[Editor's Note: Andrew Wilkinson is a partner and Philip Hertz is a senior associate at the London office of Cadwalader, Wickersham & Taft. They have been involved in most of the major London market insurance insolvencies and have advised a large number of ceding companies and policyholders as to the impact of the Lloyd's Reconstruction & Renewal plan and other Lloyd's-related issues. The views expressed in this commentary are strictly those of the authors and in no way represent the views or opinions of Cadwalader, Wickersham & Taft, its clients, or Mealey publications. Responses to this article are welcome. Copyright 1998 by the authors.]
Introduction
In September 1996, Lloyds of London implemented its Reconstruction and Renewal plan (or R&R) - an extremely complex market restructuring - under which Lloyd's sought to put an end to market wide litigation as well as "draw a line" under prior year losses by reinsuring the 1992 and prior year business underwritten by its members (or Names) into Equitas, a UK authorised reinsurer.
In this commentary, we consider the reasons behind, and the aims of, the Lloyd's R&R plan before examining the Equitas reinsurance structure.
We will then consider whether the aims of R&R have been achieved and, in particular, the likelihood of a future Equitas failure and the impact this might have on not only ceding companies and policyholders with pre-1992 exposures but also the ongoing Lloyd's market.
The reasons behind and the aims of R&R
As is, by now, ancient history, the Lloyds market suffered huge losses between 1988 and 1992, totalling approximately #8 billion. These losses largely arose as a result of a combination of asbestosis and pollution related claims and the practice in the market at the time of placing inter-syndicate/inter-company excess of loss retrocession in respect of catastrophe losses - otherwise known as the London Market Excess of Loss ("LMX") spiral. These large losses ultimately led to a web of Name's litigation against many participants in the Lloyds market and forced many Names to cease underwriting. The weight of outstanding debts also impacted Lloyd's solvency and liquidity.
As a result, R&R was implemented which consisted of two principal components.
First, a settlement offer was made by the market to Names which required the Names to agree to waive existing and future claims against Lloyd's and other market participants in connection with their 1992 and prior business. Full acceptance of the settlement offer involved the Names receiving the benefit of a settlement fund worth approximately #3.2 billion. The hope and expectation was that this settlement would put an end (at least, in relation to those Names who accepted R&R) to litigation against Lloyd's managing and members' agents, brokers and Lloyd's itself.
The second component of the R&R plan was the Equitas reinsurance to close structure which was designed to "draw a line" under the markets' 1992 and prior year liabilities and provide Names with "finality" in respect of these liabilities. "Equitas" actually consists of two Treasury authorised reinsurance companies - Equitas Reinsurance Limited ("ERL") and Equitas Limited ("EL") - which were formed for the purpose of reinsuring Names' liabilities in relation to 1992 and prior business. The premium calculated for this reinsurance was #14.7 billion (consisting of amounts contributed by Lloyd's, Lloyd's market participants and the Names themselves). In order to understand whether R&R has (or can) achieve its aims, it is crucial to understand how the Equitas reinsurance structure works.
The Equitas Reinsurance Structure
(a) General Overview
Under the Equitas structure, the 1992 and prior year business of Names is reinsured by Equitas. The primary Equitas reinsurance vehicle is ERL, which is itself reinsured by EL. The rational for two reinsurance vehicles has been explained on the basis of tax planning. ERL's reinsurance obligation is contained in a reinsurance contract dated 3 September 1996 ("Reinsurance Contract"). The retrocession of EL's reinsurance liabilities to ERL is contained in a retrocession agreement of the same date ("Retrocession Contract"). Equitas discharges its reinsurance obligations to Names by paying policyholders direct or procuring the payment of policyholders out of overseas trust funds established in local jurisdictions for the benefit of policyholders resident in those jurisdictions (see Figure 1). The principal overseas trust funds exist in the United States and these are discussed later.
Notwithstanding the structure's goal of finality, Names remain "on the hook" for their 1992 and prior year liabilities. The theory is that as long as Equitas pays, Names are "free and clear". However, if for any reason Equitas cannot pay 100% of a Name's liability (and a proportionate payment plan is implemented and/or Equitas falls into insolvency), the policyholder may look to the Name for recovery of the unpaid balance.
