Helios Underwriting — Increasing asset base to attract higher yields

Insurance companies like Helios make money in two key ways: a) underwriting risk and making a margin by delivering a combined ratio of less than 100% (an underwriting profit or margin); and b) generating investment returns on the regulatory capital they hold as well as on the assets backing their substantial insurance reserves (often referred to as the free float). Investors like Warren Buffet’s Berkshire Hathaway have traditionally been attracted to P&C insurance companies, because of this return on the free float, which helps such companies to deliver operating margins well ahead of their underwriting margins and to achieve superior NAV returns (return on free float adding to the return from underwriting margin and investment return on capital).

Since 2009, interest rates in developed economies and the UK in particular have been at historically low levels and declined to close to zero when the COVID-19 pandemic hit. In addition, the wider insurance market and the Lloyd’s market in particular have adopted more conservative approaches to solvency, with most participants required or choosing to hold higher levels of capital than in the decade leading up to 2009. As a result, the historical benefits of a healthy return on free float in which P&C insurers and Lloyd’s participants used to participate were significantly diluted. At the same time, these companies also faced very low investment returns on historically high levels of capital. The result was pressure on operating margins (in the case of Lloyd’s, these were only 1.3% pa ahead of the underwriting margin from 2009 to 2020), as well as on RONAV. In the case of Lloyd’s, the RONAV contribution from investment return declined from 15% pa before 2009 to 6% pa thereafter. Companies became much more dependent on underwriting results without the boost that companies with such large asset bases and their investors should naturally expect.

Over the past year, there has been a dramatic change in global and UK interest rates with Libor rising from close to zero to more than 3%, while the UK 10-year gilt yield increased from 0.9% to 4.2% (both have been very volatile). This is a huge development for the P&C industry, which is expected to have a very positive impact on margins and returns.

FY21 was a transformative year for Helios, as it resulted in an 111% increase in Lloyd’s underwriting capacity to £232.7m before reinsurance and an almost trebling in retained capacity to £171.9m. Capacity is the lifeblood of the Lloyd’s syndicates in which Helios has exposure, which gives it the right to participate in the premiums that syndicates write and the underwriting profits they generate. Lloyd’s syndicates are emerging from an extended period of weak premium rates, which lasted to 2017 and affected underwriting results into 2020, exacerbated by COVID-19. The tide has now turned with global insurance rate increases in excess of 50% since 2017 and Lloyd’s gross written premium (GWP) growing by more than 30%.

The significant increase in Helios’s capacity takes time to be reflected in an increase in its asset base. During FY21, Helios recorded an 80% increase in its financial assets from £85.3m to £153.8m, with the bulk of this increase resulting from a large capital raise of £54m and the remainder from assets in the Lloyd’s limited liability vehicles (LLVs) acquired over the period. It was only in H122 that the company’s financial assets started to benefit from the increased capacity that it started to deploy. Over the six months to 30 June 2022, financial assets rose by 21% to £186.5m as Helios benefited from the large premium income backed by its much-increased capacity. This impact is expected to accelerate during H222 as further capacity is deployed and we forecast financial assets at £235m by year-end. Even without any LLV acquisitions in FY22, Helios’s capacity will grow by at least 9.5%, thanks to the £21.7m in pre-emptions that it expects its syndicates to offer. This increase in capacity will help to fuel further healthy growth in financial assets in FY23.

The significant increase in Helios’s asset base comes at the right time for Helios to benefit from rising interest rates and bond yields. We expect Helios to benefit from a healthy boost in investment income from FY23 as it earns c 2.5% more on cash and c 3.5% more on its fixed interest portfolio.

During H122, the spike in bond yields negatively affected fixed interest portfolio values and resulted in investment income of -£3.6m. Additional losses are likely during H222 on the back of further increases in bond yields. From FY23, we forecast a meaningful improvement in investment income of £11m, rising to £15.5m by FY25 (assuming flat yields), which contributes more than a third to group income, boosting operating margin to more than 14% and supporting a RONAV of c 17.6% (including revaluations on the uptake of pre-emption capacity).

At first glance, Helios’s H122 EPS loss of 5.39p is disappointing, coming on the back of a 0.75p loss in FY21 and resulting in a decline in NAV/share to 149p. The loss was largely driven by the negative investment income result discussed above, which is temporary and expected to improve from FY23 and drive very healthy results. Because of its fast-growing asset base, Helios is in the fortunate position of adding new investments at very attractive levels and benefiting from the higher yields that it will earn on these and its existing assets.

