Lloyd’s of London, one of the oldest continuously operating financial institutions around, faced profound troubles just thirty years ago, financial challenges that threatened to discredit or destroy it. The eyes of its regulators, customers, and thousands of member underwriters were on Lloyd’s. In recent years, banking firms in distress have created ‘bad banks’ to separate their troubled portfolios from their performing assets. Lloyd’s created something of the sort when mounting asbestos and other claims were threatening to ruin its underwriters, many of whom had their entire personal wealth at stake. The firm was called Equitas and it became Lloyd’s ‘bad bank’.
Lloyd’s
Lloyd’s of London, the insurance market founded in the 17th century, had survived crises before. In 1693, just a few years after underwriters first met at the Lloyd’s Coffee House, a convoy of ninety merchant vessels were lost to a French naval attack just outside the Mediterranean. The insured losses amounted to roughly 2% of English GDP at the time. The ‘Smyrna catastrophe’, as the Battle of Lagos became known, drove many underwriters into ruin after a legislative plan to more orderly handle the crisis failed to pass through the House of Lords. Now, exactly three hundred years after the Smyrna catastrophe, Lloyd’s was facing trouble again.
First though, it is worth recalling how Lloyd’s worked. The insurance market on Lime Street in the City of London was an insurance market, not an insurance company. Rather than employing underwriters writing policies under a single firm, Lloyd’s was comprised of individual underwriters organized into several syndicates operating without a common employer or even limited liability. The ‘Names’, as Lloyd’s members were called, accepted that their personal assets were available to make up for any losses. In 1970, property requirements were reduced for membership at Lloyd’s and the number of Names grew from 6,000 in 1970, a level around which it had been for decades, to 32,000 by 1988. Many of these wouldn’t seem to be natural underwriters; some were actors and authors; sixty-four Members of the Parliament and even the former Prime Minister, Edward Heath, were among the Names.
Needless to say, many of the new members were not experienced and found themselves at Lloyd’s as little more than novice speculators seeking to enhance their incomes. These less likely members were absentee investors, leaving their assets with agents who invested it in accumulating policies underwritten at Lloyd’s. The appeal for the new Names was that most of their assets invested into policies were merely pledged to make good on any losses rather than actually parted with. There was therefore a sense that members could make their money work for them twice over by investing through Lloyd’s. First, they would earn the premiums on the policies they underwrote and they would also earn investment income in the meantime.
These new Names quickly became enmeshed in a tangled web of commitments, to the insured parties, other insurers, and their fellow Names. The 1980s saw growth in excess loss reinsurance, a product where insurers would go to Lloyd’s to secure policies that would limit their own losses from catastrophic events. These excess loss policies grew to comprise over 25% of the insurance business conducted at Lloyd’s. Underwriters writing these policies would syndicate this exposure out to others or purchase reinsurance for themselves, typically from reinsurers who also purchased reinsurance, generating large fees for brokers who arranged these deals and a web of exposure connecting the fate of the Names. This web eventually led to what became known as the ‘London Market Excess of Loss’ spiral that would threaten to bring down the three-century old market.
Asbestos
The problems at Lloyd’s sprung into view with mounting asbestos-related insurance claims coming from the U.S. in the late 1980s. Because knowledge of the health dangers of asbestos came decades after its widespread use in construction and industry began, claims arose on policies that were decades old and for which inadequate reserves were maintained. The claims were massive, arising from policies that were open-ended in terms of the amount and timing of any claims; only in 1985 did such open-ended liability policies cease to be underwritten at Lloyd’s. It was far too late though and mistakes from decades of underwriting were cropping up at once. Asbestos related insurance claims were estimated to have reached some $50 billion by 1992.
Other catastrophes exposed Lloyd’s members to losses. First there was the Piper Alpha disaster in 1988, where a North Sea oil platform exploded and killed 167, and then the Exxon Valdez oil spill in North America the following year. However, the largest claims arose from troubled sectors and not individual events. Claims of the former sort were enlarged by American laws that imposed retroactive liability on insurers for pollution clean-up costs, for example. Together, asbestos, pollution, and health (‘APH’) losses at Lloyd’s between 1988 to 1992 summed to some £8 billion.
Lloyd’s Names faced exposure to nearly unlimited losses from these events; thousands faced bankruptcy. When absentee members, relying on agents to build their insurance portfolios, realized the dangers to their wealth, litigation between members and between members and Lloyd’s itself increased. Through the early 1990s, the troubles at Lloyd’s became common knowledge among large insurance buyers, regulators, and the members themselves. The number of active members fell to 12,000 by 1996. To survive, Lloyd’s developed and implemented a ‘Reconstruction and Renewal’ plan that saw the creation of a new entity that became something like a ‘bad bank’ for insurance, holding the most ‘toxic’ exposures.
