Record capacity for the 2002 year of account is going to be countered with yet another year in which Lloyd's reports large losses. Valerie Denney looks at the shape of the market and the current reforms under consideration.

Rumours of Lloyd's impending demise following September 11 losses are, as the saying goes, greatly exaggerated. Granted, the estimated bill of £1.9bn net of reinsurance marks the largest single loss in the market's history but it appears well equipped to cope. Last November, Lloyd's made a cash call on its syndicates of £780m, £246m of which fell to the traditional unlimited liability names. Just recently, in line with expectations, a further £564m was called, although around half of this related to the 1999 year of account making it unlikely to have arisen from September 11 losses. Analysts believe there is no cause for alarm, indicating several positive factors: the impact of WTC on the Central Fund is containable; the estimate of the market's gross exposure (currently standing at £5.7bn) is `stable' for the time being; WTC reinsurance recoveries are widely spread among top notch reinsurers; and $2bn has been transferred to Lloyd's reinsurance trust fund in the US, representing 60% of the market's reinsurance liabilities. Under the agreement reached between Lloyd's and the National Association of Insurance Commissioners (NAIC) in the US, the fund will be topped up to a full 100% of gross reinsurance losses by the end of March.

As chief executive, Nick Prettejohn has remarked: "When people say Lloyd's is in its death throes it does not annoy me exactly. People latch on to an issue or a disaster and say it is another body blow for Lloyd's. We are in the risk business and if we did not pay on claims we would be out of business. We would put our hands up. We did not foresee that terrorists would hijack planes and use them as missiles against some of the most expensive property in the world. No one did."

Coping with loss
"Anyone searching for signs of Lloyd's demise will be disappointed," added chairman, Sax Riley. "We've stated very clearly that Lloyd's can manage its losses from September 11." He went on to stress that Lloyd's prospects are decidedly rosy right now. "The 40% increase in premium income written for 2001, and the steep rate rises that have been seen since September, mean our financial performance is turning the corner rapidly."

Capacity has never been higher, as the market's capital providers scramble to maximise their prospect in the current market conditions. This year is the second in a row to witness Lloyd's capacity rising by £1bn, bringing total capacity for 2002 to £12.3bn.

Rebutting suggestions that recent cash calls would spell the end of names' participation in Lloyd's, Association of Lloyd's Members (ALM) chairman, Michael Deeny said that many names increased their capacity to take advantage of the hard market, some by 200%. Despite hefty cash calls of late, Mr Deeny remarked "there is clear evidence that names are hanging tough in the longer term with a view to making substantial profits." Capacity supplied by names represents about one quarter of the market's capital this year. Meanwhile, most corporate capital providers have upped their stakes.

The general consensus confirms that Lloyd's renewals have gone well. As one delighted underwriter points out, "we're feeling very bullish. Not all lines are equal in any marketplace but in commercial property, for example, it's the best underwriting conditions we've seen since 1985/1986. Business is flooding in and we're in a position to be highly selective."

What about the new capacity which has emerged in Bermuda? Surely that's had an impact? "Bermuda will inevitably get some business," admits another underwriter who also prefers not to be named. "That's absolutely fine. There's more than enough business to go around. However, it's worth pointing out that Bermuda is more geared to big ticket items, whereas London has the infrastructure and the know-how to deal with highly tailored, lower level business."

Bermudian effect
Analysts reflect that the flow of capital to Bermuda in the 1980s and 1990s led to Lloyd's losing its pre-eminence in catastrophe and, to a lesser degree, losing ground in D&O and some of the longer term liability lines. The current view is there will be a similar incremental decline in Lloyd's business position this year, but nothing to cause serious concern. "Lloyd's will benefit from the current hard rates," commented Stephen Searby, director of financial services ratings at Standard & Poor's in London. "Lloyd's results have been volatile. They perform worse during the bad times but consequently much better during the good times. Standard & Poor's fully expect that to be repeated in 2002/2003."

Not before time, of course. Recent results have been nothing short of disastrous. While profits for the 1994-1996 closed years were strong, Lloyd's operating performance has been in decline ever since. According to Chatset, significant losses are on the cards for the open underwriting years 1999 to 2001. Optimism about a return to profit in 2001 has waned due to the September 11 losses. For 1999, Chatset expects Lloyd's to post a market-wide loss of £1.7bn, after members' agents' charges, and 2000 is predicted to post a loss of £1.58bn. Under inception date allocation - assigning a loss on a policy to the year in which the policy came into force rather than the date of the loss - Lloyd's 2000 year of account will be taking a hit from WTC, and 2001 is unlikely to fare better with an anticipated loss of £1.74bn.

