On October 19, 2004, Aspen Re entered into an agreement for leases with B.L.C.T. (29038) Limited (the landlord), Tamagon Limited and Cleartest Limited in connection with leasing office space in London of approximately a total of 49,500 square feet covering three floors. The term of each lease for each floor commenced in November 2004 and runs for 15 years. Service charges of approximately £0.5 million per annum are payable from this date, and are subject to increase. It is expected that we will begin to pay the yearly basic rent of approximately £2.7 million per annum 36 months after the relevant date of practical completion of the landlord's works. The basic annual rent for each of the leases will each be subject to 5-yearly upwards-only rent reviews. There are no contractual provisions in any of the leases allowing us to terminate any of the leases prior to expiration of the 15-year contractual terms.
The following is a discussion and analysis of our financial condition and results of operations for the twelve months ended December 31, 2004, 2003 and for the period from May 23, 2002 to December 31, 2002. The following also includes a discussion of our financial condition at December 31, 2004. 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.
The following overview of our 2002, 2003 and 2004 operating results and financial condition is intended to identify important themes and should be read in conjunction with the more detailed discussion further below.
The capacity of Aspen Bermuda was expanded by the injection of $250 million of additional capital and the transfer of the majority of our London-based property reinsurance underwriting team to Bermuda. The consequent increase in our underwriting activities in Bermuda will mainly relate to cedents in the U.S., Japan and the U.K.
Net income for the twelve months ended December 31, 2004 was $195.1 million, or $2.82 per share, compared to $152.1 million, or $2.63 per share, for the twelve months ended December 31,
Our net premiums written of $1,357.6 million for the year ended December 31, 2004 represented 85.6% of gross premiums written of $1,586.2 million, which indicates that we ceded reinsurance premiums of $228.6 million. Of the ceded reinsurance premiums, $43.4 million 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 expect to make recoveries in respect of windstorm losses in the third quarter of 2004.
We monitor the ratio of expenses to net earned premium (the "expense ratio") as a measure of the cost effectiveness of our business acquisition, operating and administrative processes. The expense ratio was 25% for 2004 and for 2003.
We generated net investment income in 2004 of $68.3 million in a year in which our total investment, cash and cash equivalents increased from $1.85 billion at the end of 2003 to $3.02 billion at the end of 2004, requiring us to invest significant amounts during a volatile bond market. Investment income in 2003 was $29.6 million and in 2002 was $8.5 million.
• a net decrease in currency gains, investment losses and losses on derivatives accounted for as Other Comprehensive Income of ($9.3) million.
The increase in shareholders' equity resulted in an increase in diluted book value per share (treasury stock method) of 14% to $20.79 at December 31, 2004 from $18.17 at the beginning of 2004.
On a premium weighted average basis, our whole portfolio experience was flat in terms of rate adequacy during January 1, 2005 renewals. Within this overall figure there are many variations, some of them being significant. Our insurance lines saw more competition than our reinsurance segment and it is important to note that the reinsurance component is considerably larger. In the U.K., both commercial property and employer's liability insurance saw some resurgence of price competition during January 1, 2005 renewals. These lines saw downward rate movements of approximately 12% and 5%, respectively. While this is unwelcome, we believe that both lines have been performing well and we have strategies in place to retreat to our core top performing risks if need be.
Rates in the marine and energy lines were stable to rising with the best increases in offshore energy related business, especially if the risk has sustained a loss from Hurricane Ivan. With the recent recruitment of our underwriting team for marine insurance, we believe this offers us an excellent business opportunity during the course of 2005.
Rate reductions in European property, which represents about 15% of our total property reinsurance account, averaged about 15%, while U.S. business in general saw reductions of approximately 5%. We managed to increase our share in some well-priced contracts and cancelled some less well rated contracts with the net effect of increasing our rate adequacy by approximately 4% across the property reinsurance lines as a whole. This is a positive achievement, although as the year progresses, we are unlikely to continue to buck the market trend.
In the casualty reinsurance segment we saw rate increases, typically by single digit percentage points in our medical malpractice business. Workers' compensation clash is showing sizable reductions while the rest of the U.S. business, in common with the international market, has been flat.
We test our allocation of capital to different lines of business seeking to reduce or even exit those that are becoming less attractive and endeavoring to be one of the first carriers to target new and improving opportunities. This has led us to avoid or maintain minimal exposure to the two areas of property and casualty reinsurance and insurance we currently regard as the most challenging, mainly
Fortune 500 or multinational property and directors and officers insurance, where rate reductions in the range of 20% to 40% are not uncommon.
