The following table sets forth our selected historical financial information for the period ended and as of the dates indicated. The summary income statement data for the period from our inception at May 23, 2002 through December 31, 2002 and the twelve months ended December 31, 2003 and the balance sheet data as of December 31, 2003 and 2002 are derived from our audited consolidated financial statements included elsewhere in this report, which have been prepared in accordance with U.S. GAAP and have been audited by KPMG Audit Plc, our independent auditors. These historical results are not necessarily indicative of results to be expected from any future period. Due to our limited operating history, the ratios presented may not be indicative of our future performance. You should read the following selected consolidated financial information along with the information contained in this report, including Item 8, "Financial Statements and Supplementary Data" and Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the audited consolidated financial statements, condensed consolidated financial statements and related notes included elsewhere in this report.
(1) The financial information for this period reflects our results for the period from May, 23 2002, the date of our formation, to December 31, 2002.
(3) The expense ratio is calculated by dividing acquisition expense and general and administrative expense by net premiums earned.
(6) Book value per share is based on total shareholders' equity divided by the number of shares outstanding of 56,876,360 and 69,179,303 at December 31, 2002 and December 31, 2003, respectively.
(7) Fully diluted book value per share is calculated based on total shareholders' equity at December 31, 2002 and December 31, 2003, divided by the number of shares outstanding of 56,876,360 and 69,179,303 at December 31, 2002 and December 31, 2003, respectively. Potentially dilutive options
The following is a discussion and analysis of our financial condition and results of operations for the twelve months ended December 31, 2003 and if relevant, for the period from May 23, 2002, the date of formation, to December 31, 2002. The following also includes a discussion of our financial condition at December 31, 2003. See also the Syndicates Financial Information beginning on page P-1 for further information with respect to Syndicate 2020 and Syndicate 3030 which include the initial lines of business written by the Company. See also page M-1 for "Management's Discussion and Analysis and Underwriting Results of Syndicates 2020 and 3030." This discussion and analysis should be read in conjunction with our audited consolidated financial statements and accompanying notes included in this report. This report contains forward-looking statements that involve risks and uncertainties that are not historical facts, including statements about the Company's beliefs and expectations. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and particularly under the headings "-Risk Factors" and "Business" in Item 1 of this report and "Forward-Looking Statements" contained in Part I of this report.
Net income for the twelve months ended December 31, 2003 was $152 million, or $2.63 per share, compared to $28.6 million, or $0.89 per share, for the period ended December 31, 2002. Management considers this per share increase in net income to reflect a strong overall performance in 2003 given the relatively short period since the Company started its operations in June 2002 and the relative immaturity of its earnings profile. We measure the maturity of the Company's earnings profile by the ratio of net premiums earned to net premiums written, which has increased from 38% for the period ended December 31, 2002 to 74% for the twelve months ended December 31, 2003. In a 'steady state' in which written premiums were neither increasing nor decreasing from one year to the next, earned premium would equal written premium.
Gross premiums written increased from $374.8 million for the period ended December 31, 2002 to $1,306.8 million for the twelve months ended December 31, 2003. This increase is reflected in similarly significant increases in net written premiums, earned premiums and expenses, all of which increases are primarily driven by the fact that the results for 2002 reflect only the period since we began our operations in June 2002 whereas the results for 2003 reflect twelve months of operations.
Our net premiums written of $1,092.8 million for the year ended December 31, 2003 represented 84% of gross premiums written of $1,306.8 million, which indicates that we ceded reinsurance premiums of $214 million. Approximately $80 million of the ceded reinsurance premiums represented proportional cessions of which our shareholder Montpelier Re was the main recipient under arrangements established at our formation. The remaining amount of the ceded reinsurance premiums mostly comprises premiums for retrocessional protection of our property reinsurance account from which we do not expect to make any material recoveries in respect of accident year 2003 because there have not been any loss events of sufficient scale.
