S&P’s Positive Reaction to Equitas/National Indemnity Deal

October 20, 2006

Standard & Poor’s Ratings Services reacted positively to the news that Berkshire Hathaway’s National Indemnity will initially back and could eventually take over Lloyd’s run-off vehicle Equitas Ltd. (See related article)

The rating agency revised to positive from stable its outlook on the U.K.-based Lloyd’s insurance market and on The Society of Lloyd’s. At the same time S&P affirmed the “A” insurer financial strength ratings on Lloyd’s, as well as the “A” counterparty credit rating on The Society of Lloyd’s.

The agreement in principle with National Indemnity Co. – rated “AAA”/ Stable – provides substantial reinsurance protection to Equitas Ltd. Under the proposed transaction, “Equitas could receive up to £3.8 billion ($7.0 billion) of additional cover above and beyond its existing undiscounted net reserves. The transaction is expected to complete before March 31, 2007, and is subject to various regulatory and other approvals,” said S&P.

The rating agency indicated that it would “conduct detailed due diligence of the structure in the context of Equitas Ltd.’s liabilities. However, we recognize that based upon what has been disclosed to date it may remove any realistic potential for reserve inadequacy at Equitas Ltd. to undermine confidence in Lloyd’s—in particular, amongst clients, brokers, and capital providers.”

Concerning the ratings affirmation, S&P said its ratings “continue to reflect Lloyd’s strong competitive position, strong operating performance, strong capitalization, and strong financial flexibility (defined as the ability to source capital relative to capital requirements).

“These positive factors remain partly offset, however, by the
London market’s legacy administrative processes, relatively high reinsurance reliance and significant exposure to reinsurance recoverables, and continuing operating performance volatility. The consistency and effectiveness of strengthened catastrophe risk controls are also yet to be tested.”

Major rating factors, cited by S&P include the following:
— Competitive position is strong, supported by the positive attributes associated with Lloyd’s unique brand, attraction as the world’s largest subscription market, London’s continued position as a major international insurance and reinsurance market, and policyholder loyalty. Offsetting these strengths are its highly credit-sensitive underwriting portfolio, and the London market’s legacy administrative processes.

— Prospective operating performance will be strong in light of very favorable underwriting conditions and a reduced reserve-deterioration impact. Standard & Poor’s improved view of management control within the Market underpins a belief that performance will not be allowed to return to its historically marginal and excessively volatile profile. Some performance volatility will remain, however, reflecting the nature of the business lines on which Lloyd’s focuses, such as catastrophe-exposed property (insurance and reinsurance), energy, and aviation.

— Capitalization is strong, having recovered from low levels immediately following the events of Sept. 11, 2001. It is supported by strong capital adequacy and the expected continued efficacy of capital-setting processes. These positive factors are partly offset, however, by capital quality issues and the ongoing cost of supporting otherwise insolvent, nontrading capital providers. Capital quality is adversely affected by reliance on reinsurance, set against the backdrop of a very challenged reinsurance environment. A significant further reduction in reinsurance capacity could have negative implications for Lloyd’s competitive position and future earnings.

— Financial flexibility is strong, being principally derived from capital providers’ continued support. This was most recently demonstrated by capital providers’ response to the capital and liquidity demands generated by the 2005 hurricane season and the Market’s capacity increase for 2006.

— The 2005 performance of some Lloyd’s franchisees highlighted some catastrophe risk control deficiencies that appeared to be common to the reinsurance and insurance industries. Management action in the intervening period has sought to address highlighted weaknesses, but its consistency and effectiveness is yet to be tested.”

S&P said “the ratings could be raised in the event of a satisfactory combination of the following:
— The successful conclusion of a deal between NICO and Equitas that demonstrably reduces Lloyd’s exposure to Equitas Ltd.;
— Further improvement with regard to the London market’s administrative processes;
— Subject to normal catastrophe loss experience for 2006, the Market posting a combined ratio of less than 95 percent and ROR of more than 10 percent;
— Lloyd’s main capital providers remaining committed to the Market;
— Catastrophe-related operational weaknesses being successfully strengthened; and
— Capital adequacy remaining strong, as reflected in central assets available for solvency purposes remaining at about £1.75 billion and Lloyd’s solvency ratio remaining above 300 percent.

“The outlook could be revised to stable or negative, however, should NICO and Equitas fail to conclude a deal as envisaged, or if prior to closing, material deterioration in Equitas’ solvency were to occur.”

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