Chapter 5 – webnotes


Webnote 28: Summary of alternative structures for Newco/Equitas *

A paper by Sarah King, a senior member of Heidi Hutter’s team, considered the alternatives if the DTI were to refuse to authorise Newco because of continued uncertainty about the size of the reserves needed, or a failure to agree on what would constitute adequate assets and capital. One possibility would be to leave all existing Lloyd’s syndicates open if they contained 1985 and prior liabilities. Another would be to require all syndicates to adopt the reserving standards developed for the Newco project, without changing the structure. Another was to create a new central agency – effectively a super run-off vehicle – centralising many of the functions but leaving liability with the syndicates. But these less ambitious options would not enable Names to be released.
A more radical option would be to reinsure all the 1985 and prior liabilities into a new, specially created jumbo syndicate. This would avoid the need for DTI authorisation which carried with it the need for capital. It would achieve many of the same objectives as Newco, including a release by RITC for the Names. But it carried the disadvantage that the on-going Lloyd’s would need to be ready to support long tail liabilities indefinitely through the central fund. Any way one looked at it, if Lloyd’s were to create a proper separation between old and new Lloyd’s – without central fund support for the old liabilities – regulatory approval in the UK and the US would be needed. A final option would be to bide one’s time, hoping to apply again in future, perhaps after a change of Government. A future Labour government might, said the paper, be more supportive of intervention in order to protect the country’s balance of payments position.
Sarah King's paper also considered a situation in which it was not possible to raise sufficient capital to provide Newco’s solvency margin. External sources might be unwilling to support such a venture because it was seen as too risky or unable to provide sufficiently attractive financial returns. One option would be to levy the on-going market. Another would be to seek a one-off contribution from the government or another financial institution with the support of the Bank of England.
The paper also considered ways of tackling a situation in which the data was not sufficiently reliable to proceed with the project for all syndicates. It might be possible to create the structure without mutualising all the reserves. Instead syndicates might have a series of separate reinsurance contracts, at least initially. Alternatively, the paper toyed with the option of establishing Newco using current market reserves, without additional payments by the less well reserved syndicates. This would breach the principle of equity between Names. Another option might be to ‘cherry pick’ syndicates with reasonable data, leaving the rest to struggle. A variation on this theme would be to stagger the reinsurance of syndicates, starting with those with better data and moving on later to take in others.
Another option raised was to seek to devise a mechanism to place Lloyd’s 1985 and prior liabilities into a partial or total insolvent run-off, through the equivalent of a scheme of arrangement or some other legal device. It might only be possible to achieve this by a private act of Parliament and obviously the effect would be damaging on the on-going market. But it might be possible to explain that Lloyd’s problems were not unique. Many other insurers and reinsurance in the UK, US and Europe faced similar problems. It might be possible to negotiate an industry-wide approach to long-tail liabilities that reduced their long-term impact. However this might require government intervention and cooperation.
The paper also considered the implications of the on-going dispute between Lioncover and the syndicates that PCW had reinsured. It threatened the establishment of Newco because the scale of the liabilities was itself in dispute. The issue was extremely contentious and the way in which it was handled by the reserve group would influence the market view of the fairness of the reserving exercise. It could also have a direct impact on the central fund.
Recognising the extreme difficulties, the paper also considered whether Newco could in effect become the run-off vehicle for the old Lloyd’s. If a significant number of Names were to become insolvent, creditors might prefer an orderly run-off of liabilities rather than a free for all pursuit of Names.  Newco could act as the central vehicle for any scheme that creditors might agree. If Lloyd’s had to be wound up, an act of Parliament, defining the process might be necessary to ensure a controlled situation. Newco could feature as the vehicle to administer the process. In the event of Lloyd’s failure, those syndicates that were trading profitably and had capital support could apply to the DTI for separate recognition as insurance companies. To strengthen their appeal to investors, those with 85 and prior exposure might set up Newco as a joint-venture to handle their old year liabilities – achieving the benefits of centralisation.
Finally, the paper considered the effect of the resignation of one or more influential reserve group members at a critical time in the calculation of the Newco premium. It noted that resignations could be triggered by disagreements within the group on the application and content of the reserving methodology or by disputes with external advisers to the project. If this happened, Council support and market support would be critical. A PR contingency plan to handle the situation should be ready.
In February 1995, LMB considered the future capital structure options for Equitas. NM Rothschild had been appointed in December 1994 to advise on its formation. They had taken advice from Touche Ross, Equitas’ taxation advisers, the Lloyd’s taxation department, Leboeuf and Freshfields. Their first choice would be a DTI authorised UK company, possibly incorporating subsidiaries in lower tax jurisdictions. This option had the overriding advantage of meeting the Business Plan intention and obtaining the seal of approval implicit in DTI authorisation. The tax bill would be higher than some alternatives, but the extra cost was thought manageable and justified. An overseas company had some practical difficulties: key staff would need to be employed overseas; and a perception would be fostered that Lloyd’s had somehow failed to secure DTI authorisation. The solvency margin would probably be about half that of the DTI authorised company. A jumbo syndicate was distinctly less attractive, failing to make a strong ring fence.