We monitor the ratio of losses and loss adjustment expenses to net earned premium (the "loss ratio") as a measure of relative underwriting performance where a lower ratio represents a better result than a higher ratio. Our overall loss ratio was 53% for 2003 compared to 64% for 2002. There was a release of reserves in 2003 from the 2002 accident year, equivalent to around 1.1 percentage points on net earned premium for the year. Further information relating to the release of reserves can be found below under "-Critical Accounting Policies" below.
We comment further on loss ratios and expense ratios in our discussion of the segmental results later in this section.
We generated investment income in 2003 of $29.6 million in a year in which our total liquid assets doubled from $932 million at the end of 2002 to $1.8 billion at the end of 2003, requiring us to invest significant amounts during a volatile bond market. Investment income in 2002 was $8.5 million.
Total shareholders' equity increased from $836.9 million at the beginning of 2003 to $1,298.7 million at the end of 2003 as a result of:
• the issuance of shares to the Names' Trustee in connection with the exercise of the Names' Options for a total consideration of $1.6 million;
• the issue of employee options at a fair value of $7.5 million credited to additional paid in capital;
The increase in shareholders' equity resulted in an increase in diluted book value per share (treasury stock method) of 18% to $18.17 at December 31, 2003 from $15.44 at the beginning of the year.
ensure that they are able to meet their insurance and other liabilities as they become due and was satisfied that there was a comfortable margin of liquidity as at December 31, 2003 and for the foreseeable future.
In our U.K. insurance business, we are expecting continued strong overall performance. We had anticipated that U.K. liability rates would have peaked by this stage, but this has not, in fact, been the case. Rates in our liability book of business are actually up approximately 8% year to date, and we continue to see a number of favorable opportunities in this area. Our U.K. property insurance business also remains strong. In 2003, our property insurance was highly profitable and we are expecting continued profitability for this business in 2004 as rates continue to remain adequate.
In January 2004 we recruited a Connecticut-based team of property reinsurance underwriters that we hope will provide approximately $40 million of gross written premiums in 2004 with possible greater premiums thereafter. We also established an office in New Jersey to write casualty facultative reinsurance risks, mainly in worker's compensation and umbrella lines, but we have discontinued the automobile facultative line that we wrote through WU Inc. We currently believe that our casualty facultative written premium in 2004 could reach about $35 million.
In addition, we have in 2004 moved our property retrocession underwriting operation to Bermuda from London and also expect a modest increase in other reinsurance underwriting directly out of
Bermuda following the injection of $150 million of additional capital into Aspen Bermuda following our initial public offering. We expect this business to contribute an increasingly important part of the overall operation in the future. The majority of our property reinsurance business will, however, continue to be written in London.
We derive our revenues primarily from our insurance and reinsurance contracts. These revenues are included in our statement of operations after taking into account amounts payable to our reinsurers.
The amount reported under this heading in any period includes payments in the period plus the change in the value of the reserves for unpaid losses and loss adjustment expenses between the beginning and the end of the period.
Our method for setting the reserves for unpaid losses and loss adjustment expenses at the end of any period is discussed below under "-Critical Accounting Policies."
We believe that the following critical accounting policies affect the more significant estimates used in the preparation of our consolidated financial statements. The descriptions below are summarized and have been simplified for clarity. A more detailed description of the significant accounting policies we use to prepare our financial statements is included in the notes to the consolidated financial statements. If factors such as those described in "-Risk Factors" in Item 1 above cause actual events to differ from the assumptions used in applying the accounting policy and calculating financial results, there could be a material adverse effect on our results of operations and financial condition and liquidity.
Premiums. Written premiums comprise the estimated premiums on contracts of insurance and reinsurance entered into in the reporting period except in the case of proportional reinsurance contracts where written premium relates only to our proportional share of premiums due on contracts entered into by the ceding company prior to the end of the reporting period.
