Helios Underwriting — Increased Lloyd’s participation at the right time

Helios Underwriting is an AIM-quoted holding company established in 2007 (as Hampden Underwriting) to provide investors with a limited liability direct investment into the Lloyd’s insurance market. Helios’s attraction to investors is twofold. First, it offers a unique opportunity to invest directly in a diversified portfolio focused on higher-quality Lloyd's syndicates, benefiting from underwriting results and investment return on underlying capital. Second, it has a proven track record of growing its portfolio through actively acquiring interests in syndicates, provided it has sufficient capital resources. Its attraction to current Lloyd’s Names, which own exposure through individual LLVs, is that it provides an elegant and tax-efficient exit option, or allows them to convert their Lloyd’s exposure from an illiquid LLV to a much more liquid and diversified investment in Helios itself. Lloyd’s managing agents find Helios attractive as they can diversify their capital via a single, large capacity provider which is not a competitor.

Helios’s lifeblood is ‘underwriting capacity’ (capacity), which gives it the right to participate in the premiums that syndicates write and the underwriting profits they generate. The gross written premiums (GWP) of a syndicate may not exceed capacity, so top-line growth requires capacity growth. Helios can grow its own underwriting capacity, and has been doing so, by participating in Lloyd’s auctions, buying directly from other holders of such capacity or supporting new syndicates. A key measure of performance is return on capacity (RoC), which is calculated as the cumulative underwriting profits earned on the level of deployed capacity during a particular underwriting year (January to December). It takes 36 months from capacity deployment in a particular underwriting year of account (YOA) until the final RoC can be measured, but the yearly RoC build-up can be monitored through quarterly syndicate updates.

An important store of value for Helios is the value of the capacity fund or weighted-average value (WAV), which is carried as an intangible asset on the balance sheet. It is industry practice to place a value on the capacity owned, which is held and marked-to-market annually based on the publicly traded (in the Lloyd’s auctions) prices for each syndicate and applied on a weighted-average basis. The FY21 value was disclosed at £60.1m, which is a 4.6x increase over the past four years, driven by LLV acquisitions, organic capacity growth in Helios’s existing LLVs (pre-emption capacity) and a large revaluation in FY21, reflecting the higher prices paid in the 2021 auctions.

The operational upside of Helios is well supported by Lloyd’s market dynamics and the outlook for improved RoC. After declining rates since 2014, Lloyd’s has seen cumulative rate rises (premium increases) since 2018, in excess of 30%. Helios has consistently outperformed Lloyd’s for all closed YOAs since 2013. This outperformance is forecast to continue (by Helios and us) and we expect a meaningful recovery from the negative RoC in the 2017 and 2018 YOAs, and a small profit for 2019. We expect healthy increases in the RoC from the 2020 YOA, consistently rising to c 12% for the 2022 and 2023 YOAs, which will emerge in FY24 and FY25.

The operational upside that we forecast for Helios will have a much larger impact on its value as a result of its significant capacity grab in FY20 and FY21, with the timing well aligned to the high RoC YOAs that we expect for 2021 and 2022. However, because Helios has a strategy to use all surplus free working capital at the end of each year to fund capacity growth, and did so in FY21 (as noted above), this depleted the large cash resources it acquired in its March 2021 capital raise of £54m (after costs). Operational performance should add £14.5m to working capital over the next two years (FY22 and FY23), allowing for an ordinary dividend of 3p/share. After funding additional capital requirements by Lloyd’s, including following its pre-emption rights to participate in syndicate capacity growth, we estimate there is only room to grow capacity by c £5m per year through acquisitions over the next two years (3% to 4% including organic syndicate growth).

Lloyd’s solvency capital requirements must be physically deposited in the Funds at Lloyd’s (FAL) and are determined by Lloyd’s after assessing the underwriting outlook for individual syndicates and the level of syndicate members’ balances (broadly the net assets on syndicate balance sheets). This is more cautious than the rest of the insurance industry where insurers have the freedom to determine their own appropriate solvency cover range with reference to a regulated minimum. The combined FAL and members’ balances at Lloyd’s have steadily crept up from 69.5% of total GWP in 2012 to 81% in H121 (77% from FAL and 4% from members’ balances). There is an argument to be made that current FAL requirements (plus members’ balances), which are 4% higher relative to GWP than the 10-year average and 10% higher than the 20-year average, could moderate if underwriting improvements are sustained and supported by lower solvency cover ranges for the wider insurance industry. If Lloyd’s moderates its solvency requirements, significant working capital releases could be possible.

