January 21st, 2009

Lloyd’s – Relative Strength

Posted at 1:01 AM ET

Mike Van Slooten, Senior Vice President

Lloyd’s was tested in 2008, like the rest of the (re)insurance industry. Underwriting discipline instilled by the Franchise Board, coupled with a relatively conservative investment strategy, has left the market well-positioned to capitalize on opportunities that may arise in 2009. This is reflected in recent out-performance of the Lloyd’s listed sector.

The gap between the Lloyd’s Index and the other insurance indices first widened in the second half of September 2008, coinciding with the collapse of Lehman Brothers. It has since spread further, with the perception that larger Lloyd’s operations stand to benefit most from current market dislocation.

Corporate Activity at Lloyd’s in 2008

The continued high level of corporate activity is the most obvious sign of the market’s health. In particular, seven insurance groups - five Bermudian, one American, and one Japanese - completed their entries into Lloyd’s in 2008. As a result, six managing agents overseeing 11 syndicates and GBP1.6 billion (USD2.3 billion) of underwriting capacity changed hands.

The number of active syndicates rose to 78 at the beginning of 2009, from 75 at the start of 2008, mainly reflecting new initiatives by existing operations. Of these, 72 are writing open market business, and six are purely providing reinsurance support to other syndicates.

Other trade investors are currently engaged in the process of gaining entry to Lloyd’s, and several new syndicates are expected to be approved in the first few months of 2009. There is also no shortage of interest among private investors, as Amlin PLC demonstrated in establishing its GBP50 million “sidecar” syndicate for 2009. The ability of leading Lloyd’s operations to tap private investors in this way represents a significant competitive advantage in the current environment.

What is Driving Investor Demand?

To a large extent, surplus capital is a thing of the past, but certain insurance groups, many based in Bermuda, are still looking to diversify or enhance their operating structures. Access to business via the market’s worldwide licenses, strong and stable financial strength ratings, the currently low cost of mutualization and the ability to fund underwriting with letters of credit are attracting them to Lloyd’s. These features generate the potential for strong returns, as consistently demonstrated by leading syndicates.

Operating Performance

Pre-tax profit for the first half of 2008 virtually halved to GBP949 million, with underwriting conditions becoming marginal. Pure year technical profits slumped by 58 percent to GBP292 million, based on a combined ratio of 95.4 percent, partly due to significant risk losses, but mainly due to declining rates. All classes other than energy and property treaty were below the level seen three years previously.

The overall investment result dropped by 59 percent to GBP346 million. The relatively conservative and short duration assets held by syndicates in their Premiums Trust Funds, yielded 1.2 percent. The notional return on funds at Lloyd’s was calculated at 0.7 percent, based on index yields on each type of asset held. Mutually-held assets, which are held for the long-term and therefore more aggressively geared, made a loss of 0.9 percent.

On October 21, 2008, Lloyd’s released a provisional net loss estimate of USD2.3 billion for Hurricanes Gustav and Ike, based on an aggregate industry loss of USD20 billion to USD25 billion. Given continuing capital market turmoil in the second half of the year, Standard & Poor’s (S&P) expects the market to report an overall profit in the range of GBP500 million to GBP1 billion for 2008, according to its European Insurance Industry Report Card, issued on December 11, 2008.

Such an outcome would continue the good performance registered by Lloyd’s since 2002. A key factor has been the reduced volatility stemming from improved central risk management. As the chart below shows, overall results are strongly driven by technical performance, which is why the biggest danger historically has been a prolonged buyers’ market. Current market dislocation has dissipated concerns in this area.

Capital Resources

Unlike most major peers, Lloyd’s as a whole did not suffer a material reduction in capital in 2008. Central assets remain close to an all-time high and a member contribution rate of 0.5 percent represents the lowest cost of mutuality in more than a decade.

Going into 2009, there is some uncertainty around the cost and availability of letters of credit, as well as a heightened focus on counterparty credit risk. Looking further ahead, Lloyd’s continues to lobby for the use of letters of credit as underwriting capital under the Solvency II regime.

Outlook for 2009

In the face of continued rate declines, several of the larger managing agents were proposing capacity cuts of 5 percent to 10 percent early in the mid-year business planning process. However, many plans were later revisited, as the extent of capital constraints elsewhere in the industry became apparent and the underwriting outlook improved. Ultimately, Lloyd’s opened 2009 with record underwriting capacity of GBP16.6 billion, with the market looking to leverage its stable profile to take advantage of a desire among risk managers for greater diversification in the placement of their risks.

In U.S. dollar terms, the original currency for around 60 percent of Lloyd’s business, market capacity has actually fallen by 24 percent, due to the dramatic swing in the exchange rate. Lloyd’s vehicles will be required to deposit additional capital centrally in the coming months to account for rising rates and the effective increase in underwriting exposures. Two operations have moved already. On December 8, 2008, Omega Underwriting Holdings Ltd. announced fully underwritten plans to raise GBP130 million of equity, demonstrating that operations with a strong track record still have access to capital. On January 6, 2009, Hardy Underwriting Bermuda Ltd. announced a late GBP65 million increase in underwriting capacity to accommodate expected additional business volume.

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