Ready, willing and stable

If one were to think of a market that, in recent years, has exemplified the volatility of the modern insurance cycle, then that market would surely be Lloyd's.

A cursory glance at the amazing swing in results that occurred in the period 1999 to 2003 illustrates how both record losses and record profits have occurred within this relatively short period. In 1999 Lloyd's made a £1.9bn loss; in 2000 a £2.4bn loss and this was capped in 2001 by a loss of £3.1bn - a result of a catastrophic combination including the events of 11 September 2001, Air Lanka terrorist attacks and the loss of the Petrobras oil rig. Yet the results since then have been extremely positive, with the market bouncing back to record an £834m profit in 2002 and a £1.89bn profit for 2003.

On a superficial level, such results would indicate a market that is determined to prove the inherent volatility of the property and casualty cycle in the modern market. And there is no doubt that Lloyd's is particularly susceptible to the vagaries of the cycle, given the nature of the risks it writes and the extremes in rating that are all part of writing significant global placements.

So, is such volatility likely to remain a feature of the market? A Lloyd's spokeswoman says: "Volatility remains as inherent as the cyclicality in the global insurance industry. At Lloyd's, we are now in a better position to deal with this volatility. The capital strength of the businesses in the market, the impact of the Franchise Board and a prudent capital system mean that there is now a far more disciplined approach to performance management. The market's response to last year's exceptional hurricane activity, the ratings upgrades and the successful debt issue are testimony to the stability of the Lloyd's market."

Clearly, a degree of cyclicality is always going to be present, but it is the extent of such cyclicality that is important going forward. Simply put, the question that investors want to know about Lloyd's is whether this is a market that is likely to make them suffer losses in a few years' time when the soft market starts to bite on the same scale as experienced previously.

Positive indicators

The good news it seems, for the market, is that the indicators are remarkably positive. And much of the credit for the renewed confidence is being put down to the work of Lloyd's itself under the guidance of chief executive Nick Prettejohn, who has sought to weed out the weaker players and put pressure on syndicates to come up with more stable business plans under the aegis of franchise performance director Rolf Tolle.

According to Barrie Cornes - an analyst at Cheuvreux - this is a market that, structurally, looks to be in a much better shape than it was only a few years ago: "Overall, you get the impression that things are on a more stable footing at Lloyd's, and that is not just as a result of the introduction of the franchise, though that is a real tangible reason. A lot is down to Nick Prettejohn, as some of the reforms he has put down are very healthy for the market."

But how will the market stand up when things really start to soften?

"I think it will be better," Cornes continues, pointing out that investment income is still not there for syndicates to fall back on and that, in any case, the technology is more sophisticated these days so that underwriters can monitor their portfolios better than they would have been able to do previously.

The structure of Lloyd's, with a diverse capital base consisting of trade capital, UK-quoted capital and individual investors, is also a real feather in its cap according to Robert Miller, a spokesman for the Association of Lloyd's Members, which represents approximately £3bn of the market's overall capacity: "The people operating at Lloyd's will have different incentives and are unlikely to all get it wrong at the same time."

He claims that, although there has been a downturn in market capacity, overall there has been a gradual increase in support from Lloyd's Names, which are now increasingly sophisticatedinvestors that understand the nature of their commitment. "Capital that is committed to the cycle will be able to work with the grain of the Franchise Board," he explains.

Recent trading reports from the likes of Amlin and Wellington have also been encouraging, Miller adds, and that the evidence so far is that the renewal season has been a fairly good one for the market, with no sign of the collapse that was expected in some quarters.

Miller is also an advocate of the strength of management now in place, which he feels is very much to the market's advantage: "Lloyd's has fared very well; much of the corporation has been very good indeed and it has been able to attract some very good people - would that have been the case ten years ago? Also, where the businesses are concerned, there has been a serious winnowing-out - the worst ones have gone and there is no one like Duncanson & Holt or Cotesworth nowadays, and Tolle would not stand for it. There are now some outstanding businesses at Lloyd's such as Hiscox, Kiln and Wellington - some very classy performers."

