The London insurance market has come a long way from the dark days of the early 1990s, when it was plagued by losses derived from asbestos, pollution and catastrophe claims, exacerbated by the existence of the excess-of-loss spiral. In fact, it could be argued that it is stronger today than it has ever been. However, London players need to face up to a number of challenges if they are to successfully compete with other centers of insurance expertise, such as Bermuda.

The London market's recent financial performance has been very strong. This reflects the relatively benign claims experience recorded in 2006 and 2007, as well as the favorable premium rate environment of the last few years.

Fitch upgraded Lloyd's financial strength rating to "A-plus" in March 2007. This action was driven by:

o Positive developments in underwriting results and capital accumulation.

o Berkshire Hathaway's decision to provide up to $5.7 billion in reinsurance protection above the existing reserves of Equitas (the runoff facility designed to cover pre-1993 liabilities).

o Ongoing improvements in operating practices and process reform.

However, to maintain its profitability and good standing, the London market must clear a number of internal and external hurdles, including:

o Cycle Management:

The biggest challenge facing the London market is its ability to successfully manage the underwriting cycle.

Premium rates for most lines have been declining since 2004, except for property-catastrophe lines that were buoyed by substantial losses arising from Hurricanes Katrina, Rita and Wilma in 2005.

Additionally, as 2006 and 2007 produced lower-than-average insured catastrophe claims, premium rates for the majority of lines underwritten by London market insurers declined during the January 2008 renewal season. Fitch expects this trend to continue in the absence of large catastrophes that result in significant insured losses.

The critical challenge faced by underwriters is to exit or reduce exposure to lines of business when they are no longer able to support the required return on capital employed. This challenge is heightened for the London market, as it is a recognized center of expertise for marine and aviation risks--currently among the softer segments of the insurance industry.

While London market underwriters say they are committed to maintaining underwriting discipline, only time will tell if they will be successful in doing so.

Historically, the London insurance market has produced results that have on average been more volatile than those recorded by European and U.S. peers. This has partly been driven by London's focus on more volatile business--such as marine, aviation and property-catastrophe lines--but also to some extent on a historical lack of underwriting discipline.

In 2003, Lloyd's established a Franchise Board to improve the market's risk management framework. By focusing on underwriting performance and cycle management, the board's formation led to significant improvements in risk management.

This enhanced risk management framework is likely to reduce Lloyd's historically volatile earnings but will not be truly tested until the completion of the next soft phase of the underwriting cycle.

o Capital Management:

Following strong capital formation and softening underwriting conditions, capital management has become an increasingly important consideration for London insurers.

From a credit perspective, retaining excess capital is a preferred strategy--particularly during periods of investment or underwriting volatility. However, publicly traded companies understandably manage their capital with a focus on shareholder value, resulting in a range of capital management strategies being employed.

Over the last year, several London companies--such as Amlin, Beazley, Brit and Hiscox--have announced share-buyback programs. While not as conservative as retaining capital, Fitch views this as a reasonable strategy in situations where capital formation has been strong and premium rates are softening.

Conversely, maintaining or growing premium volume in a softening market is a potential recipe for disaster and is a criticism that could be levelled at some London market participants in the past.

Positively, most of the leading Lloyd's agencies have opted to cut their underwriting capacity levels for 2008 by approximately 5 percent in the face of softening premium rates.

Of more concern to Fitch would be London insurers that decide to employ excess capital by expanding or diversifying their businesses. While insurers can benefit from a well-thought-out and appropriately controlled diversification strategy, such diversification--if ill-conceived or without sound strategic rationale--can result in operational risks that far outweigh any capital or strategic benefits.

o Regulatory Changes:

Insurers operating in the London market need to be prepared for the introduction of Solvency II by 2012. Fitch believes this new risk-based solvency framework for insurers regulated in the European Community will improve risk management and transparency.

However, Fitch does not expect the implementation of Solvency II to result in widespread license withdrawal from London market companies, as most of these insurers already hold capital that is well in excess of minimum solvency requirements under the existing Solvency I regime.

Prudent levels of capital are currently held to maintain credit ratings or to meet the requirements of insurers' own internal capital models.

Although complying with Solvency II will entail an initial cost, the discipline derived from allocating capital between lines of business and business operations should enhance the ability of London insurers to efficiently manage capital and price business.

It is generally recognized that the U.K. insurance industry is further advanced toward Solvency II than many other European countries due to the Financial Services Authority's implementation of its Individual Capital Assessment Standards.

Since its introduction in 2005, ICAS has advanced risk management, technical competence, business processes and accountability. However, there are differences between Solvency II and ICAS that will necessitate careful planning and implementation by the London market.

o Business Process Reform:

The London market has made significant progress by implementing business process reforms in recent years. Nevertheless, this is an area that continues to represent a challenge for London firms when competing with insurers located in other domiciles where risk placement, claims processing, and accounting and settlement is more efficient.

The historic structure of the London market among insurers and Lloyd's syndicates--characterized by close physical proximity, the near complete reliance on broker distribution and dependence on legacy technology systems--resulted in a preference for paper-based, face-to-face negotiation and inefficient business processes.

For example, policy wordings were often not provided to policyholders for many years after the inception of an insurance contract, if at all.

To keep London competitive, the Market Reform Group--a cross-sector trade organization--was formed to pursue process reform and modernization. The group has established various targets for electronic placement, claims processing, and the accounting and settlement of risks.

Significant advancements have been made over the last 24 months toward achieving reform in these key business processing areas. However, process reform remains a significant challenge, as some elements of the London market are responding more slowly than others.

Fitch expects Lloyd's might start publishing league tables showing relative performance to encourage underachievers to improve.

o Subprime Exposure:

Recent reports from the London market suggest it is largely unaffected by exposure to subprime-related investments. Most London companies have reported minimal exposure, while the most noteworthy announcement was that made by Catlin Group in November 2007--when the company reported that it expected to take a charge of $75 million against the value of its subprime-related securities (representing just 1.3 percent of the company's total cash and invested assets).

There is a concern that the London insurance market's exposure to subprime losses might increase as related legal actions commence in the United States. The market could be exposed to liability claims under directors and officers as well as errors and omissions policies.

It is too early to predict the magnitude of likely D&O and E&O claims that will develop from the U.S. subprime crisis, and also the split of ultimate liabilities among the U.S., Bermuda and London insurance markets. However, preliminary predictions suggest this is more likely to be an earnings issue for the London market, rather than a capital issue.

In conclusion, the London market benefits from excellent levels of capitalization and recent strong underwriting results. It has access to global business through extensive licenses and is recognized as a center of technical expertise.

These strengths have encouraged an inflow of capital to the market over the last 12 months--largely from Bermuda, but also from the United States, Europe and Asia.

However, the London market needs to face up to a number of challenges, both internal and external, if it is to retain its reputation as the preeminent location in which to conduct insurance and reinsurance business.

Special Reports /

London Market In Great Shape, But Must Clear Internal, External Hurdles

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