17th Mar 2005 07:01
SVB Holdings PLC17 March 2005 17th March 2005 SVB HOLDINGS PLC Preliminary results for the year ended 31st December 2004 Highlights Continuing business • Technical profits of £65.0 million (2003: £68.9 million) and operating profits of £46.7 million (2003: £56.7 million) • Combined ratio of 84.8% (2003: 81.2%) after windstorm losses and 2001 and prior year reserve strengthening on Specialty business • Return on average equity capital employed of 25.3% (2003: 29.6%) underscores the strength of the business • Net tangible assets per share 31.6p (2003: 55.6p) Discontinued units • Clear segregation between continuing business and run off of discontinued units • £103.6 million provision established as at 30th June 2004 • £26.4 million of provision utilised in second half after investment income of £4.1 million; non-cash cost of commuting the ADC £6.0 million • Full year effect of discontinued units £74.3 million • Discontinued Business Unit fully operational Q1 2005 Outlook • 2004 whole account rating index was positive at +1% (2003: +18%) • £280.0 million of unearned premium reserve carried forward (2003: £238.1 million), written at the peak of the rating cycle • Distribution businesses expected to provide around one third of 2005 premium income Commenting on the results, Matthew Fosh said: "2004 was a tough year. However, that did not deflect us from continuing tobuild momentum behind SVB's recovery. At every level of the operation we havedrawn a distinction between our damaging legacy and our excellent ongoingbusiness. Measured by the combined ratios published by our peers, the ongoingbusiness has firmly established itself as a top quartile Lloyd's franchise. Ourstrategy is clear: we remain focussed on bearing down on the legacy we haveinherited and delivering a powerful and sustainable ongoing insurance business." Enquiries: SVB Holdings PLC 020 7903 7300Matthew Fosh M Communications 020 7153 1539Nick Miles A presentation to analysts and investors will be held today at 10.00a.m. at 1Ropemaker Street, London EC2Y 9HT SVB HOLDINGS PLC Preliminary results for the year ended 31st December 2004 Chairman's statement In my previous Chairman's statement I indicated that I felt SVB was poised for aperiod of growth as the strong underwriting results from 2002, 2003 and 2004outpaced the underwriting losses from 2001 and prior which have proved sopersistently damaging in the past three years. 2004 has indeed been a year in which strong, sustained profitability has beendelivered from those 2002 - 2004 underwriting years; but it has also been a yearin which the old business from 2001 and prior again cast a shadow over theGroup's fortunes. Since the executive directors came together as a team between November 2003 andApril 2004, their whole focus has been to protect and nurture the powerfulongoing business, against a background of bearing down relentlessly on these oldyears. The arrival of Oliver Corbett on the Board at the end of 2003, and PeterMatson and Jeremy Adams in April 2004, completed the team under the leadershipof Matthew Fosh. Measure after measure taken by this group of executivedirectors has sought to isolate and cauterise the back year problem. There are three specific measures I should like to mention. Firstly, thepresentation of the accounts has been fundamentally changed to allow a visibleand transparent distinction between our successful and highly profitable ongoingbusiness, written since 2002, and the damaging US casualty business from 2001and prior years. Secondly, you will know that, after further reserve deterioration from pastunderwriting in the first and second quarters of 2004, we established anexceptional £103.6 million provision as at 30th June specifically in respect ofliability reinsurance, healthcare and third party liability business(collectively "the discontinued units"). This was designed to recognise infinancial accounting terms the potential damage from any future deteriorationwhich may emerge from the discontinued units. It was painful medicine; but itwas indicative of the Board's determination to deal realistically and robustlywith the problems of the past. Thirdly, following the appointment of run-off specialists Omni Whittington inthe third quarter of the year to advise on our legacy issues, a dedicated,self-contained Discontinued Business Unit was created specifically to handle therun-off of SVB's discontinued units. The final outcome from these long-tail classes is notoriously difficult topredict with certainty; but the structure of the Group is now configured toisolate so far as possible this damaging past, and to allow the continuingbusiness to flourish. Turning to our continuing business, it again delivered a powerful performanceacross our full range of classes. The performance of SVB's traditional directSpecialty classes, such as FI, PI and D&O, further confirmed the strength of thefranchise we enjoy in this area. The Property underwriters withstood one of themost damaging catastrophe years for decades, and still delivered valuableprofits; whilst our Aviation & Marine and Liability segments made a significantcontribution to the Group. From a distribution standpoint, it has been a stated objective of SVB in thepast few years to blend the traditional large ticket, international risks,sourced from the London subscription market, with a greater proportion of UKregional commercial business. This process accelerated during 2004. Fusion and Novae, the Group's two keydistribution subsidiaries, provided over a quarter of SVB's premium income. Thisis forecast to grow to around a third in 2005. Diversifying our sources ofdistribution remains a key objective for the Group overall. Fusion's regionaloffice network, coupled with the automated trading platform developed by Novae,together deliver valuable alternative outlets for our range of products. Such have been the difficult circumstances in which SVB has operated during2004, whilst at the same time working to preserve and build the excellentongoing business, that I would like to pay tribute to the dedication andprofessionalism of the management team as they have addressed the challenges wehave faced. It is difficult properly to recognise such efforts at a time when the perniciouseffects of business that long pre-dates current executives continue to buffetthe business; however, when these problems have been resolved, and SVB is onceagain on