Lloyd’s interim results not reflective of “sustainable profitability”

The world’s oldest insurance and reinsurance market Lloyd’s of London has announced its interim results this morning, providing a snapshot of how the traditional re/insurance market has been fairing in the softened and challenging market environment.

In the first-half of 2016 the Lloyd’s markets results have suffered due to an increase in attritional loss and expense ratios, higher catastrophe losses and lower reserve releases, taking the combined ratio of the market close to the point of underwriting unprofitability at 98%, up from 89.5% in the prior year period.

Despite the high combined ratio, which suffered due to major losses as well as attrition with the Fort McMurray, Canada wildfires the biggest hit of the half-year, Lloyd’s actually reported higher profits at £1.46 billion for H1 2016, up £260 million on H1 2015.

But CEO Inga Beale and Chairman John Nelson explain that one-offs have helped Lloyd’s out of a much worse set of results, with a bounce back of investment return to 1.8% (compared to just 0.6% in the prior year) and foreign exchange gains of £300 million due to the change in dollar to sterling rates boosting results and profitability.

Neither of these factors “represent sustainable profitability” Beale and Nelson wrote in a joint statement, and “The underwriting result clearly reflects the challenging market conditions we have previously reported.”

Low interest rates, which Beale and Nelson say show no immediate sign of changing, large losses such as Fort McMurray and “an unparalleled amount of capital coming into the market” all contributed to ongoing pressure on premium rates and saw Lloyd’s underwriting profit plummet by £850 million for the half-year.

It’s interesting that yet again Lloyd’s felt the need to discuss capital coming into insurance and reinsurance. Calling it unparalleled in the year that growth of alternative capital and insurance-linked securities (ILS) has slowed significantly is perhaps telling, either that Lloyd’s feels the pressure is building, or that it feels that capital is flowing in rapidly into traditional insurance and reinsurance businesses as well.

Interestingly, Lloyd’s combined ratio was higher than a competitor group weighted average (which was 95.1%) for the first time since 2011, according to Beale and Nelson, which they put down to the higher attritional loss and expense ratios in the half-year.

The accident year loss ratio for the first-half was 103.7% (up from 97.5%) due to the increase in attritional losses and major claims that Lloyd’s faced. Major losses added 5.7% to the combined ratio in the first-half, compared to 2.7% a year earlier.

Reserve releases helped by then reducing the combined ratio by the same amount, at 5.7%, although this is quite a bit less than the 8% in the prior year so reserves are perhaps something to watch out for.

Both administrative and operating expenses are up in the first-half of 2016, another factor to watch out for in a lower underwriting return world. Efficiency is key at Lloyd’s, as it is at any reinsurance or ILS firm these days and expense control is increasingly important.

“While these results show the impact of the highly competitive environment we are in, they demonstrate that Lloyd’s is in robust financial shape,” Beale and Nelson wrote in the statement as Lloyd’s capital position remains robust rising 6%, premiums written increased by 5% (although only 0.6% excluding the effects of foreign exchange rates).

“While rates have continued to decline, volumes have increased, reflecting the strong footprint Lloyd’s has globally in the specialist insurance and reinsurance market,” the Lloyd’s leadership wrote.

This is of course great news, writing more business at lower returns, as long as Lloyd’s can control its attritional loss and expense ratios, as well as build back up reserves so they have more of a positive contribution to the combined ratio.

But if those cannot be controlled and if the world is heading into a new reality where catastrophe and weather losses are more frequently impacting the market, then managing profitability could be more difficult without the assistance of one-offs, as seen this last half-year.

One bright spot for Lloyd’s could be the potential of the ILS market and capital market investors to help the market reduce the cost of its underwriting capital. By augmenting the capital of the market with ILS structures perhaps Lloyd’s could hike its capital efficiency, becoming more selective about which risks sit within the market and which it earned fees for becoming the originator, analyst and pricing hub for.

Beale and Nelson reiterated that due to the new priority of focusing on Brexit Lloyd’s has “decided to pause our work on the Lloyd’s Index.”

However, continuing to display a desire to embrace alternative capital more readily, the pair wrote that the market “will continue discussions with the Insurance Linked Securities Taskforce over the coming months.”

The key message is that this is an unsustainable situation, created by a number of one-offs on both sides of the balance sheets. Higher than expected losses, both attritional and major, but offset to a degree by higher investment income and foreign exchange effects.

These factors cannot be relied upon and it is underwriting that Lloyd’s must make its profits on, while its business model remains as it is.

But by embracing alternative capital and the ILS market, sharing some of its risk with ILS investors, perhaps through whatever transformer structure the ILS taskforce develops, and leveraging its ability to source, analyse and price risk, Lloyd’s could add a very attractive source of fee income to the markets results.

Would that cannibalise the results of its members though? That has always been the fear and it’s difficult to say.

But in the new reality of lower investment yields, more fungible and accessible capital, growing demand for insurance-linked returns and the push for more efficient risk transfer business models (which insurance technology alongside efficient capital will accelerate), perhaps Lloyd’s just needs to embrace change more wholeheartedly.

Also read:

– Innovation needed to facilitate all types of capital within Lloyd’s.

– Could Lloyd’s names capital start to look a lot like ILS capital?

– Alternative capital to continue disruption of reinsurance: Nelson, Lloyd’s.

– Efficient ILS structure will help secure London’s future: Beale, Lloyd’s.

– Lloyd’s continues to loosen up to alternative capital & ILS.

For a detailed look at how Lloyd’s has shifted increasingly towards embracing ILS and alternative capital read our article from December.