Webnote 29: Lloyd’s American Trust Fund (LATF) Negative Balances *

When considering how the Lloyd’s crisis impacted the market’s investment strategy and liquidity position a little history is needed by way of explanation. On the investment side up to 1986, when specific tax legislation was enacted in the UK and in the US, Lloyd’s trust funds including the Lloyd’s American Trust Fund (LATF) had generally been run as a straightforward bond washing operation: what would have been income, chargeable at high income tax rates, was converted into capital gains, chargeable at much lower rates. Once this strategy was nullified by tax changes, syndicates had to adopt a more conventional insurance investment strategy. This inevitably reduced liquidity, especially as the trust funds were held in several 'pots' to comply with rules.
To improve the investment return on cash held in the LATF, and later on the Lloyd’s Canadian Trust Funds (LCTF), a ‘virtual money market fund’ for the Trust Fund as a whole was set up, known as the '91 Account' and run by Citibank’s asset management arm. This was effective in improving the return on cash. It also enhanced syndicates' daily liquidity: a temporary cash shortage in any syndicate was effectively netted off against the cash holdings of other syndicates in the Trust Fund. Such temporary deficits were charged a rate of 2% over the relevant base rate to prevent syndicates taking advantage of what amounted to an overdraft facility. The arrangement complemented Lloyd’s ‘Central Accounting’ machinery, whereby inward premiums and outward claims flowed between syndicates and brokers. In profitable times, funds flowed smoothly. There was no need for a market level bank overdraft facility for US or Canadian Dollar transactions.
Problems were encountered when some syndicates incurred very large losses. Some agents were slow to call up cash and some members stopped responding to cash calls; effectively the oil supply was cut off to parts of the engine. However the machine kept running, because as a practical measure the '91 Account' was allowed to take the day to day strain. Regulators were comforted by the existence of a sizable Central Fund which they regarded as a backstop. They tended to treat Lloyd's as a single entity, like the insurance companies they also regulated. In the US, the lead regulator was the New York Insurance Department (NYID) as the LATF was held in trust by Citibank in New York. They were regularly visited by relevant Lloyd’s Corporation staff, the LATF trustee and Lloyd’s US lawyers and were generally aware of these arrangements.
Nevertheless, amid bad press coverage, regulatory concern with Lloyd’s position was mounting. This was compounded by influential disaffected US Names who left few stones unturned in voicing their anxieties. The LATF deficits of some loss-making syndicates (colloquially known as ‘negative balances’) had grown to be structural in nature; in total they now exceeded $400 million. This gave rise to technical legal concerns: strictly deficits were not permitted in US Trust Funds. It was also questionable whether individual Names had agreed to the inter-name borrowing involved in the '91 Account' operation, although they benefited through improved investment returns. The NYID suddenly mounted a fact finding investigation.

Webnote 30: Liquidity pressures on Additional Securities Limited (ASL) *

The liquidity pressures were also evident in the balance sheet of a Corporation subsidiary company, Additional Securities Ltd (ASL), which funded the deposits required in various overseas territories where there were no trust fund arrangements. ASL was in effect a multi-currency lending/borrowing operation and Mark Camp was the Company Secretary. By 1993 the size of this operation had grown to over £400m due to the rapid increase of business in the EU. Although the operation was very cost effective, it was entirely reliant on wholesale short term funding from the money markets/banks. Like Northern Rock, more than a decade later, Lloyd’s found that wholesale market funding dries up remarkably quickly once an institution loses its ‘blue chip’ status. Fortunately for Lloyd's the European Third Non-Life Directive was by now finally approved and it meant that deposits were no longer required in EU countries. In the main the repayment of these deposits was swift and extremely convenient as Lloyd’s was losing its funding sources at an alarming rate. However in Italy it was much more protracted and £60 million of Lire was at stake.
By now the loss of funding facilities was getting critical and the US-owned Chemical Bank, a long term supporter of the Lloyd’s market, had requested full repayment of its £30 million facility to ASL. After some tense negotiation an extension was agreed with Lloyd’s Treasury Department so that repayment fitted in with the recovery of funds from Italy, which had now been finally agreed. Both deals were due to be consummated on a particular Friday afternoon. Anxiously awaiting the funds from Italy, Camp checked each hour, but by 2.00 pm the well known Italian bank had still not paid. He deduced that they were planning to hold the money in order to earn interest on it over the weekend.
In the absence of the CEO, and with the Finance Director’s position vacant, Camp called the Chairman’s office to ask them to pile on the pressure. Payment was needed by 3pm to transfer it in time to the Chemical Bank otherwise Lloyd’s faced the very real disaster of defaulting on the London Money Market, which could have had far reaching consequences for the Corporation and the market at the time. Rowland was not available. Camp decided to act, dreading the prospect of Lloyd's being in default. He called the office of the Chairman of the errant Italian bank, using his chairman's authority to say that if the £30 million was not paid within the next half hour, they would receive the largest lawsuit in their history on Monday morning. The money came through with 15 minutes to spare and Lloyd's was able to discharge its obligations. He told his chairman later that afternoon what he had done. After an initial dressing down, Rowland shook his hand, grinned and said well done.  The overseas deposits and trust funds are funded directly by syndicates in modern day Lloyd’s.

