Just 13 days after the September 11, 2001, Morgan Stanley published an industry overview updating its assessment of the effect the terrorist attacks will have on the property-casualty insurance industry. Its analysts assert that "Lloyd’s is in jeopardy" and posed three questions concerning Lloyd’s ability to meet its obligations to policyholders and reinsureds as a result of the destruction of the World Trade Center.

• "What are Lloyd’s gross and net liabilities associated with the World Trade Center tragedy?"
• "What is the collectibility of Lloyd’s reinsurance recoverables?"
• "What is Lloyd’s plan for meeting its obligation in mid-November to fund the American trust funds?"

As the insurance industry takes inventory of its known and potential liabilities, the questions become more pertinent because of Lloyd’s role in the insurance market place. Lloyd’s underwriters not only sell insurance to individual policyholders, they reinsure policies sold by competing insurers. According to Lloyd’s, it is the fifth largest commercial lines insurer in the world (ranked by net premiums), and the sixth largest global reinsurer (ranked by reinsurance premiums net of retrocessions premiums). Overall, Lloyd’s share of the global market is approximately 1.5% measured by insurance premium.

Estimates of the cost of the terrorist attack are changing daily. On September 12^th, the industry estimated its losses at $15 billion. A week later the amount doubled to $30 billion. A report issued by Tillinghast-Towers Perrin in New York estimated losses could go as high as $58 billion. Milliman U.K. consultants concluded that a cost range of $75 to $100 billion is not unreasonable. Because the only certainty is uncertainty, financial analysts are reluctant to lock on to any early forecasts, having learned from prior catastrophic events that the loss figures ultimately increase two to three times original estimates.

Analysts are expressing concern that individual insurance companies are reporting their expected losses net of reinsurance recoveries. Due to the increasing number of insurance companies and reinsurers that have been declared insolvent during the past several months, they are skeptical that the full amount of reinsurance recoveries taken by the carriers will actually be collected. Morgan Stanley opined that some of the numbers reported by carriers "are likely significantly understated, mostly because they are net of reinsurance recoverables that in many cases will never be collected" and "the implied amount ceded to reinsurers is large enough to bankrupt many reinsurers."

Lloyd’s too, has publicly approximated its WTC loss net of reinsurance recoveries, which it estimates at $1.9 billion. John Oxendine, Georgia Insurance Commissioner and chairman of the National Association of Insurance Commissioners’ Reinsurance Task Force has disclosed that Lloyd’s gross loss estimates are now approaching $10 billion. Based upon recent developments more fully discussed later in this paper, it is apparent Lloyd’s is being cautious about publicly estimating its gross numbers because they affect the amount Lloyd’s syndicates must deposit in their American trust funds. Lloyd’s media manager, Adrian Beeby recently attempted to dispel concerns about the quality of Lloyd’s reinsurers by assuring that 90% of Lloyd’s reinsurance is provided by companies that have a credit rating of A or better. Beeby apparently chose to ignore that it is highly likely many of the reinsurers will have lower ratings when Lloyd’s submits its WTC claims.

The day before the terrorist attacks, A.M. Best reported that two of Lloyd’s syndicates managed by one of its oldest managing agencies, Cotesworth & Co. Ltd., had been forced to suspend underwriting due in part to the financial collapse of their reinsurer. The failure of the reinsurer left underwriters holding the bag for a $500 million loss resulting from the explosion and sinking of the Petrobras oil rig in the ocean off of Brazil. Because the WTC losses are compounded by the recent terrorist attacks in Sri Lanka and a chemical plant explosion in France, there is little doubt that other reinsurance failures will occur. Since the gross loss numbers will not be known for some time, Cotesworth’s suspensions wave a red flag. At this early stage, financial analysts and insurance regulators should treat any assessment of potential reinsurance recoveries as pure speculation and take Lloyd’s net numbers with a healthy dose of skepticism.

Morgan Stanley’s third question, concerning Lloyd’s plans to meet its obligations to fund its American trust funds, zeroes in on the core issue. Just how strong is Lloyd’s chain of security? To find the answer, one needs a clear understanding of the significant differences between Lloyd’s and other professional risk bearers.

Lloyd’s syndicates conduct business in the U.S. on a non-admitted basis subject to compliance with the surplus lines laws and regulations in each of 48 states (Lloyd's is admitted in Kentucky and Illinois). For all practical purposes, regulators have little authority over non-admitted carriers. Subject to certain exceptions, the carriers are only allowed to transact business through surplus lines brokers licensed by the states. The brokers are generally prohibited from doing business with alien insurers that do not meet minimum financial standards. Brokers who violate the laws and regulations are subject to fine and loss of license. Typically, the only recourse regulators take against alien carriers is to issue cease and desist orders and remove them from their lists of approved non-admitted carriers.

