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“IF YOU had to invent an insurance market, you'd never invent Lloyd's,” it is often said of the 316-year-old London-based institution. Lloyd's is most famous for almost going bust in the 1990s at the expense of the individual “names” who used to provide its capital. Lately, however, it is showing signs of having made a remarkable recovery. It reported profits of £1.9 billion ($3.1 billion) for 2003, more than double the previous year. And its reputation is riding high. Not only did it willingly pay huge claims after September 11th, but also it expects to have no trouble riding out the succession of hurricane-related claims currently battering the insurance market. Its final payout for hurricane Charley, for instance, was a modest £300m or so, hardly enough to dent a market that has annual underwriting capacity of £15 billion, almost half of which is directed to the reinsurance business.

Lloyd's new-found health is galvanising its bosses, who think the market can do even better if only it will shed some of its quirkier characteristics and embrace modern technology and business practices. Nick Prettejohn, chief executive since 1999, talks of changing the behaviour of the whole enterprise: “We're trying to make up for an awful lot of lost time.”

A brief walk round the market suggests he is right. Despite its modern setting, Lloyd's is replete with traditions. Brokers still march around with bulging folders of documents as they seek to place business. Encouraging them and underwriters to make better use of electronics is only one of several big changes Mr Prettejohn has in store. He rattles off eight priorities, ranging from the adoption of annual accounting (Lloyd's has traditionally reported results with a delay of three years) to obtaining more licences for doing business round the world and getting easier treatment on reinsurance from regulators in America. The most important of all, however, involves improving the performance of the 66 underwriting syndicates that inhabit Lloyd's. “People should be able to demonstrate a well-argued business plan,” he insists.

If that seems an unremarkable goal, then consider that Lloyd's is not a company, but a highly unusual market. Its syndicates are mostly backed by big insurers, which have their own chief executives and announce their own results. Despite competing against each other, the syndicates also report to the centre, which pools some of their risk. In this sense they form a unique structure—a “voluntary, mutual, capitalist society”, in the words of Graham McKean, chairman of Ballantyne, McKean & Sullivan, a firm of brokers.

Lately, however, the mutual society has been behaving more like a company. Two years ago it created a “Franchise Board” to promote Lloyd's powerful brand and push through reforms. Its interventions have not been to everyone's liking. Many among the market's thousands of underwriters and brokers support toughness in theory, but remain fiercely independent. They appreciate Lloyd's prestige and global reach, its protections and the face-to-face haggling that has existed ever since Lloyd's began its days as a coffee-house offering insurance for the British empire's merchant fleet. They come to Lloyd's to deal in big risks, complicated risks and just plain weird risks (a man once obtained insurance against seeing a ghost).

History partly explains why many underwriters and brokers are residually wary of central management, which gobbles up 1.75% of syndicates' premium capacity and has a lamentable track record. “The centre has always had the power to intervene in the past. It demonstrably lacked the ability,” says Mr McKean.

Indeed, Lloyd's barely squeaked into the modern era. Between 1988 and 1992 it lost £8 billion as claims poured in from litigation in America about asbestos and pollution cases, as well as from a string of disasters. The names who provided the market's capital had unlimited exposure to Lloyd's risks. More than 1,500 of these (out of 34,000) were financially ruined. They sued for negligence, which had indeed appeared rampant. To save itself, Lloyd's embarked on a huge actuarial exercise. In 1996 it hived off all of the pre-1993 liabilities into a new reinsurance vehicle called “Equitas” and managed them separately from the ongoing business. The enraged names were offered a settlement, which most accepted.

Lloyd's breathed another day and began to change its ways. In 1994 new rules allowed companies to invest in Lloyd's syndicates for the first time. They have since largely replaced names, who now account for less than 20% of Lloyd's capital base. Many big insurers, such as America's AIG or Bermuda's XL Capital, back Lloyd's syndicates. In turn, Lloyd's has internationalised, with America providing more than one-third of premium income and Asia marked for future growth. The theory behind the switch to corporate capital was that companies could bear losses better than individuals. But premium rates stayed low in the late 1990s, and some companies considered pulling out.

Then came September 11th. Paradoxically, the attacks helped to resuscitate Lloyd's. The syndicates' collective bill (before receiving reinsurance payouts) ended up at around £5 billion, or one-quarter of the total for the World Trade Centre. But Lloyd's paid up and did not collapse as many feared—indeed, the market resumed writing terrorism cover within 48 hours of the disaster. The huge losses from the attacks, combined with deep confusion about which insurers were bound to which policies, helped to spur the internal agenda for change. “That tragedy concentrated people's minds,” says Mr Prettejohn.

