Kin Group Regulatory News (KIN)

5 Apr 2005 07:01

Kiln PLC05 April 2005 Kiln plc Preliminary results for the year ended 31st December 2004 Kiln plc, the specialist Lloyd's insurance group, announces record results. Financial highlights • Gross written premiums £313.5m up 17% • Record profits before tax of £38.1m, up 15% • Earnings per share of 13.34p, up 11% • Return on equity 21.2% • Shareholders' funds increased by £17m to £145.2m (8.3p per share) • Full year dividend 3.0p per share (final 2.4p). This is a five foldincrease on last year's 0.6p dividend Financial summary 2003 2004Profit before tax £33.1m £38.1mEarnings per share 12.04p 13.34pCombined ratio 77% 86%Return on equity 22.6 % 21.2%Dividend per share - full year 0.6p 3.0pNet assets per share 63p 71p Operational highlights • Market leading combined ratio of 86% and claims ratio of 53% • Catastrophe related claims ratio 15% • Net earned premiums of £221.8m, up 21% • 2005 rating environment stable; pricing levels remain good Outlook for 2005 • Multiple income streams all delivering • Strong renewals season at start of 2005 with average renewal rate reductions of only 2% in the first two months of the year • Continuing underwriting discipline and underwriting for profit not volume Commenting on these results, Chief Executive Officer Edward Creasy said: "These record results were achieved despite a challenging year and have enabledus to propose a five fold increase in the dividend. 2005 has started well and the short-term outlook for Kiln remains good. We haveconsiderable unearned underwriting profit and profit commission still to flowthrough and believe underwriting conditions will continue to allow us togenerate good value for our shareholders." 5th April 2005 Enquiries:Kiln plc Tel: 020 7886 9000Edward Creasy, Chief Executive OfficerPeter Haynes, Chief Financial OfficerKate Rogers, Head of Communications College Hill Tel: 020 7457 2020Tony FriendRoddy Watt Photographs available on request Notes to Editors Kiln, established in 1962, is an international insurance and reinsuranceunderwriting group that specialises in complex, unusual risks. Kiln plc islisted on the London Stock Exchange. Its operating subsidiary, R J Kiln & CoLimited has £703 million of capacity under management for the 2005 year ofaccount, making it one of the largest agencies trading in the Lloyd's insurancemarket. A recognised leader in each of the five main business areas in which itoperates: reinsurance, accident and health, aviation, marine and special risks,and property, Kiln enjoys a security rating of 'A' (Strong) assigned to Lloyd'sby Standard and Poor's. 2004 Kiln plc report and accounts Chairman's report As the incoming chairman of Kiln plc I am delighted to report that the companyhas earned record profits before tax in 2004 of £38.10 million, which representsa return on equity after tax of 21.2% and is an increase of 15% on 2003.Thecompany had a successful year delivering against the strategy set out at thistime last year, and continues to position itself to meet the opportunities andchallenges inherent in its areas of expertise. Bearing in mind the record profits and the strong improvement in cash flow thatwe expect over the coming years, weighed against the need to continue to developand strengthen our balance sheet as we seek to fulfil our strategic objectives,the directors have decided to propose a final dividend of 2.4p per share for2004, making a total of 3p per share (2003: 0.6p). Unless there are exceptionalcircumstances which make this approach inappropriate, we intend to maintain thedividend at or above this monetary level throughout the insurance businesscycle. Subject to the approval of shareholders, it will be paid on 29th June2005 to shareholders on the register on 29th April 2005. 2004 was a challenging year for the specialist insurance industry. The Asiantsunami in December 2004, despite its enormous human consequences, will not havea material impact on our bottom line. This event, combined with the fourhurricanes in the US, all of which were among the top ten most costlycatastrophes in the US in the last 35 years, and a number of typhoons in Japan,combined to make 2004 a year of exceptionally severe natural disasters.Notwithstanding these events, Kiln has delivered record profits. Kiln's strategy remains consistent: the company specialises in producing returnsfor its shareholders through the acceptance of risks where both the incidenceand the scale of losses are quickly apparent; it takes a prudent approach torisk management, particularly in the areas of capital, investment, andoperations; and it exploits the advantages of having multiple sources of income.Fundamental to this strategy is a management approach that is committed totraining and development which is crucial to our success as a business thatrelies on high quality people. Our focus remains on underwriting for profitrather than premium income and we will adjust our underwriting portfolioaccording to the conditions prevalent in the insurance business cycle. Lloyd's remains our central route to market, and we continue to take goodadvantage of its franchise, its brand, its international licences and itssecurity rating. Lloyd's continues to make good progress in terms of improvingits capital base, security and reputation. The challenge facing the market nowis to maintain an entrepreneurial environment while streamlining and modernisingits processes and satisfying the ever-increasing regulatory obligations that itfaces. Lloyd's debut in the international debt market in October 2004strengthened its capital structure, which helps to keep it an attractive placefor Kiln to conduct its business. Since the last quarter of 2004, the nature of relationships in the insuranceindustry has become a subject of close public scrutiny. Kiln puts considerablestore by its open and equitable business relationships and so we welcome themove towards greater transparency in all insurance transactions. The wholesaleinsurance industry can appear somewhat arcane to the outside world. Theincreased scrutiny, along with the