a sound footing, their role in the rehabilitation of SVB will beacknowledged and recognised. I would also like to thank my non-executive colleagues for their support andprofessionalism during a challenging year. And finally, I would like to thankevery single member of staff at SVB, who in extremely difficult circumstances,have all worked to protect and build SVB's future, for the benefit ofshareholders and assureds alike. Paul Selway-SwiftChairman17th March 2005 Chief Executive's report 2004 has been a tough year, but that has not stopped us in our determination torehabilitate and rebuild SVB. We have changed the way in which we manage SVB by drawing a distinction at everylevel between the ongoing business and the discontinued units. We have mademajor steps in strengthening and simplifying business processes. We haveaddressed a significant change in the way in which the Group is regulated, notonly in the underwriting area but also in relation to our distributionbusinesses. Finally, we have continued to attract and retain key managers,underwriters and staff at all levels and in all areas of the business.Underwriting performance has not been sacrificed in the pursuit of these goals.The combined ratio from our continuing business is now firmly established in thetop quartile of our peer group. Financial performance Our continuing business generated technical profits of £65.0 million, equivalentto a combined ratio of 84.8% (2003: £68.9 million and 81.2% respectively),despite property catastrophe losses, which had a net £8.0 million impact onprofitability, and £22.0 million of reserve deterioration in our Specialtybusiness from 1999-2001. This is an excellent performance from our continuingbusiness. After deducting other income less other costs, the first halfdeterioration on discontinued units and the exceptional loss provision, theheadline loss before tax was £110.1 million (2003: £17.8 million profit beforetax). Underlying profit before tax, excluding discontinued units and short terminvestment fluctuation, was £46.7 million, representing a pre tax return of25.3% on average equity capital employed (adjusted for the unutilised portion ofthe exceptional loss provision) of £184.8 million (2003: £56.7 million, 29.6%and £191.3 million respectively). Year end shareholders' funds were £123.5million, or £190.6 million after adjusting for the unused portion of theexceptional loss provision (2003: £210.6 million). Strategy We remain committed to the generation of shareholder value through the creationand development of a leading specialist insurance franchise. Within thatcontext our major objectives are as follows: • Exceeding our hurdle rate when deploying capital. We have extended this approach to underwriting, with individual operating units being required to demonstrate economic value added after servicing cost of capital • Distinguishing between discontinued units and our ongoing business, and ensuring that we bear down effectively on the run off of the discontinued units • Pursuing underwriting excellence in our ongoing business • Acquiring the remaining third party capacity on Syndicate 1007, and its eventual merger with Syndicate 2147 • Supporting the measured and controlled development of our distribution businesses Group structure Our legal structure now represents the operational substance of the Group. Wehave two distinct operations. Underwriting Our underwriting operation contains the Group's managing agency and Lloyd'scorporate member. It generates a return from underwriting on the Group'saccount on Syndicates 1007 and 2147, and through earning fees on the residualthird party capacity on Syndicate 1007. We also earn investment return on thesolvency capital held by our corporate member. Distribution SVB Distribution is the parent of SVBUSL, Fusion and Novae. SVBUSL and Novaeare wholly-owned subsidiaries. SVB has an 80% stake in Fusion, with itsmanagement holding the balance (management's interest may increase under aperformance-related formula). The distribution businesses earn commissionagainst which their costs are offset. Whilst profitable in their own right,they play a more fundamental role in securing high quality business for ourunderwriting operation. Underwriting in 2004 We analyse the ongoing business by segment, differentiating between Specialty,Property, Liability and Aviation & Marine. Following our July 2004presentation, we continue to show separately the effect of the discontinuedunits. Specialty Specialty business accounted for £193.3 million of total gross written premiums(2003: £195.5 million), over 40% of the whole, and is recognised as an area inwhich SVB is a prominent leader. Its 2004 combined ratio was 89.8% (2003:90.4%) but for Syndicate 1007, where most of our ongoing specialty business waswritten in 2004, it was 75.3% (2003: 83.1%). We are pleased with theperformance of our current business in this sphere. As previously reported this segment has the potential to suffer losses fromwell-publicised issues over recent years such as IPO laddering and the failureof high profile corporate entities such as Enron. These are important issuesaffecting business written in 2000 and 2001. We have continued to adopt acautious approach to the large claim potential that they present, which hasaffected the profitability of the Specialty segment. In the case of Syndicate1007 this is largely offset by reinsurance so the net impact is small. Incontrast Syndicate 1212, which is reinsured into Syndicate 1241, has encounteredsome elements of reinsurance exhaustion which have meant that the net impact isnot so well-contained. Syndicates 1212/1241 also have claim potential fromother high profile issues such as direct professional indemnity insurance for USlawyers, and this too has eroded overall profitability. The reduction inreinsurance protection to Syndicates 1212/1241, in part a result of utilisationby the discontinued units, has materially damaged the performance of the 2000and 2001 Years of Account. Notwithstanding the very encouraging claims experience on business transacted bySyndicate 1007 in recent years we have maintained a cautious approach to profitrecognition. This has resulted in some small reserve releases from businesstransacted in 2002 and 2003 in 2004 which have helped to mitigate thedeterioration from prior years. We have also adopted a conservative approach to profit recognition from businesswritten through