Kin Group Regulatory News (KIN)

23 Mar 2006 07:02

Kiln PLC23 March 2006 Part 1 Kiln plc Kiln plc, the specialist Lloyd's insurance group, announces £8.5 million profitfor 2005 Financial summary 2005 2004 Profit before tax £8.5m £37.9mEarnings per share 2.74p 12.15pCombined ratio 114% 86%Return on equity 4.3% 22.7%Dividend per share 3p 3p- full year in respect of 2005/2004Net assets per share 74p 67pGross written premiums £353m £313.5m Operational summary • Combined ratio of 114%, 36% attributable to 2005 hurricanes • Adapted underwriting approach in recognition of changed environment • Increasing share of Syndicate 510 • Overall rates up 12.5% to date in 2006 • Prospects for rates to continue to harden in 2006 Commenting on these results, chief executive officer Edward Creasy said: '2005 was a turbulent year and a thorough test of our ability to manage ourunderwriting risk, from which Kiln has emerged strongly. We remain focused ondelivering good returns to our shareholders and believe that we are in greatshape to take advantage of the underwriting environment that 2006 offers us.' 23 March 2006 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 The figures in this preliminary announcement are unaudited. Kiln plc 2005 Report and accounts for the twelve months to 31 December 2005 Chairman's statement The first half of 2005 continued Kiln's healthy trend of generating strongprofits and growing shareholders' equity of recent years. Shortly before wereported our half year results for 2005, the hurricane season began in the Gulfof Mexico. The financial impact of those hurricanes was enormous. The insuredlosses resulting from Hurricane Katrina alone were close to twice the total forthe terrorist attacks of 11 September 2001.This hit Kiln hard along with therest of the specialist insurance industry. When considered in isolation, thehurricane related losses cost Kiln shareholders £77 million. Notwithstandingthis, the full year resulted in profit before tax of £8.5 million (2004: £37.9million). Net tangible assets per share rose to 67p (2004: 59p). Our key challenge as we approached 2006 was to position the company to take bestadvantage of the changed business environment that arose following thehurricanes. The impact on the market was fundamental and profound, and Kilnresponded with a corresponding change to the way it underwrites. We believe thatour underlying strategy holds good. We remain focused on underwritingspecialist, short tail risks and this is balanced with prudent financialmanagement. Following the hurricane seasons of 2004 and 2005, we have madesubstantive changes to the way in which we underwrite, particularly with regardto our approach to hurricane-prone territories. We are looking with fresh eyesat how we assess risk, in terms of probability, frequency and scale. Chiefexecutive officer Edward Creasy goes into detail about this response in hisreport. The losses from the windstorms dealt the market a serious blow in 2005. Theother side of that coin is the improved trading conditions which we are alreadyseeing in 2006. We expect these to become more favourable as the year continues,particularly in marine, reinsurance and property lines. In anticipation of theseimprovements we launched a rights issue in November 2005 which raised £72million after expenses. We used the majority of these funds to finance anincrease in underwriting capacity at Lloyd's. This will continue to position uswell as the market presents us with greater opportunities to generate profitsfor shareholders. At 96%, the take up of existing shareholders' rights wasoutstanding. I am grateful to investors for their support, which has allowed themanagement team the opportunity to make the most of the improved marketconditions. This commentary has focused largely on the financial impact of the hurricanes of2005, but we are acutely aware of the appalling suffering that they inflicted onthe people of the southern United States. Our thoughts remain with them as theywork to rebuild their lives. From our industry's point of view, it was aparticularly harrowing and difficult time for local insurance professionalsworking to ensure that valid claims were paid quickly and efficiently toalleviate policyholders' distress. Kiln made a commitment to shareholders at this time last year to make dividendpayments of at least 3p per share throughout the cycle, unless exceptionalcircumstances made this course of action inappropriate. In spite of the impacton profits of the hurricanes of 2005, the directors of Kiln have proposed afinal dividend at 2p per share (2004: 2.4p), making a total of 3p per share forthe year (2004: 3p) and maintaining the level established at this time lastyear. I believe it is a measure of the underlying strength of Kiln that theunprecedented hurricane losses of 2005 are not deemed to be exceptional intoday's market environment. Subject to the approval of shareholders, thedividend will be paid on 26 May 2006 to shareholders on the register on 31 March2006. The Kiln management team is successfully employing a number of strategies aimedat reducing the deficit attributable to Kiln shareholders on the defined benefitpension scheme. At the 2004 year end that deficit was £19.8 million and at the end of 2005 itstands at £7.1 million. This considerable reduction has been achieved through anongoing successful enhanced transfer value programme and the attribution of thedeficit financing to the appropriate syndicates. Reg Brown retired from the board of Kiln in 2005, and I thank him for hiscontribution and commitment to Kiln over the years. Charles Sebag-Montefiore hasalso decided to retire from the board of Kiln and this will take effect as fromthe annual general meeting on 24 May 2006. My thanks go also to Charles for hiswise counsel on the Kiln board, his chairmanship of Kiln Underwriting Limitedand for his trusteeship of the staff pension scheme. We made two appointments to the board at the beginning of 2006, and I welcomePaul Hewitt and Paul Wilson to Kiln. These two new directors are bothoutstanding professionals who bring complementary skills and knowledge to theboard of Kiln and I look forward to working with them. Finally, I thank the employees of Kiln for their hard work, skill and resiliencein a difficult year. It is our employees who make Kiln what it is, and it istheir combined effort that allows the company to focus on delivering value toshareholders. Chief executive officer's report Overview 2005 was a difficult and challenging year for Kiln, primarily because of thesignificant losses incurred as a result of Hurricanes Katrina, Rita and Wilma.Katrina was the largest such loss incurred since accurate records began by afactor of close to two, and Rita and Wilma both feature in the list of the topten most expensive disasters. Kiln is in the business of insuring against catastrophes and our much reducedprofit before tax of £8.5 million and return on equity of 4.3% reflect theyear's