Equitas
At the core of Reconstruction and Renewal was the creation of an entity in 1996, called Equitas, to reinsure the non-life insurance business conducted by Lloyd’s members prior to 1993. In total, £15 billion in outstanding claims were reinsured by Equitas, roughly evenly split between APH and non-APH claims. Equitas was capitalized by a charge levied on Lloyd’s members. The levy was paid by both existing and inactive underwriters who faced losses from their past policies, 34,000 underwriters in total.
The levies charged to members were large and so as part of a settlement with the Names, £2.8 billion in financing and debt forgiveness was offered by Lloyd’s to its distressed members. Essentially, each Name was presented with the cost of reinsuring their share of the liabilities modified by a settlement offer that varied by member. Those who accepted the offer had to agree to drop current and future litigation. This requirement motivated some to hold out, though in the end over 90% of the Names accepted the plan.
In addition to rescuing members, the appeal of founding Equitas as Lloyd’s ‘bad bank’ was that it would allow for economies of scale in managing claims and reinsurance functions and could enhance investment returns by funding the company with permanent locked-in capital. As a single entity, Equitas was also perhaps better positioned to proactively settle with potential claimants to reduce future liabilities, something which it did do. Nonetheless, claims continued pouring into the firm. Those paid in 1997 amounted to over £2.5 billion in addition to around £2.25 billion paid out in each of the following two years. Total claims outstanding only fell to £10 billion in 1999. A mountain of potential claims remained and annual disbursements fell below £2 billion only in 2002.
Though much progress was made, concerns grew in the late 1990s and early 2000s that the reserves at Equitas would be insufficient to cover all the remaining claims. Much of the fall in claims outstanding came from the non-APH lines; asbestos exposure remained large. By 2002, APH made up 75% of outstanding claims and asbestos alone was 50%. If there were to be a shortfall, then the underwriters at Lloyd’s would once again be liable since Equitas had merely reinsured the exposure. However, even if the firm’s finances held up, the Names were still in limbo, uncertain until all claims had run off, a process which was expected to take decades.
Buffett
In the end, the reinsurer was reinsured. In 2007, Equitas and Lloyd’s paid just shy of £400 million to secure a $7 billion reinsurance policy from National Indemnity Company, a subsidiary of Warren Buffett’s Berkshire Hathaway. The deal meant that Equitas, and by extension the thousands of affected Names at Lloyd’s, were adequately covered against potential losses. The Names even received a small £50 million distribution. More importantly for most though, National Indemnity had deep pockets so they were now certain that they would not have to contribute further to cover pre-1993 claims arising from asbestos or other hazards.
By the time of the 2007 deal, Lloyd’s had changed; the number of active individuals underwriting for their own account at Lloyd’s had dropped to a mere 1,500. On the other hand, corporate membership had opened up under the same Reconstruction and Renewal plan that created Equitas. Whatever the changes, the three-century old marketplace had survived one of its greatest threats.
Lesson
The National Indemnity transaction more or less ended the uncertainty plaguing Lloyd’s and its members, many of whom had no business underwriting policies or treated the risk as only theoretical. It also concluded the story of insurance’s ‘bad bank’, created to run off costly exposures in an entity separate from Lloyd’s itself, not unlike the ‘bad banks’ created as part of more recent bank restructurings. It was hardly a triumphant creation, but Equitas allowed Lloyd’s to provide greater certainty to its members, curb costly lawsuits, and restore its image with regulators.
More from the Tontine Coffee-House
Learn about the ‘Smyrna catastrophe’, an earlier crisis that convulsed London’s insurance market. Also read about where Lloyd’s stood in the history of marine insurance, its oldest business line, and how a fire in a major German city created the reinsurance business.
Further Reading
1. Duguid, Andrew. On the Brink: How a Crisis Transformed Llyods of London. Palgrave Macmillan, 2014.
2. Equitas. 1999, Report & Accounts for the Year Ended 31 March 1999.
3. Equitas. 1998, Report & Accounts for the Year Ended 31 March 1998.
4. Pearson, Robin. “Delusions of Competence: the near-Death of Lloyd’s of London 1980-2002.” The Long Run, Economic History Society, 14 May 2019.
5. Treanor, Jill. Warren Buffett Rescues Lloyd’s Names. The Guardian, 20 Oct. 2006.
6. Wilkinson, Andrew, and Philip Hertz. “The Lloyd’s Reconstruction And Renewal: A Success Story or Is the Jury Still Out?” Mealey’s Litigation Reports: Insurance Insolvency, vol. 10, no. 11, 4 Nov. 1996.