Novae, our Specialty UK regional distribution business whichbegan operations in 2004. Property After two years of comparatively benign claims experience for our Propertybusiness, 2004 saw a series of major windstorm events. In October we indicatedthat the combined impact on the profits of SVB of the US hurricanes and Japanesetyphoons was expected to be no more than £10 million, which was based on acombined cost from these events net of reinsurance of £25 million (the effect onprofitability being the cost net of reinsurance less the budgeted loss fromproperty catastrophe losses of this type for the year). In November, whenissuing third quarter syndicate forecasts, we reported that these losses wereemerging within our earlier expectations. At the year end, based on exchangerates then prevailing, our assessment is a combined net cost of the order of £23million. Property business accounted for one third of our total gross premium income, at£153.9 million (2003: £111.3 million). Of this total, £103.2 million (2003:£66.8 million) came from Fusion, our UK regional property and commercialcombined business. This gives breadth to our Property exposures, complementingas it does the US and International perspectives of our London market propertybusiness. The combined ratio of the Property segment was 80.4% (2003: 56.5%). While thisresult benefited from a strong performance at Fusion, a combined ratio of 105.0%for the London market operations of Syndicate 2147 is a highly satisfactoryoutcome given the scale of catastrophe losses. It indicates a very healthylevel of underlying profitability. Once again we believe our Propertyunderwriters have demonstrated the overall quality of their business and on thisoccasion it was a result achieved in much more demanding circumstances. Liability Our continuing Liability operations accounted for 19% of total gross premiumincome, at £87.0 million (2003: £62.0 million). This is consistent with ourpreviously expressed desire to restrict their contribution to around 15-20% oftotal income. The combined ratio was 83.7% (2003: 104.4%). Just over half of this Liability business arises in Fusion, where it forms partof the commercial combined package that is the principal product sold to smalland medium sized businesses. Notwithstanding the encouraging development ofthis business we have maintained a cautious view of profit recognition, evidentin a Fusion Liability combined ratio of 90.1%. Similar caution applied to the Liability business of Novae is reflected in acombined ratio of 104.1% notwithstanding our conviction that the business isprofitable. This result also reflects the start up nature of Novae, as costswere incurred and capital deployed to generate a new book of business. The remainder of our Liability book arises from London market business. Currentbusiness is expected to be profitable based on the rating levels prevailing butwe have restricted profit recognition at this early stage. Business written inearlier years is the principal source of profit, notably on Marine Liabilitybusiness. Aviation & Marine With our Marine Liability business included in Liability, the Aviation & Marinesegment is dominated by Aviation Reinsurance. Again this unit enjoyed a benignyear from a claims perspective. The full extent of the profit contribution fromAviation Reinsurance was depressed by timing differences in the first half whichhad not fully unwound by the year end. Our much smaller involvement in Space business had a less favourable year.Marine business transacted in recent years has been profitable. However, theoverall Marine result was affected by late claims development on excess of lossbusiness, a class from which SVB withdrew in 2002. This segment provides around 6% of total premium income at £26.0 million (2003:£27.9 million) and its combined ratio was 62.1% (2003: 60.4%). While small inthe context of the Group it provides useful diversification and has made avaluable contribution to profits in recent years. Discontinued units The discontinued units, comprising liability reinsurance, healthcare and thirdparty liability, produced a substantial adverse impact of £37.8 million in thefirst half of the year. Although syndicate-level reserves were and continue tobe set on the basis of actuarial best estimate, late reporting by US cedants hadled to quarterly movements in reserves held by SVB. As a result as at 30th June2004 the Board made a provision of £103.6 million over and above actuarial bestestimate to cover the possibility of future deterioration. In the second half we saw a further £26.4 million of adverse impact from thediscontinued units, net of £4.1 million of investment income attributable to thediscontinued units. We also took the decision in December 2004 to commute theAdverse Development Cover ("ADC") purchased by Syndicate 1212. The ADC offeredno further protection to Syndicate 1212 (or Syndicate 1241, into which it wasclosed), exposed the Group to continuing cost through the funds withheldinterest accrual and complicated the presentation and analysis of our results.The profit and loss account effect of commutation was to crystallise a non-cashcharge of £6.0 million in respect of the discontinued units. This has beenadded to the second half reserve deterioration from discontinued units toproduce a 2004 charge against the provision of £32.4 million net of investmentincome or £36.5 million gross. This takes the financial cost of thediscontinued units to £138.5 million, made up as follows: (£'m) (£'m)2001 financial year 20.52002 financial year 18.62003 financial year 25.1H1 2004 37.8Total taken through profit and loss account (other than 102.0through the exceptional loss provision)Q3 2004 8.1Q4 2004 18.3Investment income transferred to long term rate of return 4.1Cost of commutation of ADC 6.0Utilised against the exceptional loss provision 36.5Total financial cost of discontinued units 138.5 The remaining £67.1 million of the exceptional loss provision is carried forwardinto 2005 and is available to absorb any future deterioration from thediscontinued units. This does not affect our solvency capital position for2005. Loss reviews relating to two large contracts accounted for most of the fourthquarter movement. In one instance a new reviewer (the second new firm appointedto conduct the review in the last twelve months) was asked to look in particularat those cases for which the cedant had posted nominal