claims activity. The deterioration of the 2005 combined ratio to 114%compared with 86% for 2004 (and with 77% for 2003), is also a direct consequenceof these events. The catastrophe losses themselves contributed 36% of the 114%combined ratio, equivalent to a net loss to Kiln shareholders of £77 millionwhen considered in isolation. This compares to equivalent figures for 2004 of17% and £37 million. Gross written premiums rose to £353.0 million in 2005 from £313.5 million in2004, an increase of 13%, as we increased our share of Syndicate 510'sunderwriting portfolio in what were then satisfactory but unspectacularunderwriting conditions. The higher increase in our net earned premiums (to£221.6 million in 2005 from £181.3 million in 2004, an uplift of 22%) reflectsour reducing reliance of whole account proportional reinsurance (qualifyingquota share). Kiln was able to continue its trend of releasing claims provisions from prioryears as the estimates of losses incurred became more certain. The releasesamounted to £11 million (2004: £16 million); we have maintained a consistentapproach to reserving, and the release reflects the cautious approach that Kilnadopts in managing the reserving risk. Investments generated returns of £13.6 million in 2005 against an equivalentfigure of £9.7 million in 2004, reflecting a modest increase in funds availablefor investment and improved returns on our chosen conservatively managedportfolio. The result for the year also benefited from accounting gains onforeign exchange of £7.6 million and proactive management of the pensionsdeficit, which enhanced the profit by £3.2 million. Putting the 2005 result into the context of the medium term, Kiln's performanceover the past three years continues to be more than satisfactory. Our two keyperformance indicators show a weighted average combined ratio of 93% and aweighted average return on equity of 15.1% over the 36 months, a period whichcontained five of the eight worst natural disasters on record. We have increasedour share of ownership on Syndicate 510 by 23% during that time and our grosswritten premium has also increased by 32%. 2005: a market changing year The size of the hurricane losses, and in particular the devastation caused byHurricane Katrina in New Orleans, Louisiana and Mississippi, came as anunwelcome surprise for many in the insurance industry. This was the case notonly for Kiln and our capital providers who bore the brunt of the monetary loss,but also for the rating and modelling agencies and our regulators. The hurricanes triggered a major, worldwide reassessment of underwriting riskand led to the inevitable conclusion that we are facing a period of increasedvolatility. There was immediate and intense pressure from the rating agenciesfor property catastrophe reinsurers to strengthen their balance sheets. Thiswill start to put a strain on returns on capital unless there are dramaticadjustments to the reinsurance product offering. Direct property insurers willin turn also be forced to demand greater returns for the consequentiallyincreased exposure that they will be asked to accept from their customers. Theexpectation that there will be further significant hurricane activity during2006 is the final factor leading to the need for enhanced risked adjustedreturns for the industry. As a consequence, we believe that trading conditionsfor the industry will continue to improve throughout the course of the year. Kiln's response The fundamental shift in the industry's valuation of capital calls for acorresponding shift in our underwriting tactics. Kiln aims to reduce the threatthat severe catastrophes hold, at the same time taking best advantage of thestrong trading and rating conditions. We approached 2006 on the assumption thatwe were likely to face further catastrophic loss from around the globe and ourunderwriters began to take action at the end of 2005 on that basis. Simply raising rates is not enough. We have reviewed the degree of risk we areprepared to accept from our customers and have recalibrated the exposure thatKiln is prepared to take. Examples of this shift are that the aggregate limitsthat we now accept are considerably reduced from the levels of 2005. We haveexamined the losses of 2005 in a variety of ways, analysing affectedtopographies and similar coastline exposures. We have studied the effect ofextreme storm surge - one of the unexpected aspects of Hurricane Katrina - andthat knowledge too is shaping our underwriting approach in 2006. Kiln's business model remains consistent • Specialist short tail underwriters • Manage the insurance cycle • Multiple sources of capital • Prudent financial management • Encouraging a culture of financial accountability • Building and maintaining business relationships Kiln's business model remains consistent: we are specialist underwriters, wetake a prudent approach to risk management, and we generate income for ourshareholders from multiple sources of capital. We focus our underwritingexpertise on those short-tail, specialist lines of insurance and reinsurancebusiness where we know straightaway that a loss has occurred, and can make moreimmediate reliable estimates as to the extent of the losses we might expect. Wealso have detailed knowledge of the risks we underwrite. The combination ofthese two factors helps us to assess the impact of a major insured loss on ourbalance sheet. Kiln seeks to differentiate its financial performance in the way it manages theinsurance cycle: expanding underwriting capacity in response to favourableunderwriting conditions and ensuring corresponding reductions as marketconditions deteriorate. Over the cycle, Kiln has tended to perform best for itsshareholders immediately following a market-wide loss. It is our intention toexploit to the full the continuing market conditions that led us to launch thesuccessful rights issue in 2005. We are in the business of taking insurance risk, which we do through theportfolio of specialist, short tail risks that our experienced and stable teamof underwriters manage. We balance that insurance risk by taking a cautiousapproach to the non-underwriting parts of our business such as capital and debtmanagement, reserving risk and investment risk. This allows us to protectinvestors' capital and expose it to the potential that our underwritingexpertise affords us. A review of 2005 2005 will be remembered as a year of extreme weather in the Gulf of Mexico. Thefinancial impact of the three hurricanes that made landfall in the southernUnited States between August and October dominate 2005's results. This type ofcatastrophe is the reason that Kiln is in business. We responded first to ourcustomers' needs, paying valid claims as quickly as we could and servicing ourlong-standing relationships. We then quickly turned our attention to thebusiness opportunity that the changed insurance landscape has offered. Insurance pricing for Kiln's specialist portfolio had been reasonably