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Lloyd's, also known as Lloyd's of London, is a British insurance and reinsurance market.[1] It serves as a meeting place where multiple financial backers, underwriters, or members, whether individuals (traditionally known as Names) or corporations, come together to pool and spread risk. Unlike most of its competitors in the insurance and reinsurance industry, it is not a company. The Society of Lloyd's was incorporated by the Lloyd's Act 1871.
History
Formation
The market began in Edward Lloyd's coffeehouse around 1688 in Tower Street, London. His establishment was a popular place for sailors, merchants, and ship owners and Lloyd catered to them with reliable shipping news. The shipping industry community frequented the place to discuss insurance deals among themselves. Just after Christmas 1691, the coffee shop relocated to Lombard Street (a blue plaque commemorates this location). This arrangement carried on long after Lloyd's death in 1713 until 1774 when the participating members of the insurance arrangement formed a committee and moved to the Royal Exchange as The Society of Lloyd's.
First Lloyd's Act
The Exchange burned down in 1838 and, although rebuilt, many of Lloyd's early records were lost. In 1871, the first Lloyd's Act was passed in Parliament which gave the business a sound legal footing. The Lloyd's Act of 1911 set out the Society's objectives, which include the promotion of its members' interests and the collection and dissemination of information.
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.
Changes in the UK financial markets
During the 1970s, a number of issues arose which were to have significant influence on the course of the Society. The first was the tax structure in the UK: capital gains were taxed at 40 per cent, earned income was taxed in the top bracket at 83 per cent, and investment income in the top bracket at 98 per cent. Lloyd's income counted as earned income, even for Names who did not work at Lloyd's, and this heavily influenced the direction of underwriting: in short, it was desirable for syndicates to make a (small) underwriting loss but a (larger) investment profit. The losses were 98% funded by the taxpayer while the gains largely accrued to the Names; when Margaret Thatcher's government greatly reduced the top rate of income tax, the proportion of the losses paid by the Names increased astronomically. The investment profit was typically achieved by 'bond washing' or 'gilt stripping': buying the bond 'cum dividend' and selling it 'ex dividend', creating an income profit and a capital loss. Syndicate funds were also moved offshore (which later created problems through fraud and self-dealing).
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.
Arising 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.
Second Lloyd's Act
In 1980, Sir Henry Fisher was commissioned by the Council of Lloyd's to produce the foundation for a new Lloyd's Act. The recommendations of his Report addressed the 'democratic deficit' and the lack of regulatory muscle.
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.
1988 - 1996
In the late 1980s and early 1990s, Lloyd's went through the most traumatic period in its history. Unexpectedly large legal awards in US courts for punitive damages led to large claims by insureds, especially on APH (asbestos, pollution and health hazard) policies, some dating as far back as the 1940s. Many of these policies were designed to cover all liabilities not excluded on broadform liability policies.
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:
- Lloyd's withheld their knowledge of asbestosis and pollution claims until they could recruit more investors to take on these liabilities that were unknown to investors prior to investing in Lloyd's.
- Enforcement officials in 11 US states charged Lloyd's and some of its associates with various wrongs such as fraud and selling unregistered securities.
- Ian Posgate, one of Lloyd's leading underwriters, was charged with skimming money from investors and secretly trying to buy a Swiss bank. He was later acquitted.
'Recruit to dilute'
It may be wondered how the current Members of Lloyd's could be liable to pay these historical losses. This came about as a result of the Lloyd's accounting practice known as 'reinsurance-to-close'.
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. The practice at Lloyd's 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 notified 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 its (strictly, its members’) 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 enrol 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.
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 [...].).
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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 hundred 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.
Structure
Lloyd's is not an insurance company. It is an insurance market of members. As the oldest continuously active insurance marketplace in the world, Lloyd's has retained some unusual structures and practices that differ from all other insurance providers today. Originally created as an unincorporated association of subscribing members in 1774 it was incorporated by the Lloyd's Act 1871, and is currently governed under the Lloyd's Acts of 1871 through to 1982.
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.