Lloyd’s, ‘RBS of 15 Years Ago,’ Teaches the banks of today a lesson

Article From Bloomberg:

Lloyd’s of London, the 321-year-old insurance market almost destroyed by a speculative boom and bust two decades ago, is thriving, offering lessons to lenders such as Royal Bank of Scotland Group Plc in how to survive a crisis.

Just as traders repackaged risky assets into opaque securities that proved impossible to value during the credit crisis, Lloyd’s underwriters reinsured the same policies over and over to generate commissions. Claims triggered by asbestos- related sicknesses and the Piper Alpha oil platform fire cost the mutual society of investors 8 billion pounds ($13 billion) between 1988 and 1992.

Lloyd’s revival, garnering a cumulative profit of 14.7 billion pounds in the past seven and a half years, shows how the banking industry might repair itself, according to Lloyd’s Chairman Peter Levene — by improving transparency about where risk is accumulating, centralizing oversight of the activities of those risk-takers, and bundling old, impaired assets into a separate unit to free up capital.

“Lloyd’s, fifteen years ago, was the RBS of today,” Levene, 68, said in an interview. The road to recovery is “very long, hard; you haven’t got a quick-fit solution,” he said.

Banks are starting to reform, though government ownership may make it easier for them to avoid some of the changes that Lloyd’s proved will work, said Philip Booth, a professor at London’s Cass Business School.

RBS Changes

“RBS needs to make the same changes and has started,” Booth said. “Unless the government makes credible a threat to not bail out banks such as RBS in the future, then financial institutions will not have an incentive to develop long-term solutions to their problems, as happened at Lloyd’s.”

RBS said in May that it had started new credit approval rules and policies on how much risk the bank can take on with any company or country. The lender also put 282 billion pounds of its riskiest assets into a government-backed insurance program, similar to Lloyd’s decision to hive off all its liabilities from before 1993 into Equitas, a separate company. That spinoff helped Lloyd’s raise new capital from investors.

“The Lloyd’s exercise took quite a few years to sort out,” RBS Chairman Philip Hampton said today at a shareholder meeting in Edinburgh. “We haven’t followed an identical model, we have followed the same theme.”

U.K. Chancellor of the Exchequer Alistair Darling wants banks to write “living wills” to show how their operations would be wound down without government help.

Lloyd’s Mistakes

The reinsurance bubble, or LMX spiral, that imperiled Lloyd’s is comparable to the subprime crisis, said Michael Wade, who helped restructure Lloyd’s in the 1990s and is now chairman of Optex Group Ltd., a reinsurance consultant. When mortgage borrowers defaulted, losses on collateralized debt obligations and credit-default swaps similarly triggered more losses among firms, he said.

Lenders failed to learn from Lloyd’s mistakes in the credit boom, said Morgan Stanley Senior Adviser David Walker, who reviewed Lloyd’s in the 1990s and is now advising the government on the banks. Lenders sold securities exposed to one risk, and bought exposure to the same risk “without adequate central risk oversight,” he said.

“The risk capability of these risk-takers wasn’t up to standard,” Walker said of Lloyd’s. “The risk oversight ability of some of these banks was, in exactly the same way, just not up to standard.”

‘Aggregation of Risk’

Today, Lloyd’s approves every insurer’s business plan each year, so the buildup of risk across the whole market can be monitored, Finance Director Luke Savage said. Lloyd’s market practice has changed so that a policy can now typically only be reinsured twice, said Dane Douetil, 49, chief executive officer of Lloyd’s insurer Brit Insurance Holdings Plc.

“We’ve learned about aggregation of risk,” said Douetil, whose ancestor Edward Mountain refused to insure the Titanic before it sank in 1912. “The banking industry didn’t seem to have in place the same mindset that looked at causality, and underlying causality — if this went, that could go.”

Instead of tapping the government, Lloyd’s turned to its so-called Names, individual investors who had unlimited personal liability on losses. In the credit crisis, the U.K. government provided more than 1 trillion pounds to support lenders, because there was no existing legislation to close banks without taxpayer support, Booth said.

Lloyd’s Names

Lloyd’s was once so unpopular with investors that Robert Hiscox, chairman of Hiscox Ltd., the third-largest Lloyd’s insurer, had to curb his passion for shooting pheasants with them. Hiscox helped save Lloyd’s, where he was deputy chairman from 1993 to 1995.

“Shooting was always dangerous when they had guns in their hands,” Hiscox, 66, said in an interview. “Lloyd’s has made immoderate amounts of money for people now.”

Lloyd’s, where brokers still negotiate face-to-face, still hasn’t redeemed itself to Christopher Stockwell, a former Name who said he lost more than 3 million pounds and was made bankrupt in 1994. Today, most Lloyd’s investors are companies with limited liability.

“The market was allowed to carry on to the benefit of the agents and brokers who operated it but not to the benefit of any of the former Names,” Stockwell said. In 2000, Lloyd’s was cleared of defrauding investors who alleged Lloyd’s knew the asbestosis losses were looming.

The market’s change of fortune isn’t recognized enough, Hiscox said. “We get lumped in with financial services: ‘oh, you’re all bad guys,’” he said.

To contact the reporters on this story: Simon Clark in London at [email protected] Kevin Crowley in London at [email protected]