On the "assets side", syndicate reinsurances covering the 1992 and prior year business (as well as certain other rights) were assigned by Names to ERL and then "on-assigned" by ERL to EL. The assignment by Names of these and other rights formed part of the premium payable to ERL for the reinsurance coverage provided.
The Reinsurance Contract also makes it clear that the management of the run-off of the 1992 and prior year business has been delegated by Names to ERL. Under the Retrocession Contract, this function is sub-delegated by ERL to EL. EL has sub-delegated this function further to a number of sub-contractors.
(b) The Reinsurance to Close Structure
The reinsurance obligation of ERL under the Reinsurance Contract has broadly been described as what is known at Lloyd's as a "reinsurance to close". This rather begs the question as to what "reinsurance to close" actually is.
A distinctive feature of the Lloyd's market (at least, at the moment) is that the syndicates have an unusual accounting structure. While syndicates appear to trade continuously under the same underwriter, they are in fact "annual ventures"; therefore at the end of each year of account they are wound up. However the results are only calculated 3 years in arrears. The reason for this has been stated to be the need to preserve equity between Names and different syndicate years and the fact that the calculation of profits or losses should be made at the end of a 36 month period when the results should, in theory, be clear. Obviously the process is uncertain and an underwriter with exposure to "long tail" liabilities, such as pollution or asbestosis may not know his true profit or loss position for decades.
The accounting device used to "bridge" this uncertainty is known as a "reinsurance to close" ("RITC"), an unlimited reinsurance policy placed by the closing syndicate with its successor year. Therefore, in the ordinary course, after three years, the liabilities of a particular underwriting year of a syndicate will be reinsured into the earliest open underwriting year.
As a strict matter of English law, "reinsurance to close" does not operate as a full transfer of risk from the Names on the closing year to the Names on the next open year but rather as a simple reinsurance of the liabilities of the Names on the closing year. The significance of this is three-fold.
First, the original Names on the closed year remain personally liable to the policyholders.
Second, the original Names on the closed year have the benefit of a 100% reinsurance of those liabilities by Names on the open year.
Third, whilst the primary liabilities remain with the Names on the old year, the rights (including the right to claim reinsurance recoveries from "external" reinsurers) are purportedly "assigned" to Names on the open year.
While it would appear to be broadly correct to describe the Equitas reinsurance structure as a "reinsurance to close", the basic structure of a normal reinsurance to close is modified somewhat. The best way to describe this is to deal, in turn, with the reinsurance obligations of ERL and then its (and EL's) rights to collect in reinsurance recoveries. We will then look at one of the more unique features of the Equitas reinsurance structure - the proportionate cover plan.
(i) Obligations to Policyholders
As explained, the Reinsurance Contract provides that ERL's primary obligation is to reinsure and indemnify the Names in respect of their 1992 and prior year liabilities (whether on open or closed year syndicates). ERL's reinsurance obligations to Names will be discharged either by payments to policyholders via particular overseas trust funds or, in other cases, by direct payment to the relevant policyholders.
This "payment" covenant to policyholders is supplemental (and subject) to an assignment by Names (by way of security) of their rights of recovery against ERL under the Reinsurance Contract to another Equitas group company - Equitas Policyholders Trust Limited ("Equitas Policyholders trustee") - to be held on trust by the Equitas Policyholders trustee for the discharge and payment of Names' obligations to policyholders.
It would appear that there is a distinction in the operation of the Equitas Policyholders Trust between a situation in which ERL remains solvent and after any insolvency of ERL.
While ERL is solvent, the Equitas Policyholders Trust would seem to have no active function because under the terms of the Reinsurance Contract, ERL is under an obligation to make payments direct to policyholders or procure payment in accordance with the relevant overseas trust deeds.
It would, therefore, appear that the only circumstances in which the Equitas Policyholders trustee need do anything during a period of ERL's solvency is if ERL fails to make any payment it is due to make to underlying policyholders under the terms of the Reinsurance Contract.
In such circumstances, the Equitas Policyholders trustee can be required to bring an action against ERL for damages or specific performance for it to perform its payment obligations to the underlying policyholder. To the extent that any sums are recovered in such actions, the Equitas Policyholders trustee is required to pay the proceeds either to the underlying policyholder (if it has not already received payment from the Name), or if the Name has paid the underlying policyholders, to the Name.