The large capacity acquisitions in FY21 increased the diversification in the Helios portfolio, resulting in the company receiving a larger diversification credit from Lloyd’s. This drives a lower level of required capital relative to capacity than in the past, reducing the FAL increase required post acquisitions. This explains why the Helios FAL will look low relative to the total Lloyd’s position. Helios also has some options of its own to boost working capital, including the use of reinsurance, enhanced gearing and raising further capital. Although we take a conservative stance in our base case, we consider the risk to be on the upside and test the impact of stronger working capital generation on our forecasts and valuation in the sections below.

Managing the underwriting cycle is key to Lloyd’s underwriters and property and casualty (P&C) insurers in general. Helios has successfully negotiated the latest downcycle, which is forecast to turn to healthy profitability in coming years, while also significantly increasing its capacity and therefore its exposure to this upturn (starting with a large GWP increase for the hard-market 2022 YOA). Our valuation, based on an over-the-cycle RONAV versus the price/NAV approach is 212p/share. This represents a 33% premium to our forecast FY21 NAV/share of 160p and is 33% ahead of the current share price. We have also calculated a valuation based on a dividend discount model with explicit forecasts to FY25, producing a similar result. Our valuation is well supported by an earnings recovery to 16.8p/share by FY23 and a RONAV of 10%, rising even further in FY24 and FY25 if the strong anticipated 2022 and 2023 YOA RoCs are delivered.

Helios had a bumper profit in FY19 with a welcome combined ratio improvement to 96% for its underwriting portfolio, largely due to lower losses on the 2019 YOA (large losses were a feature of both FY17 and FY18) and supported by negative goodwill on LLV acquisitions as well as a reversal of syndicate impairment charges. The COVID-19 pandemic reversed Helios’s fortunes in FY20, affecting both open years (2019 YOA and 2020 YOA) and increasing the underwriting portfolio combined from 96% in FY19 to 103% (versus Lloyd’s at 110.3%). The parent company contribution was less supportive than in FY19, with additional stop-loss protection costs, continuing quota share reinsurance insurance losses (see explanation under Exhibit 1) and low interest rates offsetting the gains from the profitable sale of capacity in the Lloyd’s auction.

We forecast a combined ratio improvement to 95% in FY21, from a weak base in FY20, but still reflecting a bottom-of-the-cycle hangover, with the claims ratio for YOA 2020 elevated and profit for closed YOA 2019 depressed. The record large LLV acquisitions in the year are expected to produce healthy goodwill on bargain purchases to offset the large increase in stop loss reinsurance costs (put in place to protect against adverse claims experience and to manage solvency capital) and very weak investment returns. We expect a small loss of 0.4p/share in FY21, affected by a one-off deferred tax charge relating to the increased UK corporate tax rate from April 2023, which affects all companies. However, after a NAV/share decline in FY20, the company is forecast to deliver an increase to 160p/share for FY21.

There are reasons for optimism, which drive our forecast earnings improvement to 17p/share and NAV/share to 182.4p/share by FY23, with ROC delivery of 1.8% in FY22 (from the closed 2020 YOA) rising to 12.4% in FY24 and 12% in FY25 (2022 and 2023 YOAs). These are:

In addition to the standard sensitivities typically tested, we include additional scenarios relating to working capital generation, LLV acquisition and solvency.

Our valuation rises/falls by 6% for every 50bp change in our cost of equity assumption, while changing our terminal growth rate by 50bp gives a 9% increase and 7% decrease. The valuation is very sensitive to the combined ratio: a 2.5% change would affect the valuation by 18%.

Our calculations show that an increase in LLV capacity acquisition of 1% of opening capacity in each year from FY22 to FY25 would require an additional £13.0m of working capital over and above our base case. This working capital effect is proportional and increasing capacity growth from 6% to 10% pa requires additional funding of £54m over four years, from solvency efficiencies or capital and debt markets. Full- or part-payment by share issuance reduces the working capital impact. Adding LLV capacity is also value additive and under this scenario (without changing other assumptions to fund the additional working capital) it adds 4% to our valuation. We test the combined effects below.

We demonstrate that for every 2% relaxation of Lloyd’s capital requirements, a cumulative £14m in working capital would be released (over four years), while increasing quota share from c 27% to 32% would release a similar amount. Deploying this additional working capital to fund LLV acquisitions leads to a 4% valuation enhancement if relaxed Lloyd’s capital requirements are the source, with the quota share reinsurance route less accretive. Lower quota share reinsurance is value accretive, but needs working capital to fund.