steady inthe first eight months of 2005. It was beginning to show the gradual declinethat we expect and anticipate in the normal course of the insurance cycle. Ithad therefore been our intention to reduce Kiln's capacity in accordance withour principle of underwriting for profit rather than volume. Shortly after thehurricanes hit, we revised our business plans and announced our intention toreverse the original reduction, increasing our capacity to underwrite from ourinitial 2006 estimate by 27%. In November 2005 we launched a rights issue in order to finance this increasedunderwriting capacity. This is the second time since the company was listed onthe Stock Exchange in 1998 that Kiln has gone to the market to raise funds. Thefirst time was after the terrorist attacks in September 2001, when we raisedabout £32 million. We believe that the investment community saw that Kiln wasagain well placed to take full advantage of the favourable new underwritingconditions prevailing at the end of 2005, and we were delighted with the vote ofconfidence that the support of our shareholders gave us in taking up 96% oftheir entitlement to the new shares. The remainder was satisfactorily placedthrough the market. We used the majority of the capital raised through the rights issue to purchaseand support increased capacity at Lloyd's. In the process, we furthered one ofour strategic aims of increasing steadily and gradually the proportion of Kiln'sownership of capacity in our flagship Syndicate 510. We took our share in thatsyndicate from 41% in 2005 to 47% in 2006 and Kiln's overall ownership ofcapacity has risen from £280 million to £353 million. This increasesshareholders' exposure to profits resulting from our core activity ofunderwriting. The future Producing low returns for Kiln shareholders is not acceptable, unless theimmediate future presents us with opportunities to make good that shortfall. Webelieve that we have positioned ourselves to take advantage of the opportunitiesthat the 2006 underwriting environment offers. We will continue to explorealternative methods for managing additional underwriting capacity to extract themost from the current market conditions. We will do this through deployment ofshareholders' or others' capital, selecting classes of business and underwritingplatforms that are the most appropriate for achieving excellent risk adjustedreturns. The insurance world is changing, and Kiln continues to respond and evolve inline with those changes. We have demonstrated our ability to adapt ourunderwriting capacity as market opportunities dictate. We have increased theexposure of shareholders to our flagship Syndicate 510 in 2005 and we willcontinue to do so as capacity becomes available at what we judge to be anappropriate price. We have modified the weighting of our business split in orderto take advantage of the rate increases in particular areas of the market. Wecontinue to develop and improve our business processes in the coming year, witha particular focus on those relating to our interface with our customers andbrokers. 2005 was a turbulent year, but Kiln has emerged from it fully prepared to takeadvantage of its consequences from an underwriting standpoint. We took action inorder to make the most of the opportunities that have arisen and are in a strongposition to follow those actions through in 2006 and beyond. Business review The business review reflects the measures that the company uses in order tomanage itself. Key financial performance indicators under IFRS 12 months to 31 12 months to 31 December 2004 December 2005Kiln plcEarned premiums, net of reinsurance £181.3m £221.6mProfit before tax £37.9m £8.5mShareholders' equity £136.7m £215.8mReturn on equity 22.7% 4.3%Net asset value per share 67.0p 74.0pNet tangible assets per share 59.4p 67.0pEarnings per share 12.15p 2.74p Dividend per share relating to financial years 3.0p 3.0p Gearing 29% 19% Kiln managed syndicatesCombined ratio 86% 114%Claims ratio 53% 80%Expense ratio 33% 34% Description of the business Kiln's core business is the underwriting of specialist insurance and reinsurancebusiness in the Lloyd's market, through the four syndicates managed by R J Kiln.In addition, Kiln has a 20% stake in W. R. Berkley (Europe), Limited an FSAauthorised specialist casualty insurance business, as well as interests in avariety of other operations. Kiln has the following principal income streams: • Underwriting profit from the Kiln Corporate Members' participation on the Lloyd's syndicates managed by R J Kiln; • Fees and profit commission from R J Kiln's managing agency operations; and • Dividends and other distributions from Kiln's investment in W R Berkley (Europe), Limited which is accounted for as an Associate Undertaking in Kiln's consolidated accounts. The following table shows the split of Kiln's profit after tax for the year to31 December 2005, together with the profit/loss arising from each of the Group'sprincipal income streams: Profit/(loss) per business line 2004 2005 £m £m Underwriting 15 (8.3) Managing agency 13 13.9 W R Berkley (Europe), 1.1 1.4 Limited Kiln and consolidation (3.3) (1.2) Total 25.8 5.8 Operating review for the 12 months to 31 December 2005 Profits before tax for 2005 were £8.5 million (2004: £37.9 million). Theseprofits resulted in earnings per share for 2005 of 2.7p (2004: 12.2p), and areturn on equity of 4.3% (2004: 22.7%). The total gross capacity of the four syndicates managed by R J Kiln increasedfrom £704 million in 2005 to £803 million for the 2006 year of account and thecompany achieved its pre-emption target of an increase in capacity of 14.5% forflagship Syndicate 510, taking it to £625 million for 2006 (2005: £546 million).The company is now in a strong position to benefit from the potential of theimproved underwriting environment following the 2005 hurricane season. Kiln's earned premiums, net of reinsurance, increased by 22% from £181.3 millionin 2004 to £221.6 million in 2005 and net unearned premium, an indicator offuture profit potential, increased by 29% from £86.5 million as at 31 December2004 to £111.6 million as at 31 December 2005. Profit commission earned by R J Kiln during 2005 amounted to £18.2 million, an increase of 11% on the equivalent period in 2004 (£16.5 million). W R Berkley (Europe), Limited contributed £1.5 million to the result compared with £1.1 million at the same time in the previous year. Investment returns in 2005 of 3.7% (2004: 2.3%) made a considerably greatercontribution to Kiln's performance than in the previous year as a result ofimproving returns on funds at Lloyd's of 0.4% combined with better US dollardenominated bond performance for the year. Shareholders' equity increased to £215.8 million or 74p per share and nettangible assets per share increased by 10% year on year to 67p. In line with Kiln's policy of reducing volatility for shareholders, Kiln reducedits participation in Catastrophe Syndicate 557 for the 2005 underwriting yearfrom 23.2% to 5.2% as its risk profile and capital requirements are relativelyhigh. This has subsequently been reduced to zero for the 2006 year of account. 