In summary, we have seen the trend in pricing slope gently downwards in the case of reinsurance business and somewhat more markedly downwards for insurance lines, however, we anticipate that our lines of business will continue to offer positive returns in 2005. Terms and conditions continued to hold throughout our portfolio during the January 1, 2005 renewal season.
In March 2005, our new aviation team will be complete. Based upon the team's collective track record of producing gross and net underwriting profits for previous employers, we believe that our aviation team is one of the top in the sector. The team has a great deal of experience and a differentiated product mix which generally avoids U.S. trunk carriers and major product manufacturers.
Policy acquisition expenses. Policy acquisition expenses consist principally of commissions and similar charges payable to brokers, other intermediaries and ceding companies, many of which represent a percentage of premiums receivable by us together with staff costs directly attributable to underwriting. The amount of expenses varies according to the amount and types of contracts written.
Operating and administrative expenses. These expenses consist primarily of staff compensation, payroll taxes, accommodation costs, information technology and other operating expenses and professional fees. This heading also includes depreciation of tangible assets. Staff compensation includes salaries, bonuses, share-related compensation and benefits such as medical insurance and pension contributions.
Premiums receivable are recorded as amounts due less any required provision for doubtful accounts.
Reserve for Losses and Loss Expenses. Provision is made at the year-end for the estimated cost of claims incurred but not settled at the balance sheet date, including the cost of IBNR claims. The estimated cost of claims includes expenses to be incurred in settling claims and a deduction for the expected value of salvage and other recoveries. As required under U.S. GAAP, no provision is made for our exposure to natural or man-made catastrophes other than for events occurring before the balance sheet date.
In establishing the reserves set by the Company, the Company's actuary employs a number of techniques to establish a "range of estimates." The insurance reserves are established for the total unpaid cost of claims and loss adjustment expenses, which cover events that have occurred before the balance sheet date. These reserves reflect the Company's estimates of the total cost of IBNR claims to it. Estimated amounts recoverable from reinsurers on unpaid losses and loss adjustment expenses are calculated to arrive at a net claims reserve.
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 coverages and inflation.
Because many of the coverages underwritten involve claims that may not be ultimately settled for many years after they are incurred, subjective judgments as to the ultimate exposure to losses are an integral and necessary component of the loss reserving process. Reserves are established by the
selection of a best estimate from within a range of estimates. The Company continually reviews its reserves, using a variety of statistical and actuarial techniques to analyze current claims costs, frequency and severity data, and prevailing economic, social and legal factors. Reserves established in prior periods are adjusted as claims experience develops and new information becomes available.
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, 2004 was between $926.8 million and $1,092.9 million. The actual net reserves established as at December 31, 2004 were $1,080.2 million. 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.
Specialty Reinsurance: The net reserves of the specialty reinsurance line of business as at December 31, 2003 were $94.0 million, largely derived through the Wellington quota share arrangements. Premium and claims information received from the cedent during the twelve months ended December 31, 2004 has enabled the Company to refine its accident year assessment. Further information received concerning the development of reserves acquired by the acquisition of City Fire has also contributed to the overall release in reserves of $18.1 million.
Commercial Property: The net reserves of the property insurance line of business as at December 31, 2002 were $2.4 million. This account had only two years of Syndicates history prior to its being
written by the Company. The reserves established as at December 31, 2002 were partly based upon the historical performance experienced in those two years. During the course of 2003, the historical information improved due in particular to the settlement of one claim significantly below its case reserve. This improvement enabled us to reassess the likely level of IBNR claims in respect of the 2002 accident year, resulting in a reduction in reserves of $1.2 million.
Reinstatement Premiums. Reinstatement premiums and additional premiums are accrued as provided for in the provisions of assumed reinsurance contracts, based on experience under such contracts. Reinstatement premiums are the premiums charged for the restoration of the reinsurance limit of an excess of loss contract to its full amount after payment by the reinsurer of losses as a result of an occurrence. These premiums relate to the future coverage obtained during the remainder of the initial policy term and are earned over the remaining policy term. Additional premiums are premiums charged after coverage has expired, related to experience during the policy term, which are earned immediately. An allowance for uncollectible premiums is established for possible non-payment of such amounts due, as deemed necessary.