Issuing debt is more value accretive than raising equity capital, but there is a limit to the debt facilities available to Helios with its current equity base. Using the current £10m undrawn debt facility to add a one-off 10% of LLV capacity increases our valuation by 9%, with more uplift requiring NAV growth and higher borrowing facilities. A capital raising of £50m or c 40% of the current market capitalisation at FY21 NAV/share allows a one-off 38% increase in capacity and adds c 4% to the valuation with every 10% premium to NAV/share adding a similar amount.

Helios is a holding company that owns capacity on 20 Lloyd’s syndicates/managing agents, which allows it to participate in the underwriting results of these syndicates. Its exposure is on a limited-liability basis and is backed by underwriting capital that it must deposit in the FAL akin to the solvency margins that all insurance operations hold. It participates in syndicate underwriting results based on the share of capacity (which is the upper limit of GWPs that may be written in an underwriting year) that it owns in the syndicate and must contribute capital in the same proportion, varying between syndicates based on underlying risk.

Helios has actively increased its participation in Lloyd’s over recent years by acquiring LLVs and the associated syndicate capacity they participate in, by buying capacity in the Lloyd’s auctions and by subscribing to tenancy capacity. The latter only provides access to a particular YOA, does not provide guaranteed renewal for subsequent YOAs and does not attract a value, but does require Helios to provide the capital required to write business. However, it can provide the opportunity to dip in/out of underwriting certain risks when the return is forecast to be particularly attractive.

Helios has been particularly successful in aggregating LLVs at attractive prices, which have been below the NAV raised (LLV NAV acquired plus the WAV created for the acquisition) and Humphrey & Co valuations over the past four years (Humphreys is well recognised for providing independent valuations of LLVs’ underwriting portfolios). This has allowed it to achieve healthy capacity growth, which will drive strong growth in GWP and increased access to underwriting results.

Helios has a very light corporate structure, relying on external service providers for most of its operations. Nigel Hanbury, chief executive and chairman of Hampden Agencies (HAL) until 2009, became Helios CEO in October 2012, after the acquisition by Helios of HAL-advised NameCo 917 from his wholly owned Upperton Holdings. Nigel has responsibility for Helios’s underwriting and investments. The finance and operations functions are overseen by Arthur Manners, who is CFO. Both Hanbury and Manners have considerable Lloyd's experience ranging from broking, underwriting and member agencies to having their own LLVs with Lloyd’s exposure.

Hanbury has redefined the Helios strategy to ‘underwrite at Lloyd’s with improved capital efficiency, lower risk and higher return’. To this end, the existing portfolio of syndicates has been refined; active selection of better performing syndicates is an important way for Helios to seek to add value compared with the overall Lloyd’s market return, there is a wide spread of performance across syndicates and Helios has been particularly successful at creating and developing a portfolio that has consistently outperformed the Lloyd’s market as a whole since the 2013 YOA.

This focus has recently shifted from moderate growth and portfolio selection to aggressively growing capacity, primarily through the acquisition of LLVs. The experience, network and dealmaking skills of the management team have been borne out in numerous acquisitions at discounts to fair value. Additional value has been added to these acquisitions through capital efficiency with the use of quota share and FAL-funding excess of loss reinsurance allowing for the release of FAL in the case of most acquired LLVs.

Helios has outperformed Lloyd’s from a combined ratio and RoC point of view since 2013 thanks to careful portfolio selection. Recent increases in solvency efficiency through diversification could add to this trend of outperformance.

In association with its Lloyd’s adviser, Hampden Agencies, Helios curates this portfolio on a year-to-year basis. Its tactical management of its portfolio considers likely market conditions for the coming year and the re-balancing needed as newly acquired LLVs are added. In the same way as a trading member of Lloyd’s, Helios was offered pre-emptions that amounted to £10.7m for 2021 and £6.1m for 2022. Helios buys and sells capacity in the Lloyd’s auctions to optimise its portfolio each year.

In 2021, Helios diversified its portfolio even further with the addition of Blenheim Underwriting, reducing its proportionate exposure to all the other syndicates.

The second reason Helios outperformed Lloyd’s on both combined ratio and RoC metrics in recent years has been its tactical use of quota share reinsurance, reducing its capital needs and allowing it to add additional capacity in attractive areas. The solvency efficiency it increasingly derives from diversification provides the company with more options for such selective capacity additions.