For reported claims, reserves are established on a case by case basis within the parameters of coverage provided in the insurance policy or reinsurance agreement. In estimating the cost of these claims, we consider circumstances related to the claims as reported, any information available from loss adjustors and information on the cost of settling claims with similar characteristics in previous periods. For IBNR claims, reserves are estimated using established actuarial methods. Both case and IBNR reserve estimates consider such variables as past loss experience, changes in legislative conditions and changes in judicial interpretation of legal liability policy coverage's and inflation.
The range of estimates established by the actuary is not intended to include the minimum or maximum amount that the claims may ultimately be, but is designed to provide management with a range from which it is reasonable to select a single best estimate for inclusion in the financial statements taking into account the impact that all the factors affecting the reserves may have. The net actuarial range for reserves for losses and loss expenses established as at December 31, 2003 was between $407.7 million and $491.3 million. The actual net reserves established as at that date were $482.2 million.
In selecting our best estimates of the reserves for each line of business we take into account all of the factors set out above, and in particular the quality of the historical information the Company has on which to establish its reserves and the degree of estimation where information is received from cedents on an underwriting year basis and needs to be converted to an accident year basis. In addition, consideration is given to the point estimate produced by our independent consulting actuaries which was towards the upper end of the range.
While the reported reserves make a reasonable provision for unpaid loss and loss adjustment expense obligations, it should be noted that the process of estimating required reserves does, by its very nature, involve uncertainty. The level of uncertainty can be influenced by such factors as the existence of coverage with long duration payment patterns and changes in claims handling practices, as well as the factors noted above. Ultimate actual payments for losses and loss adjustment expenses could turn out to be significantly different from our estimates.
All of this reduction related to the business written in 2002. The reserves as at December 31, 2002 were $93.9 million gross and $81.4 million net of reinsurance.
• 64% of the net reserves as at December 31, 2002, amounting to $52 million, were in respect of business underwritten by way of the two quota share contracts under which we reinsured part of the portfolio of risks written in 2002 by the Syndicates (the "Wellington quota share arrangements"). The level of information we receive in respect of the business ceded under these arrangements is more limited than that in respect of business written directly by the Company, and is on an underwriting year basis which means that the cedents do not allocate estimates of IBNR losses to accident years. We reviewed this information and established our best estimate of the accident year claims as at December 31, 2002 using the cedents' estimates of ultimate losses and our own assessment of the allocation of those losses to accident years. During the twelve months ended December 31, 2003, we requested and were given more information by the cedents and this has enabled us to make a better assessment of how much of the ultimate losses relate to the 2002 accident year. The Syndicates have also experienced less severe development of incurred losses than they did in the immediately preceding years which has led to reductions in the actuarial estimates of ultimate losses. Both of these factors have contributed to an overall reduction in the 2002 accident year reserves for this business.
The analysis of the favorable development on a line of business basis is as follows:
As at December 31, 2003 a 5% change in the reserve for net IBNR losses would equate to a change of approximately $16.0 million in loss reserves which would represent 7.8% of income from operations before income tax for the twelve months ended December 31, 2003.
Reinsurance recoveries in respect of estimated IBNR claims are assumed to be consistent with the historical pattern of such recoveries, adjusted to reflect changes in the nature and extent of our reinsurance program over time. An assessment is also made of the collectability of reinsurance recoveries taking into account market data on the financial strength of each of the reinsurance companies.
In January 2003, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"), which requires consolidation of all variable interest entities ("VIE") by the primary beneficiary, as these terms are defined in FIN 46, effective immediately for VIEs created after January 31, 2003. The consolidation requirements apply to VIEs existing on January 31, 2003 for reporting periods beginning after June 15, 2003. In addition, it requires expanded disclosure for all VIEs. In October 2003, the FASB delayed the implementation date, for VIEs existing on January 31, 2003, to reporting periods ending after December 15, 2003. In December 2003 FIN 46 was replaced by FIN 46(R) which maintained the requirement to consolidate VIEs but revised the definitions. The adoption of FIN 46(R) has had no material impact on our consolidated financial statements.
