tier 2 assets allowance for Funds at Lloyd’s has been used, with Tier 1 capacity comprising 72% of the total, and 100% for a fifth of respondents. However, for those agents that wish to introduce or increase Tier 2 capital (perhaps because Letters of Credit remain a cheaper and more flexible alternative to most forms of Tier 1 capital), the 10% limit on per-year increases imposed by Lloyd’s demands a staged implementation towards the 50% maximum for Tier 2 capital.
Slightly more than half of respondents mentioned Economic Capital Assessment (ECA) loadings as a challenging area. The historic Coming Into Line (CIL) process was cited as difficult to manage by 28% of respondents who use third-party capital, particularly smaller syndicates, due to the narrow time window between receiving ECAs from Lloyd's and the final date for CIL. The recent change by Lloyd’s to a quarterly corridor test approach is expected to alleviate this, particularly for the benefit of smaller underwriting entities at Lloyd’s.
Capital costs, returns, and optimisation
About half of survey respondents measure their cost of capital. The average cost is 7%, but ranged from three to ten, just in line with Lloyd’s H1, 2021 reported cost of capital of 6.3%. Estimates of Return on Capital (RoC) by those agents who track it range from ten to 15%, casting Lloyd’s centrally reported RoE of 10.3% in a positive light. Syndicates generally still use traditional profitability measures such as ratio targets for developing plans by line of business. However, some now give equal standing in the planning process to internal model outputs based on line-by-line capital allocations. It is fair to say that, in practice, syndicates use a wide range of strategies to make the link between business plans and capital, including increased use of a variety of return periods to manage profit volatility.
Capital optimisation is complex for agents that are part of a larger group. Alongside Lloyd’s requirements, they must consider constraining factors such as rating agencies, regulatory capital per jurisdiction, and internal risk appetite. Intragroup reinsurance is the most important optimisation strategy, of primary or secondary importance for 61% of respondents. Among CFOs, 78% use it to manage exposures and optimise capital. A third review such arrangements annually; often making significant changes.
Precisely half of respondents cited investment strategy as primary or secondary capital optimisation tool, although 78% clarified that underwriting performance is the true driver of capital. The internal model is seen as a key capital optimisation tool by 43% of respondents, but CFOs’ trust in models’ ability to derive a true view of the business can be eroded by loadings or annual model approval procedures. Only 22% of CFOs believe the model is a primary tool to inform growth strategies. Finally, 35% of syndicates have already completed some form of legacy transaction, and another third are currently considering options such as Adverse Development Cover, Loss Portfolio Transfer, or Reinsurance to Close.
Taken together, the findings show a community of CFOs and their managing agents with a much improved range of tools to deploy in capital decision making, although the extent to which they are embedded alongside traditional profit measures varies. CFOs are actively meeting the challenges of aligning capital and strategy for profitability and growth in the evolving Lloyd’s regulatory environment, against the backdrop of favourable and improving market conditions. They are acutely aware of the increasing importance of capital management in reaching these objectives, and they’re on the case!