Lloyd's dry run guidance emphasises qualitative issues

Detailed guidance for this year’s Lloyd’s Solvency II dry run process urges managing agents to look beyond the numbers to pillar two and three provisions explains Mike Wilkinson.

Lloyd’s managing agency executives responsible for Solvency II would have returned from the Easter holidays to a fuller than usual reading in-tray. Amongst the pile they would have found awaiting their return were more CEIOPS papers on Level 2 implementation measures, a 100 page plus Lloyd’s guidance document on Solvency II technical provisions and, perhaps demanding their most urgent attention, detailed guidance and timings for the Lloyd’s dry run process to take place during 2010.

This document reinforces Lloyd’s determination to force through a cohesive approach among its managing agents. With Lloyd’s having agreed with the FSA that it will seek approval of one internal model, this is all the more necessary.

Spelling out in black and white what Lloyd’s expects, the document states: “One clear point established is that if any one managing agent does not meet Solvency II standards, this could jeopardise securing overall approval for the Lloyd’s internal model. Lloyd’s dry run process is, therefore, focused on ensuring that agents are sufficiently well progressed in their Solvency II preparations and that they have considered how they will meet all the requirements.”

What this means in practice is that every syndicate is required to have a full internal model since Lloyd’s does not anticipate resorting to the standard formula for calculating the Solvency Capital Requirement (SCR) at all.

Exacting timetable
The Lloyd’s dry run process for verifying individual internal model development has been divided into nine subject areas to be addressed in three stages.

By 1 June 2010, agents will be expected to demonstrate acceptable progress in the proposed scoping, governance and use of their internal models, together with adequate levels of planning for the systems of governance and the documentation to be used in conjunction with their model.

The next three topics, to be covered by 1 August, are statistical quality standards, model calibration, validation and profit and loss attribution, and how external models and data may be used and integrated into the internal model.

The final stage, with a deadline of 1 November, covers consideration of the Own Risk Solvency Assessment (ORSA), supervisory reporting and disclosure, and technical provisions. The latter, as mentioned, is the subject of a separate Lloyd’s guidance document and is also likely to form an important part of the QIS5 process due to take place over a similar timeframe.

At each stage, and for each step, agents will be expected to demonstrate “minimum progress expected against dry run requirements”. This will involve completion of a series of submission templates, currently being finalised by Lloyd’s, and filing of appropriate supporting evidence as detailed in the full guidance document.

With internal models being subject to scrutiny at syndicate level, regardless of any group affiliations, the proportionality principle within Solvency II is an important element of the process for Lloyd’s. The guidance states that materiality of risk should be the central issue but that agents will have to be able to demonstrate and evidence any applications or assumptions about proportionality they have made.

Quality, not quantity
While most of the recent debate on Solvency II has focused on potential capital uplifts from QIS4 levels, Lloyd’s is taking positive action to sidestep these issues. That explains the emphasis on qualitative measures in its guidance.

It states: “The internal model under Solvency II is significantly broader than the capital calculation kernel alone and it will not be sufficient just to have a sophisticated capital model. To ensure the internal model meets Solvency II standards, agents will need to demonstrate that the internal model plays a key part in the running of the business…”

The opening paragraph of its guidance document does, however, serve to concentrate the mind of its managing agents, when it says “the current calibration of the (standard) formula would see the average syndicate’s regulatory capital requirements more than double compared to the current ICAS regime.”

Such figures make uncomfortable reading for senior executives and should encourage prompt attention to that holiday-inflated Solvency II in-tray.

*Mike Wilkinson heads the risk management consulting team at international actuarial and business consultancy, EMB. The full Lloyd’s guidance notes are available here.