regulatory role of the Financial ServicesAuthority, will help us as an industry to correct that perception. It must havethe confidence to be open and transparent - as the investment banking industryhas been - about the charges it makes and the reasons behind them, and Kilnsupports and embraces this trend. Operating and financial report CEO report 2004 was another strong year for Kiln. Shareholders' funds have increased by£16.99m, equivalent to 8.3p per share as a result of profits generated duringthe year. The payment of a calendar year dividend of 3p, (2003: 0.6p), was madepossible by balance sheet management and an improving cash flow that aredescribed in detail in the financial part of this report, and particularly fromthe results of the Lloyd's 2002 Year of Account now finally released from theLloyd's system. The combined ratio of 85.5%, achieved in spite of the intenselevel of natural catastrophes, is evidence of our continuing underwritingdiscipline and increasingly rigorous expense management. The technical account clearly illustrates the strength of the performance of theunderlying business. As Kiln executed its strategy of steadily increasingshareholders' participation on Syndicate 510, Kiln's gross written premiumincreased by 17% from £267.48 million to £313.53 million during the year.Earned premiums net of reinsurance increased at an accelerated rate of 21%, from£183.24 million to £221.79 million, reflecting Kiln's determination to make themost of the underwriting opportunities available as rates peaked in the firsthalf of 2004. Claims incurred net of reinsurance increased by some 53% from£81.19 million to £124.34 million principally as a result of catastrophe lossesin the third quarter. Kiln's loss ratio for 2004 was 53% (2003: 42%) and wouldhave been 38% had it not been for the series of hurricanes and typhoonsexperienced in the second half of the year. The technical account balance was£41.4 million, a decrease of some 11% from last year, representing a returnequivalent to 32% of opening shareholders funds. Net unearned premium, anindicator of future profit potential, increased from £83.46 million to £97.04million (16%) during the course of the year. The non-technical account showed an improvement of £11.25 million before taxover the course of the year, primarily as a result of increased earned profitcommission, resulting in a record breaking profit before tax of £38.1 millionand earnings per share of 13.34p. The equivalent figures in 2003 were £33.1million and 12.04p respectively. Kiln manages its business by way of three distinct income streams. Therespective contributions from each of the income streams were as follows:- • Underwriting profit earned from participation in Lloyd's syndicates £23.4 million (2003: £27.5 million). • Fees and Profit Commission earned from Managing Agency operations £15.3 million (2003 £6.6 million). • Return on investment in W. R. Berkley Insurance (Europe), Limited £1.7 million (2003: £0.2 million loss). • More details on the operation of these income streams can be found in the Financial Review which follows this section. We have achieved these results through the execution of Kiln's strategy, whichaims to generate differentiated returns for our shareholders from specialistunderwriting in the London Insurance Market. The strategy is supported by fourpillars: • The employment, training, motivation and retention of high calibreindividuals throughout the Kiln organisation. Our underwriting teams areacknowledged as global experts within their own field of specialisation. • Focus on risk transfer activities where our operating results can bepredicted with a high degree of certainty after a short period of time, known inthe industry as a 'short tail account'. • A cautious approach to risk management; our risk appetite isconcentrated on our underwriting, where we have in-depth knowledge of theportfolio we accept. We adopt a cautious approach to other key areas of risk towhich shareholders are exposed • A distribution strategy which concentrates on partnership with thosecompanies who promote and buy our product, through which long-term relationshipscan be developed that allow us a clearer and better understanding of the qualityof risk that we accept into our underwriting portfolio. Looking to the future, to achieve our strategic objective of generatingdifferentiated returns for our shareholders from specialist underwriting in theLondon Market, we are clear as to what actions we will have to take: • As pricing reduces over the course of the next few years, we willreduce our underwriting activities; we will focus ever more strongly onunderwriting profit rather than premium volume. Our objective at this stage ofthe cycle is to preserve shareholders' capital rather than to assume additionalunderwriting risk. • At the same time, we will seek steadily and gradually to increaseshareholders' underwriting participation on our flagship Syndicate 510,redeploying capital made available both as a result of current profitability andreduced underwriting activity. • It remains our constant and long term intention to maximise ourunderwriting exposure when pricing conditions are in our favour whilstprotecting shareholders from the inevitable detrimental excesses of thedownturn. When conditions turn strongly in our favour again, it is our strategyto be in a position to take full advantage of Kiln's core strengths: ourtechnical underwriting expertise, our relationships in the London Market andacross the world, and the strength of our commercial brand. • We will seek to enhance and develop our relationships with our corespecialist producers, but through the concept of partnership rather thanoutright ownership. Our business model is driven primarily by our underwriting returns. Investmentincome, whilst important, remains a secondary contributor to shareholders'returns and our policy is, above all, to preserve and enhance the growth ofshareholders' capital whatever the pricing environment may be. The deploymentof both shareholders' and other third party capital to underpin our underwritinginevitably