Lloyd's of London is a British insurance market. It serves as a meeting place where multiple financial backers or “members”, whether individuals (traditionally known as “Names”) or corporations, come together to pool and spread risk. Unlike most of its competitors in the reinsurance market, it is not a company. The Society of Lloyd's was incorporated by Lloyd's Act 1871.
Between 1688 and 1807, one of the primary sources of Lloyd's business was the insurance of ships engaged in slave trading, as Britain established itself as the chief slave trading power in the Atlantic. Slave trading became one of the primary constituents of all British trade, and its dangers meant that insurance of the ships was a major concern. With slave-trading forming such a prominent part of Lloyd's business, the organisation was one of the chief opponents to abolition of the trade.
The membership of the Society, which had been largely made up of market participants, was realised to be too small in relation to the market's capitalisation and the risks that it was underwriting. Lloyd's response was to commission a secret internal inquiry, known as the Cromer Report, which reported in 1968. This report advocated the widening of membership to non-market participants, including non-British subjects and women, and to reduce the onerous capitalisation requirements (which created a more minor investor known as a 'mini-Name'). The Report also drew attention to the danger of conflicts of interest.
Because Lloyd's had turned itself into a tax shelter, the second issue affecting Lloyd's was an increase in its external membership, such that, by the end of the decade, the number of passive investors dwarfed market investors. Thirdly, during the decade a number of scandals had come to light, including the collapse of the Sasse syndicate and the disgrace of Christopher Moran, which had highlighted both the lack of regulation and the legal inability of the Council to manage the Society.
Simultaneously with these developments, were wider issues: firstly, in the United States, an ever-widening interpretation by the Courts of insurance coverage in relation to workers' compensation in relation to asbestos-related losses, which had the effect of creating a huge, and initially unrecognised and then unacknowledged hole in Lloyd's reserves. Secondly, by the end of the decade, almost all of the market agreements, such as the Joint Hull Agreement, which were effectively cartels mandating minimum terms, had been abandoned under pressure of competition. Thirdly, new specialised policies had arisen which had the effect of concentrating risk: these included 'run off policies', under which the liability of previous underwriting years would be transferred, and 'Time and Distance' policies, whereby reserves would be used to buy a guarantee of future income.
The Lloyd's Act of 1982 further redefined the structure of the business, and was designed to give the 'external Names', introduced in response to the Cromer Report, a say in the running of the business through a new governing Council.
Immediately after the passing of the 1982 Act, evidence came to light, and internal disciplinary proceedings were commenced against, a number of individual underwriters who had siphoned sums from their businesses to their own accounts. These individuals included a Deputy Chairman of Lloyd's, Ian Posgate, and a Chairman, Sir Peter Green.
In 1986 the UK government commissioned Sir Patrick Neill to report on the standard of investor protection available at Lloyd's. His report was produced in 1987 and made a large number of recommendations but was never implemented in full.
Also in the 1980s Lloyd's was accused of fraud by several American states and the names/investors.
Some of the more high profile accusations included:
Membership of a Lloyd's Syndicate was not like owning shares in a company. An individual “joined” for one calendar year only – the famous 'Lloyd's annual venture'. At the end of the year, the Syndicate as an ongoing trading entity was effectively disbanded.
It was very common for the Syndicate to re-form for the next calendar year with more or less the same membership and the same identifying number. In this way, a Syndicate could appear to have a continuous existence going back (in some cases) fifty years or more. But in reality it did not. There would have been fifty separate incarnations of the Syndicate, each one a unique trading entity that underwrote insurance for one calendar year only.
Claims take time to be reported and paid: so the profit or loss for each Syndicate took time to become apparent. Lloyd's practice was to wait three years (that is, 36 months from the beginning of the Syndicate) before 'closing' the year and declaring a result.
For example, a 2003 Syndicate would ordinarily declare its results at the end of December 2005. The Syndicate's members would be paid any underwriting profit during the 2006 calendar year, in proportion to their 'participation' in the Syndicate; conversely, they would have to reimburse the Syndicate during 2006 for their share of any underwriting loss.
Part of the result would include setting aside reserves for future claims payments; that is, reserves both for claims that had been notifed but not yet paid, and estimated amounts required for “incurred but not reported” claims (IBNRs). The estimation process is difficult and can be inaccurate; in particular, liability (or long-tail) policies tend to produce claims long after the policies are written.
The reserve for future claims liabilities was set aside in a unique way. The Syndicate bought a reinsurance policy to pay any future claims: the premium was the exact amount of the reserve. In other words, rather than putting the reserve into a bank to earn interest, the Syndicate transferred liability to pay future claims to a reinsurer. This was “reinsurance-to-close” – a transaction that allowed the Syndicate to be closed, and a profit or loss declared.
