Lloyd’s vulnerabilities exposed by the soft market

At first glance, there is nothing exceptional in Lloyd’s results. Pre-tax profit remained flat in 2016 at £2.1 billion compared to the prior year. But the bulk of it, £1.64 billion, came from investment returns and foreign exchange movements. The core underwriting business contributed only £468 million to the total.

Lloyd’s investment returns were boosted in 2016 by a downward yield shift in the bond markets.

“Yield curves managed yet again to surprise people and fall,” says Lloyd’s chief financial officer John Parry during a March 30 annual results press conference. In addition, the investment income was propped up by foreign exchange gains, principally caused by sterling depreciation on the back of the UK’s Brexit vote.

“Those drivers are presumably not sustainable,” Parry admits. Sterling would need to go to parity with the dollar [from a current rate of £1 to $1.25] to produce a similar effect in the results for 2017, he noted.

The risk that this may not happen becomes particularly clear when comparing the 2016 investment results to the ones from 2015, when investment returns only contributed £75 million to pre-tax profit. It was, therefore, mainly a lucky coincidence that saved Lloyd’s from reporting a massive drop in profits for 2016.

In addition, on the underwriting side of the business, the 2016 results were flattered by prior-year reserve releases, however lower than in 2015.

Without prior-year reserve releases, Lloyd’s produced underwriting losses in all classes of business in the 2016 accident year. The performance was particularly bad in motor, which recorded a combined ratio of 109.3 percent in 2016, impacted by a severe reduction of the Ogden personal injury discount rate in the UK. A severe cut to the Ogden rate inflicted a substantial one-off increase in prior year reserves on UK motor re/insurers and is set to also affect the 2017 accounting year.

The marine business did not perform much better than motor with a combined ratio of 108.4 percent, followed closely by aviation, property and energy. Reinsurance was among the better performing classes with a combined ratio of 102.3 percent, as well as casualty with 102.9 percent.

“We have been flagging the movement in pricing over a number of years, and that’s coming into the numbers now in terms of the current accident year performance,” Parry explains.

The re/insurance industry is generally facing a soft market due to excess capacity. Pressure is particularly high in reinsurance property treaty, Parry notes.

While Lloyd’s cannot rely on investment returns to save its results in the future, it can also not blame large losses for the disappointing underwriting performance of the market.

“2016 was not an exceptional year for major claims,” Parry notes.

Major claims rose to £2.1 billion in 2016 from £0.7 billion in the previous year, primarily due to Hurricane Matthew and the Fort McMurray Wildfire in Canada.

The 2016 total was above the 15-year average of £1.7 billion, but it was far below exceptional years like 2011 with major claims of £4.9 billion.

The underwriting performance at Lloyd’s is worrying Parry not least because of the dependence it creates on unreliable prior year reserve releases. Referring to the total 93.9 percent combined ratio excluding major claims, he says that there is “not a lot of margin to take actually major claims and you are really needing that prior-year releases we’ve seen this year to come into profit.”

Lloyd’s has decided to take action and is conducting a portfolio review, focusing on the poorly performing classes, and is talking to syndicates about potential action.

“Everybody has got a class of business that is not doing very well,” Parry notes.

In the 2017 plans, Lloyd’s aims at reducing the business volume of particularly challenging classes by £400 million, Parry notes. In 2016, syndicates had already reacted to the lack of profitable underwriting opportunities. As a result, actually written premium was markedly below the total allowed level, Parry notes.

As part of the review, Lloyd’s can tell syndicates to pull out of certain businesses by using the argument that the Central Fund, which at the discretion of the Council of Lloyd’s, can meet any valid claim that cannot be met by a member, won’t back it in an emergency.

“We have all the tools we need from a prudential point of view to say that as a threat to the Central Fund we don’t see that as a sustainable line of business,” Parry says.

But reducing exposure to underperforming classes is not all Lloyd’s is doing. Because of the situation on the pricing side, Lloyd’s is also talking to managing agents about cost reduction opportunities.

Lloyd’s expense base across business acquisition costs and administrative expenses as a share of net earned premium is higher than competitors’, Parry notes.

“What we can do about acquisition costs is making sure that it is the focus of attention for underwriters,” Parry says. However, Lloyd’s does not have much power to control how the contracts are designed between brokers and underwriters regarding additional charges or fees and services, he admits.

Lloyd’s also wants to control administrative expenses. Operating expenses grew 11 percent year-on-year to £9.21 billion in 2016.

“As a corporation, we said that we would not spend more in 2017 than in 2016, and that’s absorbing things like Brexit,” Parry states.

Following the decision of the UK to leave the European Union, Lloyd’s is setting up a new European insurance company to be located in Brussels to secure access to the EU market after Brexit.

As a result of the Brexit negotiations, the UK re/insurance industry may lose its EU passporting rights. The mechanism provides a company authorised in one member state the ability to conduct cross-border business without being required to apply for any additional authorisation or hold assets locally.

The decision to create a unit in Brussels in order to avoid being cut off from the EU market will cost Lloyd’s “tens of millions [of pounds] rather than hundreds of millions [of pounds], Parry notes.

But the move will generate more cost, which needs to be collected from market members, he admits.