means that our processes are more complicated than many: our expenseratio will never be the lowest, but we expect our claims ratio and our feereceipts from managing independently owned funds to compensate fully for thiswhen we are compared with our peers. We place great emphasis on understanding how and where we win business, and onworking to develop and maintain strong relationships with our core clients. Interms of the specialist account we write, this translates into the need for ourunderwriters to build a thorough understanding of those clients and theirbusiness so that we can support them intelligently and be seen as ready torespond to their changing needs. It also means doing everything in our power todeal with their business efficiently and economically: an issue that is becomingincreasingly important for the London Market as a whole if it is to preserve itsposition within the global insurance market. Our approach to long-term relationships is also fully visible in our approach toclaims management. We pay our claims quickly and fairly; if a dispute shouldarise, we prefer to agree and settle claims as swiftly as possible in a way thattakes account of the interests of all those involved. 2005 has started well and the short-term outlook for Kiln remains good. Themost recent renewal season showed good business discipline, with renewal pricesonly some 2% less than the 2004 equivalent, with premium volume at the end ofFebruary marginally ahead of the same time last year. We believe that theseunderwriting conditions will allow us to generate good value for ourshareholders, with estimated unearned underwriting pre-tax profit of £24 millionon the 2003 and 2004 syndicate underwriting years and estimated unearned profitcommission of £18 million before tax still to flow through the 2005 and 2006profit and loss accounts. Corporate cash flow will also improve significantly asprofits from the 2003 and 2004 Years of Account are released from Lloyd's inJune 2006 and 2007 respectively. These forecasts, together with the caveats thatattach to them, are described in more detail in the underwriting review thatfollows. We are well placed to confront the challenges of the inevitabledownturn in premium levels. Although we would prefer to see underwritingdiscipline in the market maintained, we are fully prepared to take action toprotect our position and our shareholders' funds should that not be the case.Kiln is positioned to make the most out of the underwriting environmentsurrounding our specialist portfolios, whatever it may be, and we look tostrengthen our position over the coming years to take full advantage of thebusiness opportunities that will inevitably come our way. Financial review Business Model Kiln achieves a balanced spread of risk exposure achieved through threediversified income streams: 1. Underwriting profit from participating in Lloyd's Syndicates Our primary source of income comes directly from underwriting profits resultingfrom the participation in the Lloyd's syndicates that we manage. We haveincreased our participation in the underwriting by an average of 8% year on yearin the period covering the 2003 year of account to the 2005 year of account. Wehave expanded overall capacity as well as reducing the proportion of capacitysupplied by third party reinsurers. This is in line with our strategy ofincreasing our shareholders' ownership of our flagship Syndicate 510 over time.We will do this only when the cost expended does not damage our future abilityto generate an acceptable level of return on equity for our shareholders. Theunderwriting result before tax in 2004 was £23.4 million (2003: £27.5 million).This result was achieved despite an estimated cost to shareholders from the 2004hurricane season of approximately £19.4 million after tax. 2. Fees and profit commissions from Managing Agency Operations We have proven expertise in managing others' capital to generate returns forthose capital providers and our shareholders, primarily by extracting maximumbenefit from our core skill of short-tail underwriting. Managing others' capitalenables us to increase the overall scale of our underwriting. In other words, itallows us to punch above our weight, and thus maintain an organisation with amore sophisticated infrastructure and a greater range of skills than Kiln couldsustain on the strength of its own capital base alone. We derive income fromthis activity in two ways: • by charging the third party capital an annual management fee of, typically, 0.75% of their capacity. • from a profit commission of, typically, 17.5% on the profits that our underwriting expertise generates. 3. Investment in W. R. Berkley Insurance (Europe), Limited We also gain exposure to the longer tail, casualty insurance cycle through our20% investment in W. R. Berkley Insurance (Europe), Limited (WRB(E)), an FSAregulated insurance company. In the case of WRB(E), income is derived from ourshare of the entity's results, together with interest received on the Loan Notesreceived from WRB(E) as part of the initial capitalisation in July 2003. WRB(E)has produced a profit despite being in its initial start up phase, having beenin operation for only 18 months. In summary, these income streams have performed as follows: 2004 2003 % changeUnderwriting Result (pre-tax) £23.4m £27.5m (14.9%)% Return on Capital Employed (post tax) 16.08% 20.02% -Managing Agency (pre-tax) £15.3m £6.6m 131.8%% Return on Capital Employed (post tax) 89.05% 75.99% -W. R. Berkley Insurance (Europe), Limited (pre-tax) £1.7m (£0.2m)% Return on Capital Employed (post tax) 7.48% - - *Underwriting results include the actual investment return attributable to ourunderwriting capital. Underwriting review We are in the business of offering our customers protection from the impact ofcatastrophes, the shock of large losses and the drip feed of smaller claims,each of which has the potential to damage their business and affect theireconomic performance. In particular, we know enough about the patterns of howcatastrophes occur to understand that the essential uncertainty in relation