Hanging in the balance

Lloyd's annual results for 2003 showed a profit of £1.89bn, an increase of 127% on 2002's healthy profit of £834m. Combined ratio for 2003 was an impressive 90.7%, and capacity is at a record £14.9bn.

Significant structural changes have also been introduced under the direction of chief executive, Nick Prettejohn, most notably the establishment of the Franchise Board and the appointment of franchise performance director, Rolf Tolle, whose job it is to ensure a greater degree of stability going forward. One could almost be forgiven for not remembering that this is the very same market that managed to lose some £8bn between 1998 and 2001.

The fact of the matter is that Lloyd's is performing well because it ought to have been. The last couple of years - following in the wake of the events of 11 September 2001 - with depressed equity markets and a reduction in capacity, have been exceptionally profitable for a major property and casualty player such as Lloyd's, so much so that Hiscox chairman Robert Hiscox has referred to the present conditions 'the best in living memory'. However, a couple of excellent vintages do not in themselves guarantee the future quality of even the most prestigious grand cru.

What that takes is continued investment and the resolve to produce a lesser amount of higher quality when the conditions are not so favourable.

The key issue is whether Lloyd's will be able to maintain the quality of the vintage in the less fruitful years that are certain to come.

One of the main ways in which Lloyd's has sought to differentiate itself from its company market competitors is through a much stricter underwriting regime and a desire to eliminate from its ranks the bottom quartile performers that have dragged the rest down when times have been unfavourable. One of the main ways of attempting to do this has been through a more active management of syndicates and, in particular, through the post of franchise performance director, whose remits extend to scrutinising and approving business plans to ensure that former excesses are eliminated.

According to Prettejohn, maintaining a consistently profitable market place throughout the cycle remains the cornerstone of Lloyd's agenda.

He explains: "While the Franchise Board recognises the strength that comes from maintaining a market place of independent, entrepreneurial businesses, this must be balanced with the need to maintain underwriting standards and discipline."

Prettejohn insists that Lloyd's has the tools in place to bring about the positive underwriting performances he so craves: "The Franchise Board has a number of powerful levers at its disposal to achieve this, including the business planning process, setting performance goals, creating a risk management framework and setting capitalisation levels. The Franchise Board has also shown it is prepared to take tough action and impose constraints on those franchisees that threaten Lloyd's security and profitability. We remain confident that this twin-track approach will help to ensure that the worst effects of the cycle are managed."

It is not just those at the top who are straining to impose more discipline on a famously ill-disciplined market place, for the businesses themselves are adamant they are doing all they can to ensure that the disastrous losses of the past are not repeated as we enter the next down-cycle. It is certainly true that there have already been some interesting decisions by syndicates to turn down unattractive business, most notably Brit's decision last year to walk away from much aviation business, blaming poor rates and an unfavourable underwriting model.

According to Ewen Gilmour, chief executive of listed Lloyd's vehicle, Chaucer, profits rather than size are what matters - and, given that the business posted pre-tax profits of £35.8m in 2003, the comment is not entirely disingenuous. He speaks of a need to concentrate on low-risk business going forward and says the plan is to cut business and, if necessary, going into the next down-cycle in 2005.

Bob Stuchbery, group underwriting director at Chaucer, outlines a number of measures that the company has embarked on that are designed to reduce volatility: "We have moved away from liability business, we write more direct property business, we have a low risk-based capital ratio and it helps our merged business that 25% of the account is motor insurance."

Mark Graham, Chaucer's group finance director, says that the aim is to seek a 10% return across the cycle: "We won't accept a business plan that does not achieve this but, in order to do that, we really have to cut back when the returns really aren't good enough."

Will such measures work going into a softening market? Barrie Cornes, an analyst at Cheuvreux, is hesitant to suggest that Lloyd's has really overcome the excessive volatility that has so plagued it over the last 15 years, with the sort of peaks and troughs that would have seen off many a weaker player.

"I suppose it is probably too early to say whether it will create stability," he says, in relation to the creation of the Franchise Board. "The real test will be the next downturn in the market. I do not think the two syndicates they have already reproved are a true litmus test," he says with regard to Goshawk and Dex, both of which the Franchise Board was happy to see leave Lloyd's last year.