2005 is the first period to report under IFRS. The introduction of IFRS did nothave any significant impact on how Kiln manages its business or on itsfundamental economics, its capital solvency or its ability to pay dividends.Kiln management does, however, believe that the new IFRS accounting standardsintroduce greater volatility to its income statement. Specifically, one of themost material aspects of the new IFRS requirements is the treatment of theforeign exchange (FX) for non-monetary items (for example, unearned premiumreserves and deferred acquisition costs). IFRS dictates that their value isfixed and carried in the accounts at the historic exchange rate at the time ofthe transaction. As these items are recognised in the following period's incomestatement at these rates, volatility is thereby introduced to the result. Pension scheme The introduction of IFRS on 1 January 2005 resulted in the pension deficitliability in respect of the R J Kiln pension scheme which at that date was£19.8m, being recognised in the Kiln consolidated accounts. The syndicates thatKiln manages have been charged for their share of the pension deficit. At theKiln Group level, the consolidated pension deficit liability now comprises twocomponents: the gross liability to the R J Kiln pension scheme and the amountrecoverable from the syndicates. The total gross pension deficit before tax as at 31 December 2005 is £19.9million, but this reduces to £10.0 million after the allocation of that part ofthe deficit attributed to the syndicates. Net of the imputed deferred taxcredit, the deficit has been reduced to approximately £7.1 million. Kiln has also continued to pursue initiatives designed to reduce the Schemedeficit and to help protect Kiln shareholders from the risks inherent in anydefined benefit pension arrangement. Summary of the Kiln Group pension scheme 31 December 2004 31 December 2005 £'000 £'000 Present value of assets 37,361 42,438Present value of obligations (65,674) (62,424) Gross deficit in the Scheme (28,313) (19,986) Allocated to syndicates - 16,716Of which Kiln Group share - (6,703)R J Kiln share - (3,270)Gross deficit attributable to the Kiln Group (28,313) (9,973)Deferred tax credit 8,494 2,844Net deficit attributable to the Kiln Group (19,819) (7,129)Pension Trust asset - 5,000Balance (19,819) (2,129) Pension Trust R J Kiln & Co Limited, in common with many companies with a defined benefit (DB)pension scheme, has a deficit in the Scheme's overall funding. Rather than takethe traditional route of relying solely on increased funding and movements inthe financial markets, Kiln is also tackling the deficit having established aPension Trust. This approach helps enable the company to fulfil its obligationsto the Scheme at the same time as allowing it access to the funds if and whenthe Scheme moves from a funding deficit to a surplus. Funds will be transferredto the Trust periodically. The level of this funding is determined by referenceto the overall net pension scheme deficit on the Group's balance sheet. A Pension Trust has several advantages both for Kiln and for the pensionscheme's Trustees: For Kiln: Funds can be released back to Kiln if and when the Scheme approaches fullfunding. Funds are therefore not 'trapped' in the Scheme if it moves intosurplus. Kiln's defined benefit scheme, although closed, still has at least 50years before its final pensions are paid, over which time movements in thefinancial markets could push the Scheme into surplus: • The assets of the Trust are available to fund the deficit of the Scheme. • Kiln maintains control over the investment policy of the Trust. • The tax treatment of the Trust is neutral for the Kiln Group. For the scheme's Trustees: • The Trust gives extra comfort to the Trustees and Scheme members in respect of pension obligations. • The Trust provides added protection for the pension scheme's members in the event of Kiln becoming insolvent. Enhanced transfer values In 2005, Kiln began a series of exercises to offer enhanced transfer values(ETVs) to certain populations in the Scheme. For example, all deferredpensioners over a specific age have been offered 100% of their transfer valuethrough a combination of Scheme assets and cash directly from Kiln, togetherwith an additional cash bonus. The success rate of the exercise has beenencouraging. The key drivers for the exercise are: • Obligation savings. The combination of Scheme assets paid out and cash from Kiln typically amountsto less than the value of Kiln's obligations to each individual held as part ofthe deficit on Kiln's balance sheet. Kiln Group and the syndicates share in thissaving; the Kiln Group share is credited to the income statement. In 2005, atotal of £3.2 million has been recognised as a profit from these initiatives. • The elimination of uncertainty for Kiln shareholders. Future regulatory changes, movements in financial markets and life expectancytrends all hold future risk to the Scheme. ETVs eliminate these risks in respectof individuals accepting an ETV as he or she leaves the Scheme and therefore hasno further call on the Scheme assets. • 'A' Day (6 April 2006) For many individuals, being in charge of their own pension assets is moreattractive after the introduction of pension reforms to be introduced on 'A'Day. Kiln's operations in the Lloyd's Market R J Kiln, the Group's Lloyd's managing agent, manages four syndicates: (a) Kiln Combined Syndicate 510: Syndicate 510 is the company'sflagship syndicate It is a recognised lead underwriter in each of the mainareas in which it operates namely reinsurance, accident and health, aviation,marine and special risks, and property. Syndicate 510 enjoys a syndicate ratingof A (Excellent) from A M Best as well as the security ratings assigned toLloyd's by A M Best and Standard and Poor's; (b) Kiln Mathers Syndicate 807: underwriting short-tail business,primarily reinsurance and property delegated binding authority business; (c) Kiln Catastrophe Syndicate 557: underwriting property catastrophereinsurance, both in the US and worldwide; and (d) Kiln Life Syndicate 308: underwriting niche group and individualterm life assurance. Kiln's primary source of income comes directly from underwriting profitsresulting from the Kiln Corporate Members' participations on the Lloyd'ssyndicates managed by R J Kiln. In addition, R J Kiln also acts as managingagent for third party Names participating on the syndicates. This enables thecompany to increase the overall scale of its underwriting, and to maintain amore sophisticated infrastructure and a greater range of skills than would besustained by underwriting supported by its own capital base alone. Kiln'smanaging agency activities also enhance the Group's overall return on capital,for the benefit of shareholders. Income