When Lloyd’s implemented its Reconstruction and Renewal Plan in 1996 by transferring its pre-1993 policy obligations to Equitas, it didn’t just start with a clean slate, it had already booked underwriting profits in its 1993, 1994 and 1995 years of accounts. Few could have foreseen that it would take less than six years for Lloyd’s to become mired in the quicksand of underwriting losses and again struggling for survival. During the five years following 1995, Lloyd’s underwriters lost more than $7 billion. The added weight of $2.7 billion of losses incurred on September 11, 2001 pulled Lloyd’s further under and has it gasping for breath.

Significantly, Lloyd’s is not publicly talking about another Equitas type bailout of its underwriters. Instead, it is attempting to divert attention away from its deep financial problems by focusing on what it needs to do on a going-forward basis to compete more efficiently and cost effectively. One of the greatest threats to Lloyd’s future is the movement of underwriting capacity to Bermuda and other venues with regulatory environments more conducive to profitability. On January 17^th, Lloyd’s Chairman Sax Riley laid out a package of reforms that, if approved by its members, will radically change the way Lloyd’s has operated for over 300 years. The question is; how should U.S. regulators respond to Lloyd’s restructuring plans?

Since its beginning in 1688, the backbone of Lloyd’s has been individuals willing to pledge their entire wealth as security for the insurance policies they subscribed to as underwriters. Individuals trading severally for their own account with unlimited liability created the marketplace phenomenon known as Lloyd’s of London. It was the individual Names that made it possible for brokers throughout the world to procure insurance for virtually any type of risk, from ships at sea to orbiting satellites and everything in between.

Prior to opening its doors to foreigners in 1970, Lloyd’s membership was limited to British citizens. Between 1970 and 1988, Lloyd’s membership grew from 6,000 U.K. citizens to a peak of 32,433 including over 3,400 Americans. Following accusations by many of the new members that they had been fraudulently induced to become members, over 22,500 withdrew. Under pressure to replace the lost capacity, in 1993 Lloyd’s opened its doors to limited liability corporate memberships. By 1997, 45% of Lloyd’s capacity was provided by corporate members. Today, there are only 2,490 individuals actively trading. Over 76% of Lloyd’s $17.4 billion of underwriting capacity is provided by 900 corporate members.

It should not come as a surprise to those who have been monitoring Lloyd’s since 1996 that the cornerstone of the proposed reforms is the phasing out of the remaining individual Names. If the phase-out is adopted, no new individual members will be accepted. Existing individuals who want to continue trading after January 2005 will have to form companies that meet Lloyd’s criteria for corporate membership. Lloyd’s will restructure its governance system and become little more than a franchiser with its corporate members as franchisees.

To hold existing corporate members and attract new ones, Lloyd’s proposals contemplate the abandonment of its three-year accounting system and adoption of generally accepted accounting principles. This will end the annual venture system which requires the market to renew its capital base each year.

The foundational question is; who will benefit from the proposed changes? Mr. Riley has stated that the aims of the reforms are "profitability, modernity and transparency". Each reform is clearly designed to hold existing, and attract new, corporate members to Lloyd’s. Lloyd’s is concerned that its members and other U.K. companies only managed to attract $1.97 billion of the $25+ billion in new capital infused into the marketplace since the WTC disaster and watched as Bermuda grabbed five times as much--$9.96 billion--for startup and existing Bermuda-based companies. If Lloyd’s cannot find a way to compete with Bermuda and other venues, its relevance in the world market will continue to diminish.

Lloyd’s advertising and public relations campaigns consistently project the false image that Lloyd’s is an insurance company. Its web site www.lloydsoflondon.com presents Lloyd’s as the world’s second largest commercial insurer and the third largest reinsurer, holding approximately five percent of the world’s reinsurance. Contrary to the image Lloyd’s is attempting to project, it is a marketplace and not an insurance company. It is 3,390 individual and corporate members trading severally and not jointly, for their own account as participants in 86 separate syndicates.

