Posts Tagged ‘Insurance’

Septic banks – lessons to be learnt from Lloyd’s of London

Friday, January 16th, 2009
Lloyd’s Building as seen from street level.

Image via Wikipedia

Since the start of the credit crunch I have continually noticed the similarity, albeit on a much smaller scale, of the crisis that faced Lloyd’s of London in the early 90s.

Lloyd’s syndicates believed that they had found a risk free way of doing business by passing on the risks they took on to other insurers. Reinsurance policies became increasingly complex, and premiums dropped as the market expanded and everyone piled in to this new risk free environment where it was easy to underwrite anything and then pass on the risk to the next player. Eventually, a big loss came along in the guise of Hurricane Hugo – it soon became evident that there was no new model, as the reinsurance spiral unwound like a deck of cards.

There is a remarkable similarity in the way banks have taken up securitization over the past decade. The collapse of the US property market was their Hurricane Hugo.

Lloyd’s had additional problems to the insurance spiral – many syndicates were facing huge and ongoing losses from asbestos claims stretching back over 50 years. The combination of the two problems pushed Lloyd’s to the edge of extinction. Nobody would inject new capital into the system as there was no way of valuing the existing businesses as they could not reliably forecast future losses coming from their past liabilities.

The solution they came up with was to setup Equitas – Lloyd’s version of a bad or septic bank. Equitas took on all liabilities from before 1989 in return for a fixed reserve of cash from each syndicate in Lloyd’s. All these losses were ring fenced from Lloyd’s syndicates existing operations giving investors confidence to come back ino the market. If Equitas failed, and the aggregate reserves they took on to cover the liabiliies eventually proved to be too little, this would have come back to haunt Lloyd’s. However, this never happened – Berkshire Hathaway eventually acquired Equitas in 2007 and paid £50m back to the Lloyd’s market.

Surely there are some lessons here for setting up a toxic bank to take on the UK and US banks’ liabilities.

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