Reform is key to achieving the stability and sustained profitability that the market needs to attract investors Michael Faulkner reports.

The director of the Lloyd's franchise board has a pivotal role to play in the future investment trends at Lloyd's.Rolf Tolle has been stalking the market, keeping a watchful eye on syndicates' business plans and clamping down on errant underwriters that threaten the stability of the market. Investors are waiting to see whether he succeeds.Ben Thompson, chief executive of investment bank Noble Group, says: "Investors are nervous. There is concern as to what will happen to rates."Thompson says that investors are watching to see whether, as the market approaches its zenith, its volatility will continue. Will the past years' hard rates and profits be followed by a plunge back into the depths of a soft cycle and losses?"The alternative scenario is that the Lloyd's reforms succeed in controlling the premium cycle and preventing the downturn being too deep," says Thompson. "At the moment investors are sitting on the fence waiting to see what happens over the next year."

Substantial profitsMichael Wade, chief executive of investment management company Rostrum Group, is more bullish.He predicts a strong investment climate in the short term."The current market conditions are looking extremely good and substantial profits are likely to be earned within the 2002 and 2003 years of account," says Wade. "Even if rates begin to reduce, profitability will be extended well into 2005 due to the absence of competitive forces. The listed vehicles should produce attractive returns over an extended insurance cycle."Wade argues that as the market cycle reaches its peak the value of the listed vehicles could rise considerably, attracting new investment streams."The value of the ILVs (integrated Lloyd's vehicles) could rise by as much as 50% once the investment markets are more confident that the profits are being earned and that an attractive dividend stream will actually materialise. This will tempt the income funds to begin investing in the sector as there will be few UK stocks distributing high levels of income during 2004 and 2005."The need to attract new investors into Lloyd's is at the forefront of the managing agents' minds.Ewen Gilmour, managing director of listed insurer Chaucer, says that part of Lloyd's traditional investment base - the smaller capacity funds - is running out of money. "They are overweight; they have no new money to spend."He argues that Lloyd's needs to attract the larger funds. The key to this is for the market to demonstrate sustained profitability over time.

Institutional investorsWade agrees that the market has so far failed to attract the larger investors, but he cites a more fundamental reason for this: that the listed vehicles are simply too small to attract the big institutional investors who trade on the London Stock Exchange."The average stock market capitalisation of the listed companies is £300m. This is tiny compared to other insurance groups with London listings. Allianz has a capitalisation of £22bn, Aviva has £11bn and Royal & SunAlliance has £2.5bn," he notes."The small size generates less value for investors as the stocks suffer lower liquidity and a greater volatility to adverse underwriting results. So the type of investors will tend to be more opportunistic and fickle than longer term holders."The solution, he says, is for a number of the ILVs to merge to create a "must have" stock for fund managersWhile many agree with Wade's thesis, it is nonetheless a controversial idea that generates opposition and amusement in almost equal measure.In a market made up of so many fiercely independent and headstrong personalities, the prospect of merger would be fraught with difficulties.Notwithstanding the political issues, critics point to the business implications of such a move. Would the merged capacity of two syndicates equate to the sum of the individual capacities? Not necessarily, say the critics.And what about the loss of jobs? The merged vehicle would not need two energy underwriters, for instance."A merged vehicle is more attractive in a soft market, but it is not a creature of a hard market," says one managing agent.The creation of a merged vehicle - a stock market darling - looks improbable, so a strong, disciplined market is a must if Lloyd's is to continue to be an attractive investment. Investors will be looking to Tolle for reassurance.

WHO IS INVESTING IN LLOYD'S?Toby Esser, chief executive of Lloyd's broker Cooper Gay, predicts that companies such as AIG and XL will begin to reduce their investments as the market starts to edge downward.But it is unlikely that they will pull out of Lloyd's completely, not least because they have spent time investing capital over the years.Noble Group chief executive Ben Thompson says: "They see Lloyd's as attractive because of its talent and its licences. But they have their own agendas and can move to other areas."Berkshire Hathaway is a good example of the opportunistic investor. Previously a significant capital provider at Lloyd's through qualifying quota share (QQS) arrangements, Warren Buffet's investment giant has been withdrawing from deals this year, notably in the aviation market.Chaucer managing director Ewen Gilmour expects this decline to continue."It will have come in for the top of the market - and has done so successfully, but its exposure will reduce in 2005."But like the insurer investors, it is still expected to have a presence. Rostrum Group chief executive Michael Wade says: "Berkshire Hathaway will continue to seek out opportunities."Esser says that 2005 will see a growth in the number of institutional investors and private names (through limited liability vehicles). "They will be attracted by the market's recent profitable years," he says.The use of an investment technique known as 'stacking' has encouraged non-insurance investors. Also known as mezzanine financing, stacking is the investment version of an excess layer in an insurance policy: the investor's capital is at risk only if losses exceed a specified level.The problem with stacking is that it can give the impression that the investment is risk free but this is not the case, says Esser.Venture capitalists are not interested in Lloyd's at the moment, according to Thompson. "The returns are not high enough. They come in at the bottom of the cycle."