Is America's tragedy a risk too far for Lloyd's Names?

Just as it was beginning to recover from the disasters of the Nineties, Lloyd's has been hit by the fall-out of the World Trade Centre attacks, losses from which threaten to reach $100bn. For many Names, it could prove the final straw
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Two days after the terrorist attacks in America, the Lutine Bell clanged at Lloyd's of London. Recovered from a frigate that sank during the Napoleonic Wars, the bell was traditionally sounded to alert underwriters at the world's oldest and most famous insurance market to news of an overdue ship. Once meant bad news, twice indicated glad tidings.

Nowadays it is rung only on historic occasions, such as the death of Diana, Princess of Wales. This time it tolled to mourn the loss of thousands of lives in New York and Washington. But to many underwriters, brokers and agents swarming inside Richard Rogers' futuristic glass and steel building, it also signalled that Lloyd's is facing its biggest crisis since almost going out of business in the early 1990s.

The collapse of the World Trade Centre's twin towers on 11 September will lead to massive claims on the industry that will exceed the $20bn (£13.7bn) record set by Hurricane Andrew in 1992. How big the final number will be is anybody's guess. Like the toll of the missing in New York, it continues to rise. "Until losses reach $50bn, we believe the insurance system will stand up," says Christian Dinesen, sector analyst at the credit rating agency Standard & Poor's. "The same can be said for Lloyd's."

Insurance companies will have to pay out on policies covering life, property, employee compensation and contents loss, as well as on liability claims faced by airlines, airports and the landlords of the twin towers. And this, remember, is downtown Manhattan, the most expensive piece of real estate in the US.

Then there are business interruption claims. With so many buildings near the World Trade Centre in danger of collapse or inaccessible due to the clean-up operation, these claims alone could hit $5bn. Nobody knows for sure. The only certainty is that endless litigation looms.

Lloyd's, which declined to put anyone up for interview, has been slow to confirm how much it is on the hook for – hardly surprising when you consider it reports financial results three years in arrears. But it insists the losses are "manageable" within the context of its $27bn capital base. A further statement on the losses is expected today. Some analysts, however, believe the scale of the losses will be such that some of Lloyd's 108 syndicates will be wiped out because of their exposure to terrorist-related claims. That in turn raises question marks about whether this unique and anachronistic financial institution can survive in its present form.

Founded in Edward Lloyd's London coffee shop in 1688, not far from its current headquarters in the heart of the City of London, Lloyd's is not a company at all but a marketplace where individual insurers – the syndicates – gather to do business, providing insurance and reinsurance coverage. While the syndicates' fortunes might fluctuate from one year to the next, one thing was supposed to remain constant: Lloyd's reputation for integrity and fair play. Other insurers might backslide on their obligations to pay out in the event of a claim, but not Lloyd's.

"It's like an old-fashioned fruit and veg market," explains one underwriter. "Everybody is under one roof, sharing things like overheads, but each trader has their own stall and does their own business. If a trader goes bust there is a central fund that everybody contributes to so that the good name of Lloyd's is protected."

This form of gentlemanly capitalism was epitomised by Cuthbert Heath, one of Lloyd's most celebrated underwriters. When he was told of the San Francisco earthquake in 1906, he immediately cabled his agent: "Pay all our policyholders in full, irrespective of the terms of their policies."

Lloyd's is different in other ways, too. Originally it concentrated on the thriving marine insurance market. But over time it branched out into increasingly exotic forms of risk insurance, and it now covers anything from space satellite launches to a concert pianist's fingers. Famously, a Lloyd's syndicate once insured a comedy club against the possibility of a customer laughing to death.

For years what set Lloyd's apart from other insurers was the principle of unlimited liability for individual members, known as Names. Names provide risk capital, effectively pledging all their wealth as backing for the risk they are underwriting. Whereas the potential losses from investing in a quoted insurance company are limited to the number of shares owned, a Lloyd's Name is liable "down to his last shirt button" for losses incurred on his share of the syndicate.

To spread their risk and safeguard themselves against big losses, Names join other syndicates operating in different parts of the market. And just as a bookmaker lays off heavy bets on a favourite, Names also reinsure, either within Lloyd's or with an outside insurer.

Despite the huge risks, and for all the lack of information and transparency in this self-regulating market, Lloyd's became a magnet for the rich and famous. Membership was by invitation only. Joining this exclusive club didn't actually involve handing over much money, though. Names merely had to prove they had enough in liquid assets, excluding the value of their home. In the 1970s this sum amounted to £100,000; today it is £350,000.

