Lloyd's counts the cost of insurers' worst ever year

As hurricanes batter America's Atlantic coast, earthquakes and typhoons shake the Pacific and investment markets shudder at the looming prospect of a financial catastrophe, Lloyd's of London appears to be facing a perfect storm.

Yesterday the 323-year-old insurance market and City of London institution reported an interim pre-tax loss of £697m – the corresponding figure for the first half of 2010 was a pre-tax profit of £628m.

This is the first time the market has gone into the red since it started publishing half-yearly results in 2004. And chief executive Richard Ward has warned that Lloyd's will need something of a miracle to turn that into a profit at the full-year stage.

It doesn't get any easier after that, either: There is up to $80bn (£51bn) of excess capital sloshing around the industry. Usually when multi-billion dollar catastrophes rain down on the insurance market, those providing capital to it flee. The net effect is that premiums rise, often sharply, across most lines of business. This is exactly what happened, for example, after the September 11 attacks on the US.

But despite 2011 already shaping up to be the most expensive year for catastrophe insurance cover on record (it attained the bronze medal position after just six months), the holders of much of that capital are staying put. No surprise, then, that the amount of premiums taken in by Lloyd's went up: gross written premiums came in at £13.534bn against £13.49bn.

Why is this happening? Well, despite everything, insurance is still attractive to investors. Gold, it is not. But compared to stocks and shares or cash, it looks rather tasty. "The problem is if you look at cash, the returns are very low and equities are pretty risky, so even with everything that has happened, insurance looks like a pretty good investment," says Mr Ward.

This means that in some classes of business, premiums are even falling: "Take casualty, for example, rates are still coming down and that is long tail business, where claims can come in for years." Put together a rash of horrid catastrophes and lowish premiums, and you're going to make a loss on your underwriting. Hence Lloyd's nasty looking combined ratio of 113.3. This means that, at the interim stage, for every £100 of premium taken in across the market it has had to pay out £113.30 in costs and claims.

And don't expect investment returns to cushion the blow, as they did in the previous decade. Lloyd's investments produced a return of just 1.1 per cent during the first half for a total of £548m. That compares with 1.3 per cent and £597m in the first six months of 2010.

Notwithstanding the widely reported difficulties faced by certain economies on Europe's fringes, bond yields are expected to stay low because markets expect interest rates will remain low for the foreseeable future. Bonds are where most of Lloyd's premiums are invested.

And yet analysts says Lloyd's numbers are actually rather good given the circumstances. Eamonn Flanagan, at Shore Capital, describes them as "a cracking set of results".

"Most people had been expecting a loss in the range of $2bn – $2.5bn, extrapolating from what some of the quoted Lloyd's vehicles have done. If Lloyd's were a quoted company its shares would have probably gone up on the back of these numbers," he says. "You have to remember that they will be comparing themselves to the big US and Bermudan reinsurers. And their combined ratios have been awful. North of 120."

Perhaps this was why Lord Levene, the chairman of Lloyd's, was moved to say: "This is a very different story from the Lloyd's I joined nine years ago. If we had experienced this level of natural catastrophes back then, commentators would have openly questioned our ability to trade forward," in what was his final interim results statement.

Mr Ward, however, has warned that things cannot go on like this for ever: "To be sustainable a business has to be profitable. The message has to be, let's not chase the market. Under-priced risk creates problems and unintended consequences. Just look at all that building on flood plains in the UK. The cost of insurance for those properties is not reflective of the risk. Lloyd's must decline under-priced risks."

Hence a get-tough message to Lloyd's members. The era of wealthy individuals – Names – piling money into ultra risky syndicates with unlimited liability is now over.

But that has not stopped the market from completing reviews of both syndicates' class of business and their pricing processes. This was followed up with visits to each managing agent to ensure risks are priced in line with an agreed approach.

Lloyd's knows there could be trouble coming: hurricane season is approaching its end. But what of the quakes? As Mr Flanagan says: "If you're getting earthquakes in Washington, and I mean Washington DC and not Washington State (on America's West coast), you have to think that the plates are still moving. There could yet be another big one."

So far it seems Lloyd's of London has the strength to cope. Rating agencies give Lloyd's an A+ (strong) rating. The central fund, there to cover clients if members blow up, has £2.472bn in reserves, up from £2.377bn.

Mr Ward is keen to point to figures like this. He says Lloyd's and other insurers are not banks, and should not be hit by a regulatory backwash from the banking sector's woes. Lloyd's already has the EU's Solvency 2 to worry about, which he expects to cost £300m.

Mr Ward and Lord Levene believe Lloyd's can bounce back. But they accept the outlook is "very challenging". The trouble is, if next year is low on major catastrophes Lloyd's might return to profit. But then all that excess capital will likely stick around, pushing premiums down and making it that much harder to withstand another year like 2011 in future.