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 Re. Aspen Re commenced
In 2002, we derived a significant proportion of our premiums from two quota share contracts under which we reinsured part of the portfolio of risks written by the Syndicates and managed by WUAL (the "Wellington 2002 quota share arrangements"). With effect from January 1, 2003 we renewed reinsurance business and U.K. insurance business previously written by the Syndicates within our own U.K. subsidiary. We did however continue to assume risks in respect of other lines of business written by Syndicate 2020 from January 1, 2003 under a quota share contract under which we accepted 7.5% of most of the classes written by the Syndicate from that date. The 2003 quota share arrangement with Syndicate 2020 is a much less significant part of our business than were the Wellington 2002 quota share arrangements. In 2004, we did not enter into a quota share arrangement with Syndicate 2020.
Gross Premiums Written. In the twelve months ended December 31, 2004 gross premiums written were $1,586.2 million compared to $1,306.8 million for the twelve months ended December 31, 2003, an increase of 21.3%. The increases included $154.5 million from net new business and rate increases in casualty reinsurance, $47.1 million from new property reinsurance business written through Aspen Re America, $43.6 million from our new marine lines of business and $60.3 million of new business written by Aspen Specialty and reported under property insurance ($30.0 million) and liability insurance ($30.3 million).
Gross premiums earned. Gross premiums earned for the twelve months ended December 31, 2004 were $1,469.0 million, which represented 92.6% of gross premiums written for such period, compared to gross premiums earned of $987.8 million for the twelve months ended December 31, 2003, which represented 75.6% of gross premiums written. This reflects the stabilization of earnings following the initial growth phase of earning.
Insurance losses and loss adjustment expenses. Insurance losses and loss adjustment expenses for the twelve months ended December 31, 2004 were $723.6 million including paid claims of $164.6 million, compared to $428.4 million including paid claims of $53.9 million for the twelve months ended December 31, 2003. The increase of $295.2 million in insurance losses and loss adjustment expenses was primarily due to losses from a series of windstorms in the southeastern United States and Typhoon Songda, totaling $196.1 million net of reinsurance. Of the total gross reserves for unpaid losses of $1,277.9 million at the balance sheet date, 63% represented IBNR claims compared to 71% of IBNR for the twelve months ended December 31, 2003.
Aspen Holdings was formed on May 23, 2002 but did not commence operations until June 21, 2002. The results of operations for the period from May 23, 2002 to December 31, 2002 therefore reflects our results for only twenty-eight weeks and comparisons with the twelve months ended December 31, 2003 may not be meaningful and therefore, the two periods are not generally compared directly below.
Gross Premiums Written. For the period, gross premiums written were $374.8 million. This was derived in part from our own business and in part from the Wellington 2002 quota share arrangements. Our own business accounted for $158.4 million and the Wellington 2002 quota share arrangements for $216.4 million.
Reinsurance ceded. Reinsurance ceded for the period was $62.2 million which includes $49.9 million in respect of reinsurance contracts placed by WUAL for the benefit of its syndicates and their quota share reinsurers.
Operating and administrative expenses. Operating and administrative expenses for the period were $8.7 million, including provisions for fixed and performance-related staff compensation.
Income tax expense. Income tax expense for the period was $6.5 million, which was mainly driven by the current rate of U.K. corporation tax of 30%.
The following table summarizes gross and net written premium, underwriting results, and combined ratios and reserves for each of our two business segments for the twelve months ended December 31, 2004 and the twelve months ended December 31, 2003 and for the period from May 23, 2002 to December 31, 2002.
Net reserves for loss and loss adjustment expenses as at December 2004, 2003 and
We write reinsurance for both property, casualty and specialty risks. In 2004 our property reinsurance line of business was all written on a treaty basis. The property treaty reinsurance we write includes catastrophe, risk excess and pro rata, including retrocession. In 2003 we also wrote a limited amount of property facultative reinsurance.
In 2004 our casualty reinsurance line of business was written mainly on a treaty basis with a small proportion of facultative risks. The casualty treaty reinsurance is primarily 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 covers United States umbrella, workers' compensation and general liability business.
Our specialty reinsurance line of business includes aviation and marine reinsurance. In 2002 we also included under this heading our quota share reinsurances of Syndicates 2020 and 3030 in respect of the lines of business that we did not write under our own name, including marine, energy, accident and health and aviation risks. For 2003 we reinsured Syndicate 2020 for all its lines of business but not Syndicate 3030. Our quota share reinsurance of Syndicate 2020 did not continue into 2004 and the quota share of Syndicate 3030 did not continue after 2002.
