Frozen out

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The Lloyd's market has been frozen out of the recent rapid consolidation in the UK broking market, handicapped as it is by the 1982 Lloyd's Act but, as Kirstie Redford reports, there is a growing feeling that the divestment rules are outdated and should be scrapped

It has been an eventful 12 months for the UK broking market, with some major consolidation taking place. However, the Lloyd's market has been unable to ride this wave of change, primarily due to a rule contained in the Lloyd's Act 1982.

The principle of 'divestment', which prevents Lloyd's brokers and managing agents from having an interest in each other, was introduced at the time to improve governance of the unregulated market. But as the rest of the UK broking market is reaping the rewards of increased consolidation - creating a market that is arguably both more efficient and profitable - could it be time to create a level playing field for Lloyd's and ditch this 25-year-old rule?

Revision required

Andy Baldwin, insurance partner at Ernst and Young, says that the London market should be given the same freedom to consolidate. "It would be unusual for anything to exist for 25 years without considering whether or not it is still fit for purpose - so it is only prudent to review the divestment rule," he says.

Mr Baldwin adds that the fundamental changes currently happening in the rest of the UK broking market are not of detriment to the customer, rather they are making the market more efficient. "Lloyd's now needs to challenge the inefficiencies prevalent in its market place. Having financial interest between underwriters, brokers and managing agents could actually be a good thing and be a catalyst for making the market more efficient; improving engagement and the supply of information with managing agents," he says.

Changing business models are influencing the needs of the market and making the divestment principle look decidedly out of date, according to head of general insurance at KPMG Tony Hulse. "We have seen the growth of various insurance operating models - bancassurers, virtual insurers, combined insurance and reinsurance broking models, and, in the Lloyd's market, ownership of non-Lloyd's brokers has become more common. Therefore, it seems anachronistic to persist with the prohibition on Lloyd's agents owning Lloyd's brokers and vice versa. In my opinion the focus should not be on the ownership structure, rather the governance and management structure in managing potential conflicts of interest," he says.

Andrew Holderness, head of the corporate insurance department at law firm Clyde and Co, says that the divestment rule was put in place for a good reason - scandals had rocked the market with brokers channelling the best risks to their own syndicates. "It stopped all the profitable businesses coming through the door from going straight into the baby instead of main syndicates," he says.

However, he adds that the introduction of the rule was "like using a sledgehammer to crack a nut".

There is no doubt that the introduction of the divestment principle was a response to a specific set of circumstances at the time. But Lloyd's was unregulated then. Since 2005 all Lloyd's brokers have been subject to regulation by the Financial Services Authority, to and its rules relating to dealing with conflicts of interest, with which all regulated intermediaries must comply.

Bespoke regulation

Heidi Ashley, spokesperson for the FSA, says that the relevancy of the Lloyd's Act is a matter for Lloyd's and the Treasury to debate and not something the regulator can comment on. However, she says that regardless of the Act, the FSA would continue to focus its efforts on managing conflicts of interest.

"Clearly our regulation of Lloyd's has changed since the Act and we also now regulate brokers. The FSA's principle 8 refers to managing conflicts of interest, applying to both brokers and insurers - including Lloyd's managing agents. We don't have a fundamental problem with insurers owning brokers, or vice versa; however, there is an obvious potential conflict of interest and we would expect the matter to be managed properly," she adds.

If Lloyd's wanted to ditch the divestment rule, Ms Ashley says that the FSA would consider the implications, as it has a general obligation to review changes to its by-laws. "Our main focus would be on ensuring on a case-by-case basis that any conflicts were managed," she explains.

Toby Esser, group chief executive officer at broker Cooper Gay, believes as long as the FSA continues to adopt this approach it should provide sufficient safeguards without the need for the divestment rule. "With the FSA, transparency is so extreme that it would be very difficult for any broker to do anything that they shouldn't be doing. If there were concerns, the industry would question whether brokers should have interests in their own syndicate and it would be addressed," he suggests.

And it is the FSA's new powers in the Lloyd's market and predominantly its principles-based approach to regulation, which many believe is making the divestment rule seem out of touch.

"Regulation has moved on," says Andrew Holman, chief executive of Lloyd's broker Holman's. "No longer is it about having rules on what you can and can't do, it is based on principles. This black and white rule is now out of date because the rest of the market is free to do what it wants with regards to mergers and acquisitions. Now that the FSA has come on board, the Act is preventing there being a level playing field. The issues that the Act was set up to take care of - such as conflict of interest - have now been taken care of by the FSA, so effectively two sets of legislation exist."

