Lloyd's of London starts 2003 with a hard market and more capacity than ever. And, as Dermott White reports, the market's reform programme aims to keep it profitable, through good times and bad.

Profitability and return-on-equity are the new buzz words at Lloyd's of London. Of course, bottom line performance has always been important to the 315-year-old insurance market. But in the last ten years Lloyd's has managed to create the impression that it is simultaneously becoming less efficient and vying for top-spot on the table of re/insurance loss makers.

No longer. After September 11 rammed home the miserable effects of an extended soft market, the market's collective hand wringing culminated, in 2002, in the `radical' reforms of the Chairman's Strategy Group (CSG). These reforms, with a few minor concessions to Names, the wealthy private investors in the market, have now been approved by the Lloyd's membership and are being introduced from 2003.


Their aim is to make Lloyd's profitable throughout the underwriting cycle. The other good things that a leading insurance market needs will follow: top quality capital, people, business and investment ratings.

In a speech to market members in mid-January, Lloyd's chief executive Nick Prettejohn put the objectives like this: "... to make Lloyd's the preferred market of choice for policyholders, brokers, underwriters and capital; to create and maintain a commercial environment in which the long-term return to all capital providers is maximised; and to create a disciplined marketplace of well-managed businesses. A modern, transparent and profitable market."

How is this to be achieved? There are three main reforms: the creation of a franchise; the introduction of annual accounting; and an end to unlimited liability investors.

Eliminating the rogues

The franchise proposals are central to restoring long-term profitability in the market. They are designed to eliminate `rogue traders' who take unnecessary risks or who start underwriting for market share when conditions soften.

The word `franchise' recognises that Lloyd's businesses share several collective assets: brand, reputation, international licences and the central fund that underpins them. But it's also about regulation. Lloyd's as the franchisor will be the franchise manager.

This means a more active role for Lloyd's in agreeing and enforcing underwriting standards across the businesses in the market, alongside existing standards of conduct and operational control, and capital requirements. Lloyd's is quick to point out that this does not mean micromanagement of underwriting from the centre, saying it would not be desirable or even feasible.

Mr Prettejohn said: "Management of underwriting remains unambiguously the responsibility and the competitive raison d'être of the individual businesses in the market. What it (the active role) does mean is the recognition that there are some common factors between the most successful businesses and the least successful. And those common factors teach some stark lessons: don't write for market share, make a gross underwriting profit, don't rely on reinsurance and don't overexpose your capital."

Lloyd's will introduce underwriting guidelines that will be honoured and enforced "with vigour and confidence". In practical terms, this means that each business will prepare an annual business plan showing how it will perform against the guidelines. It will then have a dialogue with the newly created franchise performance director - named in December 2002 as Rolf Tolle, the chief underwriting officer of Faraday, General Re Corp's Lloyd's and London market operation - and his team around the underwriting content of the plan, which will also cover risk management, operational control and service issues. Each business will be required to report progress and results on a quarterly basis.

"Above all, no-one should underestimate the importance of the planning process or the guidelines, or the determination with which we will seek to ensure that the lessons of the past are applied. Now is the time for us to be putting those disciplines in place," said Mr Prettejohn. "The success of the measures will be best judged when premium rating conditions begin to turn downwards. And while it is a demonstration of health for us today that our capacity is increasing, it could well be that a strong inclination to not grow and indeed an inclination to shrink will be a true measure of health when the cycle turns. Both our business plan discussions and the risk-based capital model will bolster the thought process when that time comes."

Changing structure

To introduce the franchise structure, Lloyd's has created a franchise board, on which the franchise performance director will sit. The Council of Lloyd's will remain the ultimate governing body of the Society of Lloyd's because, under the Lloyd's Act, it has certain responsibilities that it cannot shed.

However, the Council of Lloyd's operated historically through a tangled collection of committees. The franchise board has simplified this process with the aim of taking an holistic view of the major strategic, risk management and operating decisions of the Society. "The division between market and regulatory no longer delivers the co-ordination and priority setting that is required," said Mr Prettejohn.

The Council will retain ultimate authority to remove the franchise board and to hire and fire the chairman and chief executive. It will also, because it has to, retain the power to make and amend bylaws. But the franchise board will have substantial delegated power from the Council to run the franchise. Also, it will be smaller than the Council with 11 members, rather than 18, four of whom will be independent non-executive members.

The franchise board is expected to set the underwriting guidelines, maintain each Lloyd's operator's confidentiality and be an effective communicator between Lloyd's and its franchisees. Implementation of the franchise proposals is well underway. The board will be meeting for the first time at the end of February and Mr Tolle takes up his full-time post on 1 March. The first round of business plan meetings was held at the end of last year.

Accounts and Names

The second major reform is the switch to annual accounting from Lloyd's traditional three-year accounting system. This is designed to make the market open, intelligible and comparable with its competitors. Mr Prettejohn said progress was good on this front but added: "... there's a lot of detailed, technical work that needs to be done over the next 18 months, behind the headlines, to make all of that happen."