is derived from third party capitalproviders through charging an annual management fee (typically, 0.75% ofcapacity) and a profit commission (typically, 17.5% on underwriting profits),and the managing agency requires relatively low levels of capital. For the 2006 year of account, the Kiln Corporate Members' participations on thesyndicates managed by R J Kiln amounted to £353 million (2005: £280 million), ofwhich £57 million (2005: £35 million) was funded through third party reinsurancearrangements. In order to support this level of participation, the KilnCorporate Members were required to deposit funds at Lloyd's of £165 million.These funds at Lloyd's comprised the following: Kiln Corporate Members' funds at Lloyd's (£ millions) 2005 2006 Bank letter of creditBank letter of credit 40 40Reinsurance letters of credit and other assets 13 25Shareholders' equity* 70 100Total 123 165 * Including Kiln's funds deposited at Lloyd's and Lloyd's solvencyreleases/allowances. Kiln's banking facilities were renegotiated during the last quarter of 2005. Theletters of credit are in place to support the 2006 and 2007 Lloyd's years ofaccount and will not require renegotiation until the last quarter of 2007. W R Berkley (Europe), Limited In June 2003, Kiln acquired a 20% equity shareholding in W. R. Berkley (Europe),Limited an FSA regulated insurance company. This investment allows Kiln toparticipate in the specialist casualty insurance market in London and representsboth a diversification of risk away from Kiln's core property related insurancelines and a market diversification away from Kiln's traditional Lloyd's base.Income is derived from Kiln's share of W. R. Berkley (Europe), Limited'sresults, together with interest on the loan notes provided to W. R. Berkley(Europe), Limited as part of the initial capitalisation in July 2003. W. R.Berkley (Europe), Limited is continuing to operate profitably in spite ofincreased competition which has had an adverse effect on pricing in itsmarketplace. In 2005, W R Berkley (Europe) made a profit of £7.3million of whichKiln's share from its 20% shareholding was £1.5 million before tax. W. R.Berkley (Europe), Limited's strategy is to continue to diversify its portfolio,both in terms of geography and product base, in order to protect its revenuestreams, and grow the business with a view to profit. Other operations Kiln South Africa Kiln South Africa was established in 1999 and is a wholly owned subsidiary of RJ Kiln & Co Ltd. It currently underwrites commercial and industrial packagesbusiness, accident and health business and other specialist products on behalfof the members of Syndicate 510. Kiln South Africa has a 25% shareholding in IMMLtd, specialising in marine business. Consortium underwriting arrangement Following an arrangement which began on 1 January 2005, Syndicate 510, Syndicate557 and W. R. Berkley (Europe), Limited underwrite catastrophe reinsurancebusiness in consortium. The consortium, which is managed by R J Kiln underwrote£192 million of gross premium for the 2005 year of account and continues into2006. International Marine (Underwriting Agency) Limited R J Kiln acquired 33% of International Marine (Underwriting Agency) Limited fromJohn Cahill & Company Limited in September 2005 on behalf of the members ofSyndicate 510. International Marine (Underwriting Agency) Limited and itssubsidiaries underwrite marine risks by way of a number of delegated authoritiesgranted by Syndicate 510. Syndicate capacity and Kiln Corporate Member syndicate participations Kiln has demonstrated its commitment to adjusting its underwriting capacity, andtherefore the level of business it writes, in line with changes in marketconditions. Kiln took advantage of the increase in insurance pricing since theUS terror attacks to increase total gross capacity (including qualifying quotashare capacity) from £405 million in 2001 to £820 million in 2003. As pricingreduced in 2004 and 2005, the use of qualifying quota share capacity decreased,reducing Kiln's total gross underwriting capacity whilst allowing its managedsyndicate capacity to continue to increase gradually in 2004 and 2005. The following table sets out the development of the syndicates' managedcapacity, including qualifying quota share capacity, during the period from 2001to 2006: Total Kiln syndicate managed capacity 2001 2002 2003 2004 2005 2006 £'000 £'000 £'000 £'000 £'000 £'000Syndicate managed capacity 369,218 530,667 657,935 681,252 702,457 802,968Qualifying quota share capacity 35,956 134,504 162,173 50,797 - - Total 405,174 665,171 820,108 732,049 702,457 802,968 The Kiln Corporate Members' participations on the syndicates managed by R J Kilnare supported by the Kiln Group's own funds, bank letters of credit and also bygearing quota share (GQS) arrangements with third party reinsurers. Under theterms of the GQS arrangements, the third party reinsurers provide letters ofcredit to support part of the relevant Kiln Corporate Members' funds at Lloyd'srequirement, in exchange for receiving an equivalent proportion of theunderwriting results of that Kiln Corporate Member, less an amount foroverriding commission on premiums and profit commission on a positiveunderwriting result. The following table sets out the participation of the Kiln Corporate Members onthe Kiln managed syndicates, including the capacity supported by Reinsurance GQSarrangements, during the period from 2001 to 2006: Kiln Corporate Members' participation on the syndicates 2001 2002 2003 2004 2005 2006 £'000 £'000 £'000 £'000 £'000 £'000Net of GQS arrangements 128,467 126,499 214,746 229,543 244,414 296,555GQS arrangements 50,000 79,000 22,500 33,408 35,258 56,840Total 178,467 205,499 237,246 262,951 279,672 353,395 Kiln's approach to financial management It is Kiln's strategy to concentrate its risk appetite on underwriting classesof business where returns can be maximised from application of an in-depthknowledge of the risks. Kiln adopts a cautious approach to the financial risksinherent in managing the balance sheet, thereby protecting shareholders'capital. Claims provisioning Kiln's focus on short tail classes of insurance means shareholders should beless exposed to losses from the past that may previously have beenunderestimated. In the past, Kiln has achieved favourable developments in prioryear claims provisions. The impact of this favourable development has been arelease of claims provision reserves of £11 million (2004: £16 million).Releases typically come from across a range of years of accounts and businessclasses. Syndicate forecasting Kiln has a history of consistently accurate forecasting of syndicate results, asthe table showing forecasts for Syndicate 510 below demonstrates. For reasonsclosely related to those governing claims provisioning, syndicate forecasts aregenerally steady, with gradual improvements quarter on quarter as they develop,with volatility attributable only to major catastrophes. Syndicate 510 