When the divestment rule was put in place, it had severe consequences for a lot of Lloyd's broking groups with interest in syndicates. "Indeed, we had to sell a great deal of our business," Mr Holman adds.

The market has since changed for the better and the FSA has made it very clear that it will not stand for scandals happening again, words also reiterated more recently by former New York Attorney General Eliot Spitzer, who was the main driver of cases against many international brokers.

FSA culture

Mr Holman believes that the improved practices within the Lloyd's market are not a direct result of the Lloyd's Act. "Credit really lies in the different culture of the market and this is largely due to the presence of the FSA," he says.

Nick Stanton, head of UK global carrier management at Aon, agrees that life has definitely moved on since the rule was introduced. "Our concern is that the market continues to manage conflicts of interest as we wouldn't want to go back to how things were - but there is little danger of that happening with the FSA on board. Back in 1982 there were probably around 25,000 Names and not much, if any, corporate capital. The ethos of the market is now entirely different. However the rule hasn't held Aon back, so we're pretty neutral about it," he says.

There is some feeling within the market that the divestment rule has had a limited impact because there are legitimate ways around the law. "Many syndicates have been setting up service companies not based in Lloyd's, which has been going on for years," says Mr Holman.

Mr Esser agrees that it is possible to get around the divestment rule. "Many brokers control managing agents and it's possible for them to earn significant profits through underwriting - it is an accepted practice. There are also a number of brokers involved with captives, which again means they can take significant profits," he says.

Mr Holderness adds that as soon as the rule was introduced, lawyers began coming up with structures to allow acquisitions without breaking the law. "We are often now asked to give our legal opinion on whether the divestment rule has been breached. It just means having to jump a few more hurdles. In a way, the rule has been slowly eroded and no one is really going to blink if it is completely scrapped," he says.

There is nothing to stop agents putting in place corporate structures that are compliant with the divestment provisions. However, where Lloyd's believes that a structure is non-compliant it says that it will take steps to ensure the issue is rectified.

However, Mr Holderness says in his experience such challenges are unheard of. "I'm not aware of anyone who has ever been red-carded on a divestment issue," he says.

Despite the strong feeling in the market that the divestment rule fails to serve any great purpose, Lloyd's will not be drawn on whether or not it is pushing for the rule to be dropped. The government is, however, understood to be consulting on amendments to the Act, but speculation on what, if any, amendments are likely to be proposed would be premature.

The Treasury is also keeping very tight-lipped, with a spokesman saying that no decisions had been made about which specific points of the Act will be consulted on, but it was "possible" that divestment could be one area of focus.

Edward Balls, Economic secretary, announced news of the consultation in June this year. In an official statement, Mr Balls said that Lloyd's of London had been working with the Treasury to identify areas where its corporate governance arrangements are out of step with modern practices and as a result it had decided to develop legislative proposals to modernise the governance arrangement for Lloyd's.

A cloudy future

The proposals - which will take the form of a Legislative Reform Order to amend Lloyd's Act 1982 - are scheduled to be published early in 2008 following "extensive consultation" with interested parties.

Mr Balls, who has since been made secretary of state for schools and children, claims that any amendments aim to "reduce costs and unnecessary bureaucracy". But it is unconfirmed as to whether this will include losing the divestment rule.

Mr Stanton remains sceptical: "I'm not convinced that divestment will be on the Treasury's agenda, or at least the consultation will not be driven by that issue. However, if it did happen then as long as adequate safeguards were in place to stop conflicts of interest it wouldn't be a problem. In the current regulatory environment, I don't think this would be a major risk."

Mr Holman sees the consultation as an excellent opportunity to push forward some much needed change. "If the Treasury proposes changes to divestment, I doubt it will need much debate and I suspect changes will be pretty straightforward and carried through. I thought changes to the Act were the last thing on the government's agenda, implying the market has been lobbying quite hard for change," he says.

A lot can happen to a market in 25 years and Lloyd's is no exception. Long gone are the days of baby syndicate scandals; today's brokers operate in a very different regulatory environment. There is certainly strong opinion in the market that the principle of divestment is now outdated and, arguably, no longer necessary. But whether feelings are running high enough on this issue to prompt the Treasury to propose legislative change remains to be seen.

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