The reinsurer was always another Lloyd's Syndicate. In fact, it was nearly always the succeeding year of the same Syndicate. The members of Syndicate X in 2004 reinsured the future claims liabilities for members of Syndicate X in 2003. The membership might be the same, or it might not.
In this manner, liability for past losses could be transferred year after year until it reached the current Syndicate. A member joining a Syndicate with a long history of such transactions could – and often did – pick up liability for losses on policies written decades previously. So long as the reserves had been correctly estimated, and the appropriate reinsurance-to-close premium paid every year, then all would have been well. But in many cases this had not been possible. No one could have predicted the surge in APH losses. Therefore, the amounts of money transferred from earlier years by successive “reinsurance-to-close” premiums to cover these losses were insufficient, and the current members had to pay the shortfall.
(By contrast, within a stock company, an initial reserve for future claims liabilities is set aside immediately, “in year 1”. Any deterioration in that initial reserve in subsequent years will result in a reduced profit-and-loss for the later year, and a consequently reduced dividend and/or share price for shareholders in that later year, whether or not those shareholders in the later year are the same as the shareholders in “year 1”. Arguably, Lloyd's practice of using reserves in “year 3” to establish the reinsurance-to-close premiums should have resulted in a more equitable handling of “long-tail” losses such as APH than would the stock company approach. Nevertheless, the difficulties in correctly estimating losses such as APH overwhelmed even Lloyd's extended process.)
(For a fuller explanation of the annual venture, and the various means of reinsuring-to-close, see below.)
As a result a great many individual Members of syndicates underwriting long term liability insurance at Lloyd's faced financial loss, even ruin, by the mid 1990s.
It is alleged that, in the early 1980s, some Lloyd's officials began a recruitment programme to enroll new Names to help capitalise Lloyd's prior to the expected onslaught of APH claims. This allegation became known as “recruit to dilute”; in other words, recruit Names to dilute losses. When the huge extent of asbestosis losses came to light in the early 1990s, for the first time in Lloyd's history large numbers of members refused or were unable to pay the claims, many alleging that they were the victims of fraud, misrepresentation, and negligence. The opaque system of accounting at Lloyd's made it difficult if not impossible for many Names to realise the extent of the liability that they personally and their syndicates subscribed to.
The market was forced to restructure. In 1996 the ongoing Lloyd's was separated from its past losses. Liability for all pre-1993 business was compulsorily transferred (by reinsurance-to-close) into a special vehicle called Equitas at a cost of over $21 billion and enormous personal losses to many Names. It was subsequently discovered that a bribe, described as an 'educational briefing', had been paid by Lloyd's to the California Insurance Commissioner, Chuck Quackenbush, in order that he should assist Lloyd's in preventing the prosecution of Lloyd's by the California State Attorneys Office for the sale of “unregistered securities” to US Resident Names or investors. Quackenbush then, using his office as Chair of the N.A.I.C (National Association of Insurance Commissioners) facilitated the approval of the Equitas entity.
The 'recruit to dilute' fraud allegations were heard at trial in 2000 in the case Sir William Jaffray & Others v. The Society of Lloyd's, and the appeal was heard in 2002. On each occasion the allegation that there had been a policy of 'recruit to dilute' was rejected: however, at first instance the judge described the Names as the innocent victims [...] of staggering incompetence and at appeal the Court found that representations that Lloyd's had a rigorous auditing system were false ([item 376 of the judgment:] [...] the answer to the question [...] whether there was in existence a rigorous system of auditing which involved the making of a reasonable estimate of outstanding liabilities, including unknown and unnoted losses, is no. Moreover, the answer would be no even if the word 'rigorous' were removed.) and strongly hinted that one of Lloyd's main witnesses, Murray Lawrence, a previous Chairman, had lied in his testimony ([item 405 of the judgment:] We have serious reservations about the veracity of Mr Lawrence's evidence [...].).
Lloyd's then instituted some major structural changes. Corporate members with limited liability were permitted to join and underwrite insurance. No new “unlimited” Names can join (although a few thousand existing ones remain). Financial requirements for underwriting were changed, to prevent excess underwriting that was not backed by liquid assets. Market oversight has significantly increased. It has rebounded and started to thrive again after the World Trade Center attacks, but it has not regained its past importance as newly created companies in Bermuda captured a large share of the reinsurance market.
Lloyd's itself does not underwrite insurance business, leaving that to its members (see below). Instead the Society operates effectively as a market regulator, setting rules under which members operate and offering centralized administrative services to those members.
An Act of Parliament, the Lloyd's Act 1982, defines the management structure and rules under which the British insurance market Lloyd's of London operates. Under the Act, the Council of Lloyd's is responsible for the management and supervision of the market. It is regulated by the Financial Services Authority (FSA) under the Financial Services and Markets Act 2000.
