Conceptually, Lloyd’s has changed very little during its 300+ years of existence. As Lloyd’s Chairman, Saxon Riley so succinctly stated in his 2000 Global Report to Lloyd’s members, "Lloyd’s has always been, and will continue to be, a broker market." His assertion stands in stark contrast to the image projected in a report presented by Lloyd’s Head of International Relations, Alastair M. Evans just seven days after the September 11th terrorist attacks. Evans boasts that Lloyd’s is the fifth largest commercial lines insurer in the world and the sixth largest global reinsurer. Regardless of whether one views Lloyd’s as a market place or an insurer, there is little question that it is once again struggling for survival. The question is, "should US insurance regulators give Lloyd’s a second chance?"

The first reprieve followed the New York Department of Insurance audit of Lloyd’s American Trust Funds in early 1995. The auditors reported that as of December 31, 1993 the Funds were deficient by $18.680 billion. At the time of the audit, Lloyd’s was awash in red ink and defending itself against accusations of fraud leveled by many of its members. Lloyd’s waged a vigorous campaign to convince US insurance regulators that Lloyd’s would collapse if it was not allowed to implement its Reconstruction and Renewal Plan and rejuvenate itself. In May 1995, it induced New York’s Superintendent of Insurance Edward J. Muhl to allow Lloyd’s to resolve the trust fund deficit by transferring its pre-1993 non-life liabilities to Equitas and establishing a separate Equitas trust fund.

In addition, Muhl agreed to allow Lloyd’s to continue to do business in the US after August 1, 1995 with the understanding that only those underwriting members of Lloyds subscribing risks through syndicates that established trust funds in New York that satisfied the requirements of Regulation No. 20 or No. 41 would be recognized as accredited reinsurers or eligible excess or surplus lines insurers. It was stipulated that each syndicate would deposit 100% of their gross liabilities into the appropriate trust fund.

Despite Lloyd’s overall profitability in 1993, 1994 and 1995, its members’ underwriting results began to sour in 1996. Faced with mounting losses and cash flow problems, Lloyd’s syndicates found it difficult to comply with the deposit requirements. In 1998 Lloyd’s induced regulators to reduce the syndicates’ obligation to fund the excess and surplus lines trust to 50% plus an added cushion of $200 million. Later, it obtained a further reduction to 30% plus $250 million. With these concessions in hand, Lloyd’s then concentrated on getting the reinsurance trust fund requirements reduced.

Because Lloyd’s syndicates typically reinsure a portion of the risks they assume, Lloyd’s quest to reduce the trust fund obligations to reflect recoveries from reinsurers would, on the surface, seem reasonable. The question is: "who benefits from the reductions?" The N.Y. Insurance Department’s audit completed in 1995 proved that Lloyd’s could not be relied upon to meet its trust obligations. The funding obligations agreed to by Lloyd’s in 1995 to make it possible to continue to trade in the US were required by Ed Muhl for only one reason; to protect US policyholders. Clearly US policyholders do not benefit because the reductions effectively erode the protection promised by Lloyd’s.

The benefit to Lloyd’s members is not apparent to most outside observers. One of the attractions to joining Lloyd’s is the members’ ability to leverage their investments. Generally, members are allowed to write approximately $2.50 of net premiums for each $1 held on deposit in their FAL accounts. A significant portion of the security backing underwriters’ capacity is in the form of letters of credit and qualified securities deposited in each member’s Funds at Lloyd’s account. This is a luxury not afforded to US carriers. The National Association of Insurance Commissioners statutory accounting rules do not recognize letters of credit held by domestic insurers as admitted assets.

In the event a syndicate’s incurred losses exceed premiums, the underwriters’ may have to transfer some or all of their FAL assets to other accounts such as US trust funds. When paid losses exceed available cash, the security must then be turned into cash. When the security is transferred from the FAL or liquidated, the members lose their leverage and impair their capacity. If the stock market is depressed, they may also suffer capital losses. Reductions in the amounts required to be deposited into US trust funds obviously preserve the members’ leverage and minimize the potential for loss of principal due to a depressed stock market.

By mid-year 2001, regulators had become increasingly concerned by the magnitude of losses being accumulated by Lloyd’s underwriters. The NAIC advised Lloyd’s that it was testing the integrity of Lloyd’s chain of security and would, if needed to protect US policyholders’ interests, either increase the surplus line funding level across the board or on a syndicate by syndicate basis. According to a NewsEdge publication on September 10, 2001, analysts expected Lloyd’s to lose $7.25 billion cumulatively for years of account 1996 through 2000.