case reserves. In thesecond instance experience on the 2000 year was extremely poor. The level of reinsurance recovery on discontinued units has been lower in 2004and reinsurance exhaustion is now an issue. This extended the adverse influenceforward to include the 2001 year of account because at that time SVB's outwardreinsurance was arranged to respond based on a date of loss basis. Losses whichoccurred in 2001 on treaties written in 2000 and prior also adversely affect thereinsurance protection available to 2001 business. Further refinement of actuarial assumptions is reflected in the scale of lossfrom discontinued business. In view of the uncertainty which exists, aggravatedby possible reinsurance exhaustion, the syndicates affected have not closedtheir 2002 years of account. There is still a substantial provision availableto cover possible future adverse development on discontinued business. Wecontinue to seek to put the consequences of underwriting this business behind usand 2004 bears the pain which this resolve has produced. In November 2004 SVB announced the formation of the Discontinued Business Unit("DBU") to handle the run off of the legacy liability reinsurance, healthcareand third party liability business. In January 2005 Mike Roffey was appointedDBU Manager, having previously led the Omni Whittington team which SVB was usingto advise on run off strategy. The formation of DBU and the way in which therun off is being conducted is evidence of the much greater scrutiny androbustness being brought to bear in this area under the new management team.Although the DBU is a cost that SVB has to bear, it has a key role in furtherdistancing SVB from its underwriting legacy. Underwriting for 2005 Our managed capacity for 2005 is £437 million, compared to £502 million in 2004and represents a 13% reduction year-on-year. We have maintained the capacity of Syndicate 2147 at £286 million. We havereduced the capacity of Syndicate 1007 from £216 million in 2004 to £151 millionin 2005, reflecting two issues. First, the growth in premium capacity from £151million in 2002/3 to £216 million in 2004 was primarily a response toexceptional trading conditions in Syndicate 1007's markets. Syndicate 1007 hasnow reverted to its natural size as rating conditions have moderated. Second,we have withdrawn from a number of classes of business where we are notsatisfied with the risk-adjusted return. For example, we have demanded a highreturn from US direct professional liability business, which is exposed tolitigation as well as currency and funding risk, and where we are not confidentthat such a return is available we have exited. SVB continues to provide 100% of the capacity on Syndicate 2147. Our share ofSyndicate 1007 has increased from 81% in 2004 to 82% in 2005. However, theproportion of Syndicate 1007 controlled by traditional names has fallen to underthree per cent. We remain committed to full ownership of our managed capacityon terms that create value for shareholders, as well as to the eventual mergerof Syndicates 1007 and 2147. SVB's chosen mix of business positions the Group as a late cycle underwriter.This is demonstrated by the 2004 rate index which showed a modest positiveyear-on-year whole account movement of just under one per cent. 2000 2001 2002 2003 2004 Specialty 100 125 212 280 290Property 100 118 159 165 157Liability 100 117 171 197 207Aviation & Marine 100 132 284 304 295 Whole account 100 123 193 228 230 Although rates in a number of short tail classes began to ease during the year,the key issue is and remains rate adequacy. A combination of greaterunderwriting discipline, the market-wide property catastrophe losses of thesecond half and modest rate increases in our Specialty lines business into thefourth quarter provide grounds for measured optimism for 2005. Distribution There is increasing recognition of the value that distribution businesses,sourcing less volatile regional business, can bring. SVB began its initiativein this area in 1999. Our aim remains to secure non-US dollar business in ourchosen areas of expertise in a cost effective way. Our distribution businesseswrite on binding authorities on behalf of the managed syndicates. We have simplified the operation of our distribution businesses in 2004 and ourcurrent structure is as follows: SVBUSL SVBUSL is our oldest distribution business. Historically, it has sourcedinternational and UK regional liability business both directly and throughdelegated authorities. It has a balanced book of employers' liability, generalliability and solicitors' professional indemnity. During 2004 we merged SVBAsset Protection (our kidnap and ransom business) and CIFS (which provides UKregional credit insurance) into SVBUSL in order to simplify the day-to-dayoperation of these businesses. Fusion Fusion operates from a network of seven regional offices writing UK property andcommercial combined policies for mid sized businesses. Its premium splitcontinues to be around two thirds property and one third liability. Income issourced from a network of regional brokers to whose clients additional servicessuch as risk surveying are sold. Fusion's selling proposition is to add valuerather than compete solely on price. Novae Novae writes liability business for UK small and medium sized businesses. Itskey classes include professional indemnity, directors and officers, generalliability and medical malpractice. It operates from London and Glasgow and hasalso developed an electronic trading hub. This passed a major milestone inDecember 2004 when Novae was appointed as one of three underwriters supportingthe electronic distribution initiative of one of the largest UK brokers. In 2004 our three distribution businesses generated total premium income of£142.0 million (2003: £132.6 million), made up as follows: 2004 2003 (£'m) (£'m) SVBUSL 34.0 44.4Fusion 97.3 88.2Novae 10.7 Nil Total 142.0 132.6 In January 2005 we merged SVBUSL and Novae as a single, wholly-owned corporateentity, further simplifying the corporate structure and reporting lines aroundthe Group. Capital and dividends We manage the business on three high level financial measures: capital,profitability and cash flow. We are committed to the delivery of shareholdervalue, which can best be achieved by creating the virtuous circle of effectiveand disciplined capital deployment producing profit and thus economic valueadded which is then converted into