Typically, each state requires alien carriers to post a security deposit as a condition to being allowed to transact insurance with its residents. Although most states only allow surplus lines brokers to transact business with individual Lloyd’s syndicates that meet the financial requirements, the syndicates are generally granted a waiver from each state’s security deposit requirements. This waiver applies so long as appropriate deposits are made by the syndicates to trust funds mandated by New York State Regulation No. 20, which applies to reinsurers, and No. 41, which applies to excess and surplus lines insurers. The funds are monitored by the New York Insurance Department and administered by CitiBank, NY. Lloyd’s track record of compliance is less than stellar.

Despite its return to overall profitability during 1993 and 1994, Lloyd’s fortunes began to sour again in 1995. Collectively, the Lloyd’s market lost money in each of the following years. It is currently estimated that underwriters will ultimately lose $7.25 billion dollars for years of account 1996 through 2000. Pressed by its resulting cash flow problems, Lloyd’s intensified its lobbying efforts with US regulators. In 1998 Lloyd’s convinced the NAIC to reduce the obligation to fund the excess and surplus lines trust from 100% of gross liabilities to 50% plus an added cushion of $200 million. Subsequently, the NAIC agreed to reduce the requirement to 30% subject to increasing the cushion to $250 million. Lloyd’s then concentrated on convincing the regulators to reduce the reinsurance fund requirements.

By mid-year 2001 the NAIC had become concerned by the magnitude of Lloyd’s accumulated losses and increasing number of syndicate insolvencies. The NAIC advised Lloyd’s it was continuing to test the integrity of Lloyd’s chain of security and would, if needed to protect U.S. policyholders’ interests, either increase the surplus lines funding level across the board or on a syndicate by syndicate basis. Despite the warning, Lloyd’s continued to push for reduction of the reinsurance trust fund requirements.

There can be no question that many, if not most, of Lloyd’s syndicates will find it difficult to comply with the trust fund regulations due to the unprecedented magnitude of the WTC disaster. Following the attacks, the NAIC is scrutinizing Lloyd’s chain of security to determine how well the market is positioned to pay the resultant claims. The commissioners clearly understand that the syndicates will face a liquidity crunch if they are required to fund the full $9-plus billion of gross liabilities in mid-November. In an unexpected move announced on October 15, 2001, the regulators effectively answered Morgan Stanley’s third question by agreeing to reduce the third-quarter reinsurance trust fund requirement for claims related to the WTC disaster to 60%. In response to concerns about Lloyd’s solvency, John Oxendine, Georgia Insurance Commissioner and chairman of the NAIC Reinsurance Task Force, commented that NAIC feels good about the solvency of Lloyd’s and that "[T]his is a liquidity issue, not a solvency issue." To appreciate the different perspectives, it is necessary to examine Lloyd’s structure and how its chain of security works.

For almost 300 years, only wealthy individuals willing to risk their entire personal wealth were allowed to become Lloyd’s members. From the early 1970's through the late 1980's, Lloyd's sought to increase membership and capacity, so Names of more modest means were admitted. At its peak, over 34,000 individuals had open underwriting accounts at Lloyd’s. When large numbers of members started resigning as a result of the unprecedented losses and internal turmoil that led to R&R, Lloyd’s opened its doors to corporate members in 1994. Unlike individual members who are required to put their entire personal wealth at risk, corporate members are able to limit their liability. Today, approximately 80% of the $16.1 billion in underwriting capacity provided by 108 separate syndicates is afforded by corporate names. The remaining 20% is provided by approximately 2,800 individuals. In contrast to capacity offered by conventional insurers, which is supported by the capital and surplus provided by their shareholders, Lloyd’s market capacity is the sum of the capacity secured by the wealth of individual Lloyd’s Names and corporate members trading through syndicates severally for their own accounts and not jointly. Here’s how it works.

Before being allowed to underwrite, each individual and corporate member must place qualifying assets consisting of cash, investments, letters of credit and bank and other credit guarantees into a trust account known as a "Funds at Lloyd’s" ("FAL") account. The amount of premium a Name may write is governed by the amount held in the member’s FAL. In practice, the Names decide how much they want to deposit. By posting letters of credit and bank guarantees, Names are able to keep their cash working in other investments, thereby leveraging their premium writings. Currently, the minimum capital ratio for members writing at least 85% of their business in the U.K. motor market is 35% of premium income. All others are subject to a 40% ratio. The 40% ratio allows Names to write $2.50 of net premiums for each $1 held on deposit in their FAL.

The preponderance of corporate capital must be taken into consideration when evaluating the security supporting the market’s capacity. Remember, the liability of corporate members is limited. Assuming Lloyd’s market capacity is $16.1 billion, it can be surmised that corporate members should collectively have on deposit at least $5.15 billion of the approximately $6.44 billion in total assets required to be held in members’ FAL accounts. Once a corporate member has reached its limit, the corporation has no further obligation to pay claims.

The importance Lloyd’s places on its market capacity is irrelevant. For example, Lloyd’s has represented that its $1.9 billion expected net liability for WTC losses only represents 12% of its capacity. Capacity has nothing to do with claims paying ability. Capacity is simply a measure of how much premium income underwriters can accept and is meaningful only if it is used. Current estimates are that during 2001 only 47% of Lloyd’s capacity will be utilized. During the past several years, Lloyd’s overall market share has been in steady decline. In 1993, its market share was 2.2%. By the end of 1997 it had dropped to 1.5%. Lloyd’s reports that it wrote over $5.945 billion in reinsurance premiums in 2000 and had 5% of the U.S. reinsurance market.