The Council normally has six working, six external and six nominated members. The appointment of nominated members, including that of the Chief Executive Officer, is confirmed by the Governor of the Bank of England. The working and external members are elected by Lloyd's members. The Chairman and Deputy Chairmen are elected annually by the Council from among the working members of the Council. All members are approved by the FSA.
The Council can discharge some of its functions directly by making decisions and issuing resolutions, requirements, rules and byelaws. The Council delegates most of its day to day oversight roles, particularly relating to ensuring the market operates successfully, to the Franchise Board.
The Council of Lloyd's of London presently (2007) includes
Recent results have benefited from tougher underwriting standards imposed by the Franchise Board and improved terms and conditions following widespread underwriting losses during the period 1998 to 2001, the attack on the World Trade Center on 9/11/2001, and large hurricane-related property and energy claims in both 2004 and 2005.
Unlike most businesses, accountancy at Lloyd's does not assume the “Going concern” basis, because it is expected that each venture will last for three years and then end. The origin of this accounting cycle was in the shipping business. Syndicates would insure a ship before the start of its voyage, and the three-year period was considered to be the amount of time that it took a ship to sail around the world.
Since the 1930s, many Lloyd's syndicates branched out to underwriting policies providing coverage for general liability, and excess liability beyond that covered by other insurance policies, as well as providing upper layers of reinsurance. Comprehensive unrestricted general liability policies were very popular in the US market from the late 1940s to mid 1970s. These types of policies involve time spans longer than the finite three years of a Lloyd's venture. Insurance policies that cover liabilities that may extend for many years are called long-tail policies because the “tail” of the liability can extend out for many years into the future (for instance, subsidence damage is often not detected until the relevant building is subjected to a structural survey, which typically may not occur for many years until it is about to be sold; it is only at this point that the insured person contacts the insurer, who then has to estimate the cost of rectifying the damage. See also “Asbestosis” below). Short-tail insurance relates to liabilities that are notified and settled quickly (for instance motor vehicle insurance and domestic house contents insurance).
Before an insurance venture can be closed at the end of three years, its liabilities must be balanced by paying out all outstanding claims which have not been paid, and making provisions (setting aside reserves) for any unpaid claims and for any incurred but not reported losses which may occur in the future. An example of an IBNR loss is a lawsuit filed in the future seeking damages for business activities that occurred in the insured time period. Another would be relatively minor damage to a salesman's leased company car that was sustained during the period of insurance but not indentifed until he returned the car at the end of the lease (because he preferred to live with the damage than to be without the car for the time it was being repaired).
Inside the Lloyd's system, potential incurred but not reported losses are reserved for and transferred (reinsured) at the time of closing by estimating the potential total future liability, and then paying a one time premium for a reinsurance-to-close policy(s) (RITC) which transfers the risk. Typically, the reinsurer is the following underwriting year of the same syndicate, but it may be with another syndicate(s). The transfer of residual capital as RITC premiums from year to year and venture to venture ensures solvency for future liabilities.
Long-tail policies are thus rolled over from year to year and in theory there is always capital available from accumulated RITC premiums to pay claims. It also means that the largest insurance risk typically underwritten by a syndicate are its own reinsurance liabilities for previous years. If the premiums paid for reinsuring previous years were too low, then the syndicate may become undercapitalised thereby forcing it to rely on the unlimited liability of the Names. This follows from Lloyd's practice of policyholders always being paid in full irrespective of any financial difficulties individual Names might have.
The structure of triennial accounting and RITCs is considered by some to be ill-suited to modern business. The root of the problem is the difficulty of forecasting the results of risks which have a long duration (or 'tail'). The system of RITC can convey enormous amounts of latent liability onto the shoulders of latter year investors. If the full nature of the liabilities is not understood and cannot be quantified, then it is impossible to reserve for it properly. This can result in highly subjective opinions determining the outcome of different years of account.
The general public knows Lloyd's for some unusual policies it has written. Lloyd's has insured
In the great Underwriting Room of Lloyd's stands the Lutine Bell, which was struck when the fate of a ship “overdue” at its destination port became known. If the ship was safe, the bell would be rung twice: if it had sunk, the bell would be rung once. (This had the practical purpose of immediately stopping the sale or purchase of “overdue” reinsurance on that vessel.) Now it is only rung for ceremonial purposes, such as the visit of a distinguished guest (two rings), or for the annual Remembrance Day service; and for major world catastrophes, such as 9/11 and the Asian Tsunami Disaster (one ring).
Lloyds was named Business Insurance Readers ChoiceTM winner 2007 for Best Reinsurance Company