As fascinating as Homer’s recounting of the wandering of Odysseus after the fall of Troy is, it is not nearly as intriguing as Equitas’ annual reports and accountings of its manipulation of the financial remnants of what was Lloyd’s prior to its reconstruction and renewal in 1996. Like the phoenix of Egyptian mythology, Lloyd’s renewed its self after being consumed by fires of financial disaster wreaked upon its underwriters (Names) by a scourge of plaintiff lawyers carrying the plague of asbestos, pollution and health hazard claims. Those Names affected by Lloyd’s R&R, including their policyholders and claimants and concerned insurance regulators, will find many of the passages in Equitas’ recently published journal for the year ended March 31, 2001 intriguing.

Lloyd’s was struggling for its survival when it chartered Equitas to embark upon a journey that would relieve its ongoing underwriters of the burden of pre-1993 claims and bring finality to the obligations of essentially all Names responsible for their payment. On September 3, 1996, Equitas embarked upon a course mandated by the terms of a Reinsurance and Run-off Contract crafted by Lloyd’s ostensibly in concert with Names’ representatives. When Equitas set forth, it carried the responsibility of more than 34,000 Names for 740 pre-1993 syndicate years of account. Few of them understood that the Contract includes a "proportionate cover" provision that essentially holds them responsible for any short-fall should Equitas run out of money.

Equitas has now published six chapters of its journal. The first chapter provides an accounting of its gestation period commencing December 5, 1995 and ending September 4, 1996. The second picks up on the effective date of the Reinsurance and Run-off Contract and ends seven months later on March 31, 1997. Thereafter, Equitas has published new Reports & Accounts as of March 31 of each subsequent year. Bottom line, the Names want the reports to provide answers to two questions. How much is owed, or expected to paid, to policyholders and claimants? How much money does Equitas have to pay claims, claims settlement, and wind down expenses? Unfortunately, the reports are difficult for laymen to understand and do not provide clear answers to the two questions. This paper provides a different perspective of the progress of Equitas’ journey.

Equitas’ prepares its financial statements in accordance with the standards prescribed by the United Kingdom Companies Act of 1985. Anyone familiar with the statutory accounting standards prescribed by the National Association of Insurance Commissioners (NAIC) and its Convention Statement format will find the two vary significantly. The Convention Statement format makes it possible, even for laymen, to track each carrier’s claims history, operating results and surplus development with relative ease. Not so with Equitas. Not only do its statements lump sum many line items separately detailed in the Convention Statement, it only compares the current year data to the immediate past year. To perform a meaningful analysis, it is necessary to extract data from each of its annual reports, mine the footnotes and other commentary for details, and compile the results into a more usable format.

With the benefit of hindsight, one would expect that a clear picture of Equitas’ journey to financial finality would emerge from an analysis of its annual reports. Unfortunately, the images most significant to the Names do not come through clearly. If anything, attempts to answer their questions make it appear highly unlikely that Equitas will be able to achieve finality. If it fails, the Names can expect to be called upon to make up the short-fall. The following summary brings Equitas’ progress into focus.

During the early development of R&R, Lloyd’s estimated that £5.9 billion ($8.378 billion @ $1.42) would be needed to fund Equitas. By November 1995, the amount of funding needed increased almost twofold to £11.4 billion ($16.188 billion). Of this, £1.9 billion ($2.698 billion) was to come from Names. After encountering resistance to R&R from a considerable number of Names, in May 1996, Lloyd’s lowered the amount needed from them to £1 billion ($1.42 billion). Lloyd’s explained that it had discovered that claims from some lines of business had been over reserved and that the potential reinsurance recoveries were substantially more than anticipated. Dissenting Names looked upon the reduction as a ploy to entice them to accept R&R.

Because it is virtually impossible to accurately predict the amount of money that will be required to pay claims that have been incurred but not reported, it can be assumed that Equitas’ estimates are as good as anyone else’s. What is troublesome, however, is its reports do not provide a clear tracking of claims settlements and reserve developments. It’s nearly impossible to accurately calculate how changes in foreign currency exchange rates, discount rates, reinsurance recoveries and treaty commutations have affected the estimates. Those of suspicious mind may believe it’s a continuum of Lloyd’s deceit.