Reflecting these challenging conditions, the number of syndicates doing business at Lloyd's has slumped to just 86 this year, compared to 108 for the 2001 year of account. Unlimited liability names have dropped from 2,852 to 2,490, although a number are thought to have set up Scottish limited partnerships or trusts to enable them to cap any losses. Analysts agree this development is not simply a Lloyd's problem but larger re/insurance market forces at work, weeding out the weaker players in what, until recently, has been a tough industry.

The ongoing commitment of corporate capital is not in doubt. Last November saw the opening of a new AIG-backed syndicate, managed by Ascot Underwriting. Focusing on general insurance, the operation is backed by a £100m facility, and although few now expect another arrival of similar size and prestige, the move marked another vote of confidence in the market.

Overseas insurers continue to provide the lion's share of capital to the Lloyd's market. The ten largest corporate capital providers supply 50% of total market capacity. ACE alone controls a massive £899.9m for the 2002 year of account, while Amlin is close behind with £800m.

Such substantial investments almost inevitably raise questions surrounding the running of the marketplace which is Lloyd's. In a recent hard-hitting speech to the Insurance Institute of London, Tony Markel, president and chief executive officer of Markel Corp, a large US carrier with a £200m-capacity Lloyd's syndicate, warned that the market must change fundamentally if it is to survive. Criticising its terms of business and policy wordings, Mr Markel remarked that while Lloyd's has made steps when it comes to regulation, "it is still concentrating on the minutiae rather than the core issues which threaten to overwhelm it."

Contrary to the general `staid' image, long-established players agree that many of Mr Markel's points are valid, although they're quick to stress that the same could be said of the London market as a whole. "I suppose someone's got to say these things," commented one underwriter. "It does us no harm. It gets us all thinking." However, another observer remarked - somewhat cynically - that Mr Markel's tirade may have had more to do with his company's underperforming Lloyd's operation than the market generally.

Mr Prettejohn is the first to admit that Lloyd's has a long way to go in terms of reform. "We are still too complicated for people to put money into." In addition, recent moves could hardly be dismissed as `minutiae'. Working in conjunction with the company market, Lloyd's has formed a new, jointly-owned company, ins-sure, to commercialise the London market processing facilities. In addition, Lloyd's and the International Underwriting Association have introduced standardised London market slips, although it will take some time before these are generally accepted. Meanwhile, the exclusive `club' of regulated Lloyd's brokers has been opened up to a much wider population. In the first year of the new broker accreditation programme, 21 new brokers have been given access to the market from as far afield as the US, France and Canada. Requests from Australasia, Italy and the Far East are currently being considered.

Impetus post-review
The biggest development of all has come courtesy of a strategic market-wide review commissioned by Mr Riley early last year and carried out by a group of market practitioners in conjunction with management consultant Bain & Co. As a result of the review, a package of radical reforms designed to modernise Lloyd's is currently under consultation, carrying proposals addressing Lloyd's structure and reporting systems.

A single franchise board will replace the existing regulatory and market boards. Lloyd's will act as a franchisor in the management of the marketplace, with the managing agents as franchisees. The current three-year accounting system will be replaced by more conventional GAAP accounting. Unlimited liability underwriting and the annual joint venture system will be abolished. Any existing names who wish to continue underwriting will have to convert to limited liability by January 2005. A new vehicle to enable names to participate in the market after 2005 will be set up, and names can support Lloyd's businesses on a contractual basis. A number of options will be looked at with the aim of retaining key features of names' current trading status.

It is generally agreed that the proposed reforms address many of the market's structural weaknesses which, if left unresolved, would prove seriously detrimental to Lloyd's global standing in the long run. However, they will be challenging to implement, to say the least. Mr Deeny, who served on the strategy group since it was set up last summer, has resigned from the group stating that neither he nor the ALM - the body representing the interests of individual names - could support some of the proposals.

The central tenet of the reforms, the creation of a franchisor/franchisee relationship, has been largely accepted as a good idea by names and corporates alike. "This will give clarity to the relationship between Lloyd's centrally and the wider Lloyd's market. It will also result in greater clarity and a reinforcement of the business planning and monitoring process at Lloyd's. As the franchisor, Lloyd's will have an explicit interest in the profitability of the franchisees. Having the direct authority to remove `loss-making' franchisees should, in the long term, improve the overall profitability, and therefore the attractiveness, of Lloyd's for capital providers," said Mr Searby.

"However, there is a risk that the franchisor's new role might threaten the level of underwriter innovation, for which Lloyd's has always been widely recognised. In addition, many of the corporate capital providers have investment alternatives in more lightly regulated jurisdictions. The challenge will therefore be to strike the right balance between underwriting freedom and regulation of the franchisees."