September 11th also ushered in a long bull market for insurance. Lloyd's has taken advantage and its own financial health has improved. In August it even received a long-sought upgrade from A.M. Best, a credit-rating agency. The management team, led by Lord Levene, Lloyd's globetrotting chairman, and the lower-key Mr Prettejohn, has also impressed many. “Lloyd's is stronger than at any time in its history,” says Robert Hiscox, eponymous chairman of an insurer that runs one of Lloyd's biggest syndicates.

Still, Lloyd's faces lots of challenges. After three strong years, rates for many types of insurance have recently begun to fall. Capital flooded into the industry after September 11th. Competition from Bermuda and elsewhere is intense. The question that preoccupies every underwriter and broker is this: will Lloyd's be able to maintain its new regime of discipline when the market turns?

To put Lloyd's ambitions in context, consider the following: few insurers have ever broken, or much moderated, the dramatic swings of the industry's fortunes. Insurers unfailingly pay lip service to “breaking the cycle”; then they proceed to slash rates and write slacker policies in order to hang on to market share. As Warren Buffett, whose Berkshire Hathaway is a competitor to, as well as a participant in, Lloyd's, has observed, it is “difficult for able, hard-driving professionals to curb their urge to prevail over competitors”. Restraint is all the harder because, unlike in other businesses, insurers only find out years later, when claims are settled, just how inaccurate was their pricing of risk.

If only everybody would slash capacity rather than rates—ie, write less business at higher rates when times get hard—then returns would be steadier. Or so the theory goes. But of course insurers cannot act as an oligopoly. Even within the Lloyd's marketplace, syndicates regularly steal each other's business by cutting rates.

Why, then, is cautious optimism rippling across the market? The answer lies in the emergence of a credible economic regulator (an internal appointment, separate from outside regulation of Lloyd's by Britain's Financial Services Authority). Last year Lloyd's created the post of “franchise performance director” as part of its overhaul. Rolf Tolle, a blunt-spoken reinsurance specialist from Germany, began the job in March 2003. His goal is to generate returns for Lloyd's of about 7% annually, averaged across good and bad years.

Mr Tolle's method is to conduct a careful review of syndicates' business plans. In the past this was only ever done scrappily. This year, the first full year of the new regime, every syndicate had to provide two drafts of its business plan for 2005. Mr Tolle will give (or withhold) approval in November. The idea is that, because he sits at the apex of the market, with all sorts of information at his fingertips, he can more easily spot market trends. He can deduce, say, by how much marine business is likely to fall off. He can then demand justification from individual syndicates that seem out of line in setting premiums too low or terms too loose.

Mr Tolle's impact on this hidebound institution is hard to exaggerate. In July he asked 15 syndicates to resubmit their early drafts and scrawled comments on many more. Next year he is expected to insist on cuts in capacity as the insurance cycle moves downward. Most in the market view him as tough and capable.

Still, concerns abound. Everyone is waiting for an almighty clash between Mr Tolle and one of the bigger syndicates. “The franchise board's day of judgment will come when it says to a major, major business, ‘You can do that, but you can't do that here',” says Mr McKean. “And they will say, ‘Well, if you force us to take that out, we'll take our whole business out.'”

So far, the only public clashes have been with Goshawk—a specialist reinsurer that decamped to Bermuda last year after producing dreadful losses—and Dex, a small marine operation that withdrew because it wanted to underwrite far more business than Lloyd's considered prudent. Meanwhile, the politicking is intense. Smaller syndicates grumble that Mr Tolle picks on them. Bigger ones retort that this is sensible, as their smaller counterparts are more prone to writing foolish business.

With so many warring interests, the quality of Mr Tolle's information also worries some. True, he is advised by several senior, well-respected underwriters, and he also circulates widely. However, argues Mr McKean, the system is “potentially dangerous”. The flipside of Mr Tolle's life-or-death powers over syndicates' business plans is that he must make correct distinctions between serious insights into marketplace behaviour and the mere ups and downs of genuine competitive jockeying. In that sense, his information gathering could be open to abuse.

As usual, there are dozens of different opinions on the subject—and others argue that all the tongue wagging at Lloyd's actually makes Mr Tolle's job simpler. “It's a terribly easy market to regulate because we all see each other's risks,” says Mr Hiscox, himself a former Lloyd's regulator. “It's wonderfully gossipy.”

At their core, though, the jitters about central supervision boil down to two questions. First, will it succeed as rates soften? And second, will it succeed too well? Too much interference could curb the creativity of Lloyd's underwriters—the very reason people seek cover from the London market. “One hopes [the new regime] will reduce the risk. The fear is that it will reduce innovation,” says one broker.

The doubters cite a ruckus in the 1970s over medical-malpractice insurance in America. Most insurers thought it was plain daft to reinsure doctors' mutuals. Lloyd's went ahead and became something of a monopoly, making a fortune. Should a similar situation arise today, says Mr McKean, “I really don't know whether the franchise board could get their head around such an incredible opportunity.”