free cash flow. The payment of dividends is an effective way of channelling free cash flow toshareholders as well as imposing capital discipline on the business. However,in the context of needing to take radical action to address SVB's legacy issues,the Board reluctantly concluded that it would be inappropriate to recommend afinal dividend for 2004. We remain committed to the resumption of dividends assoon as it is financially prudent to do so. Employees On behalf of shareholders I want to acknowledge and thank all our staff fortheir effort and commitment in 2004. They have fought SVB's corner consistentlyand highly effectively in a competitive market, and have never lost their beliefin the business. We have a strong, well motivated and enthusiastic team and wecan ask for little more. Outlook 2004 was a challenging year. However, we were not and will not be deflectedfrom our commitment to rebuild SVB. We continued to strengthen our seniormanagement team. We brought greater resources and transparency to running offthe discontinued units. We have nurtured our current underwriting business. Wehave invested significantly in business process and in meeting the risingexpectations of our regulators. We remain committed to SVB's rehabilitation andthe delivery of shareholder value. We look forward with confidence to buildingon this base in 2005. Matthew FoshGroup Chief Executive17th March 2005 Finance Director's review Group results The Group results show an operating profit from continuing businesses based onthe long term rate of return of £46.7 million (2003: £56.7 million); aftercharging the first half loss from discontinued units, the £103.6 millionexceptional loss provision and the short term fluctuation in investment return,the loss before tax for the year was £110.1 million (2003: profit of £17.8million). This is summarised below: 2004 2003 (£'m) (£'m)Ongoing business technical result 65.0 68.9Other operating income less costs (18.3) (12.2) Ongoing business operating profit based onlong term rate of return 46.7 56.7 Discontinued units - H1 (37.8) (25.1)Exceptional loss provision (103.6) -Short term fluctuations in investment return (15.4) (13.8) (Loss)/profit before tax (110.1) 17.8Taxation 23.5 (5.5) (Loss)/profit after tax (86.6) 12.3 Of the £103.6 million exceptional loss provision, £36.5 million was utilisedduring the second half of 2004 (comprising £26.4 million of reservedeterioration, the £6.0 million non-cash cost of commuting the AdverseDevelopment Cover and the reallocation of £4.1 million of investment income tolong term rate of return). The remaining provision at 31st December 2004 is thus£67.1 million. Technical profits generated from the continuing business were £65.0 million(2003: £68.9 million). Other operating income, being managing agency income onthird party capacity and non-underwriting income generated from the distributionbusinesses, totalled £9.0 million (2003: £2.9 million). The largest componentin other operating costs of £27.3 million (2003: £15.1 million) was the cost ofnon equity capital expensed in the year (£11.0 million). Balance sheet SVB's consolidated balance sheet as at 31st December 2004, together with theprior year comparator, is summarised as follows: 2004 2003 (£'m) (£'m) SVB's share of technical assets 1,432.1 1,288.3SVB's share of technical liabilities (1,467.5) (1,264.2) SVB's share of net technical (liabilities)/ (35.4) 24.1assetsFunds at Lloyd's 215.8 207.0Intangible and fixed assets 13.3 13.3Deferred tax 44.3 19.1Net working capital and other assets 20.4 (5.0) 258.4 258.5 Shareholders' funds 123.5 210.6Unutilised exceptional loss provision 67.1 -Convertible bond 48.3 47.9Subordinated loan notes 19.5 - 258.4 258.5 Net assets per share were 34.2p (2003: 58.5p) and net tangible assets per sharewere 31.6p (2003: 55.6p). The exceptional loss provision, less amounts utilisedduring the year, was equivalent to 18.6p per share (2003: nil). Regulatory capital SVB's regulatory capital requirement continues to be set by Lloyd's under itsRisk Based Capital ("RBC") regime. For 2005 the RBC requirement is £312.4million to support aligned capacity of £409.1 million, equivalent to a RBC ratioof 76% (2004: RBC of £303.1 million, aligned capacity of £460.1 million and RBCratio of 66%). The components in the movement in RBC from 2004 to 2005, and the prior yearcomparatives, are set out below: 2005 2005 2004 2004 (£'m) (£'m) (£'m) (£'m) RBC requirement b/d 303.1 239.0Effect of change in ownership (33.6) 32.0(including pre-emption)Effect of change in RBC ratio 42.9 32.1Annual increase 9.3 64.1RBC requirement c/d 312.4 303.1 SVB's RBC requirement has increased from £169.5 million for 2001 (equivalent toan RBC ratio of 49%) to £312.4 million for 2005 (equivalent to an RBC ratio of76%). Of the increase of £142.9 million, £28.5 million (20%) is attributable toa net increase in ownership and £114.4 million (80%) to a rising RBC ratio. The 2005 RBC requirement, and 2004 comparator, is made up as follows: 2005 2004 (£'m) (£'m) Own capital (cash, investments and 233.0 213.1personal reserves)Third party letters of credit 79.4 90.0Total 312.4 303.1 We remain committed to reduce further the amount of third party capital as thecycle starts to ease. However, given the sustained increases in the RBCrequirement in recent years we have been obliged to seek capital largely on thebasis of availability rather than price and form. Of our 2005 capitalrequirement, 75% is attributable to reserving risk and 25% to underwriting risk.As reserving risk is satisfied ahead of underwriting risk, the consequence ofan RBC shortfall is a geared reduction in underwriting capacity. In recentyears, therefore, managing the composition of the capital base has beensubordinated to ensuring it is fully met. From January 2006 capital will be set by the FSA under a regime very similar tothat applied to the company market. The FSA will set a base Enhanced CapitalRequirement ("ECR"), which is calculated by applying weighting factors tobalance sheet and profit and loss account footings. Based on data supplied byLloyd's in 2004, SVB's 2003 ECR was fixed at £155 million, or £183 million aftera pro rata adjustment of 18% required to improve Lloyd's overall S&P rating toAA. The FSA also requires firms to undertake their own Individual Capital Assessment("ICA"). In December 2004 we submitted our preliminary ICA to Lloyd's. On abest case estimate our