If ERL is insolvent (and there are a number of defined insolvency events in the Equitas Policyholders Trust instrument including the presentation of a winding-up petition against ERL or ERL being unable to pay its debts in accordance with the trust under the UK Insolvency Act 1986), the Equitas Policyholders trustee is obliged to take steps in the liquidation of ERL (or any scheme of arrangement implemented for ERL) to prove or claim for the benefit of underlying policyholders in respect of the rights under the Reinsurance Contract that have been assigned to it.
In these circumstances, any proceeds received by the Equitas Policyholders trustee will be distributed among the underlying policyholders rateably in proportion to the amount which the Equitas Policyholders trustee determines is owing to them from Names in respect of their underlying policies.
(ii) Reinsurance Recoveries
On the "assets side" under the Reinsurance Contract, all syndicate reinsurances in respect of 1992 and prior years underlying business (as well as certain other rights) have been assigned to ERL and under the Retrocession Contract on-assigned by ERL to EL. This assignment was made as part of the premium for the reinsurance retrocession.
As a result, in relation to the collection of outward reinsurances, the position would appear to be that EL (as well as any contractor to whom it delegates its functions) is the entity which has the right to collect syndicate reinsurances.
(c) The Proportionate Cover Plan
One of the most unique (as well as controversial) features of the Equitas reinsurance structure is the fact that the Reinsurance Contract provides for the possibility of the implementation of a proportionate cover plan.
Under the proportionate cover plan, EL and ERL will be entitled to pay a proportion of each claim under the Reinsurance Contract and Retrocession Contract, respectively, and their indemnity obligations will then be adjusted downwards, accordingly. Due to the fact that Names retain ultimate liability for these claims, policyholders will then be forced to pursue Names for the proportion of any claim not met by ERL.
The proportionate cover plan proposals provide that the boards of both ERL and EL must decide when (and if so how) a proportionate cover proposal should be implemented.
Further, since assets related to American (as well as Canadian) business are held subject to separate overseas trusts, the relevant boards of ERL and EL will be required to value the assets and estimate separately the liabilities for each of these categories of business and the remainder of the business and will then set a pay-out rate for each of the three "pots", equal to the ratio of relevant assets to relevant liabilities (in the case of the American or Canadian trust "pots" this will be the higher of the average ratio across all business and the ratio for the "pot" on its own).
The inclusion of the proportionate cover plan in the Reinsurance Contract is justified in the Settlement Offer Document issued by Lloyd's in July 1996 on the basis that, given the inherent uncertainty in any insurance business, there is a risk that Equitas may not be able to meet the 1992 and prior liabilities in full. If Equitas determines that there are insufficient assets to meet its liabilities in full it must then decide whether to implement a proportionate cover plan (or, if such a plan is already in place, to amend the existing plan) or pursue normal insolvency procedures (including a scheme of arrangement).
The rationale behind the introduction of the proportionate cover plan into the Reinsurance Contract is that the "usual" insolvency procedures are said to have a number of disadvantages including a sometimes lengthy delay on claims payment and, initially, a low level of payout. Lloyd's claims that the proportionate cover plan is advantageous due to the fact that Equitas is being established for a single transaction and is, therefore, in the unique position of being able to agree a proposal with its body of creditors at the outset in order to deal with the contingency that it may be unable to pay its claims in full.
However, the key question is what the effect of such a plan will be.
As a result of the inclusion of the proportionate cover proposals, we consider that there is more of a risk that Names may never obtain "finality" - i.e. they will always have a residual liability to policyholders in the event that Equitas fails to pay their liabilities in full. In the event that a proportionate cover plan is implemented whereby Equitas pays, for example, only 70% of 1992 and prior year liabilities, policyholders will be left to claim for the balance against the Names. Since, on an English law analysis of the position, any claim by a policyholder must be made against the Names who were on the syndicate in the year of account when the insurance or reinsurance was originally written, this then gives rise to the problem that policyholders may not be able to locate the Names against whom they have claims - particularly those Names which wrote old year business in, say, the 1960's. Further, even if the relevant Names are located, the cost of suing each Name individually may well be prohibitive. Finally, there is also a strong possibility that such Names may be either dead or bankrupt.
