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Lloyd’s at crossroads as underlying returns slide to zero

The need for change at Lloyd's was brought into sharp focus last week by 2017 results that showed a market lagging its competitors and losing money underwriting on an underlying basis.

The aggregated result of the 95 Lloyd's syndicates was a £2.0bn ($2.9bn) loss and a combined ratio of 114.0 percent.

But even more striking was an accident-year ex-cat combined ratio of 98.4 percent in a market that typically takes 6-8 points of cat losses annually.

Reserve releases are also on a clear downward trajectory, sliding from 5.1 percent to 2.9 percent of net earned premium, with market sentiment suggesting that the calendar-year and accident-year results will continue to converge.

The expense ratio narrowed modestly but remains unsustainable at 39.5 percent, with acquisition costs again higher and 5 points above the levels seen a few years ago.

Market-wide rates were up by about 3 percent at 1 January, but this will scarcely cover loss-cost inflation and any margin accretion is likely to be more than cancelled out by the worsening back-year picture.

The investment yield of 2.7 percent was also the highest delivered by the market in at least five years.

On a normal cat load the market generated almost a 0 percent return on capital in 2017 and with the same assumption will struggle to do materially better in 2018.

The market also continued to underperform peers, including The Insurance Insider's Bermuda, US specialty and global reinsurer composites, and was 7 points worse on the combined ratio than the competitor group specified in its analyst presentation.

Two CEOs of major London market (re)insurers with Lloyd's businesses said the results meant that senior figures were asking "existential questions" about Lloyd's for the first time.

A number of others were more sanguine about Lime Street's prospects, or believed the issues were problems for the specialty (re)insurance market as a whole rather than a Lloyd's-specific malaise.

Nevertheless, all of the market executives spoken to by this publication acknowledged that the Corporation of Lloyd's and managing agents need to address the issues thrown up by the results.

Real work is needed to ensure the long-term health and competitiveness of Lloyd's and the London market, they said.

Tackling underperformance

There is no simple prescription to turn around the fortunes of the market, but there are six clear areas that could be examined.

Firstly, the go-forward underwriting. Multiple sources suggested the Lloyd's market had grown by taking on poorly priced risk, failing to abide by the strictures of counter-cyclical underwriting.

The onus here is on the underwriters themselves not the Corporation of Lloyd's to get the fundamentals right.

Secondly, the market must look to establish a clear competitive advantage that is defensible in the long term.

The market runs at a significant cost disadvantage to its competitors and its relative advantage in terms of capital efficiency has progressively narrowed over the years, with moves to scale back the use of letters of credit only set to exacerbate this trend.

If the move from major composites like Axa and AIG to acquire specialty platforms is followed by similar moves from Allianz and Zurich it raises the prospect of the Lloyd's advantage on licensing becoming less significant.

The market's key competitive advantages are the subscription market, EC3's talent pool and "product".

Lloyd's could build on these advantages by cooperating effectively to get the most out of the market's mutuality.

This could include sharing lead capabilities via consortia, procurement savings, and the research and development investment that allows product innovation.

As Liberty Specialty Markets president Matthew Moore said at an event held by The Insurance Insider earlier this year, the Corporation of Lloyd's could have a key role in fostering cooperation in this way by acting as a "dating agency".

Thirdly, although the market ran with overheads that were 2 points lower than Bermuda last year, it can still squeeze this down from the current 12.5 percent.

To do so, Lloyd's will need to make a success of its electronic placement initiative, Placing Platform Limited, and the other market modernisation projects that are in train.

It will also have to grasp the nettle of expense reduction, with MS Amlin's move to lower its employee costs by 10 percent potentially pointing the way.

The Corporation of Lloyd's has reduced levies on the market, but it will also have to make a meaningful movement on its expense levels, which edged sideways from £307mn in 2016 to £306mn last year - up 35 percent on 2014 levels.

Despite a headcount reduction programme, the Corporation saw its average headcount climb by 2.9 percent to 1,157.

Profit drain

Fourthly, the acquisition cost ratio - which hit 27 percent in 2017 - needs to be brought under control after three years of heavy inflation which are sucking more than £1bn of underwriting profit out of the market annually.

Senior figures in the market believe there is scope to challenge the big three brokers on commission levels, although it is not clear how this would work in practice given the dominance of the major intermediaries owing to the "few-to-many" structure.

It is likely that the environment in 2018 will be more amenable to a concerted, Lloyd's-led push on commissions and fees, with the brokers currently the subject of heightened regulatory interest.

A more obvious avenue to pursue is the use of technology to compress the hugely extended and expensive value chain, allowing Lloyd's carriers to reach retail brokers or customers directly via digital solutions, reducing reliance on open market business in London and coverholder business overseas.

Fifthly, a number of the senior underwriting sources spoken to by this publication had serious misgivings around the role played by the Corporation of Lloyd's.

At present the Corporation is a hybrid of quasi-regulator, central service provider and franchise promoter.

Most senior managing agent sources spoken to by this publication believe the amount of intrusion from Lloyd's into the running of their businesses is excessive and damaging.

New business written by multi-platform players in London is often being written on company paper, sources said, because the Lloyd's planning process makes life too difficult.

The sources stressed that Lloyd's would be best to stand back and allow the market to operate, accepting that blow-ups and failures are a natural part of any successful market.

In its most extreme form, this view maintains that the Corporation has misconstrued its role.

It suggests that it has become a kind of over-expensed civil service with too much focus on protecting the downside and a commitment to franchise and footprint growth at the expense of existing members.

One source suggested the Corporation should acknowledge that the Prudential Regulation Authority is the market's supervisor and stop acting as a quasi-regulator - a move that would curtail both central costs and compliance costs.

Another said the Corporation needed to focus on remodelling its culture and way of operating to enable commerciality and entrepreneurialism in the market.

Lower return money

Finally, managing agents could look to follow the lead of Bermuda and draw more heavily upon capital with lower return hurdles.

With an accommodating retro market, in-house insurance linked securities (ILS) funds and total return reinsurance joint ventures backed by high-net-worth money, Bermudian (re)insurers have been able to lay off progressively more risk to other forms of capital, generating steadier fee income in the process.

There has also been a move towards less of the specialty and reinsurance risk being supported by public markets equity capital over the last few years, with a range of London and Bermuda players delisted after buyouts.

Lloyd's has a history of third-party capital in the form of Names, which continue to support a decent minority of underwriting. But it could hollow out its capital base and underwrite on behalf of third-party capital that would accept lower returns, shifting its earnings towards fees.

The corporate member structure and three-year accounting at Lloyd's lends itself to the involvement of ILS capital, and makes it an obvious place for pension fund money that does not want to make direct equity investments to access primary risk.

"Beazley Beta" - the facilities-only sidecar set up by the leading Lloyd's franchise at the start of the year - points the way and seems likely to be followed.

It also seems to stand for the market's acceptance that there has been a long-term change in distribution that will see the open market squeezed and more business packaged and placed on a portfolio basis.

Lloyd's must find a way - using its licensing advantages - to become the permanent home for such business and to try and curb the current tendency for all of the attendant cost savings to go to the brokers.

Change

It is easy to overstate the importance of the 2017 results. Lloyd's can easily withstand the losses. The publicly traded Lloyd's carriers - admittedly best-in-class players now - all change hands at high multiples.

Buyers for Lloyd's assets at premium valuations remain, and there is no concentration of underwriting expertise in the world to match EC3.

But Lloyd's faces intense cyclical pressures, alongside structural threats, and the 332-year-old market must now embrace change if it is to ensure it can thrive in the long term.

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