tothese events lies in the matter of timing, scale and location, rather than therebeing any question of whether or not they will happen. This knowledge is builtinto our underwriting approach, so that it is always our intention to ensurethat our investors are not presented with unpalatable surprises. This skill wasput to the test in 2004, which was a year of unusual intensity in terms ofnatural catastrophes. Although the Asian tsunami in December 2004 had enormoushuman consequences, it will not have a material impact on our bottom line. Thehurricanes and typhoons, on the other hand, have affected results across themarket but, in spite of them, we delivered a claims ratio of 53% (2003: 42%)which is one of the best in the market, as well as a lower expense ratio of 33%(2003:35%) which together result in a combined ratio of 86%. Along with therest of the market we have benefited from the favourable and exceptionallystable underwriting environment that has prevailed since 2002. Had the unusualcatalogue of natural catastrophes not occurred towards the end of 2004, thecombined ratio would have been 71%, a considerable improvement on the alreadyexcellent ratios of recent years, namely 84% and 77% for 2002 and 2003respectively. We focus hard on the accuracy of our forecasting and we attribute the results inthis area to our deep knowledge of our specialist underwriting book, supportedby the strength of our relationships both with brokers and with clients. Underwriting portfolio analysis and commentary Premium split Renewal Risk count Proportion led pricing movements 2004 % 2004 as % of % change on % change on % change 2003 2003 2003 on 2003Accident & Health, Life 9.8 +18.3 101.6 +20.3 -3.0Aviation 6.1 -1.0 98.2 +14.7 +16.0Marine 13.8 -5.7 97.2 -5.4 +40.9Property 53.6 - 99.1 -8.7 +8.4Reinsurance 16.7 -3.8 96.2 +5.4 +5.3 The table above shows the component parts of our 2004 total accepted premium.Property remains the largest sector followed by Reinsurance (which is againmainly property-based). Given the stable rating environment in which pricesreduced by only 2% overall in 2004, the make-up of the account showed no radicalchanges in percentage terms from 2003. Nevertheless we succeeded in expandingsignificantly in Accident & Health, but cut back in Marine and also reducedslightly in Reinsurance. This can be explained in terms of the pricing changeswe saw during the year. Where prices continued to move up, in Accident & Health,we took the opportunity to increase our book. In Marine, the pricing fall waslargely attributable to the Energy account so we reduced our involvement in thatarea. In Reinsurance, which is essentially a non-attritional book, a ratingreduction of just under 4% is less material and hence there is less of areduction in relative volume. At individual business class level the picture of where we are in the cycle ismore complicated; in some classes prices rose in 2004, indicating that the peakof the cycle for that class may not yet have been reached, while in otherclasses price reductions, albeit modest ones, have taken hold and it isappropriate to think in terms of the downturn being underway. A further analytical measure which we use in order to understand what ishappening to levels of underwriting activity is Risk Count; this measures thenumber of policies our underwriter is accepting. The changes in Accident &Health, where risk count increased during 2004, and Marine, where it decreased,make good sense given the pricing changes in those two accounts. The fall inProperty risk count marks our deliberate move away from what we call facultativeor individual risk business, which inevitably has a high risk count, towardscoverholder business. Rating was falling in much of the facultative account butholding firm in the coverholder book during 2004. The increase in Reinsurance is partly due to some customers, particularly in theUSA, deciding to buy additional layers of protection early in 2004 in responseto the release of new catastrophe modelling software late in the previous year. The increase in Aviation risk count is a specific reflection of our continuingstrategy to develop our General Aviation and Aviation Hull War books. In most sectors other than Accident & Health we increased the percentage ofbusiness which we led, measured by premium income. These figures may appearsurprising, but are in fact confirmation of our overall underwriting strategy,particularly as the downturn begins; we do not necessarily seek to leadopportunistic business, but we do aim to build leadership positions on businesswe consider to be core. As the pricing in a sector comes down from its peak weinevitably start to decline some of the more opportunistic business in thatclass first, opportunistic business generally being the most volatile in termsof pricing, while we continue to build our core book in those parts of thesector where rates are relatively firm. As a result, percentage leadership tendsto rise. The reverse may happen in a sector such as Accident & Health whererates are still rising; in this case, additional opportunistic business maystill be in good supply, so our leadership percentage may actually drift down aswe take advantage of that. In this case the opportunity came mainly in the formof Personal Accident business for contractors working in Iraq. This analysis demonstrates that we used 2004 to take maximum advantage of theremaining opportunities being presented by the peak of the hard market, whilestarting to position ourselves for the downturn. At the start of 2005 we continue to underwrite in an attractive ratingenvironment. Of the 43 classes of business across which we monitor pricingchanges, rates are still rising in 18 of them (40%). Prepared for the downturn Nevertheless we have to be alert to the onset of the downturn; our underwritingreputation has largely been built on managing the cycle in a way that means weout-perform the market in the downturn. We remain committed to a deliberatestrategy of underwriting for profit, not premium, and of being prepared to turnaway inadequately priced business. We have