Of course the existence of Tolle as franchise performance director is all part of the corporation's attempt to put Lloyd's on a more stable footing and, so far, such a move has been welcomed as a step in the right direction. "I think that syndicates have been able to submit business plans that are reasonable and not merely full of optimism," says Alistair Speare-Cole, chief executive officer of Aon Re's UK division. "Specialist syndicates are not aiming for a 75% share of the market in five years' time."

He also says that the new level of scrutiny within Lloyd's has meant that businesses are also more attentive to what rates are really acceptable: "Syndicates are looking very hard at their 'jump-off level' - the rating point at which it simply becomes too low for them to write. That has now changed and Lloyd's now demands a rating rationale that is explicable to the Franchise Board. That has and will continue to bring in a definite discipline."

Neil Coulson, a partner at accountants Littlejohn Frazer and a Lloyd's specialist, also welcomes the establishment of the Franchise Board and the ramifications that this brings: "People can assume that there is somebody looking over things, raising questions and presenting them with challenges that they would not have had externally before. Yes, some people find it uncomfortable but they are keeping an eye on things - they are not just paying lip service."

Coulson also says that the new risk management is pointing to a more stable Lloyd's: "To comply with the requirements of the Financial Services Authority and those of the corporation, people need to assess risks and work out how to control them. It is early days, but it should highlight things and concentrate matters on where people want to run risks - hopefully there will be more checks and balances."

Coulson is more sceptical, however, when it comes to the extent to which real underwriting discipline can penetrate the market going into a soft cycle, though he still holds out hope. "People are talking up underwriting discipline now more than in the past, but how real will this be?" he asks.

"A number of entities in Bermuda have Lloyd's interests, so one would hope they have some strategy for not cutting the throat of one of their divisions."

One positive indication for the market in terms of underwriting discipline is the bald fact of the reduction in capacity that has taken place for 2005, which is expected to be in the region of £13.7bn, compared to £14.7bn last year. For those interested in the long-term stability of the market, such a reduction in capacity is evidence of a much tougher stance being taken by Lloyd's over the amount of business it really wants to write in a softening market.

While Prettejohn and Tolle have previously said that the intention going forward is not to chase market share at the expense of profitability, many had wondered just how far this would really be put into practice.

The significant 9% reduction in capacity has taken many by surprise and has proved many of the doubters wrong.

As Prettejohn said at the time of the announcement of the reduction, such a move should be welcomed: "Given current market conditions and the focus on delivering underwriting profit, it is a positive sign that there has been a decrease rather an increase in capacity at this point in the insurance cycle."

According to one senior London-market insider, the indications of this move for profitability are indeed positive, and could contribute to a run of good results for Lloyd's: "2004 looks like bringing a decent year's results. If we hadn't had the hurricanes and other natural disasters, it was hoped that 2004 would have come up with a return on capacity of some 20%. But, even with these natural catastrophes, we are still looking at return of 15%. It is not a vintage year, but it isn't bad. As for 2005, with a benign catastrophe scenario, you might be looking to get a return that is similar to that of 2004."

Such a positive outlook bodes well in terms of a more stable Lloyd's and is backed up by the largest players in the market themselves. As Amlin said in its trading statement made in early January: "Overall, this 2005 renewal period for Amlin has been satisfactory with premium volume of £168m written to date - only 4% down on the previous period. International property catastrophe and other large property risks have come under some pressure, but US catastrophe reinsurance renewals have seen only small reductions in rates. This is encouraging, given that the principal renewals of programmes impacted by the hurricane and typhoon losses are later in the year. Other classes have remained relatively stable."

Of course some potential problems still lurk in the shadows for Lloyd's, not least is the extent to which capital will continue to support the market when returns are poor. As Cornes says: "The fall will be better, but one issue will be a large company that wants to do business outside of Lloyd's. That will not happen in 2005 - it won't be until 2006 or 2007 - but it is an issue nevertheless."

There is also the continued unpredictably of property and casualty business itself, with Lloyd's forming a part of much bigger global picture. As Aon's Alistair Speare-Cole comments: "There are problems that are going to arise in that there are always elements of risk that London deals with - large risks that are more concentrated. From that point of view, the type of risk that comes into London is always going to be more difficult and other things will arise, such as the loss of the oil rigs in the Gulf of Mexico. But I think that Lloyd's is pretty robust and the Franchise Board has done a good job."