Now comes September 11, 2001. Despite being concerned by the magnitude of Lloyd’s pre-911 losses, the NAIC agreed to help Lloyd’s resolve its cash flow problems by reducing the reinsurance trust funding requirement from 100% to 60% until the end of the first quarter of 2002. At the time of its decision, Lloyd’s had estimated that the market’s gross liabilities for the WTC disaster would total $7.67 billion. By November 28^th, the estimate increased to $8.09 billion. Significantly, its net loss projections after estimated reinsurance recoveries increased from $1.86 billion to $2.7 billion. Lloyd’s Finance Director Andrew Moss attributed the increase in the net amount to a shortfall in expected reinsurance recoveries.

The NAIC’s decision to reduce Lloyd’s trust fund requirements raises several concerns. Foremost, are the numbers being offered up by Lloyd’s accurate? The answer is; nobody knows. As Morgan Stanley puts it, "Lloyd’s accounting is nontransparent, lacks real-time information, and does not conform to international accounting standards." Not only are the numbers constantly changing, they differ depending upon the source. Lloyd’s was required to make its third quarter deposits on November 15, 2001. Although Lloyd’s reportedly deposited $2 billion into the funds, there is no reliable published accounting of how the deposit was allocated between the excess/surplus lines and reinsurance funds or how it was split between WTC and all other claims. Reports obtained from various news sources indicate that between $3.34 billion and $5.33 billion of the $7.67 billion of gross WTC liabilities was due to reinsurance claims with the remaining $2.34 billion to $4.33 billion allocated to surplus lines claims. Instead of depositing $2 billion, the calculations indicate that Lloyd’s should have deposited between $3.3 billion and $3.9 billion just to fund its WTC losses.

If accurate numbers are not available, how can the NAIC know the correct amounts that should be on deposit in the trust fund accounts? Lloyd’s implicit answer is, trust us! NAIC has shown its skepticism by retaining the accounting firm of Arthur Andersen to comb through Lloyd’s books in London at an expected cost of over $1 million to find its own answer. Unfortunately, the audit will not be completed until the first quarter of 2002, well after Lloyd’s has commenced its new trading year.

Despite the fact Lloyd’s accounting system is not recognized by any major international standard-setting body, it has not been changed significantly during Lloyd’s 300-year history. Lloyd’s syndicates start each calendar year with a new slate. The operating results of each underwriting year of account are kept open for three years after which they may be closed. Typically, syndicates close out a given year by purchasing Reinsurance to Close to transfer claims incurred but not reported under policies issued during the year of account being closed. Unlike the statutory accounting rules imposed by the NAIC, reserves for unearned premiums are not carried forward into subsequent underwriting year and claims are charged to the underwriting year the policies were issued instead of the year reported. For example, $923 million of WTC losses have so far been charged to syndicates’ 2000 year of accounts.

Each year of account stands on its own to accommodate the departure of existing members and to allow new members to begin trading. The RTC concept provides the departing members with a sense of finality although they remain responsible for any deterioration in reported claims. Because each year stands on its own, there is no way members can use future profits to reduce prior underwriting year losses. At best, if members elect to continue to trade, they may be able to offset some of their investment losses should they make a profit in subsequent underwriting years. Therefore, if the WTC and other losses are not adequately funded, and those members who actively traded during 2000 and 2001 years of account are financially unable to meet their obligations, US policyholders may be forced to look to Lloyd’s Central Fund for payment of their claims.

In assessing the importance of the Central Fund, the NAIC appears to have overlooked the significant change that has taken place in Lloyd’s membership since 1996. Prior to 1993, only individuals were allowed to become members/investors. Each traded severally for their own account and not jointly with other members and exposed their estates to unlimited liability. That all changed in 1993 when Lloyd’s opened its doors to corporations with limited liability. Lloyd’s membership had peaked at 32,400 in 1988, and declined precipitously thereafter as Lloyd’s struggled to defend itself against allegations of fraud leveled by many of its members. The only way Lloyd’s could replace the lost capacity was to accept corporations as members. At the time of R&R there were 14,744 individual and 140 corporate members. By the beginning of 2001 the individual count had dropped to 2,848 and number of corporate members had increased to 895. In 1995 almost 77% of Lloyd’s $14.5 billion market capacity was provided by individuals. In contrast, by the beginning of 2001, individuals provided only 16% of Lloyd's $15.7 billion capacity. Because Lloyd’s underwriting is dominated by corporate members with limited liability, and there is a high likelihood that many will not be able to meet their Lloyd’s liabilities, prudence dictates that the security provided by Lloyd’s Central Fund should be considered, at best, to be marginal.