developed sophisticated tools andindices to enable us to spot the warning signs regarding changes in the qualityand profile of the portfolios we are underwriting, using more subtle indicatorsthan mere price. We look at the change in factors such as risk count, renewalrates, line size, leadership percentage and the like, and the interrelationshipbetween them. Applied to our current underwriting, these measures arespecifically designed to signal to us whether or not we are continuing todeliver on that chosen underwriting strategy. Reconciling our syndicate forecasts with the Kiln plc financials Kiln shareholders' portion of profits reported in the syndicate forecasts on the2003 and 2004 open years of account is currently estimated at £58 million. Ofthis, profits of £34 million have already been recognised through the 2003 and2004 published accounts, leaving some £24 million yet to be recognised aspotential profit in future years, based on current syndicate forecasts. These figures have to be treated with considerable caution as they contain anumber of significant assumptions, including estimates for future losses onunearned premium, which will change depending on the future claims environment,and investment income yet to be earned on syndicate investments In addition, noaccount has been taken of Kiln corporate expenses and associated taxliabilities. The catastrophe claims incurred during 2004 have been fully recognised in the2004 published accounts under UK GAAP. Kiln Underwriting's share of theseclaims amounted to £6.6 million on the 2003 year of account £28.0 million on the2004 year of account. People and culture Kiln's resources are dependent on two key factors: capital and people. Theability of Kiln to produce above average long term returns on its shareholders'investment lies to a great extent in the calibre of the workforce and thestability of their underwriting relationships. Kiln has relationships goingright back to when the company began in Lloyd's in 1962. We recruit, train anddevelop high calibre underwriters and managers focused on individual areas ofexpertise. Our underwriters are encouraged to balance risk and reward, and totake ownership and accountability for the capital they manage on shareholders'behalf. This is one of our key sources of competitive advantage. Kiln's culture and remuneration structure encourage underwriting staff to studyfor professional qualifications. Of those at Kiln who have underwritingauthority, 81% have university degrees, 85% have ACII professionalqualifications, and 75% have both. Our Chartered Insurance Institute exam passrate across all qualifications was considerably ahead of the national average. CII qualification Kiln pass rate % National average %Advanced diploma 72 53Diploma 80 58Certificate 100 77 We provide the structure, the tools, the distribution framework and theenvironment to allow our employees to apply their knowledge and skills tomaximum effect. We aim to create a working environment and a remuneration policythat encourages our people to build a long-term career with us, particularly forthose who rise to the challenge of accepting the rigorous levels ofaccountability and responsibility that we expect and encourage. Rewards arestrictly aligned with performance, both in terms of return on equity andultimate underwriting profitability. Of our senior underwriters (that is theactive underwriters and their deputies) their average tenure at Kiln isapproximately 18 years. We believe that this is a key achievement in themaintenance of Kiln's ability to achieve superior underwriting returns acrossthe cycle, delivering one of the best combined ratios in the market. Financial management Growing and managing the balance sheet Recent profitable performance by Kiln has led to a rapid rebuilding of the groupbalance sheet after the losses following the atrocities of 11th September 2001. Growing Shareholder value 2002 2003 2004Net Asset value pershare 53p 63p 71pEarnings per share 4.56p 12.04p 13.34p Through maximising the growth in net assets, we seek to deliver shareholdervalue. It is Kiln's strategy to concentrate our risk appetite on underwriting inclasses of the market where we can maximise the returns we can generate from ourin-depth knowledge of the risks. Conversely, we adopt a cautious approach tothe risks inherent in managing our balance sheet, and similarly to protectingour shareholders' capital. Investments Our investment policy reflects our strict approach to capital risk management,where our aim is to generate satisfactory investment returns while preservingour shareholders' capital. We are less reliant on investment returns than manyof our competitors, because of our strategy of specialising in short tail riskwhere the incidence of claims is quickly known and settled. Our strategy avoidsundue fluctuations in our non-underwriting results and has the express intentionof ensuring that shareholders' capital is employed in support of Kiln's keycompetency: its underwriting expertise. We have a conservative investmentstrategy and manage risk through holding a portfolio of investments with matcheddurations and with over 98% of our syndicate assets held in instruments with arating of AAA. Investment durations & Credit Exposure 510 USD 510 GBP Threadneedle FAL Newton FALInvestment 0.58 0.89 0.91 0.64duration (years) Credit exposure: All Syndicates 2004 2003AAA 98% 92%AA 1% 5%A 1% 3% Credit exposure: Funds at Lloyd's 2004 2003AAA 75% 42%AA 20% 52%A 4% 5%Cash 1% 1% It remains our intention to enhance and grow our capital, and focus it on ourprincipal underwriting unit, Syndicate 510 at Lloyd's. We will continue tomeasure and monitor the amount of capital to support our underwriting, and wewill adjust our capital level and our investment appetite to match both thespread of risks that we accept and the market conditions we face. Reserving We adopt a prudent policy to establish reserves for future losses. Our focus onproperty rather than liability means shareholders are not generally exposed tolosses from the past that have been previously underestimated. 