Lloyd’s is in an excellent position to usher in the changes of Solvency II, but shares the industry’s concerns about the implications of a standard formula

With its unique place in the industry, Lloyd’s has more challenges than most when it comes to preparing for Europe’s coming Solvency II regime. Luke Savage, director of finance, risk management and operations, explains why Lloyd’s has got a headstart on its internal models and why, despite the promise of some transitional measures, it won’t be resting on its laurels.

Q. What are some of the unique challenges from a Lloyd’s perspective when it comes to preparing for Solvency II?

A. Under the directive Lloyd’s is recognised as one body, which effectively means that Lloyd’s is one entity rather than 55 different managing agents or 857 different syndicates. So we’re looking at getting one model approved which represents the Lloyd’s market, not 55 separate models. This might sound easy, but the reality is we have to demonstrate that the whole of the market operates to a Solvency II standard. That means running one model to represent all 55 managing agents. That’s quite a big burden.

Given the complexity of the challenge, we started our work a lot earlier than most, and we’re trying to lead not just the Lloyd’s market but also the UK non-life market down a path towards Solvency II.

Q. Where are you in the process now?

A. We’ve been on risk-based capital since 1995 but the model we used has evolved over 15 years so we’ve used Solvency II as an opportunity to rewrite those models. That central end-to-end model is now in test and by the beginning of Q4 this year we expect to not only have that model running and tested, but to actually be producing our raw data populated by inputs from 55 managing agents.

We’ve also gone through an overhaul of our governance structures internally to align it with Solvency II frameworks, which will make it easier to demonstrate we’re complying.

Q. Is there any concern that you won’t get model approval?

A. It’s always conceivable – although we think highly improbable – that we won’t. But we’re spending in the region of £250m preparing for Solvency II, have hundreds of people working on it and are starting from a well risk-managed position. If that doesn’t get internal model approval I don’t know what will.

Q. Why is internal model approval so critical for Lloyd’s and its syndicates?

A. It’s because the standard formula does not work for Lloyd’s or for any big global diversified player.

There are many things that are defective in the standard formula and a couple which impact us, such as the way that global catastrophe risks and currency exposure is modelled. In trying to come up with a standard formula – something which fits everyone - they’ve actually come up with something that doesn’t fit anybody.

Q. Should insurance companies seeking internal model approval be concerned about the standard formula?

A. Yes – we’re very concerned about it and we are lobbying. The real concern is that the standard formula will probably end up being used as some kind of benchmark – by regulators or less informed individuals such as analysts at banks – whether it is meant to or not. If it’s used as a benchmark between insurers it will produce very misleading outcomes resulting in individuals jumping to the wrong conclusion about financial strength.

Q. What are the implications of the Omnibus II Directive, in particular the inclusion of transitional measures?

A. At the moment nobody quite knows what the transitional measures will end up looking like, because the European Union has given EIOPA – the regulatory body – the ability but not the obligation to introduce transitional measures for periods extending up to certain limits. So rather than relying on them and then finding you’re disappointed, our take is that we’re well resourced enough to be ready. We’ve been working on this for three or four years and we believe we will be ready in time. If we slow down all it’s going to do is make everything take longer and cost more money, so there’s no benefit to be had in it.

Q. Has there been enough clarity from the FSA on how it will be approaching internal model approval?

A. I wish there they were more to be honest. I wish the FSA were more consultative in their approach by giving us more guidance on what they think will be adequate. Nonetheless, I quite understand that in order to maintain their independence they must leave it up to insurers.

Q. What advantages will an internal model bring to an organisation?

A. From a Lloyd’s perspective, having risk-based capital means that we should have more confidence that our individual businesses at Lloyd’s are adequately capitalised to withstand significant shocks. Therefore they are less likely to get into trouble, to go bust and hit the Central Fund and tarnish our reputation and credit rating in the process of doing that. So for us, it gives us a more stable market.GR