Aspen Holdings was formed on May 23, 2002 and acquired City Fire on June 21, 2002. City Fire was subsequently renamed as Wellington Re and then as Aspen Insurance UK Limited. Aspen Re commenced underwriting on June 21, 2002. Aspen Bermuda was formed on November 6, 2002 and commenced insurance operations on December 9, 2002. Our fiscal year ends on December 31. Our financial statements are prepared in accordance with U.S. GAAP. The following is a discussion and analysis of our consolidated results of operations for the period from our incorporation on May 23, 2002 to December 31, 2002 and for the twelve months ended December 31, 2003.
Gross Premiums Written. In the twelve months ended December 31, 2003 gross premiums written were $1,306.8 million, including $78.4 million under the 2003 quota share arrangement with Syndicate 2020.
Reinsurance ceded. Reinsurance premiums ceded for the period were $214.0 million.
Gross premiums earned. Gross premiums earned for the period were $987.8 million which represents 75.6% of gross premiums written.
Operating and administrative expenses. Operating and administrative expenses for the period were $53.3 million, including provisions for fixed and performance-related staff compensation.
representative of future performance although it may decline to some degree in the future if the contribution of Aspen Bermuda to total pre-tax earnings increases. This is because the operations of Aspen Bermuda are not subject to taxes on income.
Gross premiums earned. Gross premiums earned for the period were $163.8 million which represents 43.7% of gross premiums written. We expect gross earned premiums to continue to lag significantly behind gross premiums written while our operations are in their initial growth phase. The amount of gross earned premiums derived from the Wellington 2002 quota share arrangements was $111.6 million.
Income before tax. Income before tax for the period was $35.1 million, including underwriting income of $13.6 million, investment returns of $8.4 million and other revenues of $13.1 million.
We write reinsurance for both property and casualty risks. Our property reinsurance line of business in 2002 was mainly written on a treaty basis but some facultative property risks have been written from January 1, 2003. The property treaty reinsurance we write includes catastrophe, risk excess and pro rata, including retrocession.
Our casualty reinsurance line of business is written on both a treaty and a facultative basis. The casualty treaty reinsurance is written mainly on an excess of loss basis and includes coverage for claims arising from automobile accidents, employers' liability, professional indemnity and other third party liabilities. It is written in respect of cedents located mainly in the United States, the United Kingdom, Europe and Australia. The casualty facultative business in 2002 was restricted to automobile liability business in the United States with a focus on liability relating to commercial vehicles. In 2003 we began to accept other facultative casualty risks.
Our specialty reinsurance line of business includes aviation and marine reinsurance. We also include under this heading our quota share reinsurances of Syndicates 2020 and 3030 in respect of the lines of business that we do not write under our own name, including marine, energy, accident and health and aviation risks. Our quota share reinsurance of Syndicate 3030 did not continue after 2002.
Losses and loss adjustment expenses. Losses and loss adjustment expenses were $303.0 million for the period, representing 50.8% of net earned premiums for the period. The only material claims incurred during the period arose from a series of tornadoes in the mid-west of the United States between May 2, 2003 and May 11, 2003 ($6.3 million), Hurricanes Fabian and Isabel ($5.6 million and $7.2 million respectively), Brush fires in the United States ($15.3 million) and a Philips factory loss in Normandy, France ($16.2 million).
The following table summarizes gross and net written premiums and underwriting results for each of the lines of business within our reinsurance segment for the twelve months ended December 31, 2003:
Premiums. Gross premiums written for the period were $288.2 million, comprising $117.6 million property, $27.8 million casualty and $142.8 million specialty. The specialty premium for this period comprises entirely that part of the business assumed under the 2002 Wellington quota share arrangements that is not included under any other heading.
