In search of the audit trail

One type of special reporting work which has attracted increasing interest in many quarters is auditors' work in relation to Lloyd's syndicates. In recent years, claims resulting from

asbestosis and pollution have resulted in enormous losses by many syndicates. Some actions by groups of Lloyd's Names alleging negligence against underwriting agents and syndicate auditors have already been launched, and expert accountants instructed by their solicitors are now involved in the formulation of claims and the investigative work required to support such claims.

As in other types of forensic accounting work, the expert accountants will need to work closely with the instructing solicitors and counsel. Professional advisers involved in these cases will need an understanding of the Lloyd's market and the main audit issues.

A unique feature of Lloyd's syndicate accounts is that accounts for a specific calendar year are not closed off until two years after the end of that year. A syndicate's membership may change each year so that a syndicate may be composed of different Names for different years of account. Three-year accounting is intended to reflect the period of time over which premiums – and more particularly claims – relating to insurance business written in the first year are notified.

Normally, sufficient information is available by the end of the third year to determine the result for that year of account, so that the year of account can be closed and the profit or loss apportioned between all the Names in the syndicate. In order to do this, the syndicate reinsures its outstanding risks, often with the same syndicate in the next year of account, by means of a

special form of reinsurance premium, known as 'reinsurance to close'. In some cases, however, it may be very difficult, if not impossible, to assess the reinsurance to close, and the underwriter and managing agent may decide it is not possible to close the account after three years. The account will, therefore, be left open and will be known as a 'run-off account'.

The arrangements whereby open accounts are closed through reinsurance requires the managing agents and underwriters of syndicates to have regard to equity between the syndicate members in each successive year. If the premium for the reinsurance to close does not accurately reflect the likely pattern of future claims or if the level of future claims is impossible to determine, the syndicate members for the year which accepts the reinsurance will be at a serious disadvantage compared with the members in the syndicate in the previous year who reinsured their risk.

The auditors' work on reinsurance to close will be at the heart of most audit negligence litigation relating to Lloyd's work.

The expert accountant's role in actions against underwriters is likely to involve assistance to other experts by way of the preparation or scheduling and analysis of financial information. By contrast, the expert

accountant's role in audit negligence cases will be much more central to the case in that the expert accountant will help instructing solicitors and counsel to determine liability.

Issues which expert accountants will address in connection with actions against Lloyd's syndicate auditors will include:

– Scope of the auditors' work

This includes the extent to which the scope of the auditors' work was prescribed by Lloyd's requirements and whether these requirements could be said to have limited the scope of the auditors' work in any way.

It may also be necessary to consider the various parties to whom the auditors had a duty to report and to whom they may be said to have owed a duty of care. Auditors report on Names as part of a statutory process of reporting on the overall solvency of the Lloyd's market and to Names on the performance of their particular syndicates.

Until the year ended 31 December 1990 solvency reporting was a two-stage process involving syndicate auditors and auditors appointed by members' agents. There were, therefore, various contractual and reporting relationships.

– Reinsurance to close

Auditors have recognised for many years that reinsurance to close a year of account is normally the area of greatest audit difficulty, because it is arrived at with a substantial degree of underwriting judgement. The degree of subjectivity involved in the estimation of reinsurance to close will vary between syndicates according to the type of risk they take on.

As part of the assessment of the appropriate range within which the auditors might expect the premium for the reinsurance to close to fall, auditors need to consider: the nature of the syndicate's business; the overall size of the syndicate; the impact of the reinsurance protection programme; and the accuracy of previous estimates.

Reinsurance to close has two basic components. The first is an assessment of the amount of known outstanding claims. The second, which causes the greatest difficulty, is an estimate of the value of claims which have not yet been notified to the underwriter, but which will emerge in the future.

– Interaction between solvency work and reporting to Names

The issues which may arise in this context concern the extent to which auditors carrying out work on, for example the solvency of syndicates and/or Names for the purposes of the statutory report to Lloyd's may and indeed should have taken into account information which they acquired in the course of performing that work when carrying out audit work for the benefit of reporting to Names.

– Auditing standards

Two major issues under this heading will be: what were the prevailing standards; and the extent to which auditors can plead in their defence that they were carrying out work in accordance with standards which were generally accepted at the time.

An issue which will need to be addressed is the extent to which the then current general auditing standards and guidelines applied to the audit of Lloyd's syndicates. By the early 1980s the accountancy bodies whose members carried out Companies Act audits had recognised the need to codify auditing standards and guidelines and in April 1980 issued (inter alia) the Auditor's Operational Standard.

The message conveyed by this standard, which was essentially a set of principles, was that auditors were required to devise audit procedures which, if followed with sufficient rigour, would minimise the possibility that the auditor fails to detect material misstatements in the accounts and that the auditor's opinion is therefore inappropriate.

More generally, by 1984 at least, Lloyd's took the view that general auditing standards applied to syndicate audits. And in July 1984, Lloyd's issued a consultative document on syndicate audit arrangements which stated that auditing standards should be followed by auditors in carrying out syndicate audits.

As far as generally accepted standards of work are concerned, it will be interesting to establish the extent to which defendant auditors assert that any allegedly deficient audit work was on a par with the general standard of work prevailing at the time, and the extent to which the courts allow this argument to be advanced.

It is clear that from the auditor's point of view, Lloyd's was and is a self-contained world in which auditors' responsibilities were complex and accounting arrangements were unusual. Expert accountants clearly have a vital role to play in helping to support or defend negligence actions, by investigating the factual background, analysing the often copious information obtained and giving expert advice on the numerous audit issues to emerge in this specialised area.

George Sim is a member of the Academy of Experts and a partner of Sim Kapila, a chartered accountants firm which specialises in forensic and

investigative accountancy.