(d) The Lloyd's US Trust Funds
In addition to the above infra-structure, there are a number of US trust funds securing Lloyd's U.S. obligations in respect of the 1992 and prior year business. All of these funds form a chain of security to support the 1992 and prior year business (see Figure 2).
Payments to policyholders on US Dollar denominated business will be made initially out of the Lloyd's American Trust Fund ("LATF"). The LATF was the original US trust fund set up in 1939 to ensure that the impending World War would not prevent Lloyd's from meeting its claims, were its assets to be seized. Following regulatory revisions in the US, the LATF now only supports pre-August 1995 business. The LATF trustee is Citibank NA ("Citibank")
As part of R&R, a large portion of assets in the LATF - some US$5.5 billion - were transferred into a new trust fund - the Equitas American Trust Fund ("EATF") - which was established to support and secure Equitas' reinsurance obligations to Names. Citibank in its capacity as LATF trustee is the sole beneficiary of the EATF. As a result, payments from the EATF will be channelled via the LATF to policyholders. However, it will not be possible for policyholders to make direct claims against the EATF.
The next link in the chain are the CFUS 1 and 2. The original Central Fund United States Trust Fund - ("CFUS (1)") was the U.S. Branch of the Central Fund in London, one of whose purposes is to make good on defaults by Lloyd's Names. In 1995, Lloyd's established the Central Fund United States Trust Fund (Number 2) ("CFUS (2)"), which it funded with a US$500,000,000 contribution which was required after the New York Insurance Department ("NYID") determined that the LATF was underfunded on a gross basis. Direct claims are only permitted against these funds 5 days after a claim has been filed with the LATF.
The last line of defence are the Lloyd's American Surplus or Excess Lines Insurance Joint Asset Trust Fund (collectively, the JATFs) established by Lloyd's in 1993. Each JATF is meant to fund only the required statutory surplus, not liabilities. The JATFs are now critical because they secure both the business reinsured into Equitas as well as Lloyd's ongoing business. As a result, they represent a potential breach in the "ring fence" between the old and new Lloyd's: if either the reinsurance or surplus lines JATF falls below the requisite levels because of claims on 1992 and prior business, the ongoing market will be required to top it up in order to continue to do the type of U.S. business it supports.
Have the aims of R&R been achieved?
Having looked at the reasons behind, and aims of, R&R as well as the Equitas reinsurance structure itself, the issue then arises as to whether the aims of R&R have been achieved.
It is clear that R&R has obviously been successful - bar a small number of exceptional claims - in stemming the vast majority of litigation against Lloyds and market participants. In addition R&R has been successful in boosting attempts to separate the problems of the past from the operation of the ongoing market. On the back of this the reputation of the Lloyd's market as a whole has been enhanced with a number of reforms being made including a strengthening of both the "chain of security" at Lloyd's and the regulatory management in the market, with oversight of market regulation to pass to the Financial Services Authority at some time next year. Lloyd's has also, most recently, opened itself up as a domicile for "captives".
These factors together with the market's excellent brand, business reputation and strong market share in many of its chosen classes have lead to an enhanced reputation, particularly in the light of record global results for the 1995 year of account.
Additionally, with the influx of corporate capital - which has now reached 60% of capacity (and is predicted by A.M. Best to rise to 70% in 1999) - the market has also been subject to a lively and sometimes fierce debate between individual and corporate Names at Lloyd's as to the structure of the market and the future of the "annual venture" nature of syndicates and the three year accounting system.
In the wake of the implementation of R&R and in light of Lloyd's market's seemingly good position in the insurance market, Lloyd's as a whole has also received security ratings from both Standard & Poor and A.M. Best of A+ and A (Excellent), respectively. A.M. Best and Standard & Poor reconfirmed these ratings in April and July of this year, respectively.
Notwithstanding these achievements, however, one of the main questions concerning a number of market participants is whether R&R will be successful in achieving "finality" for Names in respect of their 1992 and prior year business.