insurance/reserving risk is currently some £140 million,rising to £220 million on a conservative basis. On our internal analysis allother risk groups attract a combined capital requirement of £46 million, makinga total of £186 million on a best case estimate and £266 million on aconservative estimate. In practice, we would set our minimum capital at apremium to the best case ICA. As a result, it is clear that based on the current assessment SVB's capitalrequirement under direct FSA regulation would be lower than under the Lloyd'sfranchise system. It is unrealistic to assume that SVB will enjoy immediatecapital relief when the FSA becomes the regulatory capital setter in 2006. As aLloyd's franchisee SVB will continue to have to satisfy Lloyd's that its capitalis adequate. However, it is reasonable to assume that over time the FSA andLloyd's regimes will show some convergence. Weighted average cost of capital and capital allocation We estimate the weighted average cost of capital ("WACC") each month end.Average pre-tax WACC during 2004 was 11.1%, the monthly range being 10.2%-11.7%.In allocating capital we have adopted a pre-tax hurdle rate of 15.0%, buildingin a margin over WACC. The hurdle rate remains unchanged in 2005. We judge requests for capital against this hurdle rate, which may be loaded toreflect risk. This discipline is applied in the deployment of capital both tosupport corporate initiatives (such as the acquisition of CIFS) and in ourunderwriting business. Individual units bid for capital to support theirbusiness plans and their performance is assessed on their ability to generate areturn in excess of the cost of that capital. Cash flow The components of corporate cash flow may be broken down into three broadconstituents: • Underwriting cash flow • Cash flow from other Group companies • Central items, including cash cost of capital Under Lloyd's three year settlement pattern, cash flow from underwriting isgenerally received in the July three years after the year of inception. Thusfor the 2002 Lloyd's year of account, cash settlement would ordinarily occur inJuly 2005. The principal exception is where large losses are incurred which aremet by means of an interim cash call. In common with Lloyd's as a whole, SVB's managed syndicates posted a loss forthe 2001 year of account. This loss was settled in July 2004, rendering theGroup underwriting cash flow negative at the corporate level. The positive cashflow enjoyed at syndicate level since the 2001 year of account will be receivedat Group level as those years of account close. The settlement of 2001 year ofaccount losses net of previous cash calls resulted in a cash outflow in 2004 of£34.8 million. Other Group companies had a broadly neutral effect on cash flow. Cash flow fromthe managing agency has been used to support the development of Novae and CIFS.Fusion, although cash flow positive, retains this cash in accordance with itsshareholders' agreement. Central costs include the day-to-day expenses of the parent company togetherwith the cash cost of capital. This includes the interest payment on ourconvertible and subordinated debt, third party letters of credit and dividendpayments to shareholders. The cash cost of the 2004 capital stack was £14million (the profit and loss charge was £11 million). The cash cost of the 2005stack is expected to be around £17 million excluding the payment of anydividends to shareholders. Risk and risk management 69% of SVB's gross assets are accounted for by investment and reinsurance assets(2003: 70%). The bases on which these are monitored and controlled, togetherwith our approach to foreign exchange risk, are summarised below. Investment assets At the year end SVB controlled investment assets of £798.9 million, of which£727.6 million were held for its own account and the balance were attributableto third party capital. Own assets fall into one of three categories: • Solvency capital (2004: £215.8 million; 2003: £207.0 million): this is held to support our underwriting. The difference between the year end amount and the amount for which credit is given by Lloyd's reflects mark to market adjustments and income movements in the period to the year end. Solvency capital is held exclusively in sterling. 50% of the total is held in cash and the balance in short duration government and high quality corporate bonds • Insurance working capital (2004: £510.8 million; 2003: £449.7 million): this is held in cash and short duration government and high quality corporate bonds. Assets are retained in the currencies in which the original premiums were received so as to preserve the natural currency hedge. A proportion of these assets are managed by Lloyd's centrally, mainly in relation to minor currencies • Insurance investments (2004: £1.0 million; 2003: £1.4 million including the shareholding in BRIT (the book value of which was £0.4 million) which was sold in March 2004): accounted for by SVB's sole legacy investment, being an equity holding in Advent, an unquoted Lloyd's insurance entity We ask our managers to estimate calendar year total return every month. Theircurrent 2005 estimates, calculated on a simple average basis, are 4.5% forsterling solvency capital assets; and for insurance working capital 4.6% forsterling assets and 2.7% for US $ assets. Reinsurance asset SVB's reinsurance asset as at 31st December 2004 was £499.2 million (2003:£448.1 million). Our reinsurance asset is greater on both an absolute and arelative basis than many of our peers. This is a result of three factors: • Business mix: because SVB is a medium tail business, its reinsurance asset represents a proportionately greater accumulation of reinsurance recoverables than a similar sized short tail business. In the 12 months to December 2004 we collected some £112 million in cash from reinsurers. This is consistent with the overall amount of our reinsurance asset and the tail characteristics of the business • Depth of reinsurance: although the quality of the underwriting from the discontinued units was poor, it was generally well protected through reinsurance. As a result, significant recoverables have built up as these units are being run off • Proportional business: SVB was an active user of proportional reinsurance to write large lines in the last soft market. Although the quality of the markets used was high, and there has been no evidence of inability or unwillingness to pay, the