Reform anxiety
The proposed abolition of the annual venture, three-year accounting and unlimited liability, meanwhile, has got names hot under the collar. As Mr Deeny pointed out in a recent letter to ALM members, much research has been conducted over the years by Lloyd's, members' agents and the ALM on a method of private capital to participate at Lloyd's without the annual venture. To date, nobody has come forward with a concrete proposal that would retain the key advantages of the annual venture, such as the double use of assets and various tax benefits. Mr Deeny concluded that the proposal to abolish the annual venture is premature and against the interests of names.

With respect to annual accounting, he accepted the arguments in its favour, including easier comparison with Lloyd's competitors, but remained concerned that names will once again be losing out. He contended that reinsurance to close after 12 months would be likely to produce diminished profits, adding, "Lloyd's has three-year accounting, not because of some slavish respect for tradition, but because it provides a more accurate method of calculating the profits of an insurance business than annual accounting. Indeed, many of the world's leading insurance companies use three-year accounting internally for the calculation of their underwriting profits."

Lack of evidence
As for the abolition of unlimited liability, the ALM is vociferous in its view that no evidence has been put forward to show that unlimited liability would damage Lloyd's future profitability or that it is fundamentally against the interests of the market generally. In addition, as Mr Deeny pointed out, "There are certain very significant tax advantages that go with unlimited liability underwriting that would be lost from a compulsory conversion to limited liability. The most important danger is that losses from 1998 to 2001 that exceeded the other taxable income of names in any of those years could not be carried forward into a limited liability vehicle. Such a change by the Council of Lloyd's might compulsorily deprive some unlimited names of substantial sums."

In summation, the ALM contends that there is no evidence that the heavy losses of recent years have been produced by the capital structure. Indeed, if the average 1999 and 2000 forecast losses for overseas insurance capacity are compared to that provided through members' agents, the latter has suffered substantially lower losses.

Most Lloyd's players concur that while many of these points are valid, the fact of the matter is the market must move with the times. "Standard & Poor's has never said that unlimited liability is bad and limited liability is good," remarked Mr Searby. "While advantages and disadvantages are offered by both corporate capital and third-party capital, it is not efficient for both types of capital to coexist. Separate systems and procedures have to be established for so-called mixed-bathing syndicates. The influence of, and costs associated with, unaligned capital in Lloyd's businesses will be reduced if these proposals are successfully implemented."

With the Lloyd's market now dominated by organisations accounting on a GAAP basis, questions must be raised about the future viability of three-year accounting, though nobody disputes that it does have certain benefits.

"Three-year accounting is a PR disaster," said one broker. "Lloyd's has to announce estimates for bad years repeatedly over a three-year period, thereby harming the credibility of the market. We've already been subjected to the usual press speculation over WTC losses. While companies will take the one hit and it won't be heard of again, we'll be talking about WTC until the 2001 year of account is closed. Moreover, the three-year system allows people to delude themselves for too long.

"The bottom line is that in modern business culture you cannot afford to be different. I think there's this complete misunderstanding among names of the overall position of Lloyd's globally. We're a gnat's bite compared to the rest of the world."

An important aspect of the proposed reforms is the formalisation of corporate capital as Lloyd's primary capital structure. Contrary to some opinions, Lloyd's has no wish to declare war on names; it is merely facilitating future capital growth. Today's record capacity would not have been possible without corporate investors.

Following informal market consultation over the next few months, a final set of detailed proposals will be introduced prior to voting on the reforms later this year. There will an inevitable `watering down' but it is essential that the overall thrust is adopted if Lloyd's wishes to play a significant role in the future global re/insurance industry. On the current one-member, one-vote basis, individual capital providers enjoy a major influence on the ultimate approval of the planned reforms. To what extent the recent voicing of names' discontent is merely posturing to extract the best possible price for their unlimited liability status remains to be seen.

Immense challenge
The challenges are immense. A move to annual accounting, for example, would require the solvency regime to be rewritten and a new insurance directive from the European Union. The whole process will take years. Names aside, however, most players concur that Lloyd's has to be seen to doing something in order to silence its ever-sniping critics and propel the market into 21st century business culture.

"Lloyd's has come a long way in the last five or six years. It has suffered more than many of its competitors through the bottom of the cycle. The key thing now is that the market equips itself for the ravages of the downswing that will inevitably follow and in doing so, retain current capacity," concluded Mr Searby.

An old-fashioned phrase for a modernising market, but only time will tell.

By Valerie Denney

Valerie Denney is a freelance re/insurance journalist.