The achievement of "finality" for Names is important not only from the point of view of the Names who wrote "old year" business - who remain on the hook in respect of unpaid balances by Equitas - but also for the new market. As is apparent from the structure of the US trust funds the JATFs provide security not only for the "old year" liabilities but also for the "new year" liabilities and remains an integral part of Lloyd's licence to do business in the US. If Equitas fails and policyholders begin to make claims against the JATFs, the new market will be faced with a choice - either to keep Lloyd's underwriting license in the US alive by possibly having to continually top up the JATFs or not. Given that the US business accounts for a substantial proportion of Lloyd's business this will be a difficult decision to make. We shall look at this again below.
"Finality" will only be achieved if Equitas is able to pay the 1992 and prior year business liabilities in full and it will only be able to do so, principally, if its reserves are sufficient to support these liabilities.
Equitas: sufficiently reserved?
From the Settlement Offer Document published in July 1996 and distributed to all Names, in setting the R&R premium and providing "finality" to Names in respect of their 1992 and prior year liabilities, Lloyd's had two principal objectives:
- to ensure that Equitas had reserves based on a "best estimate" of its future obligations; and
- to ensure that the premium had been allocated to Names on a consistent basis by applying reserving approaches across all syndicates.
The premium for the reinsurance into Equitas was calculated at #14.7 billion which was stated to include an estimate of the 1992 and prior year insurance liabilities and the future operating costs of Equitas.
The calculation of Equitas' reserves followed probably one of the most comprehensive reserving projects ever undertaken. This project was carried over two and a half years.
The 1992 and prior year liabilities were divided into two broad categories:
- APH liabilities - asbestosis, pollution and health related claims which may take many years to develop - up to some 20 to 40 years; and
- non-APH liabilities - the majority of which could be settled in a much shorter time frame.
It was estimated that Equitas liabilities were made up of approximately 40% of APH and 60% non-APH liabilities.
Therefore, it is clear that an immense effort has been put into actuarially estimating the reserves required for Equitas. Further, in the period ending 31 March 1997, Equitas' surplus increased from #588 million to #617 million. Following the publication of Equitas' report and accounts for the period ending 31 March 1998, the surplus has increased further to #718m, following Equitas' agreement with Lloyd's this year to reinsure the liabilities of Lioncover - the reinsurance company incorporated in 1987 to reinsure the liabilities of Names on the PCW syndicates - and the #66 million payment by Lloyd's to Equitas to settle the #100 million debt owing by Lloyd's to Equitas under R&R.
Notwithstanding all of this, however, the inherent uncertainties in Equitas' long-tail business - principally the APH business - is still a source of concern for some in the market.
This is a view which has been confirmed in part by the rating reports produced by both Standard & Poor and A.M. Best as well as the report produced by Moody's.
Although Standard & Poor rated the Lloyd's market at A+ in October 1997 and re-confirmed that rating in July this year, it is clear that Standard & Poor's rating did not apply to Equitas itself. Notwithstanding this, Standard & Poor acknowledge that Equitas' liabilities and, in particular, the potential for Equitas' loss reserves to deteriorate significantly did have a bearing on the continuing Lloyd's market and this was a factor which had been reflected in the rating assigned.
In particular, it was stated in the Standard & Poor October 1997 report that:
"there is a strong possibility that the Equitas surplus will be eroded and that it could become insolvent at some point in the future"
This comment is almost made in passing but is something about which many policyholders and ceding companies with 1992 and prior year exposures have expressed concern, particularly in the light of the fact that there is the - as yet completely undetermined - potential for liabilities other than APH liabilities to impact upon Equitas' reserves.
The two types of exposure which come to mind relate to Tobacco litigation and, more topically, the "Millennium Bug" or Y2K exposure.
It is clear from documents disclosed in one of the Tobacco Litigation cases brought by the State of Louisiana that Lloyd's was an insurer of at least one of the Big Tobacco companies. As against this, however, in Equitas' first report and accounts, Equitas' CEO, Michael Crall, did state the company's belief that "no significant tobacco-related claims against Equitas will arise".
In relation to Y2K, in a recent report by Paul Hodges of Schroders, it is clear that estimates for world-wide repair and litigation results relating to the Y2K problem could run as high as US$3.5 trillion with the potential for the trigger of liability to impact across a large time frame. This could have the result that Y2K liability could indeed impact old year policies (particularly Comprehensive General Liability policies) covered by the Equitas reinsurance and, as a result, Equitas' reserves. Whether or not this will occur will depend on the Courts (particularly those in the US) and their interpretation of the coverage triggers in the relevant policies. On the basis of precedent (namely, in relation to asbestosis and pollution covers), there is a strong possibility that the Courts will find coverage triggers which stretch back many years, for example, to the installation of the computer or its initial programming.