Helios’s relative size and market position allows it access to quota share reinsurance deals that may not be available to all other Lloyd’s participants. As market conditions improved, Helios has reduced the proportion of business ceded to its quota share reinsurers and retained more risk. For 2022, it is retaining £172m of its capacity, compared to £63m in 2021 (an increase of 173%). A component of mitigating the effect of losses on the Helios portfolio has been the use of stop-loss reinsurance. For 2022, Helios purchased stop-loss reinsurance for its retained capacity of £172m, with an indemnity of 10% of its share of the capacity; a claim can be made if the loss for the YOA at 36 months exceeds 107.5% of capacity, with provision for funding solvency deficits as they arise. This gives the portfolio an added measure of protection.

With the meaningful growth in capacity delivered by Helios in FY21, its risk exposure has shifted somewhat from Property and Reinsurance to Casualty (reflecting syndicates’ focus on specialist liability risks).

Lloyd’s is a unique insurance market, underwriting (re)insurance since the late 17th century. Please see the appendix at the end of this note for a more detailed description of Lloyd’s, its market structure, its capital providers and its capital structure and links for further information.

The internal financial accounting at Lloyd’s, determining the timing of profit distributions, continues to be on a three-year accounting basis, despite the Corporation of Lloyd’s and the quoted Lloyd’s underwriting sector moving to annual accounting for external reporting.

Members join a syndicate for each calendar year, referred to as the YOA. All risks written during the year are allocated to that YOA, along with all related premiums and claims. Policies are written throughout the year and it takes more than 18 months before all premiums have been earned and longer still for all claims to materialise. By leaving the YOA open for another two years, the managing agent can calculate a truer picture of premiums, claims and earnings for that YOA.

It is important that profits are allocated as accurately as possible to a YOA because syndicates are annual ventures (that may continue for many years) and capital providers may change from year to year. Hence three-year accounting ensures the fair attribution of profit/losses to capital providers.

The typical profit profile that is targeted, priced for and reserved for is:

Exhibit 7 below shows how the three-year accounting has developed for Helios over recent years and our forecast to FY25 (the 2023 YOA).

FY20 showed an improving outlook for the Lloyd’s market, with H121 adding support. While Lloyd’s generated a -2.8% return on capital in FY20, the underlying profitability excluding COVID-19 claims was an improvement year-on-year. Major claims contributed 23.0% to the combined ratio (FY19: 7.0%), with COVID-19 related claims accounting for 13.3% of this. The Lloyd’s market continued its trend of prior-year releases, contributing positively to the combined ratio with a benefit of 1.9% (FY19: 0.9%). There have been prior-year releases across all lines of business bar casualty, which was strengthened. H121 annualised return on capital improved to 8.3%.

Adjusting the combined ratio for the contributions from major claims, the Lloyd’s market reported an underlying accident year ratio of 87.3% in FY20 versus 95.1% for FY19, followed by a further improvement to 85.4% in H121. The main contributor to the improvement in the underlying accident year ratio is the reduction in the attritional loss ratio from 57.3% in FY19 to 51.9% in FY20 and 50.5% in H121, a 6.8% reduction over the period. The improvement in the attritional loss ratio is the result of sustained risk adjusted rate increases on renewal business and the market’s actions to drive sustainable profitable performance. There has also been an improvement in the market’s overall expense ratio, which reduced to 37.2% from 38.7% in 2019, and fell further to 35.8% by H121. Lloyd’s targets a reduction to 30%.

Originally, Lloyd’s was an exclusive club, requiring (individual) Names participating in its market to be wealthy, primarily due to their unlimited liability exposure. Significant changes undertaken in the 1990s introduced the concept of corporate capital and limited liability for Names through the use of LLVs. However, participation remained limited to Names with the means to provide the significant capital required as FAL deposits and the ability to trade capacity for Names remains restricted. Even today, Lloyd’s is a very illiquid market that only trades syndicate capacity three times a year, with a limited number of individual transactions (in 2021 there were only 442 transactions) and a large average transaction size.

