Return on capital targets and capital deployment
(Thomson Reuters ONE) - Novae Group plc Return on capital targets and capital deploymentNovae Group plc ("Novae" or "the Group") today announces the outcomeof an appraisal of its return on capital targets, together withrelated implications for its deployment of capital.HighlightsThe Board has* set an objective for a post-tax cross cycle return on equity of 13-15% assuming normal market experience* identified the current return on equity constraints within the Group* set out actions and timings to deal with those constraints and meet the Board's return targetsObjectives, actions and timingThe Board has set an objective that the Group should earn a post-taxcross cycle return on equity of 13-15% assuming normal marketexperience. The Board has agreed a series of specific actions thatwill be taken, starting immediately, to optimise Novae's returns.These are:* Redeployment of the surplus capital within NICL. This will be achieved by:o renewing business currently underwritten by NICL into theGroup's Lloyd's businesso NICL's in-force policies, subject to regulatory and courtapproval, will either be transferred to the Group's Lloyd's businessor run-off. This business transfer process is expected to besubstantially complete during 2010The restructuring is expected to release a substantial element of the£60 million of surplus capital held by NICL, which will then beavailable for deployment in underwriting elsewhere in the Group orwill be returned to shareholders. The Board has agreed that anyconsequential return of capital will be announced before the end of2010, subject inter alia to regulatory consent. Taken together thesesteps would potentially improve post-tax returns by up to 3%* The Group has already announced an increase in its underwriting risk appetite as measured by its "Willingness To Lose" ("WTL"). WTL is the maximum exposure considered acceptable from specific, modelled events. More recently, the Group has made progress in its continuing objective of reducing its reinsurance spend, as outlined in the 2008 annual report. This is consistent with a rise in risk appetite as capital constraints and inefficiencies are eased across the Group. The financial effects of a lower reinsurance spend relative to gross written premiums will be apparent in 2010 when, assuming normal loss experience, they are expected to improve post-tax returns by around 2%* Pre-tax savings in structural and organisational costs as a result of these measures of not less than £2 million (on an annualised basis), beginning in 2010. The benefits of these measures are expected to add around 1% to post-tax returns by 2011* The continuing pursuit of a transactional solution under which a third party would assume financial responsibility for the run off of the 2002 and prior underwriting. The Board has specifically not placed a timeline on such a transaction to avoid limiting its negotiating flexibility. This would potentially improve post-tax returns by up to 2%, subject to termsThe Board, following its review, is committed to delivering itsobjective of enhancing return on equity for Novae's shareholders.When taken together these measures offer potential improvements inthe Group's return on equity of up to 8%.BackgroundIn August 2001 Novae announced a reserving shortfall in its USliability business. In 2003, following repeated reservedeterioration, the current management team was appointed to stabiliseand rehabilitate the business.In 2004 the Group reorganised its legacy US liability underwritinginto a dedicated run-off entity known as the Discontinued BusinessUnit ("DBU"). An exceptional provision was established to absorbpossible further reserve deterioration from the DBU.Since 2004, the DBU has run off within the provision and has achievedits objective of allowing the performance of Novae's continuingbusiness to be assessed with less distortion from legacyunderwriting. However, the run-off of the 2002 and prior businesscontinues to require solvency capital. This is currently around £40million, which inevitably acts as a drag on Novae's return onequity.By early 2006 Novae's legacy business was stabilising but, followingmarket losses from the 2005 US windstorm season, the Board concludedthat the Group at that time was too thinly capitalised to exploit theprevailing market opportunities. In addition, the Board believedthat the opportunities presented by UK SME business could best beaddressed by the formation of Novae Insurance Company Limited("NICL"), a stand-alone FSA-regulated insurance company operatingoutside the Lloyd's marketplace.As a result, in March 2006, Novae announced a rights issue to financethe capitalisation of NICL, which commenced trading on 1 July. Froma Group perspective, the capitalisation of NICL also allowed Novae tomove forward with a significantly more robust consolidated