As if all this were not ambitious enough, Lloyd's has also embarked on a costly effort to modernise the way it handles business. Although Lloyd's is known for proffering coverage speedily, its systems for processing policies are typical of the insurance industry: they are a mess. It has sometimes taken five or six months to finalise a policy on a complicated risk. Worse, negotiations can take place even after coverage has started.

Lloyd's is trying to streamline its own processes and make sure underwriters and brokers know exactly what they are signing up to. For starters, it has ordered the market to use a standard form (called a ‘slip') that states basic information about the underlying policy (the names of the client and broker, how much they are insured for and over what period, etc). Most have complied, albeit grudgingly.

Far more controversial is an ongoing overhaul of Lloyd's IT systems that would change the way brokers and underwriters interact. At the moment, brokers often shop for coverage in the vast underwriting room with hard copies of the risk they are trying to place; later they finalise the policies with the underwriters by e-mail (very old policies, of course, are on paper only).

E-mail has drawbacks. First, it is not secure. Second, it is inefficient, since data are not stored in a standard way. The agreed premium and deductible and so on must be re-keyed into each party's spreadsheets. In other words, the same risks must be re-entered into lots of different systems. Far better, says Lloyd's, to create a single system that everyone can access from their desks. This would make it faster and more secure to hammer out policies. It would also help companies crunch numbers and thus understand their exposures better. Banks built such systems long ago. A year ago Lloyd's hired Iain Saville, who has run such projects at the Bank of England and elsewhere, to head its IT efforts.

Lloyd's new system, called Kinnect, is not much liked or understood. It has cost £50m and counting, but only a paltry number of transactions go through it. Everyone seems to have a different idea for a better and cheaper system. A few even worry that the technology will supersede the face-to-face exchanges between brokers and underwriters—the very essence of the Lloyd's market—though this seems unlikely, especially for complicated risks.

Lloyd's seems determined to push on with its project. Two huge global brokers, Marsh & McLennan and Willis, are backing its efforts and Lloyd's is energetically courting others. A milestone of sorts may be passed later this year, when all North American property business is supposed to be handled by the new system. But the real gains will come only when everyone starts using it. So far only six of Lloyd's 44 managing agencies (which oversee syndicates) have signed up.

As Lloyd's pours money into Kinnect and into the salaries of managers who peddle its brand and preach the virtues of market discipline, somebody has to pay for it all. To date, Mr Prettejohn has managed costs well. He has got rid of hundreds of staff jobs and outsourced services such as claims processing. Better technology should bring more savings—eventually.

But Lloyd's is not a cheap place to do business. This is plain in an industry whose margins have fallen in recent decades. Syndicates contribute 0.5% of their premium capacity towards annual operating costs of around £170m. Lloyd's bizarre capital structure creates still more costs. To the annoyance of some syndicate managers, the remaining names are allowed to shift their investments around every year in an auction. This forces syndicates to re-form, and capital to be re-raised, annually. Administrative costs pile up.

The biggest cost, though, is the 1.25% of premium capacity that syndicates contribute to what Lloyd's calls its “Central Fund” (a separate 2% premium levy ended last year). This is a pool of money, currently around £700m, established to provide backing for syndicates overwhelmed by losses. (It is separate from Equitas, the fund that is running off or settling all pre-1993 liabilities.) In 2002 claims on the central fund reached £466m, much of it in the wake of September 11th.

The backing of the central fund allows syndicates to underwrite huge risks, such as satellites, that they would not be able to handle alone. But there are constant tensions. In binding arbitration begun last year Lloyd's says Swiss Re and five others that provided insurance to the central fund should pay for some of the losses caused by the September 11th attacks. The insurers argue the £500m contract is invalid.

More generally, big syndicates complain that smaller ones free-ride on Lloyd's deep pockets and good credit. And everyone feels that they are being squeezed for a disproportionate share of capital. The squeals will only grow louder assuming Lloyd's follows through on plans to triple central-fund holdings to £2 billion by 2008, although Lloyd's might introduce a system that allows syndicates to make loans to the fund in addition to the annual levies.

And as the centre grows ever more muscular, the Lloyd's gossip machine is starting to speculate about where it will all end up. Is incorporation on the horizon? Might Lloyd's demutualise and transform itself into a limited company? Mr Prettejohn rebuffs such suggestions, noting that Lloyd's has no source of income that could generate value for external shareholders.

The market gossips, however, will not be denied. Mr Hiscox predicts eventual incorporation or even a takeover bid for the market. At the moment, he says, the key impediment to such progress is the continuing presence of the names. They would have to be bought out, and some may refuse to go. Today's names will die off, and Lloyd's is not allowing any new ones to join with unlimited liability. Meanwhile, central management will carry on trying to drag the rest of this ornery market, kicking and screaming, into the modern era.

Copyright © 2004 The Economist Newspaper and The Economist Group. All rights reserved.