historic forecasting of results as a percentage of syndicatecapacity Quarter 6 7 8 9 10 11 12 1999 -3.50% -3.35% -3.34% -5.31% 2000 1.11% -1.50% -2.25% -2.00% -2.29% -3.79% -3.61% 2001 2.21% 0.74% 0.27% 0.30% 0.58% 3.51% 2.54% 2002 16.28% 16.14% 15.92% 16.37% 17.10% 18.92% 17.64% 2003 15.52% 15.22% 16.95% 18.97% 20.32% 21.54% 23.42% 2004 7.79% 5.78% 5.54% Investments Kiln's investment policy reflects its relatively cautious approach to capitalrisk management, with all investments held in lower risk fixed income investmentgrade assets or cash. Its aim is to generate satisfactory investment returnswhile preserving shareholders' capital. Kiln is less reliant on investmentreturns than many of its competitors because of its strategy of specialising inshort-tail risks where the incidence of claims is more quickly known andsettled. The strategy is designed to avoid excessive fluctuations innon-underwriting results and is intended to ensure that shareholders' capital isemployed in support of Kiln's key competency: its underwriting expertise. Kiln'sconservative investment strategy manages risk through holding a portfolio ofinvestments designed to ensure liquidity, with the majority of syndicate assetsheld in fixed income instruments with a rating of AAA. Given the inherentvolatility of equity investments, it is not Kiln's current policy to hold suchassets in either syndicate or group funds. Equities are, however, held by the R J Kiln pension scheme where the Scheme hasrun a mismatch between its assets and liabilities so as to benefit from strongequity market returns. As at 31 December 2005, the defined benefit section ofthe Scheme held £22.5 million of equities which returned 22.7% over the year. US$/£ annual investment performance 2004 2005Syndicate 510 £ 4.76% 5.11%Syndicate 510 US$ 1.12% 2.51%Funds at Lloyd's £ 4.70% 5.26% Reinsurance Reinsurance is used extensively to protect capital against underwriting riskvolatility, either as a result of large catastrophes, large individual losses orthe increased incidence of losses in a given period. The hurricane seasons of2004 and 2005 placed strain on many reinsurance company balance sheets. This hasled to a sustained recapitalisation of sections of the industry in order torebuild and strengthen balance sheets and maintain credit ratings. Creditexposure and aggregate exposure to reinsurers is managed by Kiln's reinsurancesecurity committee. The following table sets out the credit ratings applying toKiln's reinsurers. Credit rating of reinsurers 2003 2004 2005AAA 5% 3% 1%AA 23% 18% 16%A 48% 63% 76%A (less than) 12% 9% 3%Not rated 12% 7% 4% Not rated is a term used by external rating agencies where the rating agencieshave no current opinion about the financial security of the particular entity ortheir guidelines do not promote a rating. Kiln also makes extensive use of outstanding claims advances in managing itsreinsurance assets. For example, following Hurricane Katrina, Kiln receivedUS$200,791,489 in outstanding claims advances (OCAs) from its reinsurers; an OCAis a form of cash deposit allowing crystallisation of an outstanding reinsurancerecovery. OCAs called represented 49.3% of the total amounts owed to Kiln'ssyndicates from the relevant claims from Hurricane Katrina. Borrowing The following table sets out Kiln's off-balance sheet debt relative toshareholders' equity.Gearing 2001 2002 2003 2004 2005 £'000 £'000 £'000 £'000 £'000Shareholder equity 56,504 108,600 128,180 136,682 215,758Gearing ratio 10% 5% 23% 29% 19% On balance sheet debt 592 341 63 - - Off balance sheet debt 5,500 5,500 30,000 40,000 40,000 Kiln aims to set borrowing and gearing levels that are appropriate for its riskappetite and the relevant phase of the insurance market. Kiln's capitalstructure is optimised by holding letters of credit as part of the KilnCorporate Members' funds at Lloyd's. Letters of credit, which are effectivelyoff-balance sheet debt, are an attractive, cost-effective and highly flexibleform of financing which, used appropriately, should enhance shareholder returns. As at 31 December 2005, Kiln's corporate vehicles had a net liquidity positionof £77 million and in addition held £40 million in outstanding off-balance sheetletters of credit. There is no seasonality to Kiln's borrowing requirements andKiln's outstanding borrowings under its letters of credit have remained constantsince 31 December 2004. In addition to this letter of credit facility, in December 2005, Kiln renewedits £15 million revolving credit facility agreement with Lloyds TSB. To datethis standby facility has not been utilised. Any amounts outstanding under the£15 million revolving credit facility would be secured by fixed and floatingcharges over all assets and undertakings of the company. Capital assessment and allocation Kiln has implemented a capital allocation model under the FSA's IndividualCapital Assessments (ICA) regime. Lloyd's may approve the level of ICA assubmitted or has the power to require the assessment to be increased. Suchapproved or amended ICAs are currently uplifted by Lloyd's by an economiccapital margin of 35% to produce an amount of syndicate capital known as theEconomic Capital Assessment (ECA). The level of the ECA is set to ensure thatLloyd's overall aggregate capital is maintained at a level necessary to retainits desired credit rating. The move from the centrally imposed Lloyd's RiskBased Capital (RBC) regime to a devolved bespoke ICA/ECA regime (albeit withfinal approval from Lloyd's and/or the FSA) means that Kiln has far greatercontrol over the process by which the capital required to run the business isset, and that such capital accurately reflects the risks the business faces. Themodel permits Kiln to allocate capital to business lines that will deliver thegreatest return to shareholders at various stages in the cycle. Further changesin the model are planned to be introduced for the 2007 calendar year. Protection against foreign exchange rate fluctuation Kiln accepts a significant amount of its business in US dollars. This businessis subject to currency risks because of the effects of the translation of theoverall underwriting profit and/or loss into sterling. Typically, Kiln starts tohedge the forecast future cash flows around the 18 month point of a developingLloyd's year of account, when the account is substantially off risk given thenature of the short-tail book. Kiln's foreign exchange exposure, and thereforeits hedging strategy, relates solely to the receipt of future US dollar profitsand a variety of instruments are used, from traditional forward contracts tolower risk derivatives. Claims on all US dollar-denominated business are settledin dollars, so there is an automatic match of assets and liabilities and nofurther protection is necessary. As at 31 December 2005, Kiln had in place anoptions structure for US$30 million and two forward contracts to sell US$17million covering the distributable profits from Lloyd's, with