Underwriting performance (excluding investment income) was mediocre, relative to expectation, with a combined ratio of 94.5% compared with 93.5% in H122 and 93.9% in FY21. This was caused by a weak performance for the 2022 year of account (YOA) and a lower-than-expected 2021 YOA recovery, while 2020 was strong. The 2021 YOA was affected by conservatism around the potential Ukraine liability (most notably related to aviation), resulting in a loss ratio of 57.5% versus an expected recovery to 55% or lower. While further Ukraine losses cannot be ruled out (and we have lifted our FY22 loss ratio forecast to 59%), we take comfort in the track record of Helios’s syndicates to reserve very conservatively in year one and for excess reserves to be released over time as there is more clarity on ultimate liability. Much of the Ukraine liability remains a matter for the courts and it may take time before there is clarity for Lloyd’s as a whole.

The underwriting loss for the 2022 YOA was largely driven by the impact of aggressive GWP growth and a lower-than-usual level of earned premiums in the six months. This is forecast to normalise as earned premiums grow strongly in the second half and are better able to cover the higher expense base and strong claims reserving requirements. We have modestly increased our forecast return on capacity (RoC) for the 2020 and 2021 YOA, with higher investment income moderating the Ukraine reserving impact. The outlook for the underwriting result and RoCs for the 2023 YOA and thereafter remains very optimistic. We have upgraded our 2023 YOA RoC forecast from 12.8% to 13.4%.

Other than the two near-term and temporary blots on Helios’s results, the H122 performance provides very strong support for our investment outlook. The highlights are as follows:

We explored Helios’s track record of delivering growth through acquisition in our initiation report published on 24 February 2022 and expanded on it in our FY21 results commentary of 31 May 2022. The H122 results provided an up-to-date view of working capital management and utilisation to fund capacity growth. Working capital at 30 June 2022 was £13m, which is a healthy position and is expected to remain around this level at the end of the year. We do not forecast any LLV acquisitions over the remainder of the year. We forecast Helios to be well positioned to ramp up LLV acquisitions from organic working capital generation, including an increased contribution from investment income, in FY23, driving capacity growth by 8–10% to FY25.

However, as stated in our initiation report and highlighted by Helios in its FY21 results, the potential for tapping into the c £3bn capacity represented by LLVs is meaningful. Helios’s organic working capital generation will not be sufficient to fund an aggressive acquisitive strategy in this attractive space, which will only be possible if the company is able to raise further capital and, on the back of this, increase its gearing and use of excess of loss agreements.

Our sensitivity calculations show that raising capital at levels above its NAV will be very value enhancing for Helios. Current share price is approaching a 7% premium to the H122 NAV of 149p/share.

Driven by negative investment income in H122, which is expected to continue in H222 as well as the Ukraine impact on the 2022 YOA underwriting result, we have cut our EPS forecast from 7.2p to a loss of 1.1p , but increased our forecast NAV/share from 165.4p to 166.5p, with a pre-emption revaluation and a reversal of the deferred tax charge in FY21 (with the decision to raise corporate tax rate having been scrapped), providing other comprehensive income offsets to the impact of lower EPS.

We have lifted our FY23 EPS by 18.5% to 21.9p, driven by higher forecast investment income on the back of higher interest rates and yields. FY24 and FY25 EPS have been lifted by 6.5% and 7% respectively on the expectation of higher investment income. We forecast RoC for the 2021 YOA of 9.0%, rising to 12.4% for 2022 YOA and 13.4% for 2023. We forecast RONAV of 12.9% in FY23, rising to 15.8% by FY25. Including revaluations on the uptake of pre-emption capacity, the returns are 14.8% in FY23, rising to 17.6% in FY25.

For the purposes of our valuation, we look at an average RONAV from FY23 to FY25 and exclude revaluations. This results in an average 14.6% return, which we use in our RONAV versus P/NAV valuation.

Our base case valuation of 240p/share uses a 14.6% over-the-cycle RONAV, derived as the average return forecast from FY23 to FY25. This is a 7% increase on our previous valuation of 225p/share, supported by a much more optimistic outlook for investment income, which is expected to boost operating margins and RONAV.

We have increased our cost of equity to 10.5% based on a risk-free rate of 4.0% (up from 1.9%), a risk premium of 6.5% and a beta of 1x.

Our fair value for Helios is at a 1.44x multiple of its FY22 forecast NAV of 166.5p/share and at a 50% premium to the current share price. The valuation is not well supported by expected 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 11.0x and declines rapidly to 6.9x in FY25. Similarly, the dividend yield becomes more attractive from FY23.

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