Profits were calculated from the premiums paid plus the income from investing them less claims paid out, and distributed to the syndicate members. This helps explain how Lloyd's got its money-for-old-rope reputation. Apart from paying a joining fee, Names could effectively make money twice over because their capital could be invested elsewhere as long as Lloyd's itself was profitable. In reality, returns varied, depending on the incidence of natural or man-made disasters, but for many members that was not the point.

"To be a Name at Lloyd's ... was a matter of pride," writes Adam Raphael in his definitive book on the subject, Ultimate Risk. "It was not generally the route to a fortune but in most years the market made money."

A roll-call of pre-war Names reads like a Who's Who of the aristocracy and landed gentry: the Duke of Marlborough, the Cadogans and the Marquis of Salisbury, as well as the great banking families of Rothschild, Cazenove, Barings and Coutts. But Lloyd's also attracted aspiring members of the middle classes and provided valuable income for farmers whose wealth was mostly tied up in land. By the 1970s, after entry requirements were relaxed, a new kind of investor had been lured to Lloyd's. Sports stars such as Tony Jacklin, Henry Cooper, Virginia Wade and James Hunt were persuaded to join, as were Conservative politicians, including Edward Heath, Michael Howard and, of course, Jeffrey Archer. From the business world came Rocco Forte, Robert Maxwell and Lord Weidenfeld. At first they enjoyed high returns. But within a decade, Lloyd's was on its last legs, having racked up staggering losses of £8bn between 1988 and 1992. Names now discovered what unlimited liability really meant; that the flip side of potentially fat profits was the risk of financial ruin. Thousands of them faced bankruptcy. There were several reasons for this near-fatal reversal of fortune. Insurance is an inherently cyclical business and Lloyd's is particularly volatile because it underwrites so many big risks. The five-year period between 1988 and 1992 saw an unprecedented series of catastrophes, including the Piper Alpha oil rig disaster and two US hurricanes.

The rapid expansion of the insurance market in the 1980s had also led to overcapacity. Too much money was chasing too few risks, driving premiums down too low. What's more, a number of syndicates raised the risks they took on by reinsuring other syndicates in what one judge later likened to a dangerous game of pass the parcel, where the parcel was the underlying risk that was being moved around.

To make matters worse, there was a huge rise in US claims for industrial injuries and work-related conditions. In many cases, these claims were on policies that had been issued decades earlier, when the risks from materials such as asbestos were largely unknown. Policies were loosely worded, allowing US courts to rule later that claims could be made at any time in the future for accidents of exposure in the past.

As if that wasn't bad enough, Lloyd's unique system of closing accounts meant that it was the current Names who were forced to pay up. The system worked well for short-term risks such as motor insurance; by the end of the three-year accounting period almost all claims would be known and assessed.

But underwriters with exposure to so-called "long-tail" liabilities, such as asbestos, may not know their final profit or loss position for decades. If the liability cannot be accounted for and reinsured, underwriters are forced to leave the syndicate's financial year open.

As Adam Raphael explains in Ultimate Risk: "The problems this poses for Names are serious, for they have no idea what their eventual liabilities will be. Names on open years are unable to resign from Lloyd's until they are closed. Even death does not release the Name, because the liabilities of an open syndicate will be charged against his estate."

Perhaps the biggest factor, however, behind the crisis that engulfed Lloyd's in the late 1980s was the manner in which it was run which many consider to be antiquated. For years Lloyd's was run by a cosy committee of 16, largely made up of leading underwriters.

Until 1983 external Names were not represented at all, and had no protection under the Financial Services Act. This apparent lack of governance bred more than just complacency and conflicts of interest between underwriters and Names. Mr Raphael claims that it also encouraged some instances of insider dealing and other sharp practices. "Some underwriters cheated their Names by diverting funds for their own benefit," Mr Raphael recounts. "Others defrauded them by funnelling the best risks into baby syndicates from which their friends and families stood to benefit."

The devastating claims relating to asbestos and pollution in the 1980s, and the subsequent spiral of losses, destroyed the system of trust on which Lloyd's was based. As the losses continued to mount into the early 1990s, some Names were forced to sell their homes to cover their unlimited liabilities. Others suffered nervous breakdowns, or worse. More than a dozen suicides resulted.