a value date of 30June 2006. Treasury policies Cash flows for all Kiln Group entities are managed to ensure that there issufficient cash available to settle liabilities as they become due. Cash flowmodelling is used to project long term cash balances for the Kiln Group.Forecast longer term syndicate cash flows are projected at regular intervals andare stress tested against realistic disaster scenarios in order to identifypotential future liquidity requirements of the Kiln Corporate Members. Themajority of the Group's funds are managed by external fund managers, with highinvestment grade levels used for deposit funds. The investments with thecompany's fund managers are subject to strict diversification rules in order tospread risk and meet liquidity requirements. Cash and cash equivalents are heldin sterling, US dollars and Canadian dollars. Principal cash flows The primary sources and uses of cash of Kiln's direct and indirect subsidiariesand associates are detailed below. Kiln Corporate Members: The Kiln Corporate Members receive cash from aprofitable Lloyd's year of account which, under new Lloyd's requirements, islinked to the level of profits. Where a year of account is not profitable, acash call may be made to fund a cash flow shortfall at the syndicate level. TheKiln Corporate Members also earn investment income on the funds deposited withLloyd's to support their share of the syndicate's underwriting, and pay costsassociated with borrowings made to support underwriting. The Kiln CorporateMembers may purchase or sell syndicate capacity in the Lloyd's auctions leadingto changes in cash flow. R J Kiln: R J Kiln receives cash from two main sources; first through chargingthird party Names capital an annual management fee (typically, 0.75% ofcapacity), which is paid to R J Kiln during the relevant year of account, andsecond through a profit commission (typically, 17.5% on underwriting profits),which is paid to R J Kiln on closure of a year of account. R J Kiln isresponsible for paying all expenses related to running the syndicates. Asignificant proportion of these expenses is recharged to the syndicates. R J Kiln, as a regulated entity, is subject to solvency requirements fromLloyd's which R J Kiln must satisfy before any dividends can be paid by R J Kiln to Kiln plc. W. R. Berkley (Europe), Limited: loan notes were issued by the holding companyof W. R. Berkley (Europe), Limited as part of the initial capitalisation in July2003 and on which Kiln receives periodic interest payments. W. R. Berkley(Europe), Limited is, however, only an associate of Kiln and Kiln does notexercise management control over the company, nor can it control whetherinterest is paid on the loan notes or is compounded. Kiln plc: Kiln plc is a holding company and does not conduct insurance orreinsurance operations of its own. Dividends from direct and indirectsubsidiaries and/or associates, including R J Kiln and the Kiln CorporateMembers, together with any investment income, are expected to be the company'ssole sources of funds from which to pay expenses and dividends, if any. Risk management As a general principle, the company accepts risk to its balance sheet throughits underwriting activities; the financial risks inherent in managing thebalance sheet are managed conservatively so as to protect shareholders' equity. Key corporate risks Underwriting of insurance risks The underwriting of insurance risks is, by its nature, a high-risk business.Earnings can be volatile and losses may be incurred which have the potential toreduce shareholders' equity. The past results of the Lloyd's market, of the syndicates, and of the companymay not necessarily be a reliable guide to future prospects. Previouslyprofitable business may subsequently become unprofitable; the nature of businessunderwritten may change; reserves created against future claims may prove to beinadequate; a syndicate's reinsurance programme may be insufficient and/or itsreinsurers may fail or be unwilling to pay claims due. High returns may be theresult of skilful underwriting, but may indicate an exposure to more volatilerisks. It is inherent in the nature of insurance business that it is difficult toforecast short-term trends or returns. Not only do underwriting results changebut investment income and capital appreciation or impairment, which form animportant part of the return to an investor, are affected by interest rates,exchange rates, taxation changes and other economic events as well as thecompany's investment policy and market performance and events. The risks assumed in the company's day-to-day business activities are subject tocontrols over aggregation of risk. Concentration of risk is monitored by line ofbusiness, geographical location and credit quality amongst other elements.Strict limits are applied to manage the company's risk appetite and protectshareholders from excessive loss. In addition, and in line with Lloyd's businessplanning requirements, no syndicate should lose more than 20% of its capacitystamp from any Lloyd's realistic disaster scenario, after taking account of itsreinsurance programme. The exception to this rule is Syndicate 557, thecompany's specialist catastrophe syndicate, in which the company no longer hasan economic interest in its underwriting result. Aggregate risk is also monitored by Lloyd's and the company through therealistic disaster scenario (RDS) process. This measures the aggregation of riskand hence loss where selected hypothetical scenarios take place. For thecompany, current RDS data includes: Event Insured Industry Loss* Net loss to Kiln ** £bn £m Florida windstorm 41 51European windstorm 17 76California earthquake 31 48New Madrid earthquake 35 61Gulf of Mexico windstorm 35 73 * Insured industry loss is described as the total loss borne by the globalinsurance industry before any reinsurance is applied. ** Net loss to Kiln is the corporate share of losses less all reinsurance. *** The planned loss ratio used by the company assumes a certain level ofcatastrophe activity. Therefore in any accident year part of the loss above willhave been accounted for within our planned loss ratio. Catastrophe modelling is not an exact science and the company is constantlylooking at new data to improve modelling accuracy. The above can therefore onlybe used as a guide and is no guarantee that net losses could not be higher. Reinsurance R J Kiln, as the syndicates' managing agent, follows the customary insurancepractice of reinsuring and retroceding with other insurance and reinsurancecompanies a portion of the risks or a portion of the losses assumed under theinsurance and reinsurance policies it underwrites on behalf of the syndicates.These reinsurance and retrocession arrangements are maintained to protect thesyndicates against the severity of losses on individual policies and unusuallyserious occurrences in which a number of claims produce an extraordinaryaggregate loss. Although reinsurance does