by Robin Pearson (University of Hull)
This paper was presented at the EHS Annual Conference 2019 in Belfast.
Rapid structural change resulting from system collapse seems to be a less common phenomenon in insurance than in the history of other financial services. One notably exception is the crisis that rocked Lloyd’s of London, the world’s oldest continuous insurance market, in the late twentieth century.
Hitherto, explanations for the crisis have focused on catastrophic losses and problems of internal governance. My study argues that while these factors were important, they may not have resulted in institutional collapse had it not been for multiple delusions of competence among the various parties involved.
Lloyd’s was a self-governing market that comprised investors – known as ‘names’ – who put up their personal assets to back the insurance written on their behalf, and accepted unlimited individual liability for losses. Names were organised into syndicates led by an underwriter and a managing agency. Business could only be brought to syndicates by brokers licensed by Lloyd’s. Large broking firms owned most of the managing agencies and thereby controlled the syndicates, giving rise to serious conflicts of interest.
In 1970, Lloyd’s resolved to expand capacity by lowering property qualifications for new names. As a result, the membership exploded from 6,000 to over 32,000 by 1988. Many new names were less well-heeled than their predecessors and largely ignorant of the insurance business. Despite a series of scandals involving underwriters siphoning off syndicate funds for their own personal use, the number of entrants kept rising thanks to double digit investment returns, the tax advantages of membership, and aggressive recruiting.
While capacity was increasing, underwriters competed vigorously to write ‘long-tail’ liability and catastrophe business in the form of excess loss (XL) reinsurance. Under these contracts, the reinsurer agreed to indemnify the reinsured in the event of the latter sustaining a loss in excess of a pre-determined figure. The reinsurer in turn usually ‘retroceded’ (laid off) some of the amount reinsured to another insurer.
Many Lloyd’s underwriters went into this market despite having little experience of the business. Some syndicates doing XL reinsurance retroceded to other XL syndicates, so that instead of the risks being dispersed, they circulated around the same market, becoming increasingly opaque and concentrated in a few syndicates. This became the infamous London Market Excess of Loss (LMX) spiral.
By 1990, over one quarter of business at Lloyd’s was XL reinsurance. The spiral offered brokers, underwriters and managing agents the opportunity to earn commission and fees on every reinsurance and retrocession written.
It also enabled underwriters to arbitrage the differential between the premiums they charged for the original insurance, and the lower premiums they paid for reinsurance and retrocessions. A later inquiry also showed that those writing at the top of the spiral accepted, out of ignorance or carelessness, premium rates that were far too low for the higher layers, in the belief that these were virtually risk-free.
Unscrupulous underwriters could also offload the worst risks onto ‘dustbin’ syndicates of outsider names, while picking the best risks to be reinsured with so-called ‘baby’ syndicates of insiders. Poor information recording made it difficult to track the risks insured in the LMX spiral.
Lloyd’s membership peaked in 1988, which also marked the first of five years of unprecedented losses. ‘Long-tail’ risks on liability insurance generated many of the losses, as well as a series of storms, earthquakes, hurricanes, oil industry disasters and the Gulf war. Asbestosis and industrial pollution claims in the United States poured in, some from policies dating as far back as the 1930s.
The tsunami of claims overwhelmed Lloyd’s. Groups of names resisted calls and sued on the grounds that Lloyd’s market supervision had failed. Most political opinion moved towards accepting the need for fundamental reform, despite a fierce rearguard action from traditionalists.
In 1993, for the first time in its history, Lloyd’s permitted the entry of corporate investors with limited liability, and these soon accounted for 80% of market capacity. The number of individual names collapsed. A vehicle was created – Equitas – to reinsure all liabilities incurred prior to 1993, funded by a levy on members.
In 1996, Lloyd’s achieved a £3.1 billion settlement with its litigants. In 1998, the new Labour government announced that Lloyd’s would be independently regulated by the Financial Services Authority.
Studies of decision-making under uncertainty and the fallacies of experts are helpful in explaining behaviour at Lloyd’s revealed by the crisis, which included arrogance, elitism, greed, corruption and stubborn resistance to reform in defence of vested interests. Politically entrenched ideas about the virtues of self-regulation, and an exaggerated faith in the ability of insider experts to know what was best for the institution, also played a role.
The practice of syndicate underwriters ‘following’ the premium rate set by a recognised ‘lead’ underwriter reinforced behavioural traits such as ‘herding’, the desire to avoid being an outlier in one’s predictions; ‘cognitive dissonance’, the inability to know the limits of one’s expertise; overconfidence and optimistic bias.
The combined effect of these behaviours on XL underwriting at Lloyd’s was a heightened tendency to ignore ‘black swans’, the unknown or unimagined events that can deliver catastrophic losses. There are obvious parallels with the behaviour of investors in the market for sub-prime mortgage default risk, the collapse of which brought about the global financial crisis of 2007/08.