However, the year also benefited from a release of $34.6 million of prior year releases as discussed above under "Critical Accounting Policies - Prior year loss reserves."
The commercial liability line of business consists of U.K. employers' and public liability insurance, and casualty insurance in the U.S. on a surplus lines basis.
In 2004, we also began to write marine insurance. Our marine team writes hull, liability and energy business. We began writing aviation insurance in 2005.
Losses and loss adjustment expenses. Losses and loss adjustment expenses were $170.5 million for the twelve months ended December 31, 2004 compared to $125.4 million for the twelve months
The following table summarizes gross and net written premiums and underwriting results for each of the lines of business within our insurance segment for the twelve months ended December 31, 2004 and 2003:
At December 31, 2004, Aspen Holdings had cash and cash equivalents of $19.9 million that are available to pay its operating expenses and liabilities.
As of January 1, 2004, 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 $60.0 million. This amount increased to approximately $174.7 million as of December 31, 2004.
The ability of Aspen Bermuda to pay dividends is dependent on its ability to meet the requirements of applicable Bermuda law and regulations. Under Bermuda law, Aspen Bermuda may not declare or pay a dividend if there are reasonable grounds for believing that Aspen Bermuda is, or would after the payment be, unable to pay its liabilities as they become due, or the realizable value of Aspen Bermuda's assets would thereby be less than the aggregate of its liabilities and its issued share capital and share premium accounts. Further, Aspen Bermuda, as a regulated insurance company in Bermuda, is subject to additional regulatory restrictions on the payment of dividends or distributions. As of December 31, 2004, Aspen Bermuda could pay a dividend or make a distribution out of contributed surplus totaling approximately $126.2 million without prior regulatory approval based upon the Bermuda Insurance Act and the Bermuda Companies Act regulations.
Aspen Re and Aspen Specialty are also subject to regulatory restrictions limiting their ability to pay dividends. As of December 31, 2004, Aspen Re could pay a dividend totaling approximately $38.4 million without prior regulatory approval based upon the FSA and the Companies Act regulations. Aspen Specialty could pay a dividend without regulatory approval of approximately $10.1 million. For a discussion of the various restrictions on our ability and our Insurance Subsidiaries' ability to pay dividends, see "Business-Regulatory Matters" in Part I, Item 1 in this report.
As of December 31, 2004, the Insurance Subsidiaries held approximately $793.7 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 Company by $54.1 million during the twelve months ended December 31, 2004. Management monitors the value, currency and duration of the cash and investments held by 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, 2004 and for the foreseeable future.
Cash flows for the twelve months ended December 31, 2004. Total net cash flow from operating activities in the twelve months ended December 31, 2004 was approximately $961.3 million, an increase of $324.7 million from the twelve months ended December 31, 2003. For the twelve months ended December 31, 2004, our cash flows from operations provided us with sufficient liquidity to meet our operating requirements. We paid net claims of $164.6 million in the twelve months ended December 31, 2004. We made net investments in the amount of $1,104.3 million in market securities during the period. We paid dividends of $8.3 million, and raised $249.3 million from our Senior Notes offering. At December 31, 2004, we had a cash balance of $284.9 million.
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 Part I, Item 1, "Business-Regulatory Matters-U.K. Regulation" elsewhere in this report. Aspen Re has maintained the required margin of solvency throughout 2003 and 2004 and the value of its shareholders' equity as of December 31, 2003 and 2004 was $754.0 million and $870.9 million respectively.
We are obliged by the terms of our contractual obligations to U.S policyholders and by undertakings to certain U.S. regulatory authorities to facilitate the issue of letters of credit or maintain certain balances in trust funds for the benefit of policyholders. Our current arrangements with our bankers for the issue of letters of credit require us to provide cash collateral for the full amount of all undrawn letters of credit that are outstanding. We monitor the proportion of our otherwise liquid assets that are committed to trust funds or to the collateralization of letters of credit. As at December 31, 2003, these funds amounted to 10% of the $1.8 billion of cash and investments held by the Company. As at December 31, 2004, these funds amounted to 20% of $3.02 billion of cash and investments held by the Company. We do not consider that this unduly restricts our liquidity at this time.