Underwriting participation at Lloyd’s has shifted from Names to corporate entities, but remains pretty much out of reach to the average individual investor. UK-listed Lloyd’s insurers, such as Beazley, Hiscox and Lancashire, provide investors with access to their own syndicates, but they all have diversified their businesses, diluting their Lloyd’s exposure. Many syndicates have a corporate parent that is often publicly listed, but once again, their underwriting exposure is often not confined to Lloyd’s. Helios is unique in that it is an AIM-listed company providing its shareholders with direct and diversified access to Lloyd’s syndicates only. Although an investment in Helios comes at a price in the form of holding company corporate and reinsurance costs, the structure allows for a curated portfolio of exposures to syndicates, while employing reinsurance allows it to reduce capital requirements, especially during challenging times or when attractive acquisitions are available.

The diversification benefits that Helios experiences are quantifiable and have consistently emerged in an RoC that has outperformed the Lloyd’s market as a whole in all closed underwriting years since 2013. We forecast significant RoC improvements over coming years, with 2022 and 2023 YOAs expecting to generate c 9% after tax (seen in FY24 and FY25). Considering Helios deposits FAL with Lloyd’s at c 46% of capacity, the implied return on capital employed is attractive at the 20% to 21% level.

In addition to providing equity investors with a unique asset, Helios also offers exiting LLV owners a rare opportunity to either exit the Lloyd’s market completely, by selling their LLV to Helios in a tax-efficient way, or to swap their illiquid exposure to the Lloyd’s market for a much more liquid shareholding in Helios.

What adds to the attraction of Helios is that it is actively growing its portfolio and managing its risk exposure and working capital through the use of reinsurance. Helios has increased its capacity sixfold since FY16, from £32.6m to £232.8m in FY21. The largest contributor has been the acquisition of LLVs, an area where Helios has been particularly strong. The management team has effectively used its industry network and deep experience of the Lloyd’s market to increase the LLVs acquired (including various Namecos and LLPs) from 30 in FY17 to over 70 in FY21. In 2021 it embarked on an ambitious project and wrote letters to each of the 1,100 UK owners of LLVs that remain with Lloyd’s. Of the members approached, 100 responded (which we consider a high hit rate) and 28 transactions were concluded on the back of this. This amounted to half of the total LLV sales that were concluded in 2021 and we do not expect the company to exceed this, even if it had sufficient working capital to fund it.

Helios considers the remaining Members with LLVs as fertile ground for further consolidation, largely due to demographic realities this group faces. Individual participation in Lloyd’s has grown at less than half the rate of the market as a whole over the past decade, even as LLVs proliferated. With genuine new money entering LLVs at such a slow rate, the average age of the existing membership is rising and inevitably leads to exit pressures (either through death, retirement or the need for more liquid investments). The 1,472 LLVs trading at Lloyd’s in 2022 account for over £3bn in capacity and provide meaningful runway for Helios from the 5% of this market it has tapped into to date. Helios’s outreach to UK members will continue and will be expanded to the c 400 US members. Even if Helios were to grow capacity at 15% pa over the next five years through LLV acquisitions, it would amount to less than 10% of the estimated remaining LLV capacity.

A very attractive characteristic of Helios’s portfolio of syndicate exposures, carried at an FY21 WAV of £60.1m on the company balance sheet, is that it allows the company to access organic growth through pre-emptions. A pre-emption presents itself when syndicates in which Helios has exposure increase their capacity at the Lloyd’s auction. Helios has the option at this point to participate in the increased capacity in proportion to its stake in the syndicate and can do this without any acquisition capital outlay. All it has to do is to provide the FAL to back its share of the increased capacity.

Pre-emptions have value for Helios as they entitle the company to the underwriting profit generated from employing the increased capacity owned. As such, pre-emptions result in a NAV uplift equivalent to their WAV, which is added to the Helios WAV fund. From FY18 to FY21, 16% (£7.2m) of the £45m increase in the WAV fund came from pre-emptions, contributing to a 25% increase in Helios’s NAV. Although pre-emptions are not guaranteed to occur every year, we expect them to provide a sustainable and on balance repeatable boost to RONAV.

Another tool that Helios used in FY20 and FY21 to grow capacity was directly participating in the Lloyd’s auctions and increasing its participations by a total of £36m. This mechanism was only employed because of the large cash balance that it built up through a cumulative £76m in capital raised from FY19 to FY21. Purchasing capacity at auction is the most capital-intensive growth mechanism because Helios has to pay an auction price equal to WAV and provide additional FAL to back the capacity bought. There is no change to NAV, but working capital reduces by the purchase price plus FAL contribution.

