Testing times for the franchise

By Robert CB Miller.

The creation of the Lloyd's franchise at the beginning of 2003 can be seen as the last piece in the jigsaw of reform that began with R&R in 1996. Lloyd's response to the phenomenal losses of the 1998-2001 years of account was to establish the Franchise Board with a supporting franchise performance directorate and staff. Rolf Tolle was appointed franchise performance director. Mr Tolle has had a distinguished insurance industry career and prior to joining Lloyd's had been employed by Berkshire Hathaway to sort out Faraday (formerly DP Mann), its troubled Lloyd's subsidiary.

The main thrust of the Franchise Board is in the examination and approval of syndicate business plans in detail before syndicates are allowed to start underwriting for a particular year. In addition to a syndicate's underwriting plans, the Franchise Board focuses on its capital support.

Syndicates must be able to show that they have a business plan likely to produce consistent profits, but also that they can command the support of capital which is unlikely to evaporate leaving the syndicate in run-off.

Showing its teeth

So far there have been two well-publicised examples of the sort of drastic action the Franchise Board has been prepared to take. The troubles of the quoted Goshawk Group resulted from serious losses following a series of disastrous underwriting decisions involving the collapse of The Accident Group, its US viaticals account and the insurance of the cargo of the space shuttle Columbia. The group's wholly owned syndicate 102 is forecast to lose 58% in 2001 and a further 5% in 2002 and Lloyd's - supported by the Financial Services Authority - stepped in to close the syndicate when it became clear that Goshawk was unwilling, or more likely unable, to recapitalise it.

The case of the Dex syndicate 2241 is even more instructive. Here the syndicate managed by a subsidiary of the Thomas Miller group had the support of the Groupama insurance group for 2004. The syndicate had lost 35% in 2000, and was forecast to lose 55% and 5% respectively in 2001 and 2002.

The syndicate's business model was to write lines of 30-50% or more of a ship's value and this was incompatible with the requirements of the Franchise Board. As a result the syndicate was put into run-off and the business will be moved outside Lloyd's. Lloyd's was understandably unimpressed by a business model which produced such substantial losses even though the business appeared to have no difficulty in attracting supporting capital.

Lloyd's reputation is damaged by losses even when capital providers are prepared to stand behind a very high risk strategy. Lloyd's is not bluffing when it says that it is content to see uncooperative businesses leave the market.

Lloyd's determined approach to syndicate business plans and managing agents' application of them has caused grumbling from some market practitioners on the grounds of undue interference. But Mr Tolle explained that Lloyd's did not intend to inhibit the entrepreneurial character of the market.

He told Reinsurance: "The franchise performance directorate does not seek to micro-manage or get involved in the day-to-day running of the syndicates.

The directorate works to ensure that we have a marketplace of disciplined and well-managed businesses without blunting entrepreneurial spirit." Lloyd's sees its role in the first instance more as a coach than a disciplinarian, but with the reserve power to intervene aggressively if need be.

The down cycle test

It is significant that in the previous down cycle, Lloyd's was characterised both by extraordinarily poor performance by the bottom performing quartiles of syndicates, but also by a market inability to reduce capacity as trading conditions deteriorated. As trading conditions became loss-making from 1997 onwards, Lloyd's capacity only fell from £10bn ($18.1bn) in 1996 to £9.9bn in 1999 and actually increased to £10.1bn in 2000. This explains Mr Tolle's determination to make it clear that managing agents must expect to radically contract their businesses when trading conditions deteriorate.

Lloyd's focus on maintaining and enhancing profitability through the Franchise Board currently presents few problems. Egregious cases, such as those reviewed above, are likely to be exceptional in the current excellent trading conditions at, or close to the peak of the cycle. However, the real test of the franchise concept will emerge when trading conditions begin to worsen. Controversially, Mr Tolle has asserted that Lloyd's capacity could decline by up to 50% from its peak in the up cycle. It is interesting that Lloyd's capacity inclusive of qualifying quota shares actually fell slightly in 2004 compared to 2003, from £15.7bn to £15.1bn. Larger scale reductions would be unprecedented and could lead to a crucial test for the whole franchise concept.

While many Lloyd's businesses have shown themselves to be adept at managing the cycle by expanding and contracting their exposures with improving and deteriorating trading conditions, many have not. It is all too easy to imagine a situation where the Lloyd's subsidiaries of major international insurers, perhaps with credit ratings better than that of Lloyd's, decide to remove their business from the room as they find the restrictions of the Franchise Board intolerable. In such circumstances it might be tempting for Lloyd's to temporise on the grounds that to lose such businesses from the market would itself cause severe damage to the franchise.

This is the sort of threat the Franchise Board will face when trading conditions turn down. But if Lloyd's successfully faces down such threats to leave the market, then it will be a convincing sign that the concept of the franchise is working. It is too early to tell whether Lloyd's can meet this challenge, but the signs so far are that it will. Lloyd's knows that there can be no third repetition of the severe losses that have damaged the market so badly twice in the last 12 years. It will not get another chance.