Losses and loss adjustment expenses. The year 2002 developed well with relatively few major property losses. The catastrophe account was impacted by the European floods which have produced in excess of $3 million of claims. The only material loss on the risk excess account was a $1.8 million loss at a U.S. grain store. No material casualty reinsurance claims were reported in the period, reflecting the long tail nature of the casualty reinsurance business written. Total loss and loss adjustment expenses were $60.9 million representing 63% of net premiums earned.
Policy acquisition, operating and administration expenses. Total expenses were $24.4 million for the period, equivalent to 18.0% of gross earned premiums. This is lower than we expect to experience in the future because the premiums written under the Wellington 2002 quota share arrangements are ceded to us net of the brokerage payable by the Syndicates on the original business.
The commercial liability line of business consists of U.K. employers' and public liability insurance. We have not received notice of any individually material claims with respect to this business but this is normally the case for this class of business at this early stage in its development and it may take many years before all claims are reported, assessed and paid.
Policy acquisition, operating and administration expenses. Total expenses were $5.4 million for the period, equivalent to 19.3% of gross earned premiums.
At December 31, 2003 Aspen Holdings had cash, cash equivalents and short-term investments of $33.2 million that are available to pay its operating expenses and liabilities.
As of January 1, 2003, the maximum amount of distributions that our Insurance Subsidiaries could have paid to us under applicable laws and regulations without prior regulatory approval was approximately $30.0 million. This amount is expected to increase to $60.0 million on January 1, 2004, subject to the availability of distributable reserves. For a discussion of the various restrictions on our ability and our Insurance Subsidiaries ability to pay dividends, see Item 1, "-Regulatory Matters" elsewhere in this report.
On July 31, 2003 Aspen Re agreed to pay an interim dividend of $5.0 million to the Company and it was paid on August 11, 2003. An additional dividend of $5.0 million was paid on September 5, 2003 and $10.0 million was paid on December 17, 2003.
The Insurance Subsidiaries hold approximately $765.8 million in cash and short-term investments that are readily realizable securities. Operating cash flow, borrowing and the issuance of additional ordinary shares for cash increased the total cash and cash equivalents held by the Aspen group by $221.2 million during the twelve months ended December 31, 2003. Management monitors the value, currency and duration of the cash and investments within its Insurance Subsidiaries to ensure that they are able to meet their insurance and other liabilities as they become due and was satisfied that there was a comfortable margin of liquidity as at December 31, 2003 and for the foreseeable future.
Liquidity. Our liquidity depends on operating, investing and financing cash flows, described as follows. On an ongoing basis, our Insurance Subsidiaries' sources of funds primarily consist of premiums written, investment income and proceeds from sales and redemptions of investments.
We intend to manage these risks by maintaining a substantial proportion of our invested assets in securities having durations less than the durations of our liabilities even though this may over time reduce the yield on our investments below that which might be obtained if our asset durations were perfectly matched to our liability durations. Notwithstanding this policy, if our calculations with respect to these liabilities are incorrect, we could be forced to liquidate investments prior to maturity, potentially at a significant loss.
Aspen Re is regulated by the FSA and is subject to the FSA's Handbook of Rules and Guidance with respect to solvency requirements. See Item 1, "-Regulatory Matters - U.K. Regulation" elsewhere in this report. Aspen Re has maintained the required margin of solvency throughout 2003 and the value of its shareholders' equity as of December 31, 2003 was $754.0 million.
Aspen Re has established a Canadian trust fund with a Canadian bank to secure a Canadian insurance license. The initial minimum trust fund amount and balance at December 31, 2003 was Can$25.0 million. In addition, Aspen Specialty has a total of $4.7 million on deposit with seven U.S. States in order to satisfy state regulations for writing business there.