2004 demonstratedthat the industry remains under-reserved in certain lines of business that Kilndoes not write. There have been examples of significant transfers to reserves bycompanies both within the Lloyd's sector and in the global insurance industry.Kiln regards the strength of its reserves as a key competitive differentiator.We have consistently been able to show favourable developments in our prior yearreserves (£1million in 2002 and £4.5million in 2003), which is a cleardemonstration of the strength of our reserves and our conservative reservingpolicies. These results include a release for 2004 of £8.0 million. Foreign Exchange Hedging Kiln writes approximately 65 per cent of its business in US dollars. Thisbusiness is subject to currency risks because of the effects of the translationof the results. Typically, we start to hedge the forecast future profits aroundthe 18 month point of a developing year of account, that is, only when theaccount is substantially off risk given the nature of our short tail book. Ourforeign exchange exposure, and therefore the hedging strategy, relates solely tothe receipt of future US dollar profits and we use a variety of instruments,from traditional forward contracts to low risk derivatives. Claims on all USdollar-denominated business are settled in dollars, so there is an automaticmatch of assets and liabilities and no hedge is necessary. These results includeforeign exchange hedging gains of £3 million which offset the negative effectsof the weakening US dollar. Timely Foreign Exchange hedging Year of account 2002 Year of account 2003 Year of account 2004Forecast USD profits £51m £30m £18mafter taxHedged amount £50m £30m 0 (not yet at the 18 month stage) Gearing Increased cash flow from 2005 will give us the opportunity to review our levelsof gearing, including off balance sheet debt. We aim to set gearing levels thatare appropriate for the relevant phase of the insurance market. Optimising gearing: matching our level of debt to the cycle 2002 2003 2004Gearing 5.0% 23.0% 27.6%Return on Equity 8.8%* 22.6% 21.2% * Due to the rights issue in 2002 this figure is calculated using post taxprofit/weighted shareholder funds We optimise our capital structure by holding our Funds at Lloyd's throughletters of credit which we increased from £30 million to £40 million during theyear, and we also set up a revolving credit facility of £15 million to providebackstop liquidity. Letters of credit continue to be an attractive form offinancing and are an acceptable form of underwriting capital for the FinancialServices Authority, our regulator. Their future admissibility, however, isuncertain, and we will continue to review alternative financing structures thatwill enhance returns to shareholders. Financial operations Re-engineering our financial processes We believe our financial systems and processes need to be increasingly flexibleto meet the tightening regulatory and reporting requirements placed on us. Wehave made excellent progress in the refinement of our financial processes during2004. 2005 will see the next phase of this upgrade to cover reporting to capitalproviders and the consolidation of Kiln plc financial reporting; to this end, wecontinue to implement an integrated end-to-end system from the input ofunderwriting data through to producing data for the Stock Exchange, for Lloyd'sand for the regulators, all without the need for manual intervention. International Financial Reporting Standards (IFRS) As from 1st January 2005, the Kiln group is required to prepare its accountsunder IFRS. We welcome the introduction of IFRS, which will benefit ourshareholders and the wider investment community by providing greatertransparency and improving understanding of our business model and our profitsources. For example, IFRS will require greater transparency both on claimsreserves and on the movements in these reserves. This will allow investors tocompare the depth, robustness and evolution of our reserves with those of ourcompetitors. We are on track to meet the revised reporting requirement under IFRS: • the opening IFRS balance sheet for comparative purposes is 1st January 2004 • our 2004 UK GAAP results will be restated under IFRS and announced in the summer of 2005 • the first results prepared under IFRS will be the 2005 interims The key changes arising from IFRS as they relate to Kiln are: • Dividends: the final dividend for each financial year has hithertobeen declared after the balance sheet date. Under IFRS this represents a postbalance sheet event and therefore our dividend will not be shown as a liabilityin our accounts at the end of the financial period. The proposed dividend willinstead be disclosed in the notes to the financial statements. • Intangible Assets: we currently write off the cost over 20 years ofthe Lloyd's syndicate capacity we have acquired. Under IFRS syndicate capacitywill be treated as having an indefinite life. It will therefore be carriedinitially at cost and will then be subject to an annual impairment review. Onfirst time application, the written down value of syndicate capacity at 1stJanuary 2005 will be our deemed carrying cost. • Pension scheme: Kiln has two pension arrangements. The definedcontribution scheme will be accounted for in a similar way to its currenttreatment. Under IFRS, the net liability for the defined benefit (final salary)scheme will be accounted for on Kiln's balance sheet. Beyond the changes to the way our numbers are reported, IFRS will also introducegreater disclosure of information underlying our financial statements. Forexample, at the segmental analysis level, segmental data will reflect the way inwhich we manage our business across the individual classes of underwriting andour diverse income streams. Transition to this change is reflected in thisyear's disclosures. IFRS will change the way in which Kiln reports on and accounts for certain ofits financial data. Based on the IFRS accounting standards as currently defined,however, we do not believe there will be a significant impact on the fundamentaleconomics of Kiln's business, its