David's Blog

Questions to ask yourself

11th August, 2014

Europe is now recognising the 100th anniversary of the start of World War One. This disastrous, horrible experience lasted for four years from August 1914. Millions of young, innocent soldiers went to their death for absolutely no good reason. Alessandra is currently working her way slowly through Margaret MacMillan’s book “The War that ended Peace” and I am listening to Max Hastings’ work “Catastrophe – Europe Goes to War” in my car.

John Hamblin, the noted and very well regarded underwriter of Cathedral Syndicate 2010, is someone whose knowledge of that war is extensive and he is much engaged in following the events which unfolded during the madness of those four years. The title of Margaret MacMillan’s book is particularly important. It seems that most Europeans had got used to an extended period of peace running from 1871 at the end of the Franco-Prussian War. They simply did not realise what war meant, particularly in the context of the new weaponry which had been developed in the succeeding 40 years.

We may all wonder/marvel at the extraordinarily naïve questions which rulers/politicians/advisors/generals asked themselves in the years immediately prior to 1914. It seems that most of them wanted a war. According to Margaret MacMillan most politicians were interested in expanding or creating their countries’ empires though this is not the message which emerges from Max Hastings. Whatever the truth, war was an inviting rather than terrifying prospect. It should have become the tragedy to end all tragedies.

So what has this got to do with our underwriting commitments? The analogy may not seem straightforward. It depends on our willingness/our need to ask ourselves the right questions and make sure we get the right answers. We are not at war and we are not going to war but some historians probably including both Sun Tzu and Clausewitz might argue that business is some kind of fierce competition akin to war. The questions we should be asking ourselves are first, if there is a major disaster or series of disasters which cause us to face substantial losses in our Lloyd's underwriting, can we easily fund such losses? The second series of questions follows on the first. After we have paid the loss, can we and will we readily recapitalise our commitment to Lloyd's particularly if the risk/reward becomes obviously in our favour (as it did following the World Trade Center disaster in 2001)?

The first question should be easy to answer. If we can't answer it positively then either we shouldn’t be in Lloyd's or we are underwriting rather more than we should. The second series of questions is much more difficult. We are now almost all underwriting with limited liability. What does that mean? Simplistically, and ignoring open year profits locked into the system till the year has closed, a Name underwriting £1 million with Funds at Lloyd's requirement typically today in the region of 45% has £450,000 at risk. Let’s examine his reaction to a loss of 20%, however unlikely we believe that to arise.

He has presented to his family that the resources he has at risk at Lloyd's are limited to those funds put up to support his underwriting participation, thus £450,000. He now has to pay out £200,000 to meet his losses. His Funds at Lloyd's are reduced to £250,000. Much capital is withdrawn from the market, fear overtakes greed, and risk/reward becomes extremely attractive. The right thing for him to do is to put the loss behind him, recapitalise and underwrite rather more than his commitment when the risk/reward was unfavourable (as it certainly is now).

In order to do this he will need to put up (my suggestion) at least another £300,000 enabling him to underwrite £1,250,000. In fact when the risk/reward is much more favourable than it is now his underwriting limit should be at least 50% more than in present circumstances. Can he do this, will he do this, will his family preclude him from so doing? Do not imagine that these questions are easy to answer.

At the moment most of us may be argued to be sharing the same kind of complacency which all those people in power suffered in the years immediately before 1914. We have got used to enjoying a remarkable period of profitability all the way from 2002. At Lloyd's we credit some of this quite reasonably to the excellent input of the Franchise Board. What I describe as proactive rather than reactive regulation. Long overdue. However, neither Rolf Tolle nor his successor, Tom Bolt, would attribute too much credit to their departments. Both of them have said, and say, that the Franchise Board’s mandate is to protect Lloyd's Central Fund and to enhance Lloyd's status with the rating agencies. It is not to avoid loss altogether. This is a risk business and it is not possible to take such risks without the expectation that at some time the likely combination of inadequate pricing and exceptional disasters must produce losses.

Market conditions today are different from those in the late 1990s when the hysteria of the approaching millennium overwhelmed common sense. Now we are facing apparently logical analysis by new investors who are committing substantial sums to underwriting because they perceive the potential, even expected, returns to be much greater than the underlying funds would generate with a traditional investment strategy. What’s worse is that many of these new investors have deep pockets, very deep pockets. The amount they are currently committing to underwriting is almost negligible in the context of their available resources but substantial in terms of the inherent level of capital in the insurance world.

Ultimately this will change. So many of us regularly debate what circumstances will be required to bring about that change. My own view is that there will need to be more than one major, possibly unexpected, disaster. And the relative attraction of underwriting compared to alternative investments will need to be rebalanced. I think we are some way off that combination of events. In the meantime please ask yourself those questions, consult with your professional advisors if necessary and, where relevant, make sure that your family understands and is on your side.

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