Webnote 31: Terms of Reference and membership of Capital Structure Working Party *

Terms of Reference
To consider two sets of issues:
1. The eventual capital structure (or structures) towards which Lloyd’s should aim.  It should meet the needs of the businesses that comprise the Lloyd’s marketplace; attract an adequate supply of capital; and offer a form of participation to existing members.  A view is required on whether this structure needs to be uniform or not, and on the speed with which it should be reached.  Specifically to consider:
(a) The problem of the “annual joint venture” for the conduct of insurance business.

(b) The importance of maintaining a marketplace of many units, from the point of view of clients and capital providers.

(c) The cost and importance of the Lloyd’s central fund to provide a guarantee to policyholders, and the desirability of a high-level stop loss fund for individual members.

(d) The effects of the move to risk based capital.

(e) The cost implications of the eventual capital structure.
2. The measures by which the interest and rights of different sets of investors are each protected during the transition period and thereafter.  Specifically to consider:
(a) What conflicts exist between the interests of each type of capital provider – including individual members and corporate members, whether diversified or dedicated – and what safeguards are needed to ensure equity among them.

(b) Now that rights of tenure and pre-emption exist, should Lloyd’s proceed to introduce a market in assignment of syndicate places, and if so, when?  (A separate technical group will be studying the mechanics of how this can be done).

(c) If assignment is delayed or infeasible, should any other measures be introduced to promote access to syndicates?

(d) What restrictions, if any, should be placed on the ownership of managing agencies at Lloyd’s?  Are there any special restraints necessary in relation to parents which are insurance companies, brokers, or others?  Specifically, what should the conditions be for control and 100% ownership of a managing agency by a capital provider?
and to make recommendations on all these matters to the Lloyd’s Market Board and Council in April 1995.
Membership of the Working Party
David James (Chairman)
Jonathan Agnew  London Insurance Market Investment Trust
Paul Archard  Murray Lawrence & Partners Ltd
Andrew Beazley  Beazley Furlonge Ltd 
Andrew Duguid  Lloyd’s, Director, Policy and Planning
Robert Hiscox  Hiscox Holdings Ltd
Nicholas Pawson  FMI Ltd
Colin Spence  Sedgwick Lloyd’s Underwriting Agents
Peter Viggers  Member of Parliament
Diana Humphreys (Secretary)  Lloyd’s, Capital Management Division
Tim Cargill  Lloyd’s, Capital Management Division
Ewen Gilmour  Lloyd’s, Corporate Membership Unit