capital solvency or on its ability to paydividends. Capital allocation We have devoted considerable energy to the implementation of a capitalallocation model under the FSA's Individual Capital Assessments (ICA) regime andwere among the first wave of participants in Lloyd's to submit a model. We havealso added to our already considerable expertise in capital modelling andcapital allocation through this process. Our risk appetite is at a level thatensures we are prepared for natural catastrophes at the extreme end of theseverity spectrum. Our model uses an assumption based on a 99.6% Tail Value atRisk. It is our intention that overall underwriting capital should always beheld in excess of that required to cover a one in 250 year event (based onhistoric loss experience). This differs from the current best practice whichsuggests a 99.5% Value at Risk, which requires capital to be held only up to theamount required to cover a one in 200 year event. The move from the centrallyimposed Lloyd's Risk Based Capital (RBC) regime to a devolved bespoke ICA(albeit with final approval from Lloyd's and/or the FSA) means that we have fargreater control over the process by which the capital required to run our ownbusiness is set, and that such capital accurately reflects the risks ourbusiness faces. We should not be burdened by the failings of other businesseswhich may have hitherto dragged down averages in the RBC system. Using ourlatest version of the model we will allocate capital to business lines that willdeliver the greatest return to shareholders at various stages in the cycle. Our approach to underwriting risk is therefore governed by a capital allocationpolicy that is designed to protect shareholders' capital and to optimise thelevel of capital required by the business. In 2006 the primary responsibilityfor setting capital levels will transfer from Lloyd's to Kiln. We have developedand tested our own models to ensure that we can meet our obligations topolicyholders in the face of catastrophic loss in a way that also puts us in aposition to capitalise on the opportunities that would present themselves insuch circumstances. We will adjust our capital ratios to take account of ourchanging underwriting portfolio, pricing conditions and our exposure to lossesthroughout the world. Pension management The pension deficit remains an area of sharp focus for the management at Kiln;seeking to limit the risks to shareholders from it is a key priority. Wecontinue to review and act decisively in respect of our pension scheme deficitto limit the effect on shareholder value at Kiln. Since we last reported we: • have established a Pension Trust, the details of which are outlined below • are working with the accounting profession to ensure clear definition of the treatment of pension deficits on the balance sheets of Lloyd's syndicates. The Pension Trust Despite rising equity markets in 2004, the pension deficit, under FRS 17/IAS 19accounting conventions has increased from £18.9 million net in 2003 to £19.8million net in 2004. The key factors behind this are the rate at which futureliabilities are discounted, together with the increased life expectancyassumptions relating to the scheme. We established a pension trust in 2005 thatallows money to be placed in a legally separate trust which exists only to fundemployee benefits. This means that it can be considered as a pension schemeasset under FRS17 and IAS19, thereby reducing the deficit on our balance sheet.Monies placed into the trust are not, however, trapped in the scheme, because itis a trust and not part of the underlying pension scheme. Normally a companywould pay deficit funding directly into the pension scheme and when that schemereaches equilibrium and its liabilities becomes over funded, the money is out ofreach of the company. What Kiln's pension trust allows is for the Trustees toreturn funds from the trust to the company in the event that a pension fundsurplus is created. This is important because, although the pension is indeficit at the moment, the pension scheme has at least 50 years still to run andit is likely that at some stage inflation rates, discount rates and underlyingasset indices will be much more favourable to the scheme in the course of those50 years. The result of the establishment of the pension trust is that Kiln canregain access to money paid to cover future pension scheme obligations if it issurplus to its pension obligations. The syndicates' share of the pension deficit The introduction of IFRS from 1st January 2005 has highlighted that the pensiondeficit liability is consolidated at the Kiln group level. The syndicates thatKiln manages also have a liability for their share of the pension deficit. Weare currently working with the accounting profession to define clearly theaccounting entries around the recognition of the syndicate deficits on theirbalance sheets. At the Kiln group level, the consolidated pension deficitliability will in future comprise two components: the deficit directlyattributable to Kiln group companies and the deficit arising from Kiln's shareof ownership of the individual syndicates. The total gross pension deficit before tax as at 31st December 2004 isapproximately £29 million, but this reduces to around £15 million after theallocation to the syndicates and to around £10 million net after the imputeddeferred tax credit. We have also progressively increased funding for the pension fund deficit, andwill be funding at £2.2 million in 2005. The scheme's assets are purposelybiased towards equities relative to its obligations. The scheme is invested 55%in equities and this has allowed it to deliver an extra return; the return onequities for the year was 11.6% compared with 9.6% for the scheme's fixedinterest investments. Summary and conclusion Kiln has delivered a strong performance in a challenging year and we haveachieved this by focusing on our long term strategy, through which we aim todeliver quality returns for shareholders by focusing on our core area ofexpertise: specialist underwriting. We specialise in managing a clean, shorttail