At issue is whether the NAIC should even allow Lloyd’s to continue to operate in the US until its audit is completed and the true status of the underwriters’ ability to pay its losses incurred through December 31, 2001 has been determined. The only true difference between Lloyd’s current financial crises and that of 1995 is the absence of allegations of fraud. In 1996 Lloyd’s frightened regulators into believing the sky would fall if Lloyd’s could not shed itself of its pre-1993 liabilities and start afresh. Today Lloyd’s chooses to ignore the fact that it was already awash in $7.1 billion of red ink before the 911 disaster. Add the WTC losses and Lloyd's financial condition is as bad as, or worse than, it was in 1996. US policyholders must not be subjected to another Equitas type bailout.

While Lloyd’s is publicly professing it is solvent and only coping with a liquidity problem, its leaders are clearly concerned about its ability to remain viable. Once again Lloyd’s is attempting to convince regulators that the world insurance market, and US policyholders in particular, will suffer without Lloyd’s facilities. Morgan Stanley rebutted this assertion rather bluntly in its November 28, 2001 industry report when it opined that there is nothing that strikes it "as unique in the legal or corporate structure of Lloyd’s that requires doing business there" and that "it is simply the geographic locus, licenses and underwriting talent that make the market valuable."

Many corporate members are finding that Lloyd’s is too expensive a place to do business. Some are simply withdrawing, others, like Lloyd’s underwriter Goshawk Insurance Holdings, are moving their capacity to Bermuda. According to Chris Fagan, Goshawk’s Finance Director, the company has elected to divert capital that it could have ploughed into Lloyds to finance a new reinsurance operation based in Bermuda. Fagan believes its transaction costs will be reduced by 4% because Bermuda is more efficient, requires less capital and offers lower taxes. Alleghany Underwriting Ltd., a Lloyd’s managing agency has formed Talbot Holdings as a Bermuda holding company to facilitate a management buyout of AUL from Alleghany Corp. because of the parent company’s exit from Lloyd’s.

New money is also flowing into Bermuda. Aon and Zurich together have supplied $400 million to capitalize Endurance Specialty Insurance Ltd., a proposed Bermuda based property-casualty insurer and reinsurer. White Mountains Insurance Group Ltd. is gathering $1 billion from investors to capitalize a new property-casualty reinsurer.

Prior to the WTC disaster, carriers had begun to significantly increase their rates for property-and casualty insurance and to tighten their underwriting standards. For the first time since the mid-1980s, buyers were feeling the pinch of a hard market. Preferred risks were typically being asked to pay 20% to 30% more to renew their insurance. Those with poor loss histories or high-risk operations that were forced to look to Lloyd’s and other non-admitted underwriters found their premiums doubling. Following the terrorist attacks, the market has become rock hard as rates become near prohibitive.

Lloyd’s looks to the hardening market for its salvation. Lloyd’s Riley has asserted that a 40% increase in the premium income written in 2001 would offset the WTC losses and stated "the steep rate rises that have been seen since September mean our financial performance is turning the corner rapidly." Many investors agree with him. With rate adequacy, they recognize the opportunity to turn a profit. Brit Insurance Ltd. has made an offering of its shares expected to raise a net $218 million to increase its 2002 underwriting capacity. Hiscox is raising $77 million to support the growth of its Lloyd’s business. Most notably, American International Group’s chairman and CEO, M.R. Greenberg has agreed to put $142 million into a newly formed Lloyd’s syndicate to be managed by Ascot Underwriting Ltd. and write general insurance.

According to Lloyd’s 2000 Global Report, since 1995 Lloyd’s has not been able to utilize even half of its capacity since R&R. Between 1995 and 2000 net written premiums only absorbed an average of approximately 47% of its capacity. In 2000 it only used 31.75%. It is estimated that less than 47% of Lloyd’s 2001 capacity will be consumed. Present indications are that Lloyd’s 2002 market capacity, net of new and renewal capital less departures, will remain in the $15 billion range. If it is able to hold its existing business and collect 40% more for assuming essentially the same risks, it is expected Lloyd’s will still only use approximately 50% of its capacity. With unused capacity at Lloyd’s and all of the new capacity being created in Bermuda, the competition for premium dollars will intensify. The hard market will soften as Lloyd’s and other underwriters duke it out for market shares. In the end, only the fit will survive.

Now is not the time for the NAIC to give Lloyd’s any slack. Lloyd’s is in turmoil. If it can’t survive in a competitive environment, there is not only plenty of capacity available to fill any void left by its demise, many of its corporate members will simply move their operations to Bermuda or other more efficient venues. The regulators must remind themselves that their first and foremost obligation is to protect US policyholders. Lloyd’s should not be allowed to continue to do business in the US until the NAIC audit has been completed and the regulators are satisfied that Lloyd’s can meet its obligations.