Although Lloyd’s is boasting that its capacity increased in 2002, the number of individual Names actively trading dropped from 2,848 to 2,450, with the number of corporate members increasing from 895 to 900. At the same time, the number of syndicates the members participated in dropped from 108 to 86. Just ten years ago, there were over 30,000 members trading through 279 syndicates. More importantly, capacity isn’t the issue. What Lloyd’s doesn’t like to talk about is that since R&R, the market’s utilization of Lloyd’s capacity has steadily declined from 48.12% in 1996 to less than 32% in 2001.

It therefore follows that the ones who have the most to gain if Lloyd’s can stay in business, are those select few brokers who serve as middlemen between buyers and Lloyd’s underwriters.

U.S. regulators should be asking the more important question, how will Lloyd’s reforms affect existing and future American policyholders and insurance carriers reinsured by Lloyd’s underwriters? The answer depends upon what changes, if any, Lloyd’s will have to make to the chain of security it relies upon to "guarantee" payment of losses sustained by its underwriting members.

Although U.S. regulators white-list syndicates as approved non-admitted carriers based upon the sum of capital pledged by their participants, the only mutualization that really binds the members together is a Central Fund established and administered by Lloyd’s. The purpose of the Central Fund is twofold. Certain assets may be used to cover underwriting deficiencies of members at the end of the preceding year to enable them to pass the solvency tests and other requirements. The fund may also be used to pay the losses of those members that become insolvent or have reached the maximum of their limited liability status. At present, it is estimated that the Central Fund has $400 million in assets, funded by annual assessments levied on Lloyd’s members based upon their allocated overall premium limit. The assets are supplemented by a five-year excess of loss agreement purchased by Lloyd’s in January 1999. The contract covers cash calls made by the Fund which remain unpaid after 28 days. It may pay up to $490 million annually when such calls exceed $140 million in any one year but, it is subject to a maximum payout of $700 million over the five year period.

In principle, the Central Fund is the last link in Lloyd’s chain of security. There are two other links that must be broken before the Fund will respond. The first is the members’ Premium Trust Funds. The PTF’s are controlled by the managing agents of the syndicates through which the members underwrite and include funds deposited into Lloyd’s American trust funds administered by CitiBank in New York. The managing agents deposit premiums and other money received on behalf of the Names’ accounts into their individual PTF. Payments from the PTF may be made to meet permitted expenses including reinsurance premiums and underwriting expenses.

After the funds in a member’s PTF account have been depleted, the member’s Funds at Lloyd’s account can be tapped. 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 the member’s FAL account. The amount of premium a member may write is governed by the amount held in the member’s FAL account. In practice, the members decide how much they want to deposit. By posting letters of credit and bank guarantees, members 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 deposited in their FAL. Based upon $17.4 billion of capacity, simple arithmetic indicates that the members’ FAL accounts total approximately $6.96 billion.

Since September 11, 2001 Lloyd’s has made two cash calls totaling $1.9 billion. Obviously, the PTF funds have been materially depleted and the infusion of cash was needed to pay policyholder claims and meet U.S. trust fund deposit requirements. Members have the option of using funds in their FAL accounts or drawing from their other resources to satisfy cash calls. Faced with approximately $10 billion of accumulated losses and less than $7 billion of FAL available, it’s only a matter of time until the FAL accounts of a significant number of individual Names and limited liability corporate members are exhausted. After they are depleted, the Central Fund will be expected to make up any short-fall.

While Lloyd’s touts the virtues of the Central Fund, its existence increases the underwriters’ cost of doing business. For the past several years, Lloyd’s has assessed its members 1% of their allocated overall premium limit. Lloyd’s can also make a proportionate call of $426 million upon the members’ PTF’s without their consent. Further amounts can be called with their prior consent. This process worked efficiently before limited liability corporations became the dominant suppliers of capacity and underwriters were in the black.

