Good afternoon ladies and gentlemen. First of all Happy New Year to all of you – if there is one thing we can be certain of this year, it is that 2009 will be a challenging year.
Back to the title of this speech - I fear that this could be a very short speech because the answer to the question that the IIL have asked me is - there is no magic answer. It really is like asking ‘how long is a piece of string?’
The problem is really that there are so many variables. The answer given will depend on who you ask and when you ask them. It will also mean quite different things to different people.
For example, shareholders and individual investors want the best returns on the minimum amount of capital outlaid. Rating agencies in contrast want the highest amount of capital to demonstrate insurance strength and viability. Brokers want syndicates to have as substantial underwriting capacity as possible so they can get the best rates and choice for their clients and Managing Agents want the flexibility to be able to take advantage of changing market conditions but with enough capacity to ensure that fixed costs are covered at any time.
At Lloyd’s we adopt a goldilocks approach – not too hot and not too cold. So when rates are soft we want the minimum capacity to stay in the game and when rates harden, after a market changing event, we want the ability to take maximum advantage of prevailing conditions. Basically we want the fairytale ending where everyone lives happy ever after and we make a profit across the cycle. Our role is to ensure that optimal syndicate capacity matches underlying market conditions and our driver, rightly or wrongly, has always been focussed on gross underwriting profitability. It was the reason that the Franchise system was established and I was appointed.
I think it’s fine to say that as a market, we have gone a long way in recent years in order to change our practices, our culture and our mentality so that we don’t return to the days of boom and bust. A huge part of this work has involved capacity optimisation. We have come a long way but there is still a way to go.
So what I want to do today is give you my insight and try and unravel the capacity conundrum. In doing so I will offer my view on why it is so important to position the capacity argument relative to cycle management.
So in the words of Countdown what is today’s capacity conundrum?
I want to start with capacity trends.
Every year at this time, there is frenzy to discover what Lloyd’s capacity is. Up until last year, this was a key fixture on the Lloyd’s calendar and the figure was used as a barometer to illustrate the market’s strength. No other insurance company publicly announces how much business they are intending to write to their competitors and now thankfully nor do we any more.
Despite past interest, capacity is a meaningless number. It is merely an indication of your ability to write business rather than your intention. Much more important is Gross Written Premium and a coherent and strong approach to cycle management. We now release retrospective Gross Written Premium figures in March of every year like our competitors.
However, there are a number of things we can learn by looking back at the capacity of the market over the last 40 years.
When I was first asked to do this speech, I looked back at how capacity has developed since the 1960s in order to identify any major trends. Back in 1967, we had a capacity of approximately £500 million which sounds very small but if you rebase this to today’s values it is approximately £6.5 billion and we incurred an underwriting loss of £40 million, again on a rebased basis. By the end of the late 1970s on a rebased basis, the market had grown to approximately £11 billion, we made a rebased approximate profit of £135 million and then saw significant growth during the 1980s, up to approximately £17.6 billion in 1991 when we again had an underwriting loss of rebased £3 billion. While this is approximately the same as today’s capacity, we must bear in mind the significantly different portfolio of that time. I will talk later about the growth in the 1980s and also our response to 9/11. 2001 was not the first time we really goofed it.
Another misnomer is that Lloyd’s sets capacity. It doesn’t. Capacity is of course driven by the market with Lloyd’s oversight but it is also influenced by a number of other factors that are often out of Lloyd’s control: including the wider insurance and reinsurance markets, economic conditions, the cost and availability of capital and rates of exchange. It is also swayed by the perceived opportunity in the market at any given time. Therefore, a heady mix of factors combine to determine how much capacity is available. Our role at Lloyd’s is to try and get the right relationship between a syndicate’s capacity and where the market sits within the insurance cycle, relative to its peers.
At the centre here, we are fortunate that we have a unique helicopter view across the whole market and have the ability to analyse our position relative to other international markets. Using this data, we perform the role of a pressure valve.
Our role is to work with the market to create the conditions where each syndicate has appropriate capacity at any point in the cycle. We may have to reduce or help to increase activities.
Let’s look at two examples of when we had arguably too much capacity and not enough capacity to reflect the current market conditions.
