Lloyd’s of London recently published a market bulletin informing the market that assets and/or documents must be submitted to Market Services by close of business (5pm) on the Coming-into-Line date, Thursday 1st December 2016. However, if the asset is a letter of credit or bank guarantee, this must be received together with the supporting documentation by Friday 11th November 2016. This is earlier than the usual end of November deadline. Why the change?
Insurance companies underwrite risks through the Lloyd’s market using special vehicles called “syndicates”. Each Lloyd’s syndicate must be backed by one or more Members (which may be corporate entities or individuals) which provide a certain amount of capital, known as Funds at Lloyd’s, to support the risks that are written, with the purpose of ensuring claims can be paid promptly and in full. Each year, the managing agent of each syndicate estimates the total risks that the syndicate(s) they manage will underwrite in the next year and reports this to Lloyd’s. On the basis of this estimate and the historical performance of the syndicate, Lloyd’s calculates the amount of Funds at Lloyd’s that each Member has to provide. The Member has to post this amount of Funds at Lloyd’s by the deadline. This is known as “Coming into Line”.
What are letters of credit?
Letters of credit are promises from a bank to pay a certain amount on demand. This reduces the credit risk for the recipient, since rather than being exposed to a company’s solvency, it can rely on the more stable financial strength of a bank. In this case, the bank will provide a letter of credit promising to pay the Society of Lloyd’s (as trustee of the Funds at Lloyd’s) a certain amount on demand on behalf of the Member, in return for a fee and an undertaking that the Member (or its parent company) will reimburse the bank if the letter of credit is ever drawn down by Lloyd’s.
Banks usually require a Member to request that Lloyd’s applies any other cash and assets posted as Funds at Lloyd’s before drawing down the bank’s letter of credit. While Lloyd’s does not give a binding undertaking to follow this order of priority, it is normal to obtain a letter of comfort from Lloyd’s stating that it will take into account the requested order of priority when considering the draw down of a Member’s Funds at Lloyd’s.
Letters of credit are a form of ancillary own funds
Under Solvency II, an insurer is required to hold sufficient capital to cover its Solvency Capital Requirement. This capital is referred to as its “own funds”, which is divided into basic own funds and ancillary own funds. Basic own fund items are fully paid up and therefore would be available to absorb losses immediately if the insurer were in financial difficulty. Ancillary own fund items have the same purpose, but are mostly unpaid or contingent items, such as letters of credit and guarantees from third parties, that can be called upon to absorb losses if needed. For Lloyd’s, the letters of credit included in the Funds at Lloyd’s are regarded as ancillary own funds.
Why have an earlier Coming-into-Line date for letters of credit?
By way of safeguard, Solvency II requires insurers (including Lloyd’s) to obtain approval from the PRA before they can take ancillary own funds into account in meeting their capital requirements. The reason for the earlier Coming-into-Line deadline for letters of credit and bank guarantees is because Lloyd’s needs time to make an application to the PRA to obtain this approval. For this reason, market participants and banks should be aware:
- that they need to start earlier in their preparations for Coming into Line if they want to rely on letters of credit or bank guarantees, in order to meet the deadline of 11 November 2016
- that it is unlikely they will be able to substitute or change letters of credit in the period between 11 November and 31 December, so it is important to ensure that letters of credit applied for are right first time.