An LLV acquisition is much less capital hungry as the acquired business already has FAL (usually more than is needed after benefiting from Helios’s reinsurance programme, allowing surplus FAL to be released to working capital of up to 30% of capacity acquired) and carries cash balances, which have ranged between 18% and 32% of the cost of transactions over recent years. LLV transactions have also been conducted at discounts (10% plus) to the NAV they added to Helios’s balance sheet, which means the cash impact of creating the WAV has been less than the value of the WAV. The actual working capital impact of an LLV acquisition would depend on the exact terms and composition of the business, but has been as low as 62% of the purchase price and could even contribute to working capital if all or part of the consideration is in the form of Helios shares. As a result, we believe that as Helios is presented with attractive LLV acquisition opportunities, it may consider disposing of capacity in the auction to boost its working capital.

The final tool that Helios used to raise its capacity by a further £58m in FY21 was the addition of tenancy capacity. This form of capacity provides short-term access to underwriting performance without entitling Helios to long-term capacity rights. While the take-up of this capacity had no cost to Helios, it also has no value-add within the WAV. As with any additional capacity, Helios does need to provide the FAL to back the solvency capital for this capacity. The addition of tenancy capacity at the end of 2021 was an important tool to make sure the company used its excess working capital and gained increased exposure to the 2022 YOA, which is expected to generate strong underwriting profits. However, when there are LLV acquisition opportunities that cannot be funded by working capital and other mechanisms for boosting working capital are unavailable or undesirable, if required the company could, in theory, shed some of this capacity and use the FAL releases to fund acquisitions. This is unlikely to occur until the underwriting cycle turns down as we estimate it takes £2 to £3 of tenancy capacity shed to acquire £1 of LLV capacity, which is not sensible while expected RoC is strong.

Although capacity growth for Helios is likely to slow in the near term due to limited working capital and an expected delay in the recognition of the forecast strong working capital generation from its portfolio, we expect LLV acquisitions to continue and mechanisms to be employed to generate the working capital to achieve this.

Because of its acquisition strategy, Helios has a very capital-intensive business and working capital is quickly eroded by the addition of capacity, with replenishment taking time, especially at this point in this underwriting cycle where even if 2022 and 2023 were spectacular underwriting years, underwriting profit will only start flowing in the second YOA (ie, at 24 months). This means the capacity employed for the 2022 underwriting year will only start yielding returns in FY23 when the 2023 underwriting YOA will offer no, limited or negative return at the 12-month stage. The proper payback only occurs in FY24.

The capital-intensive nature of Helios is due to capacity acquired immediately requiring assets being either locked up at Lloyd’s or in the WAV fund. The capital intensiveness of the various mechanisms for adding capacity can be ranked as below, from most to least intensive:

Due to a combination of the above mechanisms for capacity acquisition in FY21, Helios fully used the £54m of capital it raised in the year. In the near term, working capital generation will be limited with solvency capital releases (from improvements in syndicate equity positions as their underwriting results improve) and profit likely not leaving much to spare after funding the dividend and higher capital requirements (the capacity increase at the end of FY21 will result in a large premium growth in FY22, which carries a higher capital requirement).

However, we do not expect Helios will turn away any LLVs that approach it as sellers and will instead take one of a number of actions to free up working capital or reduce the cash outlay of the transaction. The most desirable outcome for Helios would be to fund the transactions through share issuance, which would be accretive to working capital. An alternative to this would be a mix of cash and shares with the share-funded portion used to back the FAL and WAV acquired, and the cash portion paying for any cash resources acquired in the transaction. Any amount paid in cash over the cash value of the LLV would be a drain on working capital.

Other mechanisms that could be used are tapping into its remaining £10m revolving credit bank facility (potentially increasing the facility on the back of its larger balance sheet); buying more quota share reinsurance, which would release FAL, but reduce Helios’s share of underwriting result; selling capacity at the auction, which would result in cash proceeds and release working capital from FAL; and forfeiting a portion of tenancy capacity, which would not generate proceeds, but would release working capital from FAL.

We have taken a conservative view on acquisitions in our base case, but have prepared a number of sensitivities below to explore various growth options. We expect the company to continue on its path of LLV acquisition.

We forecast a combined ratio improvement to 95% in FY21, from a weak base in FY20, still reflecting a bottom-of-the-cycle hangover with the claims ratio for YOA 2020 elevated and profit for closed YOA 2019 depressed.

The record LLV acquisitions in the year are expected to produce healthy goodwill on bargain purchases to offset the large spike in stop-loss reinsurance costs (put in place to protect against adverse claims experience) and very weak investment returns.