accounting effect of this strategy is an accumulation of reinsurance recoverables. These will decline as the underlying policies to which they relate run off Our reinsurance asset is made up of two components: £342.5 million (2003: £223.4million) in respect of claim specific-amounts, either notified or awaitingnotification to reinsurers, and £156.7 million (2003: £224.7 million) in respectof gross claims incurred but not reported. A bad debt provision is carriedagainst both components, based on S&P default factors adjusted for specificreinsurer failure or insolvency. At the year end the total bad debt provisionwas £11.3 million (2003: £11.3 million). The new management team is pursuing a more aggressive approach to managing thereinsurance asset. Reinsurance arrears are followed up on a weekly basis anddelayed payment is not tolerated. We are committed to resolving genuinedisputes amicably and reasonably; where we suspect deliberate delay we rapidlyescalate the matter with the reinsurer concerned. Foreign exchange SVB reports in sterling and our solvency capital is measured in sterling.Recurring, material non-sterling balances occur at three levels: • underwriting profits/(losses)• balance sheet mis-match between assets and liabilities• losses from discontinued units in run off SVB is unusual amongst its Lloyd's peer group in having a substantial proportionof its premium income denominated in sterling. The 2005 business plan produces acurrency split by premium income of 65% sterling, 30% US dollars and 5% allother currencies. As a result, the principal non-sterling underwriting exposureis to the US dollar. We have adopted a general policy of hedging the two oldestopen years (as at December 2004, the Lloyd's 2002 and 2003 years of account) asto 75%. At the year end the unhedged position across 2002 and 2003 was a net USdollar payable amount of around $80 million. We do not hedge the youngest year(in this case 2004) until the 18 month stage on the basis that many of thepolicies remain substantially on risk until this point of maturity. SVB has financial assets invested in £, $ and C$. These are naturally hedgedwithin syndicate premium trust funds, save where local regulatory requirementsrequire surplus funding (e.g. US situs rules). The other area of balance sheetmis-match is in capital raised in currencies other than sterling. In 2004 weissued $36 million of thirty year subordinated loan notes (which count as LowerTier 2 capital). Of these $26 million were sold for sterling and swapped backto dollars at the earliest possible repayment date at an effective rate of £1:$1.80. The remaining $10 million were sold for sterling upon receipt at £1:$1.81 and are not hedged. In September 2004 we established an exceptional loss provision of £103.6 millionto absorb future deterioration on discontinued units. The discontinued unitsare almost exclusively denominated in $. Thus, future exchange rate movementcould have a material effect on the level of protection provided by theexceptional loss provision. To date this has worked in our favour as the dollarhas weakened from £1: $1.79 on 1 September to £1:$1.92 on 31 December (thedollar equivalent of the original provision having increased from $185.8 millionto $198.8 million). We are mindful of future exchange rate volatility but donot currently intend to hedge out the provision other than to the extent it isutilised. Taxation In 2004 SVB recognised a tax credit of £23.5 million (2003: tax charge of £5.5million). This reflects a tax charge in relation to current year profits lessthe tax credit emerging from the exceptional loss provision. Whilst the wholeamount of the exceptional loss provision will ultimately be able to be offsetagainst future profits, we have chosen to recognise 18 per cent. (rather than 30per cent) in our financial statements. As a result, our deferred tax asset asat December 2004 was £44.3 million (2003: £19.1 million). We believe thatfuture trading profits will be sufficient to utilise this asset fully. Apart from the deferred tax asset arising from trading activity, we continue tohave accumulated capital losses of £41.6 million (2003: £41.6 million). Theseare not recognised as an asset in the financial statements of the Group but areavailable to shelter any future capital gains that might be realised. Group structure Major progress has been made in simplifying the Group structure in 2004. Thenumber of subsidiaries has fallen from 61 in January 2004 to 12 in March 2005.The organisation of the remaining companies has been improved such that theirreporting lines and board composition reflect much more accurately theircommercial purpose. The number of managed syndicates has fallen from five in 2001 to two in 2005.As each third party supported syndicate requires over 40 annual returns,reducing the reporting burden continues to be an important aim. We have also made progress with Lloyd's in simplifying the structure of ourcapital stack. SVB was created out of mergers with SCT (1998) and CLM (1999).Both SCT and CLM had pre-existing corporate members which were subsequently soldto Mayheld, a Channel Islands entity, to run off the third party syndicateparticipations. This run off was protected by a stop loss policy issued by amajor European reinsurer. In the event that this cover failed to respond,Lloyd's could under certain circumstances have recourse to SVB. As a result,SVB's solvency capital was inter-available to Mayheld. The operation of theinter-availability mechanism and the resulting stack structure, which has itsorigins in transactions six and five years ago, was complex and flies in theface of the drive for simplicity and transparency that has been a key feature ofSVB's turnaround. In conjunction with Lloyd's, we significantly simplified thestack structure in December 2004, but without disturbing the reinsuranceprotection available to the SCT and CLM corporate members in respect of thirdparty run off years. Corporate infrastructure We have also overhauled much of the corporate infrastructure. Following itslisting in 1998, SVB had under-invested in systems and support functions;progress was made in 2004 in addressing this. A new management reportingframework was introduced in January 2004. Further investment is being made inboth underwriting and accounting systems, with the aim of making the corporateinfrastructure much more robust and scaleable. We expect the overhead (excluding cost of capital and Lloyd's charges) to bearound £40 million in 2005. Of this, the underwriting business accounts for £18million (of which the discontinued business unit represents £2 million); Fusionaround £16 million; and Novae/SVBUSL £6 million. Lloyd's charges andsubscriptions are expected to be £12 million. Cost control remains an important discipline. Notwithstanding systemsinvestments, we have delivered identifiable cash savings of £1.6 million in2004. We go into 2005 having made a further £1.5 million of annualised cashcost saving in the first quarter. Regulation and compliance The FSA published its consultation paper on the regulation of Lloyd's in spring2004. This was followed in December 2004 by the publication of the Lloyd'sPrudential Source Book ("PSB"). With effect from 1st January 2005 SVB isregulated by the FSA under the PSB as well as remaining subject to Lloyd'sfranchise rules. We monitor our annual compliance cost. In 2005, the direct, separatelyidentifiable cash costs attributable to our listings, regulation by the FSA andsubscriptions and other quasi-regulatory costs at Lloyd's amounted toapproximately £570,000. All Employee Share Ownership Plan ("AESOP"), Long Term Incentive Plan ("LTIP")and Employee Share Option Scheme ("ESOS") All full time employees are invited to join the AESOP when they complete theirprobationary period. Employees may contribute up to £125 a month, which is thenmatched by an employer contribution on a 2:1 basis. Employee and employercontributions are aggregated and used to acquire shares through market purchase,although the AESOP may acquire shares from the Employee Benefit Trust ("EBT") ifit would be more advantageous to do so. The cost of employer contributions in2004 was £0.3 million (2003: £0.2 million). At the year end 141 employees weremembers of the scheme (2003: 105). Historically, awards under the LTIP have been hedged by own shares held in theEBT. As at 31st December 2004 a total of 4.7 million shares were the subject ofLTIP awards and on that date the EBT held 4.8 million shares. As a result, theEBT had a net long position at the year end of 0.1 million shares. Options granted under the ESOS will be met by the issue of new shares. As at31st December 2004 options over 11.3 million shares had been granted,representing 3.1% of the issued share capital. International accounting standards The International Financial Reporting Standards ("IFRS") regime comes intoeffect for listed companies across the European Union for accounting periodsstarting on or after 1 January 2005. We have identified five areas in which application of the IFRS regime is likelyto produce potentially significant variations from UK GAAP. These aresummarised below: • Accounting for insurance business: IFRS 4 has been published containing highly detailed requirements for accounting for insurance business. However, the current proposed transitional arrangements are not expected to have a material effect • Financial assets: financial assets will be valued under IFRS at bid rather than mid market prices. As SVB's financial assets are exclusively held in high quality investment grade bonds or cash, this is not expected to have a material effect • Share based payments: under IFRS unvested LTIP awards and option grants are to be valued from time to time and the movement in value expensed through the profit and loss account. Currently, LTIP awards are amortised over the vesting period of the award and options are reflected in fully diluted per share calculations (such as earnings per share). Were the IFRS regime to have been in place in 2004, the existing LTIP amortisation charge of £0.9 million would have been written back to the profit and loss account and replaced by a charge for share based payments of £1.5 million. The net effect would have been a charge to the profit and loss account of £0.6 million. This change would have been required in any event under UK GAAP had FRS 20 been applied in full • Intangible assets: SVB amortises acquired syndicate capacity on a straight line basis over 15 years. Under IFRS there is no requirement to amortise intangible assets. As is the case under UK GAAP intangible assets will be subject to an annual impairment test. With no impairment having occurred in 2004, the effect of the IFRS regime would be to reverse an amortisation charge of £0.9 million, crediting this amount to the profit and loss account • Foreign exchange: IFRS requires that transactions in foreign currencies be recorded at the rate at the point of transaction or a weighted average rate (SVB's current accounting policy is to use period end rates). This requirement would have no impact on the overall result. In addition, Lloyd's require reporting of annually accounted numbers on an average rate basis with effect from January 2005 Oliver CorbettGroup Finance Director17th March 2005 CONSOLIDATED PROFIT AND LOSS ACCOUNT - TECHNICAL ACCOUNT Year Year ended ended 31st December 31st December 2004 2003 Total Total Note £m £m Gross premiums written 503.7 367.2Outward reinsurance premiums (41.0) (128.6)Net premiums written 462.7 238.6Change in the gross provision forunearned premiums 17 (41.9) (12.2)Change in the provision forunearned premiums, reinsurers' share 17 (2.3) (7.3)Change in the net provision forunearned premiums (44.2) (19.5)Net premiums earned 418.5 219.1Allocated investment income transferred fromthe non-technical account 5 39.5 26.2 Gross claims paid (279.5) (239.9)Reinsurers' share on paid claims 113.2 114.5Net claims paid (166.3) (125.4) Change in claims provision (292.9) (17.9) BeingChange in syndicate claims provisions 17 (225.8) (17.9)Exceptional loss provision less Amounts 17 (103.6) -utilised in H2 2004 17 36.5 -Change in reinsurers' share of claimsprovisions 17 51.1 23.8 Change in the net claims provision (241.8) 5.9 Net claims incurred (408.1) (119.5) Net operating expenses 4 (126.3) (82.0) Balance on technical account (76.4) 43.8 CONSOLIDATED PROFIT AND LOSS ACCOUNT - NON-TECHNICAL ACCOUNT Year Year ended ended 31st December 31st December 2004 2003 Total Total Note £m £m Balance on technical account (76.4) 43.8 Net investment return on a long term rate of 5 39.5 26.2returnNet long term investment return transferredto technical account 5 (39.5) (26.2)Other income 6 9.0 2.9Other expenses 7 (27.3) (15.1)Operating (loss)/profit on a long term rateof return (94.7) 31.6Related Shares:
Novae Group