Lloyd's of London
How Lloyd's of London Works
Lloyd's syndicates work on the basis of a three year accounting cycle (triennial accounting). Each calendar year a Lloyd's syndicate starts a new insurance venture with a clean book containing no assets or liabilities. In the first year of account, the venture accepts premiums from customers to insure risks for one year (the annual venture). At the end of the year, the venture stops writing new business, but continues to exist to pay claims for the next two years of account. After three years (one year of writing and two years of paying claims) the venture is closed. Its books are balanced, any profits left over after paying out claims and reinsurance-to-close are paid out to members. Each year's venture stands on its own with regard to paying claims and collecting premiums.
Unlike most businesses, accountancy at Lloyd's does not assume the "Going concern" basis, because it is expected that each venture will last for three years and then end. The origin of this accounting cycle was in the shipping business. Syndicates would insure a ship before the start of its voyage, and the three-year period was considered to be the amount of time that it took a ship to sail around the world.
Since the 1930s, many Lloyd's syndicates branched out to underwriting policies providing coverage for general liability, and excess liability beyond that covered by other insurance policies, as well as providing upper layers of reinsurance. Comprehensive unrestricted general liability policies were very popular in the US market from the late 1940s to mid 1970s. These types of policies involve time spans longer than the finite three years of a Lloyd's venture. Insurance policies that cover liabilities that may extend for many years are called long-tail policies because the "tail" of the liability can extend out for many years into the future (for instance, subsidence damage is often not detected until the relevant building is subjected to a structural survey, which typically may not occur for many years until it is about to be sold; it is only at this point that the insured person contacts the insurer, who then has to estimate the cost of rectifying the damage. See also "Asbestosis" below). Short-tail insurance relates to liabilities that are notified and settled quickly (for instance motor vehicle insurance and domestic house contents insurance).
Before an insurance venture can be closed at the end of three years, its liabilities must be balanced by paying out all outstanding claims which have not been paid, and making provisions (setting aside reserves) for any unpaid claims and for any incurred but not reported losses which may occur in the future. An example of an IBNR loss is a lawsuit filed in the future seeking damages for business activities that occurred in the insured time period. Another would be relatively minor damage to a salesman's leased company car that was sustained during the period of insurance but not identified until he returned the car at the end of the lease (because he preferred to live with the damage than to be without the car for the time it was being repaired).
Inside the Lloyd's system, potential incurred but not reported losses are reserved for and transferred (reinsured) at the time of closing by estimating the potential total future liability, and then paying a one time premium for a reinsurance-to-close policy(s) (RITC) which transfers the risk. Typically, the reinsurer is the following underwriting year of the same syndicate, but it may be with another syndicate(s). The transfer of residual capital as RITC premiums from year to year and venture to venture ensures solvency for future liabilities.
Long-tail policies are thus rolled over from year to year and in theory there is always capital available from accumulated RITC premiums to pay claims. It also means that the largest insurance risk typically underwritten by a syndicate are its own reinsurance liabilities for previous years. If the premiums paid for reinsuring previous years were too low, then the syndicate may become undercapitalized thereby forcing it to rely on the unlimited liability of the Names. This follows from Lloyd's practice of policyholders always being paid in full irrespective of any financial difficulties individual Names might have.
The structure of triennial accounting and RITCs is considered by some to be ill-suited to modern business. The root of the problem is the difficulty of forecasting the results of risks which have a long duration (or 'tail'). The system of RITC can convey enormous amounts of latent liability onto the shoulders of latter year investors. If the full nature of the liabilities is not understood and cannot be quantified, then it is impossible to reserve for it properly. This can result in highly subjective opinions determining the outcome of different years of account.