When Equitas commenced its journey on September 3, 1996, it assumed responsibility for the settlement of gross claims liabilities of £20.91 billion ($26.692 billion). Equitas anticipated that recoveries from over 248,500 reinsurance policies issued by approximately 2,900 reinsurers would reduce its initial reserves by £5.98 billion ($8.492 billion) to a net of £14.93 billion ($21.20 billion).

During its gestation period, £11.19 billion ($15.89 billion) of gross written and earned premiums had been collected. Simple arithmetic indicates a shortfall of £3.74 billion ($5.311 billion). Despite the indicated deficit, Equitas reported it had a surplus of £588 million ($834.96 million). How was Equitas’ able spin a deficit into a surplus? Through the machination of discounting.

According to Equitas’ independent accountants, PricewaterhouseCoopers, a significant majority of outstanding claims are comprised of asbestos, pollution and health hazard liabilities (APH), which are expected to be paid out over a period in excess of 40 years. Therefore, the provision for claims outstanding and the cost of undertaking the run-off has been discounted to reflect the time value of money. Equitas applied a 6% discount to the gross outstanding claims liabilities and reinsurance recoveries existing at September 4, 1996. As a result gross liabilities were reduced by £6.153 billion ($8.737 billion) and reinsurance recoveries by £1.695 billion ($2.407 billion). The net effect was a reduction of £4.458 billion ($6.33 billion) thereby bringing the net claims outstanding down to £10.472 billion ($14.87 billion). Instead of a shortfall, Equitas was able to report a surplus.

Because Equitas’ resources are limited, the development and settlement of claims is of primary concern to most reinsured Names. Every Name understands how difficult it is to predict the future development of claims. No one disputes the need to periodically adjust reserves based upon current events. At first blush, the rationale of applying discounts to claims and reinsurance recoveries seems logical. Since the mid-1980s, US companies have been required to apply discounts to their reserves for the purpose of calculating their federal income tax liabilities. Even though Equitas may be in technical compliance with UK accounting standards, it is difficult to accept that the use of discounting produces an accurate image of the magnitude of its unsettled claims.

Since 1996, Equitas has applied various discounts based upon interest rate assumptions ranging between 5% and 6%. In addition, it has periodically changed the number of years used to project expected cash flows. For example, APH claims, which account for approximately 70% of all claims, have a life expectancy greater than 40 years. Equitas uses a weighting method based upon the average number of years it expects it will take to settle claims. In 2000 it used eight years; in 2001 ten. Each change in a variable changes the claims liability reported on the balance sheet. Equitas’ reports would be more acceptable if the affect of the changes were clearly reported.

Because Equitas is not a going concern, it hasn’t increased its written and earned premiums since March 31, 1998. The only steady stream of revenue Equitas receives is from invested assets, which is used to pay operating and claims handling expenses. The point is, if the amount invested by Equitas is being depleted by claims payments thereby reducing the amount of income earned, and investment income is largely absorbed by operating expenses, where is the money required to unwind the discount going to come from? It is recovered through "unwinding discount" bookkeeping entries comprised of the reduction in the one year period over which net liabilities were discounted plus the affect of any change in the discount rate used in the prior year. On paper, Equitas shows a recovery of £2.126 billion ($3.019 billion) as a result of unwinding discount bookkeeping entries.

Equitas’ discounting strategy seems at least a bit incongruous when, according to its Chairman, Hugh Stevenson, it has increased claims reserves by over £1.8 billion ($2.556 billion) since 1996. And, as Stevenson warns, more increases are expected!