Yet as recession gripped the wider economy, so too did a sense of schadenfreude among many outside the closed world of Lloyd's. This was based on the mistaken belief that it was only greedy toffs and celebrities with more money than sense who had been stung. In fact, the worst hit were the moderately well-off – Middle England, if you like.

Names banded together in an unprecedented attempt to mitigate losses and stave off bankruptcy. Some refused to pay their bills. Others formed action groups and took their cases to court. There was political pressure to act, too. At least 50 Tory MPs were Names and some of this number were potentially underwater. Had Lloyd's forced them to go under, John Major's slim majority would have been threatened, since bankrupts cannot sit in Parliament.

Faced with an open revolt among members, Lloyd's finally bowed to pressure to reform. All pre-1992 policies, including those covering asbestos and pollution, were transferred to a new, supposedly ring-fenced, company called Equitas. This effectively reinsured the liabilities of the Names.

But perhaps the most significant change was the introduction of corporate capital. Almost all syndicates now have some form of corporate backing from household insurers like Munich Re and Swiss Re – the largest reinsurers in the world. But the biggest believers in the future of Lloyd's are American, notably investment legend Warren Buffett. His Berkshire Hathaway conglomerate has been busy buying up managing agencies that oversee the syndicates and Mr Buffet now represents about 5 per cent of the Lloyd's market.

Analysts say the reforms have put Lloyd's in a stronger position to absorb the hit from the World Trade Centre attacks. "If it was just Names it would have been much more difficult, especially as they have been so weakened by asbestosis claims," says Roger Doig at investment bank JP Morgan. "But about 80 to 90 per cent of Lloyd's funding now comes from corporate capacity."

Meanwhile, the number of Names left at Lloyds has dwindled to just 2,800. Tens of thousands bailed out under the Reconstruction and Renewal (R&R) settlement in 1996 that was supposed to herald a new dawn for Lloyd's.

Tail-end litigation continues, although the biggest test case ended last year when Lloyd's was found not guilty of defrauding 230 Names. The Names had argued that they were misled about the impending extent of claims related to asbestos-linked conditions when they decided to join Lloyd's.

But, in a blistering attack, Justice Peter Cresswell accused Lloyd's of being responsible for "a catalogue of failings and incompetence in the 1980s by underwriters, managing agents, members' agents and others, [which] is staggering."

The actions of Lloyd's, he said, had "brought disgrace on one of the City's great markets." He added that many Names had argued strongly that the advice they were given "was at best grossly negligent".

Until the World Trade Centre attack, Lloyd's executives, led by chairman Sax Riley, had hoped to make a profit next year, breaking a losing streak that stretches back to 1996. The key question now is how much of Lloyd's central fund – the market's collective reserve – can withstand the World Trade Centre disaster. This pot currently stands at £340m in cash, according to a Lloyd's spokesman. The central fund itself is also reinsured to pay out a similar amount in any one year.

But Lloyd's legendary "chain of security" is about to be tested to the limit. When its credit rating was downgraded by S&P last week, the agency noted: "Lloyd's will bear substantial claims, albeit significantly reinsured, given its prominence in global aviation, large commercial property, and the reinsurance business. Claims will result in substantial cash calls being made on capital providers, many of whom are global insurance businesses facing similar claims from other areas of their business."

But if actuarial predictions are correct and World Trade Centre losses are between $50bn and $100bn, the entire insurance industry faces a crisis in which only the strongest will survive. Lloyd's, the most lowly rated of the 20 leading re-insurers, might not make it in its present form.

"Lloyd's is the weakest link," says Christopher Stockwell, chairman of the Lloyd's Names' Association. "It's a flawed structure. To mix unlimited liability Names with limited liability capital is like mixing oil with water." He reckons many Names, who have already seen their spare capital decimated by the huge slide in the stock market, won't be able to meet their claims. "The same will apply for some corporate-backed syndicates," he adds. "The risk to Lloyd's is not just the scale of the loss but where it falls."

If the costs of these failures exceed the amount available in the central fund, a downward spiral might result in which capital backers and potential policyholders withhold premiums and cash call demands and take their business elsewhere. It is the meltdown scenario Lloyd's dreads but swears will not happen.

In the meantime perhaps the best long-term solution is for Lloyd's to go the whole hog, do away with the Names system altogether and become just another big insurance company with limited liability.

"Incorporation is the only way to preserve something," warns Mr Stockwell.