Firstly, in the 1980s, the Lloyd’s market saw incredible growth in capacity as investors clamoured to join the market on the back of the asset bubble (1980-1990 £3.415 billion to £11.07 billion in growth at constant rate of exchange. Global GWP increased by 2.4 times, Lloyd’s grew in excess of three times) While over the same period, Lloyd’s grew in excess of 3 times as investors clamoured to join the market on the back of the asset bubble. This led to significant growth in premium income in a rapidly softening market at the end of the decade, with the resulting major losses to the market that we are all aware of. During that period, we incurred an underwriting loss of nearly £4 billion. At that time, the Corporation was the regulator and we hadn’t heard of the word franchise. We now take a much broader view and the landscape is very different today.
Secondly, post the events of 9/11 Lloyd’s ability to write business in the very hard market that followed was severely restricted by the limitation in our ability to write substantially more after a market changing event due to our weakened capital base. This meant that many of our competitors were able to capitalise much more on the favourable rates without having being as severely impacted by the losses of September 11th. This was particularly evident in Bermuda where a substantial number of new start ups were rapidly capitalised to take advantage of this market changing event and we had to place QQS’s. We gave them the ability to grow as quickly as they were.
In both cases this demonstrated the need for a more optimal approach to align to underwriting conditions and the need to respond to both positive and negative conditions quickly. There will never be a perfect solution but I believe that through FPD we have introduced a much more commercial and pragmatic approach to oversight of the market which allows businesses to take full advantage when genuine market changing events occur.
One of the ways that we do this is through the business planning process. Every year we work with the Managing Agents in order to review, challenge if necessary, revise and ultimately approve business plans for every market business.
The aim of the process is to ensure that the market has an expectation of making a gross underwriting profit - pure and simple. It is the first and the most important underwriting guideline but more about those later.
It is also about businesses being able to demonstrate to us that they have the right processes, management, cultural approach in their senior team and good risk management processes to enable them to take advantage of changing market conditions. In the bad times it is also about having the guts to say no and if necessary walk away from business.
So what areas do we focus on when we look at business plans? We analyse the historical performance and particularly the way that businesses have managed the cycle, we assess the experience and credibility of management teams as well as all of their senior underwriting personnel and increasingly in a more technical environment we review the ancillary functions such as actuarial, loss modelling and claims.
We are the first to admit that it is early days but this process has already helped us pass a number of important tests, notably the 2005 hurricanes and last year’s economic turmoil. The fact that we have been labelled a safe haven in a year of severe economic turmoil is an incredible compliment to what we have all collectively achieved so far but we can never afford to be complacent.
Of course it is not just about approving business plans. It is also about monitoring performance throughout the year and over the course of the cycle. This is not just focused on underwriting performance but the performance across the managing agent’s business.
We regularly engage with businesses, conducting quarterly review meetings and acting as a business partner, monitoring progress and dealing with issues as they arise.
Last year we launched a new initiative that will further support and enlighten this work. The Performance Management Data Project is a tool that will help us capture and analyse a more detailed level of data on a monthly basis. The information will be captured from source and taken direct from the businesses themselves. It will raise the quality of data that we have to a whole new level, provide us with a greater understanding of trends within the market, enable us to feed better data to the market, bearing in mind of course the constraints of competition law, and ensure that Managing Agents are meeting their business plan targets. Overtime, I hope that this will drive improved data quality across the market. It will also help to improve our understanding of the risks each syndicate represents throughout the cycle and provide earlier warnings of issues so that preventative action can be taken.
This tool is very much part of the evolution of FPD as it allows us to create a deeper business partnership and build on the goodwill and trust that already exists.
The Underwriting Guidelines remain at the very heart of FPD and the Standards Framework underpins everything that we do. The guidelines were devised by senior market practitioners at the start of the Franchise system and continue to be a pragmatic set of principles, focused on gross underwriting profit, cycle management and prudent risk management. We have further strengthened the framework through the introduction of a set of minimum standards in underwriting, claims and risk management. We expect all of our businesses at Lloyd’s, at a minimum, to meet these standards and wherever possible to exceed them. I am pleased to report that a lot of businesses are already exceeding them.