Webnote 32: Range of opinions expressed by members *

Furious Debate
In January 1995, Dan McGurk, from California, sparked a furious debate among members through letters to OLS. He thought Names who had suffered the worst had every right to be livid over their treatment; some had good reason to desperately strike out to prevent themselves from being pulled into the terrible abyss of personal bankruptcy. Those like him who had only suffered affordable losses could sympathise with the 'truly hurt.' He had tried to accept as reasonable the view that Lloyd’s deserved whatever the angry Names could call down on the heads of the malefactors. He saw the case for suing particular agents, but, he said, “suing Lloyd’s is suing ourselves and it doesn’t make sense, despite what the American Names Association (ANA), Writs Response Group (WRG) and Global Defence Association (GDA) may say.” If the suits against Lloyd’s were successful, it would mean that all the losses of the last few years would be spread evenly among all Names. His sympathy did not extend to paying part of the losses of those who were “less diligent, less risk averse and even less lucky than I. Not only will I not join in the search for the jackpot, but knowing it will come out of my pocket, I will resist it to the end.”
Another member thought the losses were so unreasonable – due to the behaviour of US courts and Congress – that he was simply refusing to pay. Others agreed that 'unjust' claims should be renounced, arguing it was unlikely US claimants and lawyers would find it worthwhile chasing every Name for a decade or more.  One member said "the American lawyer prefers to bring down his prey fast and that it should be fat. Who will pay for a decade or more of painstaking litigation? How will he fare against crusty old British judges instead of emotion charged US juries? And if he manages to track down this whole carcass, it is unlikely he will find any breath in it, let alone meat.” A Canadian member advanced the far-fetched proposal that two could play at the game of changing the rules retroactively. Lloyd's should get the British Parliament to impose a cap and a time limit on all insurance policies, retrospectively.
Another regretted the 'tragedy' that Names were being divided into two camps: the big losers and those with only moderate losses. The distinction between them owed more to luck than skill; now, fairness was needed: "this desire for truth and justice, as a separate issue from financial loss, should not be under-estimated. "The Lloyd's citadel might yet be tested by those who had been cast without." Another member thought it wrong if a settlement was based purely on the principle of satisfying those "who made the most noise." Many Names were "putting up a smokescreen" to avoid liabilities; using the central fund to "appease" such activity was unfair on the rest. He thought that any capping of liabilities must be available to all the membership, not just those in dispute. It was high time that a more active approach to the pursuit of liabilities was taken. “We all know of Names who have taken advantage of the dilatory activity so far to distance themselves from their assets. Many are currently enjoying lifestyles that those of us who are paying our losses envy.”
One member complained that the litigation was increasingly showing up the ‘disgraceful behaviour’ of E&O underwriters. Most such policies paid for defence of actions against policyholders by a deduction from the limit of indemnity. Until that limit had been exhausted, there was no inducement to pay court awards. They were appealing every decision regardless of merit, saying that they must protect their Names and reinsurance, but they went beyond those duties. He also complained about Lloyd’s stance. The fact that E&O cover was not mandatory was "a disgrace and would not be tolerated in any properly regulated profession."
A member of the Devonshire Names Action Group (DNAG) was infuriated to discover that some of the money he was subscribing towards the cost of pursuing a satisfactory settlement was, in fact, being used to support both the WRG and the LNAWP – two bodies of which he thoroughly disapproved. The problems at Lloyd’s had spawned a proliferation of more than 40 groups, societies etc, "most of them destructive – all financed by Names directly or indirectly." One worrying aspect was the incestuous nature of these groups. The latest one shared the same address and fax with the Devonshire Names action group and had received a loan from it. “There seems to be a subculture of professional activists.” Action groups were now big business and had generated "their own gravy train."
Another said DNAG's newsletter represented the more militant Names, intent on vengeance and the collapse of Lloyd’s. It should represent all its members, including both hard-pressed and more moderate Names who did not see vengeance as a sensible motive nor the demise of Lloyd’s as a helpful outcome. Alan Porter, DNAG's leader, defended the use of part of the subscription to support the WRG, LNAWP etc, saying action group leaders would all prefer to be doing something else. “However, we find ourselves in the middle of the biggest financial scandal since the South Sea Bubble, and what drives us is a determination to see justice done, and not personal gain. Since we are dealing with billions-worth of claims and powerful entrenched interests, it has to be big business and not the vicarage tea party.”
Another asked about the position of Names like himself who joined in 1988, who had cash calls immediately and continuously thereafter. There were no dreams of easy money and certainly no money to be spent, foolishly or otherwise from non-existent good years. “I am sure that we all joined Lloyd’s with our eyes wide open. However, having your eyes wide open in a darkened room does not help you very much. As we all found out it was not what we were told that mattered, but what we were not told.”
Another said there was no virtue in not litigating. If there was a settlement it would be because some were prepared to get themselves organised, take legal advice, set in train complex investigations and commit themselves, not only to the immediate cost of the action, but jointly and severally to the costs of the other side if the case was lost. Those who criticised litigants as non-payers, but were happy to take advantage of their efforts, were not entitled to a penny. Another, having followed the conflict between Names continuing to underwrite and those devastated by losses, was reminded of the story of the hen and the pig walking down a street with a poster advertising traditional English breakfasts. Said the hen to the pig, ‘doesn’t it make you feel wonderful to be able to provide such a meal?’ Said the pig to the hen, ‘that’s all right for you, you are only being asked to give a contribution, I am expected to make a sacrifice.’ As one of the pigs he was not inclined to sacrifice himself and his family merely to provide an extra ‘breakfast for fat cats.’
David Durant wrote on behalf of Hardship Names, saying it would cost comparatively little to allow totally busted Names to retain a small part of their assets and use part of their legal recoveries to pay off their debts and get back on their feet. He invited others to contact him so that, strengthened by numbers, he could present a more forceful argument by demonstrating the unnecessary suffering that the present Hardship guidelines were causing. He became an effective spokesman for the hardship Names.