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Eyes on Lloyd’s U.S. trust

By Robert M. Hall
September 18, 1995

QUESTIONS about the adequacy of Lloyd’s of London’s primary U.S. trust fund may lead to greater scrutiny of U.S. ceding companies with recoverables from Lloyd’s.

The financial reversals suffered by Lloyd’s in recent years have received widespread press coverage. These reversals include approximately £8 billion ($12.4 billion) in underwriting losses over the last five years and suits by thousands of names alleging negligence and fraud.

What has been largely overlooked, however, is the impact of these reversals on the Lloyd’s American Trust Fund, or LATF.

The LATF historically has been a premium trust fund on deposit in New York. It was formed in 1939 as World War II threatened the ability of Lloyd’s to pay claims in the United States. Since then, it has evolved into a collateralization device that allows ceding insurers to treat Lloyd’s as if it were a licensed reinsurer. The result is that the ceding insurer is able to reflect reinsurance from Lloyd’s as an asset in its financial statement.

Since financial statement credit is based on the LATF, it is critical that this trust be adequate in terms of size and be sufficiently accessible to suit its purpose. In recent years, a number of creditors and regulators have begun to question the adequacy of the LATF for this purpose. The latest blow to the LATF is an examination recently performed by the New York Insurance Department, which concluded that the LATF was deficient by $18.5 billion (BI, May 29).

"Market's U.K. troubles prompting
regulators to examine U.S. trust fund"

These findings have serious implications for those companies with recoverables from Lloyd’s.

They raise questions about Lloyd’s ability to pay U.S. claims or, at least, about regulators’ continued willingness to allow financial statement credit for cessions to Lloyd’s. Disallowance of this credit could render a number of cedants insolvent and affect the financial rating of many others. Since U.S. premium represents 32% of the market of Lloyd’s, both regulators and Lloyd’s have significant incentives to resolve this crisis successfully.

New York report

Given growing concerns about the adequacy of the LATF, the New York Insurance Department initiated the first examination of the LATF in 1994. In May of 1995, the New York department issued its examination as of Dec. 31, 1993, which reviewed Lloyd’s compliance with New York’s credit for reinsurance and surplus lines laws.

The report found that the LATF violates New York statutes, which require the LATF to meet gross liabilities, i.e. not losses net of reinsurance. The report also found the LATF to be deficient by $7.8 billion on a net basis and deficient by $18.5 billion on a gross basis.

In addition, the report:

• Notes that Lloyd’s violated its own solvency tests in calculating the size of the LATF.
• Observed that there is no assurance that a name’s assets in the LATF will equal its liabilities.
• Recommended individual reporting of names’ assets or joint liability of names.
• Recommended that the LATF be limited to U.S. business.
• Observed that Lloyd’s violated New York law by failing to transfer to the LATF funds that had been earmarked in the Central Fund to cover bad debts of names.

Many of these findings did not surprise close observers given a growing awareness of the structural deficiencies of the LATF and its questionable compliance with credit for reinsurance laws.

Credit for reinsurance

Every state has credit reinsurance laws and/or regulations. Most are patterned after the model act and regulations recommended by the National Assn. of Insurance Commissioners.

The model act separates reinsurers into those that are treated as licensed and those that are treated as unlicensed. Unlicensed reinsurers must post letters of credit or trust funds for the specific benefit of individual cedants. These collateralization devices must equal reinsurance recoverables, including incurred-but-not-reported losses, for the cedant to take full financial statement benefit for the reinsurance.

By a quirk of legislative development, Lloyd’s falls under a section of the model act dealing with reinsurers that are treated as licensed in the domiciliary state of the cedant. To receive licensed treatment, however, Lloyd’s must post a trust fund for the benefit of all cedants. The size of the trust must equal liabilities to cedants, including IBNR. plus $100 million, the latter amount being held on a joint basis.

Structure of the LATF

The LATF is a several rather than joint fund. This means that Lloyd’s names are liable for their own debts but not for the debts of other names. Thus, creditors have a right of recovery under the current trust only if the names on their policies or reinsurance contracts have assets in the LATF.

The LATF has a variety of shortcomings. For instance, there are no assurances that names will have assets in the LATF when claims are perfected. Reasons for this include:

• Assets are freely transferable out of the LATF at any time before a claim is perfected.
• Lloyd’s uses a "reinsurance to close" mechanism, which allows names to reinsure their runoff exposure after three years and remove any remaining assets.
• The LATF does not maintain a record of individual names’ assets held in LATF accounts.