Cornes suggests that Lloyd's is in a pretty good state compared to its competitors, adding: "On the face of it, Lloyd's does look as if it is in better shape than other non-life companies in Europe." However, he tellingly qualifies this remark by saying that it all boils down to Equitas - the company established to reinsure and run off the pre-1993 liabilities of Lloyd's Names. It would appear that the threat of Equitas going under, which could impact on Lloyd's, seems to have receded over the past 18 months, though, with the unrelenting pressure of US-led class actions over asbestos, one can never be entirely confident.

Nonetheless, despite the concerns over Equitas, Cornes says that with earnings in the pipeline, a rejuvenated central fund - which grew by 49% last year to its current standing at £711m - and the establishment of the Franchise Board, everything is headed in the right direction.

Neil Coulson, a partner at accountancy firm and Lloyd's specialist Littlejohn Frazer, agrees that things at One Lime Street are looking up: "There is hope that things will be more stable than they were previously, and not just at Lloyd's - these noises are being made by lots of people. Renewal rates for 2004 are holding up well and things have not collapsed at the first opportunity. A lot of players realise that they are not going to make spectacular returns on investment and they must make an underwriting profit."

He says that Lloyd's itself has 'shown its teeth' in dealing with Dex and Goshawk, and also has its eyes on one or two others.

Market scepticism

According to the Association of Lloyd's Members, which represents the interests of the majority of Lloyd's Names backing the institution, the reforms put in place are indeed significant. "For the first time ever, Lloyd's has come to the realisation that its future prosperity is based on its ability to manage the insurance cycle," comments ALM spokesman Robert Miller. "Does one believe that the Franchise Board and Rolf Tolle have the skill and judgement to manage the cycle? I think they probably will, but it is a really difficult call."

He says that the real test will be when two or three companies with more than £1bn in capital invested in Lloyd's disagree with the decision of the Franchise Board when the market turns down again, risking the possibility that such players will exit Lloyd's. However, they realise this is a problem and, when a problem is acknowledged, it is three-quarters of the way to being solved.

Not all are convinced of the efficacy of the Franchise Board reforms, however. Lloyd's broker Jardine Lloyd Thompson has criticised aspects of the Board's basic thinking, such as its concern with a focus on gross underwriting profit, which it says may be considered inappropriate where expected investment returns on premiums are a significant part of the deal. JLT also suggests that restricting arbitrage against reinsurance - which is part of the thinking of the modern Lloyd's - could hinder some syndicates as this policy is often a valuable strategy, particularly when backed by modern financial instruments to manage the credit risk. Taken together, according to JLT, such policies could force syndicates into business strategies that are unsustainable in comparison to their company market competitors.

Despite the concerns, there are factors other than the profit pipeline and the Franchise Board that could work in Lloyd's favour according to Coulson: "What hasn't had such a high profile but happened last year was that, with a softening market, the risk-based capital calculations were tweaked up in 2003, so that there has definitely been a factoring into models of higher capital requirements," he explains. "It's hard to see it, but there is more capital backing each syndicate than there was the previous year."

He adds: "The reason that this slightly higher risk-based capital requirement is important at the moment is that, in effect, it soaks up some of the capital that people might have used previously to write more business; in the past there have been people charging in at the heights of the cycle."

The dangers of the wrong sorts of new players coming in to write business at ludicrous rates at preciously the wrong time is a problem that insurance will be burdened with as long as there is a cycle, but this problem seems to have hit Lloyd's peculiarly hard in recent years. According to Coulson, such cannibalism could be much reduced in future, with far more searching questions now asked of prospective new syndicates.

Future performance

Optimistic assessments regarding the future performance of insurers when times are favourable are nothing new, and Lloyd's is no exception to the this rule, particularly as it is has been such an impressive performer when property and casualty markets are really firm. And the market will no doubt return to making a loss when the market softens. The key for Lloyd's will be the extent to which it manages the time - soon to come - when the downturn in rates really starts to bite. It is certainly a more transparent market than it once was, and it does not seem to be seeking to return to the habits of old, where new entrants were often sought to pay for the losses of the old.

Underwriters, brokers and investors all have enough to savour in sampling the excellent recent vintages that Lloyd's has produced, but all good runs come to an end. Let us hope the reforms in place and the attitude of the Franchise Board are sufficient to maintain the quality of the marque in future.