Because each underwriting year stands on its own, those members that are actively trading at the end of a calendar year must decide whether they want to reestablish their trading capacity for the succeeding year or withdraw. If they withdraw, voluntarily or otherwise, they remain responsible for their policy obligations until they are able to either close the year by purchasing reinsurance to close contracts after two additional years have passed, or all policy liabilities have been settled, or, if they are limited liability members, they have depleted their capital. Given the proposed reforms and approximately $10 billion of accumulated underwriting losses, it seems illogical that any individual member would want to continue to trade at Lloyd’s.

Once all the individuals are gone, the burden of replenishing the Central Fund will be borne entirely by limited liability members. It is difficult to imagine why any company would want to trade forward as a Lloyd’s member knowing that its financial resources may be confiscated to satisfy the obligations of insolvent members. Why would any underwriter accept this exposure when it can be avoided by moving to Bermuda or another more favorable trading venue?

If Lloyd’s wants to establish a new image as a franchiser and remove the tarnish from its trade name, it will have to find a way to assure payment of its members’ existing obligations. Any Equitas-like solution will be a hard sell. Too many Names, policyholders and claimants have been soured by their dealings with Equitas. There are also troubling indications that Equitas will not be able to fully pay all outstanding claims. Although the reinsured Names were led to believe that Equitas would provide finality to their policy obligations, they are now facing the prospect that they will be called upon to make up any shortfall. Even though Lloyd’s has no contractual obligation to help the Names, many believe Lloyd’s will move to protect its reputation by assuming their responsibilities. They need to accept the reality that this just isn’t going to happen unless it is mandated by the courts or regulators.

It is understandable that regulators may be torn by the conflicting views of Lloyd’s and its skeptics. It is the American Names Association’s position that Lloyd’s optimism about the future must be tempered by the realities of its past performance. Lloyd’s has been wrapped in turmoil of its own making for over two decades and has again reached the precipice of collapse. If regulators allow Lloyd’s to trade forward without complete assurance that Lloyd’s members will meet their past and present obligations, they will be putting a new generation of policyholders at risk. The issue regulators must address is; what, under current circumstances, should they do to protect the interest of Lloyd’s American policyholders?

ANA believes the evidence that Lloyd’s is in financial jeopardy is sufficiently persuasive to warrant regulators issuance of a cease and desist order preventing Lloyd’s members from underwriting any new or renewal policies covering risks located in the United States commencing no later than July 1, 2002. This should provide ample time for regulators to determine whether a void in the insurance market will be created that cannot be filled by alternative venues. The order should include provisions for case-by-case exemptions when it can be clearly demonstrated that the national interest will be jeopardized when an applicant engaged in an enterprise critical to the national interest cannot procure insurance from an alternative source.

Even if the regulators determine that the perpetuation of Lloyd’s presence in the U.S. market is needed, withdrawal of the cease and desist order should be conditioned upon the following:

To provide transparency to the past,

• Lloyd’s must provide satisfactorily verifiable documentation that it and its members have the means to settle all outstanding obligations for policies issued during the period January 1, 1993 through December 31, 2001.
• Lloyd’s must authorize the New York Superintendent of Insurance to make public the audit report of all of the Lloyd’s American trust funds and Equitas Trust Funds commissioned by the National Association of Insurance Commissioners in 2001.
• Any deficiency in the Lloyd’s American or Equitas trust funds must be eliminated before Lloyd’s can resume trading.
• Lloyd’s must make a commitment to assume the obligations of Names reinsured by Equitas in the event it invokes the proportional cover provisions of its reinsurance agreement.

To provide a clear image of Lloyd’s vision of the future,

• Lloyd’s must provide a plan of action setting forth the pertinent details of its reform plans with specific emphasis on how Lloyd’s, on a going forward basis, intends to protect American policyholders in the event of the insolvency of any of its past, present and future members.

In this way, regulators will have served their constituents well.