That this is a potential risk for Lloyd's became clear in March of this year when Lloyd's was reported to have received its first notifications of Y2K claims. This was billed in the press as a "trickle which is expected to grow significantly as the millennium nears". Details of these claims are not publicly available but they were reported to be in the professional indemnity sector. According to further press reports in July of this year, Lloyd's is reported to have been hit by a flood of millennium claims. As with many other participants in the insurance industry, the Y2K problem is an issue which Lloyd's is treating very seriously. In its Global Results and Annual Report for 1997 it is stated to be addressing the issue from both the regulatory and commercial standpoint.
The adequacy of Equitas' reserves is also dealt with in detail in Moody's October 1997 report. Moody's comment that the Reconstruction & Renewal Plan and, in particular, the Reconstruction & Renewal premium was necessarily a compromise. On the one hand, it involved extensive work by the Equitas Reserving Project to estimate ultimate losses, but on the other hand it had to appeal to disgruntled Names in order to be accepted. Moody's states that it believes that:
"this process of negotiation, symbolised by the substantial credits provided to Names (essentially, bad debt write-offs), could have weakened Lloyd's ability to set strong provisions at Equitas. Because of the nature of the liabilities (e.g. ultimate losses are hard to estimate; long tail; discounted), and the relative illiquidity and weak capitalisation of Equitas, future deviations from the assumptions made during the reserving exercise could have material consequences for its financial strength."
At the time of the Moody's report, Moody's stated that on the basis of the September 1996 balance sheet, a 10% write-off of debtors or reinsurance receivables, all other things being equal, would wipe out the entire capital base of Equitas.
The potential for Equitas' liabilities to increase is also dependant on the discount rate applied to its long-tail liabilities. The discount rate was originally 6% but this has now been cut to 5.25% in order to reflect the impact of recent movements in the global financial markets on bond yields, which have fallen. This has added #311 million to Equitas' liability total and given current global economic conditions, the likelihood is that this rate will fall and not rise in the future.
On the assets side, Moody's commented that on a net discounted basis, 60% of technical reserves relate to short term liabilities and 40% to APH. They report that it is estimated that APH liabilities will be paid over a period in excess of 40 years (hence the application of a discount rate), while short term liabilities are expected to be paid within 5 years. In a recent conference speech Rafael Villarreal of Moody's (the individual primarily responsible for producing the Moody's October 1997 report) commented that this situation may create a tiered ranking, giving economic seniority to short tail policyholders - the corollary being that long term policyholders may be left "out of pocket". He stated that because short tail policyholders are expected to receive payments of between #6 billion to##8 billion within 5 years, such payments could deplete Equitas's funds which, in turn, would prevent the capital appreciation needed on Equitas's assets to pay long-tail claims.
This limitation in Equitas's financial flexibility was also recognise in the most recent A.M. Best report where it is stated that Equitas "can generate no income other than the income from its investments". A.M. Best also recognise that Equitas' ability "to settle its liabilities in full is also dependant upon the generation of sufficient investment income to match the increase in insurance liabilities7 [but that] 7 there are uncertainties in forecasting the generation of this investment income which may vary due to changes in interest rates, exchange rates, the ultimate cost or claims and the timing of liabilities, settlements and reinsurance recoveries".
As a final comment on this, the NAIC, in its recent report "Lloyd's: A Review by US State Insurance Regulators" also seem to accept that a key item for further future review is the development of losses in Equitas on pre-1993 business.
As for the ongoing market, what does the future with Equitas hold?
Impact on on-going market
As has become clear from our discussion of the Equitas reinsurance structure, there is not an absolute "firebreak" between the old and new Lloyd's. There is a possibility, as already discussed, that if Equitas' reserves do become exhausted, the JATFs might be used to pay 1992 and prior year claims.