book of business, so we know quickly and accurately both the incidence andthe scale of our losses. To reinforce this focus on underwriting, we take aconservative approach to risk management in our non-underwriting activities,such as capital and investment management. Specialist insurance is a highly cyclical industry, and the downturn to thecycle has long been heralded. Rates are holding up well and we believe that thehurricanes of 2004 have delayed the full onset of the downturn. Although thereis some downward pressure on pricing, discipline is being maintained in manyareas of our account. The combination of low interest rates, increasedregulation and the industry's need to continue to strengthen reserves as aresult of the poor underwriting conditions at the bottom of the last cycle maymean that we will not be as exposed to the extremes in the rating environment aswe were in the 1990s. Kiln's antennae remain finely attuned to the bellwethersof a downturn and we are well placed and ready to manage it with discipline andplanning. With substantial amounts of unearned premium underwritten on attractive termsand profit commission receipts yet to flow through the profit and loss account,we are in a strong position to continue to generate good returns on theinvestment made in Kiln by shareholders. We retain a highly experienced team ofmotivated and professional underwriters and managers who are committed toextracting the maximum benefit available for our shareholders, whatever thecondition of the market. We look to the future with confidence and thank ourshareholders for their continued support. Consolidated profit and loss accountTechnical account - general businessfor the year ended 31st December 2004 2004 2003 Note £'000 £'000 Earned premiums, net of reinsuranceGross premiums written 1 313,528 267,484Outward reinsurance premiums (74,545) (86,491) Net premiums written 238,983 180,993 Change in the provision for unearned premiums: - Gross amount (7,025) (913) - Reinsurers' share (10,169) 3,160 (17,194) 2,247 Earned premiums, net of reinsurance 221,789 183,240 Investment incomeAllocated investment return transferred from the 7 14,098 12,934non-technical account Claims incurred, net of reinsuranceClaims paid: - Gross amount (123,366) (121,343) - Reinsurers' share 36,240 54,586 Net paid claims (87,126) (66,757) Change in the provision for claims: - Gross amount (64,697) 11,274 - Reinsurers' share 27,484 (25,703) Change in the net provision for claims (37,213) (14,429) Claims incurred net of reinsurance 3 (124,339) (81,186) Net operating expenses 6 (69,986) (68,300)Other technical charges, net of reinsurance (146) (221) Balance on the technical account for generalbusiness 41,416 46,467 Consolidated profit and loss accountNon-technical accountFor the year ended 31st December 2004 2004 2003 Note £'000 £'000 Balance on the technical account - generalbusiness 41,416 46,467 Investment income 7 10,209 5,531 Unrealised gain on investments 7 1,956 898 Allocated investment return transferred to thegeneral business technical account 7 (14,098) (12,934) Other income 9 27,540 22,270 Other charges 9 (30,041) (28,680) Share of operating profit/(loss) of associatedcompanies 19 1,121 (482) Total group operating profit 38,103 33,070 Operating profit based on longer-term investment 40,036 39,595returnShort term fluctuations in investment return 7 (1,933) (6,525) Profit on ordinary activities before tax 38,103 33,070 Tax on profit on ordinary activities 13 (10,902) (8,507) Profit on ordinary activities after tax and profit for 27,201 24,563the financial year Dividends: Interim dividends paid (1,224) (408) Proposed final dividend (4,895) (816)Total Dividends (6,119) (1,224) Retained profit for the financial year 21,082 23,339 Earnings per share (pence) - basic 14 13.34 12.04Earnings per share (pence) - diluted 14 13.33 12.04 All income and expenditure relates to continuing operations. Consolidated statement of total recognisedgains and lossesfor the year ended 31st December 2004 2004 2003 Note £'000 £'000 Profit for the financial year 27,201 24,563 Currency translation differences (4,095) (3,759) Total gains and losses recognised since lastannual report 23,106 20,804 Reconciliation of movements in consolidated shareholders' fundsfor the year ended 31st December 2004 2004 2003 £'000 £'000 Profit for the financial year 27,201 24,563 Dividend (6,119) (1,224) 21,082 23,339 Currency translation differences (4,095) (3,759) Net addition to shareholders' funds 16,987 19,580 Opening shareholders' funds 128,180 108,600 Closing shareholders' funds 23, 24 145,167 128,180 Consolidated balance sheetas at 31st December 2004 2004 2003 Note £'000 £'000 Assets Intangible assetsPurchased syndicate capacity 15 9,240 10,356 InvestmentsFinancial investments 17 210,034 260,717Investments in associated undertakings 19 16,432 15,647Deposits with ceding undertakings 513 1,230 226,979 277,594 Reinsurers' share of technical provisionsProvision for unearned premiums 22,619 35,092Claims outstanding 20 101,514 91,263 124,133 126,355 DebtorsDebtors arising out of direct insurance operations:amounts owed by intermediaries 44,876 73,416Debtors arising out of reinsurance operations:amounts owed by intermediaries 77,712 36,897Other debtors 21 22,575 24,925 145,163 135,238Other assetsTangible fixed assets 16 3,605 4,457Cash at bank 17 106,987 34,855 110,592 39,312 Prepayments and accrued incomeAccrued interest and rent 844 1,709Deferred acquisition costs 37,514 29,098Other prepayments and accrued income 14,369 8,771 52,727 39,578 Total Assets 668,834 628,433 Consolidated balance sheet (continued)as at 31st December 2004 2004 2003 Note £'000 £'000 Liabilities Capital and reservesCalled up share capital - ordinary 23 2,040 2,040Share premium account 24 94,275 94,275Profit and loss account 24 25,270 8,283Other reserves 24 23,582 23,582Equity Shareholders' funds 145,167 128,180 Technical provisionsProvision for unearned premiums 119,655 118,554Claims outstanding - gross amount 25 279,782 258,355 399,437 376,909 Provision for other risks and charges 26 13,645 7,835 Creditors