Creditors also lack "privity" with reinsurance-to-close reinsurers and, therefore, have no right of action against them. Obviously, this can leave creditors without an effective remedy. For this reason, commentators have observed that the LATF issue is not just one of size, but of accessibility by creditors.

Another serious deficiency is that the LATF is net of reinsurance ceded. Other reinsurers are required to collateralize their obligations gross of reinsurance.

U.S. insurance regulators have expressed their belief that the LATF’s format is contrary to the model act and to their understanding of how the LATF worked. The model act is being clarified to make it clear that reinsurance cannot be netted off to determine assets to be held in trust.

In addition, the LATF collateralizes all business written on a U.S.-dollar basis—not just U.S. risks. This makes it difficult to match assets with U.S. liabilities and can lead to competition for assets among U.S. and non-U.S. creditors.

Other problems with the LATF include:

• Lack of investment guidelines for trust assets.
• It pays commissions, fees, brokerage and salary to a variety of parties with respect to the U.S. and non-U.S. business.
• The trustee is paid out of trust assets, which means that a trustee may resist the claim of a creditor using the very funds the creditor is trying to collect.
• The LATF contains a mechanism for policyholders to make a recovery but lacks a similar mechanism for cedants.

Given these deficiencies, there is a growing awareness that the LATF should be revised to better serve as an effective collateralization device.

Reaction to New York report

In its response to the New York examination report, Lloyd’s announced it would make several reforms.

Lloyd’s is establishing two new trust funds, one for U.S. reinsurance business and one for surplus lines business. These funds will be on a gross of reinsurance basis and will apply to new business.

Lloyd’s will contribute $500 million to Lloyd’s U.S. Central Fund. In addition, Lloyd’s intends to establish a joint fund for years 1992 and prior through Equitas, the facility designed to reinsure the old-year liabilities of names.

While these steps by Lloyd’s will close the gap somewhat, they do not solve all of the problems cited above. Initially, it is unknown whether the form of the future trust agreement will provide necessary accessibility to creditors. There is a three-year gap between the Equitas trust and the two trusts to be effective in August of 1995. Moreover, some people doubt that Lloyd’s has the assets to cover the $18 billion deficiency in the LATF that remains after the $500 million contribution noted above.

The NAIC’s reaction

After several years of effort, the NAIC is moving toward amendments that strengthen the reinsurance model act with respect to the LATF. The New York examination report lends some urgency to this process. In pertinent part, the current draft of amendments include:

• Splitting off credit for reinsurance trusts from surplus lines trusts on a going forward basis.
• Investment guidelines for trust assets.
• Requiring that trusts be funded on a gross of reinsurance basis.

It is possible that such amendments will be adopted by the end of 1995; however, it remains to be seen how many states will adopt the amendments.

Remaining problems

While the changes to the LATF generated by New York and contemplated amendments to NAIC model act and regulation are beneficial to creditors, problems remain. The most obvious is the apparent $18 billion deficiency in funding for past years.

Almost as serious is the several nature of the fund, which can deny a creditor available funds simply because the names on that creditors’ reinsurance treaty have exhausted or removed their funds. The LATF should not be used to pay extraneous loss, commissions and salaries since this drains funds available to creditors.

Finally, there should be an improved mechanism for collection of claims from the trust by cedants.

"While Lloyd's response to the report will lessen the fund's
deficiency somewhat, they do not solve all of the LATF's problems."

Lloyd’s considerable problems with losses over the past five years have been compounded by the deficiencies in the LATF and the New York examination report on point. This has jeopardized the ability of U.S. creditors to take credit for reinsurance ceded to Lloyd’s.

While these problems are formidable, it is doubtful that Lloyd’s would abandon the U.S. marketplace by failing to find a solution to the LATF problem. Regulators are equally motivated to avoid a shock wave to the U.S. insurance industry.

A short-term solution is likely if Lloyd’s has sufficient assets to collateralize its obligations in the United States. A long-term solution may require even more fundamental changes to the LATF than have been offered to date.

Robert M. Hall is a partner in the Washington office of Rudnick & Wolfe, concentrating in insurance and reinsurance practice.