The third significant move is to end unlimited liability membership of the market. In 2002, there were 2,490 Names or private investors in Lloyd's - limited and unlimited liability. Together they accounted for 20% of the market's capacity of £12.3bn ($20bn)1.

The number of unlimited liability Names will not be allowed to grow and will eventually be phased out altogether. Firstly, from this year, new unlimited liability Names will not be accepted at Lloyd's. Secondly, plans are under way to convert all unlimited liability investors to limited liability.

This is a delicate process because unlimited liability Names enjoy significant tax concessions and fear that any move to limited liability will cost them those advantages. However, Lloyd's is working with the UK government to change the tax regime so that unlimited liability members do not lose out when they change to limited liability.

"Those initiatives, which are a work in progress, if successful, should naturally result in an all limited liability market: limited liability capital sourced from insurance companies, the public and private equity markets and from private individuals. The risk profile of the global specialty insurance and reinsurance business makes this change desirable and inevitable," said Mr Prettejohn.

The back office

Underpinning these reforms is the drive to improve the market's business processes - a drive called the London Market Principles (LMP) that pre-dates former chairman Sax Riley's CSG, but one that has stuttered and started, resulting in the impression that Lloyd's is stuck in the technologically retarded mid-twentieth century.

LMP was revealed to the market in November 2000. It aims to improve the market's performance in five key areas: contract certainty, premium payment, claims payment, contract and claims processing, and policy production.

For Lloyd's to have a competitive operating environment, the cost of doing business there has to be demonstrably lower than the benefits of doing business there. Underwriting performance can have a direct impact on that calculation through less reinsurance leverage, less concentrated exposure and higher quality controls. These should mean lower losses, lower calls on the central fund and, hence, lower central fund contributions and premium levy rates.

"But the fundamental structure of the expense issue for Lloyd's and London is frictional cost. Lloyd's, the London market, the insurance industry as a whole, has a business process that needs urgent and, if necessary, uncomfortable change," said Mr Prettejohn.

In the London market - incorporating Lloyd's and the International Underwriting Association - frictional costs are simply too high. They are driven by multiple data entry and lack of contractual clarity. Also, the movement of cash and documentation are too slow.

Mr Prettejohn said technology could support and accelerate change but any technology initiative would only achieve real success if people across the market changed their behaviour. "... and that is why LMP is so important," he said. "The LMP slip is an essential first step that we must take towards contractual parity. Achievement of that first step, together with technology, can unlock significant further process improvements and real benefits for everyone.

"Failure cannot be an option if London is to be competitive in the medium to long-term. Self-preservation and the profit motive must unite to make LMP happen."

He added that a proposal had been put to the franchise board that they consider setting a timetable for mandatory use of the LMP slip once the market take-up of the slip had reached a "sensible critical mass".

"Let no-one forget that the long-term reputation, the competitiveness and the attractiveness of the franchise in Lloyd's and in London depend as much on the cost of doing business and the quality of service as they do on underwriting. Because cost and service are in the direct interest of the policyholder," said Mr Prettejohn.

The enforcer

For all the reform - all designed to support `profitability' and `return-on-equity' - nothing is possible if Lloyd's cannot introduce a winning underwriting philosophy across its many operators. In Rolf Tolle, the market has a franchise performance director from the Berkshire Hathaway school of re/insurance management (Faraday, as part of General Re, is a subsidiary of Berkshire).

In a speech given the day before Mr Prettejohn's, Mr Tolle made it clear that he would not tolerate the inadequate pricing and poor management that had characterised Lloyd's over the past 10 years. He said that the profitability of the market had been compromised by the "virus of top line growth", and underwriting losses had been made palatable by investment market returns.

"Profit has to be regained on a long-term basis. One or two good years will not make a difference," he said. "It is the only way to attract long-term capital."

He added that although he would prefer to work with franchisees as a coach and a guide, he would not hesitate to use his authority to enforce underwriting and operational standards.

The powers available to Mr Tolle include limiting a business's underwriting, preventing them from writing a particular line of business, more stringent reporting requirements and, in extreme situations, expelling them from the market.

Back on track?

It would appear that Lloyd's is taking the right steps to attract capital and fight off growing competition from other insurance markets. It has survived September 11, funded its onerous US regulatory requirements and grown its capacity to £14.4bn ($23.3bn) for 2003. Has it done enough? If the reforms are implemented with the same enthusiasm that Mr Prettejohn and Mr Tolle displayed in giving their speeches, then it may be on the right track.

But there will be no rest if they get it right. As Mr Prettejohn said: "Our resilient and promising present should not blind us to the lessons of the past. We can't afford to ignore those lessons and we can't afford to be derailed from real and far-reaching reform. In today's environment, no brand can indulge in the luxury of complacency or relaxation.... the capacity for constant self-analysis, identifying the need for change, is a source of competitive strength. And a relish for necessary change, however gut-wrenching a prospect, is the hallmark of success."


1 At the time of writing Lloyd's had not released details on the number of Names in 2003.

By Dermott White

Dermott White is assistant editor on Global Reinsurance.