The terms of the credit agreements entered into in connection with the Credit Facilities (the "Credit Agreements") require Aspen Holdings and each Material Subsidiary to pledge the capital stock owned by each of them in any Material Subsidiary as collateral for the obligations under the loans. Currently, the shares of stock of Aspen Re and Aspen Bermuda owned by us and Aspen Specialty owned by Aspen U.S. Holdings, Inc. are pledged as collateral for the obligations under the credit facilities. Each subsidiary, other than an insurance subsidiary, existing on the closing date and each such subsidiary formed after the closing date is required to become a guarantor under the Credit Facilities. A subsidiary is a Material Subsidiary if the total consolidated assets or total consolidated revenues of it and its subsidiaries exceed 10% of the total assets or gross revenues of Aspen Holdings and its subsidiaries on a consolidated basis at the end of or for, respectively, the most recently completed fiscal quarter of the Company for which financial statements should have been delivered to the lenders pursuant to the Credit Agreements, or if the net assets of such subsidiary exceed $100 million at the end of the most recently completed fiscal quarter of the Company for which financial statements should have been delivered to the lenders pursuant to the Credit Agreements. Accordingly, Aspen Re, Aspen Bermuda and Aspen Specialty are currently Material Subsidiaries.
On October 15, 2003 we made a drawdown of $90 million on the three-year credit facility. Of this borrowing, $83.9 million was used to provide part of the initial capital to Aspen Specialty and the balance was used to provide working capital to Aspen Holdings. The initial interest rate is three-month LIBOR plus 42.5 basis points. A facility fee, currently calculated at a rate of 17.5 basis points on the average daily amount of the commitment of each lender, is paid to each lender quarterly in arrears. On December 15, 2003, $50 million of the loan was repaid following receipt of funds from our initial public offering. The $40 million balance is due and payable by August 29, 2006.
We do not currently have any material commitments for any capital expenditures over the next twelve months.
Our contractual obligations other than our obligations to our policyholders and employees consist mainly of amounts outstanding under our credit facilities and operating leases. The following table summarizes our contractual obligations as of December 31, 2003:
Taxation Funding Facility Agreement. On June 21, 2002, we entered into the taxation funding facility agreement with the Names' Trustee, as trustee of the Names' Trust. Under that agreement, we agreed to make available cash advances to the Names' Trust to enable the Names' Trustee to make sub-advances to the Unaligned Members to fund payment of taxation payable (i) on the value of the rights granted to the Unaligned Members in respect of options granted to them and (ii) in respect of contingent payments received pursuant to the profit commission agreement. The value of these rights is the amount agreed in principle by us with the U.K. Inland Revenue prior to December 31, 2003, or, if no such agreement has been reached by then, the amount estimated by us in good faith, with provisions for upward adjustment in the event that the amount subsequently agreed with the U.K. Inland Revenue is higher. Any taxation payable by the Unaligned Members on these rights, which we may have to advance, will be based on such determination date. If no value is realized by the Unaligned Members, or to the extent that the value realized (after tax) is less than the advance, we have agreed to waive repayment. We expect that it is most likely that we will not incur any liability under the Taxation Funding Facility Agreement prior to 2006.
Reference is made to Item 15(a) of this report for the Consolidated Financial Statements of the Company and the Notes thereto, as well as the Schedules to the Consolidated Financial Statements.
Reference is also made to Item 15(a) of this report for the Financial Statements of Syndicates 2020 and 3030, and the accompanying Management's Discussion and Analysis of Financial Condition and Underwriting Results of Syndicates 2020 and 3030. The Syndicates Financial Statements have been included in this report following their inclusion in the registration statement relating to the Company's initial public offering in December 2003. The Company does not control the Syndicates and is not in a position to obtain audited U.S. GAAP Financial Statements for the Syndicates for the periods after December 31, 2002. Accordingly, neither the Syndicates Financial Statements, nor the Management's Discussion and Analysis of Financial Condition and Underwriting Results relating thereto, will be included in future annual reports on Form 10-K.