We never stand still and are continuously seeking to raise the bar and embed the standards throughout the market. Where businesses are struggling to meet the standards we also seek to work as a partnership to help businesses improve performance.
Of course the work that we do in FPD is not implemented in isolation to the rest of the Corporation’s activities. Everything that we do supports the work of the Three-Year Plan and ensures that we are financially strong and that our brand and reputation remain in tact.
Our aim remains to truly be the platform of choice. Today I have focussed very much on the top line income into the market and the need for us to ensure cross cycle profitability by having the appropriate capacity. However, it is equally important to focus on reducing our major costs such as claims, processing and legal fees. We have a number of initiatives underway to help us do this.
With regard to claims, we have embarked on a major claims programme and we are now beginning to implement a claims segmentation initiative. Currently a large majority of our claims are worth less than £25,000 and in my opinion should not require a lot of intervention by different claims handling parties. We need to be focussing our energies on the top 25-30% of high value, more complex claims so that our customers can have a more seamless, faster fairer claims experience. Through a number of e-Accounting and information projects we also hope to introduce straight through processing and through the Lloyd’s Exchange to simplify trading relationships.
At the heart of our strategy is the need to improve operational efficiency and drive forward long term strategic change. Syndicates need to make capacity work harder for us as this drives bottom line profitability.
We understand that it is often a difficult message for businesses to deliver to shareholders that they are not striving for growth. This is not, especially given the current economic climate, an unusual strategy.
Businesses at Lloyd’s have a responsibility to educate their shareholders about the insurance cycle and the balance of the inevitable good and bad years. There will however always be a natural tension between demands for maximum returns on capital versus the need to protect policyholder and members’ interests.
We also have a responsibility to deliver a prudent message – which is optimal profit across the cycle while at the same time protecting policyholders, the brand, reputation and Central Fund of the market.
This is not always easy. We need to tread a delicate balance between being open and transparent – and explain our views to all potential stakeholders/interested parties which can have implications for listed entities, especially when data and messages can move markets – and not returning to the days when Lloyd’s was perceived as a closed shop.
Given the current economic climate and the fact that the reputations of companies can be lost over night, our businesses are becoming ever larger, regulators are stepping up their enforcement oversight and there is much greater scrutiny from investors, capital providers, analysts and the media in our business activities. We have always to find the right balance of openness being truthful to reality without giving competitive advantages away.
Reiterating what I have said before, we now have a mature partnership with the market, based on trust. The continuation of the work that we do and a number of tools that we are seeking to introduce will only strengthen this. We cannot function as a market without complete two-way transparency between us and our managing agents.
Ultimately the capacity of individual businesses will be driven by their Board’s strategy and risk appetite.
However, over the last six years I genuinely believe that we as a market have really begun to imbed the concept of cycle management. For that we need to thank many of you here in the room for helping to make this change.
While you have a choice, we have a clear role in providing guidance, analysis and data on current market conditions and what we believe future trends will be to equip you to make your decisions. We all have to face and deal with the capacity conundrum. Overall we all have to determine what is the appropriate capacity at any time in the cycle.
So far I think we are winning the game but I think it is a while before we can truly pat ourselves on the back and crown ourselves winners.
I hope that I have demonstrated today that capacity is not an absolute but will always be a relative measure and means different things to different people.
We believe that there is now a greater consensus within the market as to the need for capacity to be linked to cycle management. However, there will always be natural, and in my opinion, healthy tensions between capital providers, rating agencies, regulators and market businesses as well as potentially between market businesses and FPD.
But ultimately from our viewpoint at the centre, optimal capacity should always be linked to the driver of gross underwriting profit. Since FPD’s inception we have focused our attention on working to help you manage the cycle, making us a better, stronger, more disciplined market and through that the market place of choice.
So why is there a capacity conundrum? Setting the right premium income levels at both syndicate and market levels goes to the very heart of what will make Lloyd’s successful. If we get the levels right then this will feed into our short and long term profitability and thus the success of this marketplace. The question posed for this talk is impossible to answer but that does not mean that we should not continue to strive for the optimal level of capacity at any given time in the cycle.
Thank you. I am happy to take your questions or listen to any comments that you may have.