Although Lloyd’s capacity is supported by members’ FAL accounts, the first link in the chain of security is secured by members’ Premiums Trust Funds ("PTF"). To protect the interests of policyholders, all premiums and other monies received in connection with a Name’s underwriting activities are initially placed in the member’s individual PTF accounts. The PTF's are managed by the managing agents of the syndicate(s) through which the member underwrites. The managing agents deposit premiums and other money received on behalf of a Name’s account into the member’s PTF. Payments from the PTF are limited to meeting permitted PTF expenses, reinsurance premiums and underwriting expenses.

When evaluating the security supporting Lloyd’s policies, it is wrong to assume that individual policyholders and claimants are protected by the total assets held by Lloyd’s in members’ PTF and FAL accounts. In fact, the Names are only linked together financially by a Central Fund ("CF"), created and maintained by Lloyd’s to pay claims incurred by insolvent Names. Because the CF is financed by mandatory annual contributions levied upon all Lloyd’s members, it partially mutualizes the Names’ capital. If funds are insufficient to pay insolvent members’ claims, Lloyd’s has the right to make pro-rata cash calls upon the members to make up any shortfall. Lloyd’s has the right to make a pro-rata call of $435 million from Premium Trust Funds without the members' consent. Any further calls require the members’ consent. Due to the time lag and difficulty Lloyd’s has experienced in collecting calls, in 1999 it purchased a five-year excess of loss insurance policy to cover cash calls that remain unpaid after 28 days. The policy agrees to pay up to $508 million in any one year where such calls exceed $145 million subject to a maximum recovery of $725 million over the five-year period.

By relying upon the existence of the CF, financial rating organizations such as A.M. Best, Standard & Poor and Fitch International Rating add to the confusion by rating Lloyd’s as though it is a single underwriting entity. In its overview, Morgan Stanley expressed its belief that the WTC losses "will sink some Lloyd’s syndicates, drain Lloyd’s Central Fund of cash, and exhaust Lloyd’s insurance coverage" and stated "[I]t now appears inevitable that Lloyd’s security will be tapped to cover uncollectible claims [e.g. cash calls and reinsurance recoveries - Editor], and quite possible that Lloyd’s security may be exhausted by those claims given the magnitude of the WTC loss." A.M. Best demonstrated its shared concern by downgrading Lloyd’s financial security rating from A to A-. S&P reduced its rating from A+ to an A. Fitch not only downgraded Lloyd’s two levels from A+ to A-, it placed Lloyd’s on its Rating Watch Negative.

It is important for policyholders, and regulators, to understand that the WTC losses will only directly affect members who underwrite through syndicates that issued policies providing some form of coverage triggered by the disaster. Regardless of the collective assets held in the PTF and FAL accounts, individual members may become insolvent, particularly if they cannot recoup their losses from their reinsurers. Timely payment of the full amount due claimants depends upon how long the process of gathering funds takes to wind its way along the chain of security. Other members will only be affected if the Central Fund needs to be replenished.

The table below puts Lloyd’s chain of security into perspective. Because the numbers presented were published by Lloyd’s on September 18, 2001, it is assumed current statistics were not available.

With an $8.03 billion balance as of Dec. 31, 2000, it is understandable why Lloyd’s wants relief from funding its gross WTC losses. It would be helpful if this balance was adjusted to reflect losses in 2001 that preceded September 11^th.

By allowing Lloyd’s members to deposit less than 100% of their gross liabilities into the U.S. trust funds, U.S. regulators have effectively weakened the first and most vital link of protection afforded American policyholders and claimants. And, it is the only link that gives U.S. regulators any power over Lloyd’s underwriters doing business in the U.S. If that link breaks, the strength of the remaining links will be compromised.

The NAIC is acutely aware of Lloyd’s accumulating underwriting losses. Long before September 11^th, it had become concerned about the adequacy of Lloyd’s U.S. trust fund deposits, the increasing amount of reinsurance bad debts, and the probable insolvency of several syndicates. Since mid-summer the NAIC has been actively considering alternative ways to increase protection for American policyholders.

Things didn’t get better as the result of the WTC disaster; they got worse. On September 28, 2001, Lloyd’s Members Agency Services Limited distributed a memorandum to Lloyd’s members asking for their comments about applications for de-registration voluntarily filed by 12 member agents and advisors. It is fair to assume that additional applications will be made. On October 17^th Lloyd’s announced that its 108 syndicates had issued $1.131 billion in cash calls, mainly to cover the terrorist attacks on the U.S. The bulk of the payments will come from corporate members, with the 2,800 individual Names contributing $356.7 million.

If there is the least bit of concern about Lloyd’s ability to survive, now is not the time for regulators to let it out of the commitments it made the last time it was struggling for survival.