balancesheet.Rating and investment environmentThe operating environment is largely determined by a combination ofinsurance pricing, interest rates and the rating agency andregulatory background.Since the 2006 rights issue the pricing environment for liabilitybusiness, an important part of Novae's business mix, has weakened.The rating environment softened in each of 2007 and 2008 and, despiteconcerns about rate adequacy and historically unprecedented lowinterest rates, pricing in many areas has not improved materiallyduring 2009. Across the market recession-related claims on businesswritten in 2007 and 2008 have not yet fully emerged, further reducingto date the market's need to react and price such businessrealistically.Under these circumstances, consistent with its disciplined policy ofavoiding writing for income if the terms are unattractive and marginsinadequate, the Group has taken a deliberate policy that NICL shouldleave capital undeployed during the last three years. This haspreserved capital but has exerted a consequential drag on the Group'sreturn on equity.As a result of this underwriting philosophy, NICL's shareholders'funds of £105.4 million (as at 30 June 2009, unaudited) aresignificantly greater than its 2009 regulatory capital requirement ofsome £40 million. NICL therefore has over £60 million of capital notdirectly deployed in underwriting on behalf of the Group.NICL's ability to grow premium income is further constrained by theneed to satisfy rating agency capital requirements. In the periodsince NICL's formation rating agencies have become more demanding intheir credit assessment process. In particular, and of disadvantageto NICL, rating agency models can have the effect of discouragingrapid organic premium growth in the early stages of an insurancecompany's life. Furthermore, adding established books of businessinto a young insurance company can have the effect of extending theperiod of capital loading that otherwise applies for the first fiveyears of operation.Operating within a weak rating environment, with low interest rates,and against a more challenging rating agency background, NICL'sability to generate an appropriate return in the early years of itslife has been especially constrained.Elements of the capital restructuringGiven the recent market and rating background described above, andconscious of the constraints imposed by non-productive capital inboth the Lloyd's business and in NICL, the Board has been focussed onthe objective of improving return on equity (defined as profit aftertax divided by shareholders' funds). In summary, there are variousreasons why Novae's return on equity has lagged that of its listedpeer group:* Unproductive capital is trapped in the Lloyd's business; around £40 million is required to support the run off of the 2002 and prior underwriting* £60 million of capital remains undeployed in NICL, reflecting unattractive rating for much of the last three years and, more recently, rating agency constraints on growing premium income as opportunities arise* As a result, over 35% of the Group's shareholders' funds (of £279.7 million as at 30 June 2009) are constrained from being deployed productively* With this degree of capital constraint, the Group's overall risk appetite is compelled to be lower, in case short-term losses should further impair capital flexibility. This in turn drives up the Group's reinsurance spend, further restricting potential returnThe Group's average annual post-tax return on equity over the periodbetween 1 January 2006 and 30 June 2009 has been approximately 8%.Over the same period the members of its listed peer group, excludingbusinesses with a high exposure to property catastrophe business,have generated average annual post-tax returns on equity of around14%. The formation of Novae Re earlier this year began the process ofbetter deploying the Group's capital, but structural change isrequired in order fully to combat the differential.DisclaimerThe financial information contained in this statement is based onunaudited management information. Certain statements made herein areforward-looking. They are based on current expectations and aresubject to a number of risks and uncertainties that could causeactual events, results or outcomes to differ materially from anyexpected future events, results or outcomes referred to in theseforward-looking statements.For further information:Matthew Fosh - Novae Group plc 020 7903 7300Nick Miles - M:Communications 020 7920 2330A meeting will be held at 11.00am on Monday, 7 December at theGroup's offices at 71, Fenchurch Street, EC3M 4HH to provide sellside analysts with a strategy and trading update.---END OF MESSAGE---This announcement was originally distributed by Hugin. The issuer is solely responsible for the content of this announcement.
Datum: 07.12.2009 - 08:01 Uhr
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