Lloyd's: The view from the top

The looming bid for insurance group IAG from industry leader QBE will require an exceptional focus on the outlook for the insurance sector. In today's Q&A interview, Eureka Report gets a view from the top. Richard Ward, the London-based chief executive of Lloyd’s Insurance, is one of the most influential executives in global insurance.

Ward's comments on the insurance sector offer a unique view of the international insurance market and the outlook for QBE, IAG and all Australian insurers.

Lloyd’s is one of the world's biggest insurers. Crucially for Australian investors, the Lloyd’s-QBE relationship is pivotal for the ASX-listed insurer. The Lloyd’s insurance market in London is QBE's second-biggest revenue earner (after the Americas), achieving $2.6 billion of the total $12.3 billion in premiums in 2007.

.Under long-term managing director Frank O Halloran, QBE has ascended to become a pillar of the Lloyd’s enterprise following two key developments: QBE's purchase of the London-based Limit business and the gradual replacement of individual “names” among Lloyd’s syndicates in favour of institutional capital providers. Several hundred Australian names (individuals who provide capital to insurance syndicates) faced severe financial difficulties following a funding crisis that hit the insurer more than a decade ago when leading Australians, including former Prime Minister Malcolm Fraser, lost money in Lloyd’s syndicates. (Lloyd’s remains an unlisted enterprise; it is technically a society of members).

Today there are only about 2000 Lloyd’s names (with about 50 in Australia) down from a peak of 34,000 in the early 1990s. However, the views of Lloyd’s will directly affect a huge number of Australian investors because IAG (which includes the former NRMA) and QBE have a combined shareholder register of nearly one million retail investors.

Lloyd’s recently reported solid pre-tax profits of £3.8 billion ($8.3 billion) for 2007 against £3.6 billion a year, earlier while Lloyd’s annual survey of underwriters released earlier this year put “managing the insurance cycle” as the key factor facing the industry in 2008, while 93% of underwriters believed the insurance industry was now in a “soft” stage of the industry cycle.

It's this challenge for the insurance industry – to manage itself a lot better in this economic downturn than the downturn faced earlier this decade – that underpins Ward's comments to Eureka Report. As he points out, insurers face challenges on both sides of the ledger: investment income is deteriorating and, after two years free of major catastrophes, a third quiet year is increasingly unlikely.

Ward pinpoints the areas – including the pointless battle for share of a shrinking market – where insurers may falter and once again find themselves reporting “extreme losses”.

Although he presents a confident picture of a reformed insurance sector, his clear message for all insurance investors is that he sees conditions worsening for insurers before the current cycle turns, suggesting QBE's move on IAG is not quite a “bottom of the cycle” initiative as some analysts have suggested.

The interview

James Kirby: The ratings agency Standard & Poor's has published a review of the Lloyd’s operations and suggested the climate for insurance companies has been “extremely benign”. Is it fair to say that until very recently it's been as good as it gets for the insurance industry?

Richard Ward: I think probably 2006 was as good as it gets in terms of a benign claims environment. We reported our results a couple of weeks ago and, yes, we reported record profits but it was important to understand the four drivers behind these records. We had a good underwriting performance but that in part was driven by the strong underwriting conditions of 2006 that fed over into the first half of 2007. We had a benign claims environment, however we did have more catastrophes in 2007 than we had in 2006, so whilst we had no major catastrophes such as the US windstorm hitting the Gulf there were more catastrophic events in 2007 than 2006.

We had strong investment returns in 2007 – 20% up on 2006 – which contributed to a better result and the other contributing factor for 2007 was the prior year releases, so we saw favourable developments in prior years that enabled us to release reserves held in higher years into the 2007 result. So while S&P describes it, it can’t get any better, in terms of underwriting we are actually starting to see a deterioration in underwriting result that was masked by the investment income.

So, is the underwriting market still enjoying “extremely benign” conditions as we speak now in April 2008?

No. We’re seeing rates soften quite significantly across all lines of business. That softening started in 2007, particularly the back end of 2007, and we are now seeing that accelerate into 2008 so the chances of delivering such a strong underwriting performance in 2008 are very limited. I think also we cannot expect there to be no hurricanes or no catastrophes this year in the way in which we’ve had no real catastrophes in 2007 and certainly no catastrophes in 2006. Three years on the trot with no catastrophes would be quite extraordinary. I was told 2006 was extraordinary when I arrived. I arrived on the back of the hurricanes Katrina, Rita and Wilma in 2005, which was an extraordinary year. And 2006 was an extraordinary year for the complete absence of any catastrophes; 2007 has in part been a somewhat extraordinary year in that we’ve had no major catastrophes.

Now on the other side of your books, we have had a relatively dramatic deterioration in investment markets. I’d like to get a sense from you to what extent insurance companies are exposed to this credit crisis in the markets?

We need to look at that from various angles. If we look at it from the asset side, of course our investment income is a very important component of our overall performance and we’ve generated over £2 billion worth of profit from our investment returns last year.

Quite clearly, the turmoil in the financial markets we currently see will probably lead to a reduced return on our assets in 2008. It will be very difficult to deliver such a strong investment return in 2008 than we saw in 2007, so that will contribute to probably a weaker result in 2008 compared to 2007. On the liability side, we are seeing some claims come through related to some sub-prime, but the magnitude of those claims is such that we would deal with it in our business-as-usual activity so we’re not seeing any real impact on that side.

So is the sub-prime fallout restricted to date to directors’ liability, that sort of thing?

