There may be trouble ahead

This week, Lloyd’s announced a 2007 profit of over £3.8bn, marking a second successive year of record profits. The results – an aggregation of the results of all Lloyd’s insurers – show a market in good health despite softening rates.

The combined operating ratio (COR) rose slightly to 84% from 83.1%, while gross written premiums fell a little to £16.37bn from £16.41bn. The results represented a pre-tax return on capital of 29.3%, compared to 31.3% in 2006.

Looking forward, finance director Luke Savage did a good job of assuaging sub-prime fears. While revealing that up to100 potential claims or notifications of potential claims had come to his attention, he also noted that this was far fewer than the number prompted by the Enron scandal. “Having got our fingers burnt with Enron, the market has adapted and writes much less financial institutions business than previously”, he stressed.

Further, he said the investments of Lloyd’s and its members did not materially suffer from exposure to bond insurers’ credit wraps – although a small amount of directors’ and officers’ cover had been placed with monoline insurers.

And while the acquisition of Lloyd’s insurers continues apace, Savage warned that the cost of acquisition was set to rise through 2008.

Though the record-breaking profits are excellent news for Lloyd’s, the headline figures do not tell the full story, and the outlook is not as rosy as it seems.

Speaking after the results, the top executives at Lloyd’s were keen to hammer the point home: underwriting will be very difficult this year and onwards, and managing agents should be underwriting for profit rather than market share alone. Indeed, Charles Coyne, analyst at KBC Peel Hunt, believes there will be no upturn in the cycle until 2010 at the earliest.

Stripping out the investment returns and reserve releases in both 2006 and 2007, Andrew Hubbard, head of insurance services at accountant Mazars, discovered a large drop in underwriting profitability for 2007. Pure underwriting profit in 2007 was £983m, compared to £1,731m for 2006 , a fall of £748m.

He attributed this to both the softening market and a slightly worse claims experience in 2007. “It shows that the current underwriting year hasn’t been as good as 2006, but given the conditions, it would seem that they are good results,” he said.

Lloyd’s Savage acknowledged that investment returns from both Lloyd’s and its managing agents had been excellent in 2007, but warned similar earnings were unlikely in 2008 in light of the credit crisis. “It is a tough time for the entire financial services sector,” he noted while pointing out that Lloyd’s itself has taken steps to reduce its exposure to the crisis.

“In the current environment, no institution is completely safe, not even banks. We had up to £200m in a single bank but now we have spread [these funds] around a lot more. We also went out and bought government

bonds rather than corporate bonds to help protect ourselves.”

As for the investment activities of managing agents themselves, he said: “We have a set of investment rules in place, which basically state that compliance with the FSA rules on investment is necessary. But in practice they [managing agents] tend to be a pretty conservative bunch.”

Consequently, because investment practices in managing agents are traditionally conservative, the more volatile underwriting side comes under closer scrutiny. The boom-bust nature of the entire insurance industry is one of its novel features, but puts it at a disadvantage compared to the rest of the financial services sector.

This is why Lloyd’s made it clear in its three-year plan, released at the start of the year, that maintaining discipline is a top priority for the duration – and the Franchise Board will use a variety of tools to monitor pricing.

Finally, the Bermuda Question – how exactly does the Bermuda market compare with Lloyd’s, and is it faring better? Within the results brief, Lloyd’s included a comparison between itself and international markets – showing that all jurisdictions bar Bermuda had seen either the same or a slightly higher COR on 2006.

“Bermuda has done particularly well to get its combined ratio down,” said Hubbard. “This is even more impressive considering the comparatively higher level of catastrophes in 2007 than in 2006, which I would have expected to hit Bermuda harder.”

However, he acknowledged that the changes in COR were small across the board, and that difficulties arose when comparing Bermuda and Lloyd’s directly. “When you consider the fact that Lloyd’s writes specialist business in many more classes than Bermuda, you must compare the two on what lines they commonly write. When you do that, it’s clear that both are on a fairly level pegging.” IT