We expect a small loss of 0.4p/share, affected by a one-off deferred tax charge relating to the increased UK corporate tax rate from April 2023, which affects all companies. However, after a NAV/share decline in FY20, the company is forecast to deliver an increase to 160p/share for FY21. EPS can be a very volatile metric due to the potential for large catastrophe claims shifting results in any given year. NAV growth and DPS are more stable metrics on which to assess the company.

FY22 should produce better results as the new capacity comes online and the hardening premium cycle starts moving the company back to a break-even position during the first year of the 2022 YOA, although the 2020 and 2021 YOAs will still add softer-cycle contributions. We expect underwriting operating profit of £9.3m and earnings of £4.8m (EPS of 6.9p/share) with a recovery in investment income and fewer one-off items in the holding company P&L. NAV/share is forecast to grow and we expect it to be 166.1p/share, generating a return of 4.3% for the year. We expect only the basic dividend of 3p/share.

In FY23 Helios should start to see the meaningful benefits of its recent growth, with the 2022 YOA expected to be particularly profitable as it benefits from lower claims and expense ratios. The underwriting portfolio’s combined ratio is forecast to decline to 88.9% and the 2021 YOA, which closes off in this financial year, is expected to generate an RoC of 9.6% and drive a underwriting operating profit of £17.6m. Reinsurance income is forecast to recover strongly as quota share profit commission resumes on the back of improved underwriting results and investment income on FAL should benefit from higher assets and an uptick in yields (albeit conservatively forecast at 2%). Earnings of £12.0m (EPS of 17p/share) should contribute to healthy NAV growth (we forecast a 10% return and a value of 182.4p/share) and a sharp pick-up in dividends with a 3p/share special dividend, in addition to the basic dividend of 3p/share forecast.

In the next two years when the 2022 and 2023 YOAs will close out and deliver the full upside of the recent significant capacity increases, we forecast earnings growth of c 52% and 17% on the back of RoCs of 12.4% and 12% and RONAV (including WAV revaluations) of 15.5% and 15.9%. The underwriting cycle will likely have started turning downwards by FY25 and it is reasonable to expect RONAVs to decline from the highs at that stage.

For the purposes of our valuation, we look at an average RONAV from FY22 to FY25 and have excluded revaluations. This results in an average 11.1% return, which is used in our RONAV versus P/NAV valuation.

Our base case valuation of 212p/share uses an 11.1% over-the-cycle RONAV, derived as the average return forecast from FY22 to FY25. We tested our RONAV assumption by considering an 11-year average RoC (including our five-year forecast), applying the new UK tax rate, grossing this return up based on a reasonable NAV/capacity assumption (ie, if the company has an NAV of half its capacity, the RONAV would be double the RoC because the same profit amount is divided by a denominator half the size) and making an allowance for the head-office structure.

Our results are summarised in Exhibit 12. This methodology provides strong support for our RONAV assumption. The average RoC is particularly conservative due to the extended four-year period of high combined ratios (including COVID-19 effects) and the historically low interest rates. The average NAV/capacity includes very high capitalisation in the earlier years and our 50% assumption is arguably high relative to current levels. Holding company average leakage allows for high stop-loss costs to continue and remains conservative on investment income.

Our cost of equity of 8.5% is based on a risk-free rate of 1%, a risk premium of 7.5% and a beta of 1x. Although this cost of equity may appear low for a company the size and liquidity of Helios, it is justified, in our opinion, by the asset side of its balance sheet being very robust, consisting primarily of FAL and WAV, with WAV a marked-to-market and very monetisable asset, and by the fact that we apply no terminal growth to our RONAV valuation.

Our fair value for Helios is at a 1.33x multiple of its FY21 forecast NAV of 160p/share and at a 33% premium to the current share price. The valuation is not well supported by expected FY21 and FY22 EPS or dividends, but once the improved underwriting conditions start to emerge from FY23, the forward earnings multiple implied by our valuation is attractive at 12.6x and declines rapidly to 7.1x in FY25. The dividend yield similarly only becomes more attractive from FY23.

We have also calculated a dividend discount model (DDM) valuation based on an explicit forecast period to FY25. This produces a slightly higher valuation, although there is an argument to be made that the WAV/share should also be added to the dividend stream, but maybe at a discount for conservatism (Lloyd’s auction prices have been high in recent years). Valuing the dividend stream without any terminal growth and adding it to the FY21 WAV after a 25% discount results in a value of 225p/share.

