Chapter 2 Question

Lloyd's FAL Capital question

Hi, I am currently reading chapter 2 of the notes and there is this statement on page 30 that I'm struggling to understand: "Ordinarily there is a minimum capital requirement of 40% of the member's capacity. In this context, "capacity" is the maximum premium, gross of reinsurance, but net of commission, that the member is permitted to underwrite in the current years."

When it says gross of reinsurance, does it mean that if a managing agent purchases loads of reinsurance for its syndicates, the Names / Members of syndicate is penalised by being asked to hold more capital in the FAL? E.g. if I'm the only Name of syndicate A year 2012, and the managing agent of syndicate A purchased like 99% quota share reinsurance for syndicate A's businesses at October 2012. Syndicate A ended up writing 100m worth of premiums gross of reinsurance, does it mean that I need to put up [40m (40% of 100m) less commission] in the FAL when the maximum profit i can make is 1m (assuming zero claims paid and expenses)?

I know the example is a little extreme, still, does it mean that this calculation may make the FAL capital amount unreasonably large (relative to potential profits) if the reinsurance purchased is very large? Does this also mean that for a managing agent to purchase reinsurance for a syndicate, they have to seek the approval from the Names / Members?

It will be great if someone can help me out with this. Thanks.

 

Hi Jedidiah,

You are right that, in your example, the Name would have to put up 40m of capital. Remember that the whole point of holding this capital is to protect the policyholders. If you were 99% QS reinsured and the reinsurer became insolvent, the syndicate would be liable for all the claims, and would need capital to back this.

However:

a) this is Lloyd's (London market) and so it is very unlikely that this level of QS would be used. Risks tend to be large and unusual and so non-proportional forms of reinsurance would be more usual. Also, business will be written via the subscription market and so, rather than using lots of QS (which shares the risks), the syndicate would just take on a smaller line.

b) the Funds at Lloyd's (FAL) doesn't have to be backed by physical assets. A letter of credit can be used instead, which means that the names can earn investment income on the capital amounts that are notionally backing the business.


Coralie