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Re-visiting Lloyds

Nigel Hanbury is CEO of Hampden Private Capital.

As an investment option Lloyds may have been blighted by past events but in recent years it has emerged as a real alternative asset class for both family offices and HNWIs. Nigel Hanbury looks at the risks and rewards of joining the insurance market

It has been some time since Lloyd's was considered a suitable investment for high net worth investors (HNWI) and family offices. This is a shame and a missed opportunity, as the structural changes that have taken place at Lloyd's in recent years are profound and have transformed the prospects for the market and its investors. Probably the most significant change has been the introduction of limited liability vehicles through which all new investors now participate, removing at a stroke, the fear of unlimited liability.

The reasons for investing in Lloyd's are now worth reviewing: double use of assets; negligible correlation to most other investment classes; immediate access to a mature, international market with one of the best 'brand' names in the sector; significant tax planning opportunities; market conditions post Hurricane Katrina in the USA are somewhere between good and excellent; and limited liability.

At present there are two methods by which a private investor can participate at Lloyd's: by forming a Lloyd's limited liability company (colloquially referred to as a Nameco) for the express purpose of underwriting, in which the investor is the only shareholder; or by forming a Scottish Limited Partnership for the same purpose. Both of the above become members of Lloyd's and participate on syndicates at Lloyd's with the advice of a members' agent.

As an alternative to using existing acceptable assets, investors may choose to use bank guarantees or letters of credit to provide the deposit for backing the underwriting so as not to disturb existing investment positions. If the investor is already the proprietor of a group of companies, a Nameco can be established as an additional subsidiary - a natural extension perhaps to an established business with a holding company.
It is possible to buy an existing Nameco, which can be a very efficient method of entering the market. A buyer can obtain an immediate cash flow benefit, probably on a discounted basis and avoid the cost and bother of setting up his own company. A lively market is beginning to develop in this area as more and more sophisticated investors become aware of it.

During 2006 a third method of participation will be added in the form of English Limited Liability Partnerships (LLPs). Potential investors should be particularly enthusiastic about this development because an investment in such a vehicle reproduces similar attractions and benefits that used to apply to unlimited membership of Lloyd's, but with the advantage of limited liability. These partnerships, although corporate bodies, are tax transparent so any income or loss accrues with that of the owner. This type of investment is beginning to appeal to a whole new generation of private investors in Lloyd's.
There are potential tax benefits in all methods of investment or participation, particularly for inheritance tax – Lloyd's assets enjoy 100% business property relief. The investor establishing the vehicle could also have the option of donating shares to others or taking them into partnership in the case of an LLP. The changes in pension rules to be introduced in April 2006 will yield additional attractions as pension contributions for directors or partners can be paid from the income generated from the vehicle.

There is a very exciting opportunity as worldwide insurance rates are buoyant following the unusually active hurricane seasons we have experienced in the last two years. Insurance market conditions at Lloyd's are looking increasingly attractive for 2006 and beyond. Uniquely, the structure of Lloyd's gives investors direct access to the underwriting returns of a diversified and mature book of insurance and reinsurance business. We expect that insurance pricing will generally strengthen throughout 2006, making 2007 an attractive entry point for investors considering a direct investment in Lloyd's syndicates.

The industry is in a classic supply-demand squeeze at this stage of the insurance cycle: firmer pricing is currently being driven by increased demand for insurance, while the supply of underwriting capacity has been eroded by the effect of the 2005 hurricane season and pressures from reinsurers who are raising their prices on both loss-affected and non-affected business.
According to Swiss Re, natural catastrophes in 2005 have caused around $80 billion of major insured property losses. To put these losses in context, Munich Re estimates that the entire capital base of the reinsurance industry is only $130 billion with reinsurers being particularly affected by $45 billion of losses from Hurricane Katrina, which is the largest natural catastrophe in history by some margin. While a significant amount of new capital has been raised by the industry in the latter months of 2005, it remains a fraction of the capital so far depleted by the major losses – the latest estimates from the insurance broker, Willis, are that the US industry has only managed to raise around 20% of the insured loss in new capital.

The impact of the 2004 and 2005 hurricane seasons heightens awareness of risk both by insured clients and underwriters. Already brokers are preparing their clients for a changed market place as we go through the renewal season for next year.

Lloyd's itself has been transformed in the last 15 years from a market of literally hundreds of small companies, many of them under-resourced, to a market of a relatively few large companies. For example, there are only three agencies at Lloyd's dealing with private capital – Hampden Capital is the largest in terms of capacity, advising £1.15 billion for the 2006 underwriting year. All agencies carry out in-depth research on the market and are very aware of an obligation to manage the cycle of insurance on behalf of the investor. In practice this means consciously reducing investors' exposure in unfavourable conditions and expanding it when market conditions are good.
Insurance has been a difficult area in investment terms for the last 15 years; Lloyd's was not alone in encountering problems from the past. In the case of Lloyd's, those problems have been overcome and its reputation has been greatly enhanced over recent years.

Because of its risk profile an investment at Lloyd's is not for everyone. However, it is an adjunct or real alternative to hedge funds or private equity or any other geared investment that HNWIs or family offices might consider and it possesses additional benefits of tax planning opportunities.

After 9/11 in 2001, Lloyd's returned a profit on capacity averaging 11.1% (27.8% ROC) for the 2002 underwriting year with profitability improving further for the 2003 year to an estimated 17.2% (43% ROC). Pricing is likely to continue to improve into 2007. In an era of low investment returns, which is a contributory factor in the underwriting profitability of the insurance sector, Lloyd's looks a particularly appealing asset class. Also, potential investors are attracted to Lloyd's because it is largely uncorrelated with other investments.  Stockmarket or property values may go up or down but the insurance cycle responds to different market forces.
Perhaps now is the time to take another look at Lloyd's.

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