not discharge the syndicates fromtheir primary obligation to pay either under an insurance policy for lossesinsured or under a reinsurance agreement for losses assumed, reinsurance doesmake the reinsurer or retrocessionaire liable to the syndicates for thereinsured or retroceded portion of the loss. The collectibility of claims underreinsurance and retrocession contracts is largely a function of the continuingsolvency of reinsurers. The syndicates have a significant number of reinsuranceand retrocession contracts designed to limit their exposure in respect ofparticular lines of business or particular risks. While the reinsurers andretrocessionaries are chosen carefully on the basis of such factors as assets,financial performance, credit rating, reputation and trading performance, thesyndicates have potential credit risk with respect to their reinsurers. If areinsurer fails to make payment, whether through insolvency, dispute orotherwise the relevant syndicate retains the primary liability to the insureds,and there could therefore be a material adverse effect on the company'sbusiness. There can be no assurance that reinsurance or retrocession arrangements will beavailable in the future, particularly in view of the potential impact of thelosses arising from the recent series of US hurricane losses. If reinsurance orretrocession arrangements are available, there can be no assurance that theywill be on terms deemed by the company to be appropriate or acceptable either interms of pricing or terms and conditions, or from entities with satisfactorycreditworthiness. The company has a reinsurance security committee which is responsible forconsidering the level of exposure to reinsurance counterparties and maintainsthe reinsurance security approved list. A table in the reinsurance section showsthe credit rating of our reinsurers over the last three years. The creditexposure arising from each reinsurer is managed with reference to a maximumpercentage of stamp capacity by syndicate, the credit ratings and the balancesheet strength of the reinsurer. Actual limits are then set within an overallmaximum to reflect the level of desired exposure. The overall responsibility formanaging both individual and aggregate reinsurance exposure lies with thecompany's reinsurance manager. Actual claims may exceed claims provisions Claims provisions represent estimates, based on an underwriter's informedknowledge and judgement and on actuarial and statistical projections, of thecompany's expectations of the ultimate settlement and administration costs ofclaims incurred. The company utilises both proprietary and commerciallyavailable models as well as historical loss development patterns to assist inthe establishment of appropriate claim reserves. In contrast to casualty losses,which frequently can be determined only through lengthy and unpredictablelitigation, property losses tend to be reported relatively promptly and usuallyare settled within a shorter period of time. Nevertheless, for both casualty andproperty losses, actual claims and claims expenses paid may deviate, perhapssubstantially, from the reserve estimates reflected in the company's financialstatements. In addition, because the syndicates, like other reinsurers, do notevaluate separately each of the individual risks assumed under reinsurancetreaties, the syndicates are largely dependent on the original underwritingdecisions made by ceding companies in relation to estimates made for claimsprovisions in respect of inwards reinsurance business underwritten. Thesyndicates are exposed to the risk that the ceding companies may not haveadequately evaluated the risks being reinsured and that the premiums ceded maynot adequately compensate the syndicates for the risks they assume. It ispossible that claims in respect of events that have occurred could exceed thecompany's claims reserves and have a material adverse effect on the company'sresults or operations in a particular period or on the company's financialposition Even though most insurance contracts have policy limits, the nature of propertyand casualty insurance and reinsurance is that losses can exceed policy limitsfor a variety of reasons and could significantly exceed the premiums received. The table below shows the development of ultimate claims (after reinsurancerecoveries) on a 100% basis, over the last five years. The underwriting businessis predominantly managed on a year of account basis. Under this basis allbusiness written to policies starting within each calendar year is written onbehalf of the capital supporting that year of account. The claims developmenttable is therefore prepared on an underwriting year of account basis. Estimate of 100% managed 2001 and prior 2002 2003 2004 2005ultimate claims at end of: £m £m £m £m £m Year 1 1,261.9 230.1 286.9 409.2 573.8Year 2 1,250.8 185.2 259.8 416.7 -Year 3 1,227.6 167.0 229.9 - -Year 4 1,227.1 163.2 - - -Year 5 1,222.8 - - - - Less: claims paid 1,126.4 138.3 164.7 207.8 75.5Less: future claims - - - 15.8 191.4 Outstanding claims reserve 96.4 24.9 65.2 193.1 306.9 Future claims represent claims on events which have not occurred at the balancesheet date. These claims will be charged against premiums reported as unearnedpremium at the balance sheet date. Lloyd's US trading arrangements The US regulators require syndicates underwriting certain risks in the UnitedStates to maintain minimum deposits (which are the subject of various trustsestablished in the United States (the US trust funds)) as protection for USpolicyholders. These deposits represent the underwriters' estimates of unpaidclaims liability (less premium receivable) relating to this business, adjustedby provisions for potential bad debt on premium earned but not received and forany anticipated profit on unearned premium. No credit is allowed for potentialreinsurance recoveries but the US regulatory authorities currently requirefunding for at least 30% of gross liabilities relating to business classified as'Surplus Lines' and the 'Credit for Reinsurance' trust fund is required to befunded at 100% The funds in the deposits are not ordinarily available to meettrading expenses. Accordingly, in the event of a major claim arising in the United States, forexample from a major catastrophe such as the US hurricanes, syndicatesparticipating in such US business may be required to make cash calls to meetclaims payment and deposit funding obligations. Managing agents have a limited ability to withdraw funds from the US trust fundsother than at the normal quarterly revision periods, provided that the amount tobe withdrawn: (a) is in respect of a specified loss event; (b) represents value for liabilities previously reserved in respect of policyholders claiming for this event; and (c) cannot be obtained from other US dollar assets held outside the relevant US trust fund. More to follow This information is provided by RNS The company news service from the London Stock Exchange