While our valuation for Helios indicates relative value on an implied forward earnings and NAV multiple basis, the company far undershoots the peer group on dividend yield. This is because the company chooses to retain most of its earnings to fund capacity growth.

In addition to the standard sensitivities we typically test, including risk discount rate, terminal growth and combined ratio, we have conducted a scenario to test the free working capital effect of more LLV acquisitions every year, two solvency scenarios to see the free working capital they create and four scenarios that unlock free working capital, which is then used to acquire LLV capacity.

Our valuation increases/falls by 6% for every 50bp change in risk discount rate assumption, while increasing our terminal growth rate by 1% has a 9% increase/7% decrease (this was tested using our DDM valuation). The valuation is very sensitive to combined ratio with a 2.5% increase reducing the valuation by 18% and vice versa.

Our calculations show an increase in LLV capacity acquisition of 1% of starting capacity in each year from FY22 onwards will require an additional £13.0m of working capital over and above our base case scenario. This impact is proportional, which means an increase in our capacity growth forecast from 6% to 10% per year would require an additional £54m in funding over four years, either from solvency efficiencies or capital and debt markets. Full or part payment by share issuance will reduce or eliminate the working capital impact. Adding LLV capacity is also value enhancing and under this scenario (without changing other assumptions to fund the additional working capital), it increases our valuation by 4%. We test the combined impacts below.

Helios has benefited recently from a diversification benefit reducing its capital requirements. However, Lloyd’s as a whole is still strongly capitalised in line with the entire insurance sector. A move towards lower solvency coverage for the entire insurance sector is possible considering the very robust performance during COVID-19 (no major insurer ran into solvency issues during this one-in-200-years event) and lower interest rates diluting returns on high surplus capital balances. Such a move could also allow Lloyd’s to relax its capital requirements. We demonstrate that for every 2% relaxation of Lloyd’s capital requirements, a cumulative £14m in working capital would be released, while increasing the quota share reinsurance from c 27% to 32% would release a similar amount. The capital requirements scenario creates ‘free’ working capital, which if deployed in 1% higher LLV capacity additions from FY22 onwards would boost our valuation by 3.8%. The higher quota share reinsurance scenario carries cost, resulting in a largely neutral valuation impact.

Our final two scenarios relate to tapping into the capital and debt markets. While issuing debt is much more value accretive than raising capital, there is a limit to the debt facilities available to Helios with its capital base. Using the current £10m undrawn debt facility and adding a one-off 10% of LLV capacity increases our valuation by 9%, but more uplift than this would require higher borrowing facilities. A capital raising of £50m or c 40% of the current market capitalisation at FY21 NAV/share would allow a one-off 38% increase in capacity and add c 4% to the valuation, with every 10% premium to NAV/share adding a similar amount.

Lloyd's of London is a unique insurance market, not an insurance company, tracing its roots to a 17th century coffee shop opened by Edward Lloyd in the City of London. Today, Lloyd’s is the pre-eminent centre for the underwriting of specialty insurance risks. There are 76 syndicates operating in Lloyd's, underwriting more than £40bn of premiums every year.

The Lloyd's market provides the brand and the legal entity under which the policyholder is insured. It has no shareholders and is governed by the Council of Lloyd's on behalf of its Members. A Member of Lloyd's is eligible to provide capital to a syndicate, which could be used to underwrite insurance risks at Lloyd's. Syndicates are effectively the risk-taking entities in Lloyd's and are organised by a managing agency. One of the key characteristics of Lloyd’s is that syndicates are annual ventures, legally formed each year and reforming the next year should the members and the underwriters wish to. Under what is known as the three-year account, syndicates hold their accounts open for (at least) two full years before declaring results in the third year. Any remaining liabilities are reinsured into the subsequent year of account. The maximum premium a syndicate can write in any given underwriting year (GWP minus brokerage) is known as the syndicate’s underwriting capacity. The Corporation of Lloyd’s oversees and supports the Lloyd’s market.

The main capital providers (members) are grouped into three main categories as follows.

Lloyd's is the legal insurance entity regulated by the UK Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA) rather that the individual syndicates, which presents an advantage for start-up insurers in the form of lower capital needs.

The Lloyd's chain of security and its three links are there to protect the policyholder in case a syndicate fails. The funds in the first two links – syndicate level assets and Members' funds at Lloyd's – are held in trust and are primarily for the benefit of the policyholders. In essence these are similar to the total assets and capital of a conventional insurance company. The third link of security is the central guarantee fund.