Yes, directors’ and officers’ liability, errors and omissions '¦ crime policies – fraud that can be proved. That’s where it will pop up and we are getting some notifications of claims coming through but at the moment the indications are that those notifications are at a reasonably low level. In part [this is] because we’ve actually reduced our exposure to financial institutions since the Enron and World Com and dotcom crises of earlier this decade, and that was a very conscious decision by our underwriters to reduce the level of exposure they had to financial institutions to a more manageable level.

Have you sidestepped the municipal bond insurance problems in the US? Has that been relevant to you?

It has not been relevant to us. I mean that’s been far more of an issue for the monoline insurers such as MBIA and Ambac. That is not the type of business that we get involved in and, again, if we look at it from the asset side, we’ve got limited exposure to corporate bonds or municipal bonds that have been wrapped by the monoline insurers.

So how do you rate the insurance sector as an investment choice?

I’m not going to give a rating on the insurance sector as an investment. It’s not appropriate for me to go out promoting Lloyd’s as a place for people to invest in. That is a decision for individuals and they need to work through their financial advisers.

On the Australian Securities Exchange, insurers have been sold off in tandem with banks, although it is clear from what you've been saying so far insurers have sidestepped the worst of the sub-prime crisis. Have you any sense as to why the insurance sector in our region has been downgraded by the investment markets?

That would be a question I’d ask of you rather than you ask of me, but quite clearly shareholders are responding to what they see as weakness in the stock and they decide to short the stock and then so be it. It’s not for me, again, to comment on that but ultimately you have to look at performance of companies to be able to make some assessment of shareholder sentiment.

Across the insurance markets, what do you think will be the outstanding issue for insurers this year?

The primary issue for the insurance industry in 2008 will be managing the cycle.

What exactly do you mean by that?

The cycle. The insurance cycle. Insurance is seen as a cyclical business and we are in a downward cycle, and in the past the insurance industry has not responded to that downward trend and as a result has posted large losses as it chases market share at unprofitable prices. That’s not in anyone’s best interests. It’s in the best interest of the insured, the customer, that we make profits so we have the cash available to pay for the claims when those claims come through so the real challenge for the industry this year is to ensure that it manages that cycle effectively. It focuses on underwriting discipline, focuses on underwriting for profit and ensures that as we come out to 2008 we don’t report extreme losses as a result of chasing market share at reduced prices.

Are you saying the insurance industry is under the spotlight because the last time the economy tanked insurers fared exceptionally badly?

It will be compared with the early 1990s. It will be compared with the late 1990s. It will be compared with the early 2000. One thing I’ve learnt is that insurance is a cyclical business and people unfortunately always seem to follow the trend and the challenge for us is to ensure that we manage that cycle and don’t follow the trend to the same extent.

Is there a difference in the environment you are working in now and back then?

The outstanding difference this time is that we have a completely different risk-management framework in place than we’ve had in the past. We now have a franchise performance structure in place at Lloyd’s that was introduced in 2003 and the sole purpose of that franchise performance structure is to ensure that we, the corporation, work with the market to ensure that the business that is written inside Lloyd’s is manageable. That the risk is manageable. That we don’t over-expose any individual syndicate to particular risks and that we don’t overexpose the overall market on an aggregate to individual risks such that we can manage the claims arising from those risks in a far more profitable manner.

Looking at one of the surveys recently from your own underwriters, the outstanding non-traditional issue that seemed to concern them was climate change. In Australia this issue is symbolised by drought, and maybe in the UK by coastal erosion. At Eureka Report we've reported on the distinct concerns on climate change among insurers (See QBE's premium offering)'¦ where do you stand?

This is a worldwide problem and I don’t think anyone can deny that we’ve seen significant changes in climatic matters. I mean, we had snow in London last weekend. The weekend before, and this time last year we were basically bathed in a heat wave. We had the London marathon on Sunday; this year it was rain and it was about 10 or 11 degrees. The previous year we had people collapsing through heat exhaustion because it was up in the 20s. So, quite clearly, the patterns we’re seeing in our climate are very different to what they were only 100 years ago so it’s not a localised phenomenon in Australia. It’s a worldwide problem that we have to address.

And to what extent is that reflected in the patterns of business in terms of new initiatives?

Well, we’re always encouraging our market – and the insurance market in general – to consider the emerging risks that they are now faced with: how they manage those risks, how they respond to those risks and how technology can be used to help mitigate those risks, so that’s a very important element. I think the public are now far more aware of the flood issues we face in the UK given the flooding problems we had in June and July 2007, so awareness of flood is far higher up the agenda than it has been in the past. Sea defences to protect coastlines against rising sea levels is now up on people’s agenda. The ABI [Association of British Insurers] continues raising this issue with Government to ensure that we have the right level of investment to protect the environment, protect habitation, and it’s important that we continue to have these discussions to raise the awareness to ensure that we can take appropriate action.

I believe there are only about 50 Lloyd’s names in Australia now – down – I expect – from several hundred in the early 1990s. What is the overall number?

Well we had about 34,000 at the peak in the 1990s. That’s down below 2000 now.

And what is an optimum number for you?

There is no optimum number.

Is that number rising?

No, that number has been fairly static for about the past two or three years. Names provide capital just as corporates provide capital and we welcome that diversity of capital, so names are welcome investors in Lloyd’s, just as corporates are welcome investors in Lloyd’s.

Do you expect, for instance, in five years’ time would that the number of names would be larger?

I won’t make a prediction on that number because we have no optimum target for the number of names. Names come and go depending on the opportunities they see, just as corporates come and go depending on the opportunities they see.