Lloyd's and its managing agents will face tough rules on capital from January 2005. Michael Faulkner explains
From January 2005, a major new capital assessment regime will come into effect for the Lloyd's market. The regime is an extension of the FSA's integrated prudential sourcebook (PRU) and will govern the capital requirements of both Lloyd's and managing agents.While the rules have yet to be finalised, the warning from the FSA is that managing agents cannot afford to wait for the final text: they must be making preparations now."There is sufficient material out there for managing agents to begin preparations. They should have read them and be working on meeting their requirements," says the FSA . The PRU regime applies to all insurers, but the FSA has added specific elements to reflect the way capital is distributed in the Lloyd's market. Under the rules, Lloyd's will be responsible for setting the capital requirements of the members, while the managing agents will have responsibility for their syndicates' financial resources. Managing agents must ensure that there are adequate financial resources to support each syndicate at all times. At the heart of the rules, is the individual capital assessment (ICA). This is a determination of the capital needed to cover the risk profile of the business.
Syndicate calculationsManaging agent must carry out an ICA for each syndicate, using the FSA's enhanced capital requirements (ECR) - a risk based minimum capital requirement - as a benchmark. A syndicate's ICA is likely to be greater than its ECR. Lloyd's will use the syndicates' calculations to calculate an ICA requirement for each member. Although, the ICA will give a capital requirement for each syndicate, it does not mean that the syndicate must hold that amount of capital. The precise level of capital holding will be determined by the 'balancing amount'. This is specific to the Lloyd's market, and reflects the different way that capital is distributed at Lloyd's compared to other markets. The balancing amount is the amount of capital not held within syndicates, but which is nonetheless needed to support the syndicates' activities. It can be held as funds at Lloyd's or central assets. Diversification of risk is also be taken into account, as this can reduce the overall risk exposure of a syndicate.To calculate the required balancing amount, a managing agent should deduct a syndicate's net assets from its ICA. Thus, a syndicate with an ICA of £100m and adjusted net assets of £20m will require a balancing amount of £80m. "The link provided by the balancing amount is necessary because of the respective responsibilities of Lloyd's and the managing agents," says the FSA."Managing agents are responsible for syndicates' financial resources but not all the capital. Lloyd's is responsible for the members' financial resources but not all the risks."When looking at their capital resources, managing agents need to take into account the new rules on capital eligibility in CP190. The FSA's new approach is to look at the quality of a capital resource, based on its permanency and loss absorbency. Some sources of capital sources are deemed to be of a higher quality (with greater permanency and loss absorbency) than others. Higher quality sources will count more towards capital than lower quality sources. There are also limits on the amount of lower quality capital that can be held. Capital is divided into two tiers. Tier 1 is the highest quality and includes items such as funds at Lloyd's, central assets, ordinary shares and profits. Tier 2 is of lower quality and includes subordinate debt and preference shares. So what should managing agents be doing now? According to the FSA, they should already have read and digested the PRU and relevant consultation papers. They should also have calculated their ECR and be starting an ICA implementation plan. This will involve collecting data and selecting appropriate stress and scenario tests."Throughout the remainder of 2004, managing agents should continue to develop their ICAs, looking at methodologies, testing and results," says the FSA. "They will also need to be able to explain the difference between their ICA and ECR calculations to the FSA, Lloyd's and also to investors and analysts."
Roles and responsibilities: the FSA's new regime
Managing agents must:
What to read: the important consultation papers