AM Best explains the capital structure of the Lloyd's Market and how the overall performance of its adequacy contributes to its financial strength rating

The Lloyd's Market represents a unique context for consideration of policyholder security. It is supported by several thousand capital providers (members), each of which is responsible only for its own liabilities.

However, to provide a market-wide base level of policyholder security, Lloyd's employs a combination of capital adequacy standards for capital providers, and a back-up support fund (the Central Fund) to meet valid claims in the event that any given capital provider cannot meet its obligations.

It also imposes controls on the use of premiums received, monitors reinsurance quality and, increasingly, the performance of syndicates (which underwrite on behalf of members).

AM Best combines these factors with its view of the overall performance and market position of Lloyd's, to produce its financial strength rating of the Lloyd's Market (currently, A-, excellent).

Lloyd's has a multi-level approach to ensuring the market's capital adequacy. This is known as the chain of security.

Trust funds
The first link in the chain is not capital, but premiums received. These are held at syndicate level in a range of trust funds for the payment of claims and syndicate expenses. They cannot be released to capital providers until a profit for the underwriting year (including the cost of future claims in the form of a reinsurance to close premium) is determined.

The second link is the members' capital committed to the market, known as funds at Lloyd's. Lloyd's employs a risk-based capital system to calculate this. This is somewhat similar to AM Best's risk based capital model, described in a previous article in this series.

Lloyd's evaluates the risk characteristics of each member's syndicate participations (that is the volume of each line of business the member will write through its participation in different syndicates). By combining the expected amount of underwriting in each line, with a calculation of the amount of diversification the member has across lines, a theoretical amount of required capital to support the overall underwriting portfolio is calculated.

Other factors such as reinsurance protection and the performance histories of the individual syndicates are also factored in.

The member is then required to maintain this minimum level of capital at the market in order to continue underwriting.

Finally there is the Central Fund (and the assets of the Society of Lloyd's). The Central Fund acts as the back-up fund in the event that a member is unable (for the relatively small amount of unlimited liability capital at the market) and/or unwilling (for limited liability capital) to provide additional funds if needed in order to pay a valid claim.

Unlike other assets at the market, Central Fund assets can be used for any claim, not simply those of the relevant member.

The fund is built up by required contributions from underwriting members each year. Currently it is also protected by a five-year reinsurance programme which expires in 2003. Lloyd's is currently reviewing the Central Fund reinsurance protection it will look for in the future. AM Best's current

rating reflects the expectation that the assets of the Central Fund and its reinsurance protection from 2003 will at least equate to the levels before the World Trade Centre losses.

The effect of this capital adequacy system is to both partly mutualise the capital at the market, via the Central Fund, and provide a consistent basis for the capital strength of each underwriting member.

This in turn allows AM Best to produce a market-wide rating, which acts as an opinion of the base level of policyholder security at the market.

There is a relationship between the rating of the market and syndicate ratings. The chain of security described earlier, in effect provides a floor or minimum level of security to policyholders such that, in AM Best's opinion, all policyholders have at least the level of security represented by the Lloyd's market rating.

However, some syndicates have characteristics that are consistent with either a rating higher than the market, but reflecting the syndicate's own qualities, or the total market profile captured in the market rating.

There are essentially two reasons for this. The first is where a single corporate member provides all the syndicate's capital and is itself rated higher than the Lloyd's Market by AM Best. In these cases, subject to AM Best's analysis of the capital provider's ongoing support and commitment to the syndicate, it could receive a higher rating than the market.

The second reason is where a syndicate's market position, and especially its expected operating performance, are consistent with a rating higher than the overall market rating. Market position and operating performance are considered by AM Best to be important indicators of the future ability of an insurer to attract and retain capital backing, including syndicates at Lloyd's.

The same analytical logic can also be applied to syndicates whose own characteristics are consistent with the market rating level. Such syndicates are assigned the same rating level as the market, but the rating text makes clear that the syndicate's own profile is key to the rating.