At this point (and as already explained), the new market has a choice - continue to top up the JATFs in order to retain Lloyd's US licence or refuse to do so. Such refusal may well impact seriously on the new market given that US business accounts for a large proportion of Lloyd's overall business. In its recent report "Lloyd's: A Review by US State Insurance Regulators", the NAIC Review Team state that Lloyd's 1997 worldwide gross premiums amounted to approximately $12.8 billion of which the US accounted for 32% or $4.1 billion.
In such a situation, problems could also be caused for Names still exposed on the 1992 and prior year business which have continued to write business in new Lloyd's, since such Names will then be exposed to old year risks and this will inevitably effect their ability to continue to provide capital to support the new market. With the ever increasing influx of corporate Names since 1994, however, this may not prove to be such a major problem.
The scenario in which new Lloyd's is asked to fund old Lloyd's was focused upon in the A.M. Best rating reports. Best states that if Equitas nears the point of considering the option of proportionate cover, Lloyd's may elect to provide a gifted contribution to Equitas to maintain it's solvency. The likelihood of Names approving such a contribution will be dependent upon the current profitability of Lloyd's and its near term prospects. If Lloyd's is enjoying good profitability, Best would expect that Names would approve of a contribution to Equitas provided that it was reasonable in relationship to the ongoing profitability of Lloyd's. However, if it is not, Best state that it would question the Names willingness to fund the capital shortfall in Equitas.
This is particularly important for at least three reasons.
(i) it is clear from reports issued earlier this year as well as the comments of Max Taylor himself in the Global Results and Annual Report that the profitability of the market place as a whole is due to decline - particularly in the 1998 year of account. In the Chairman's statement Max Taylor said that:
"Projections for 1996 and 1997 show a reduction in profitability, reflecting lower rating conditions. Regrettably, in 1998 conditions are tougher still. Underwriters will need to use all their skill and ingenuity to produce profits at the current time and we must prepare for the likelihood that some will not be able to achieve this."
Further, in August of this year, Moody's SURL forecast that at least one in four Lloyd's syndicates would make losses on their 1998 and 1999 years of accounts as a result of fierce competition in global insurance markets. In addition, while there would be an overall Lloyd's market profit of 2.8% on capacity for 1998 and 1.9% on 1999, Moody's added that both these would be loss making if impacted by a significant catastrophe. Similar reports have also emanated from other sources.
(ii) it is also clear that as the years go on the capital base of Lloyd's is likely to be supplied increasingly by corporate capital providers as opposed to individual Names. This is eminently clear from the current trends in the market and Best predicts a 70% corporate capacity in 1999. While the ultimate extinction of individual names may now have been prevented following assurances given in a letter from Lloyd's chairman, Max Taylor, that individual investors would not be forcibly removed from the market, the trend towards corporate capacity seems unceasing with reported bids by Cox Insurance and Goshawk (among others) for capacity from individual investors; and
(iii) finally, should the situation ever come about that more funds are required for Equitas, market confidence is likely to be at an extremely low ebb.
Putting this all together there must be some possibility that profitability will drop off at Lloyd's and continue in steady decline (particularly in light of the increased hurricane activity in the Caribbean and North America as well as the Y2K threat). If a cash call is made on new Lloyd's to fund any deficiency at Equitas, Names are unlikely to respond. This may become more of a risk given that by that time a vast number of Names will be corporate Names with responsibilities to their shareholders.
In such circumstances, what we may see happening is the collapse of Equitas and the Lloyd's market with the corporate Names abandoning their Lloyd's vehicles overnight and continuing to write the same business in mirror company market entities.
Conclusions
What conclusions can be drawn from the above?
R & R has enhanced the Lloyd's market reputation on one level but, as one might expect, it is difficult to draw any concrete conclusions as to whether "finality" for Names will ever be achieved. The only real conclusion that can be made is that the level of reserves in Equitas will continue to be of concern in the future to policyholders and ceding companies with exposures - particularly long-tail exposures - to Equitas as well as the on-going market, in the light of:
(i) the rise in the threat of Y2K related liabilities and the uncertainty surrounding investment returns;
(ii) the reported drop in profitability in the Lloyd's market in the coming years; and
(iii) the profile of members at Lloyd's
What such ceding companies and policyholders with exposure on 1992 and prior year business may be able to do about this problem is another story.