The discounting of future reinsurance recoveries compounds the incongruity. In its March 31, 2001 accounting, Equitas reported that the reinsured syndicates had purchased reinsurance policies from approximately 3,000 reinsurers and 2,000 reinsurance pools and that some of the reinsurers are no longer paying claims or are subject to insolvency procedures. Although Equitas reports that it has included a bad debt provision in its reinsurance account for those companies that are currently, or may in the future be, at risk, the amount is not specifically disclosed. Significantly, Equitas also reports that it has collected over £2.5 billion ($3.55 billion) in reinsurance recoveries through the commutation of several hundred reinsurance agreements. Equitas attempts to offer some consolation by reporting that as of March 31, 2001 no single reinsurer accounts for more than 6% (versus 7% in 2000) of the total expected recoveries before discounting. Attempting to decipher the entanglement of data relating to direct claims and reinsurance is like trying to unravel the Gordian Knot. No one knows with any degree of certainty what the end result of adding and subtracting the numbers will be.

The following table places the development of claims, reinsurance recoveries and the effect of discounting into perspective starting with the opening balances at September 5, 1996 and ending March 31, 2001.

ITEM

$ 1.42

£m

Gross Claims Reserved @ 9-5-96

20,910

29,692

@ 3-31-01

Total Gross Paid Claims

11,258

15,986

Indicated Remaining Reserve Balance

9,652

13,706

Total Reinsurance Recoveries

4,357

6,187

Indicated Remaining Net Reserve Balance

5,295

7,519

Gross Provision for Claims

14,085

20,001

Gross Claims Development Indicated

8,790

12,482

Gross Reinsurance Recoverable

2,545

3,614

Indicated Gross Claims Net of Reinsurance

11,540

16,387

Gross Claims Discount Applied

5,152

7,316

Gross Reinsurance Discout Applied

964

1,369

Net Discount Applied

4,188

5,947

Net Claims Balance Sheet Liability

7,352

10,440

Total Balance Sheet Assets @ 9-5-96

15,974

22,683

Total Reinsurance Related Assets @ 9-5-96

9,701

13,775

Ratio of Reinsurance Related Assets to Total Assets

60.73%

Gross Discounted Claims Outstanding @ 9-5-96

14,757

20,955

Reinsurer's Share of Outstanding Claims @ 9-5-96

65.74%

Total Balance Sheet Assets @ 3-31-01

10,356

14,706

Total Reinsurance Related Assets @ 3-31-01

2,771

3,935

Ratio of Reinsurance Related Assets to Total Assets

26.76%

Gross Discounted Claims Outstanding @ 3-31-01

8,933

12,685

Reinsurer's Share of Outstanding Claims @ 3-31-01

31.02%

(Source: EQUITAS: Reports & Accounts: Dated 4 September 1996; 31 March 1997; 31 March 1998, 31 March 1999, 31 March 2000, 31 March 2001)

As of March 31, 2001 Equitas reported it had a surplus of £700 million ($944 million) verses £588 million ($835 million) when it commenced it journey. Here’s what the surplus would look like if the discounts were not applied.

$ 1.42

£m

Surplus at 9-5-96

588

835

Deduct Discounts Net of Reinsurance

(4,458)

(6,330)

Adjusted Surplus

(3,870)

(5,495)

Surplus at 3-31-01

700

994

Deduct Discounts Net of Reinsurance

(4,188)

(5,947)

Adjusted Surplus

(3,488)

(4,953)

The method of accounting of invested assets and the effect upon surplus raises additional concerns. Under NAIC standards, insurers must value their equity investments at market value and bonds at their amortized value. Under UK standards, Equitas records its financial investments at market value. At March 31, 2001 Equitas’ balance sheet indicates a market value of £6.187 billion ($8.786 billion) of which approximately 83% is invested in debt and other fixed interest securities. A footnote indicates its investments cost £6.096 billion ($8.656 billion). Under NAIC standards, it’s clear that a significant portion of the £11.8 million ($16.756 million) difference would not have been included in the surplus number.

Stevenson summaries the concerns very well in his March 31, 2001 statement to the Names.

Mr. Stevenson can help the Names evaluate their risks by improving the quality and detail of information reported in the accounts of Equitas’ journey to finality.