December 31, 2004 was Can$55.0 million. In addition, Aspen Specialty has a total of $7.4 million ($4.7 million December 31, 2003) on deposit with 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 (as amended to the date of this report, the "Credit Agreements") provide for customary covenants, as well as covenants which require the Company to (i) maintain a ratio of consolidated debt to consolidated debt plus consolidated tangible net worth of no greater than 30% as at the last day of any period of four consecutive fiscal quarters of the Company; (ii) maintain consolidated tangible net worth at all times of no less than the sum of (a) $700 million, (b) 100% of the first $200 million of net cash proceeds of the issuance by the Company of ordinary shares after the closing date of the Credit Facilities and (c) 50% of the net cash proceeds of all other issuances by the Company of ordinary shares after the closing date; and (iii) maintain a solvency ratio (as defined in the Credit Agreements) for each of the Company and any insurance subsidiary which is a Material Subsidiary (as defined below) on the last day of any period of four consecutive fiscal quarters of no more than 135%. A subsidiary is a Material Subsidiary if (i) the total consolidated assets or total consolidated revenues of it and its subsidiaries exceed 10% of the total assets or gross revenues of the Company 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 (ii) 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 December 15, 2003, $50 million of the loan was repaid following receipt of funds from our initial public offering. We have repaid the remaining $40 million in principal amount due with a portion of the net proceeds from the offering of $250,000,000 in aggregate principal amount of our Senior Notes due 2014.
On August 16, 2004, we closed our offering of the Senior Notes under Rule 144A and Regulation S under the Securities Act. The Senior Notes are due in 2014 and have an interest rate of 6.00% per annum. We also have granted and agreed certain customary exchange and shelf registration rights (the "Notes Registration Rights Agreement") to noteholders under the terms of the Senior Notes. The gross proceeds from the Senior Notes offering were $249.3 million. A portion of the proceeds of the offering was used to repay $40 million in principal amount of outstanding borrowings under our existing credit facilities. Subsequently, in November 2004, we contributed a further $250 million to Aspen Bermuda, which was partly funded from the proceeds of the Senior Notes offering.
Under the Notes Registration Rights Agreement, we agreed to file a registration statement for the Senior Notes and cause its effectiveness within prescribed periods, and consummate the exchange offer within 45 days after the date the registration statement becomes effective. We filed the registration statement and caused its effectiveness within those prescribed periods. The exchange offer commenced on March 3, 2005.
The Senior Notes outstanding were the only material debt that we had outstanding at December 31, 2004. Management monitors the ratio of debt to total capital, with total capital being defined as shareholders' equity plus outstanding debt. At December 31, 2004 this ratio was 14.4% (as of December 31, 2003-3%). Management considers this to be well under the level at which it would expect rating agencies or customers to be concerned about excessive financial leverage.
On February 4, 2005, we filed a universal shelf registration statement on Form with the SEC for the issuance and sale of up to $300 million of debt and/or equity securities from time to time. The registration statement was declared effective on March 3, 2005 and is expected to allow us access to the public capital markets to the extent the need arises. Also included in the registration statement were 52,998,036 ordinary shares which may be offered for sale by our shareholders. We will not receive any proceeds from sales by our shareholders but may have to pay related expenses.
The following table summarizes our contractual obligations other than our obligations to employees, under long-term debt, operating leases and reserves relating to insurance and reinsurance contracts as of December 31, 2004:
In estimating the time intervals into which payments of our reserves for losses and loss adjustment expenses fall, as set out above, we have utilised actuarially assessed payment patterns. By the nature of the insurance and reinsurance contracts under which these liabilities are assumed, there can be no certainty that actual payments will fall in the periods shown and there could be a material acceleration or deceleration of claims payments depending on factors outside our control. This uncertainty is heightened by the short time in which we have operated, thereby providing limited Company-specific claims loss payment patterns. The total amount of payments in respect of our reserves, as well as the timing of such payments, may differ materially from our current estimates for the reasons set out above under "Critical Accounting Policies - Reserves for Losses and Loss Expenses".
On October 19, 2004, Aspen Re entered into a new lease for office space in London of approximately a total of 49,500 square feet covering three floors. The term of each lease for each floor commenced in November 2004 and runs for 15 years. Service charges of approximately £0.5 million per annum are payable from this date, and are subject to increase. It is expected that we will begin to pay the yearly basic rent of approximately £2.7 million per annum 36 months after the relevant date of practical completion of the landlord's works. The basic annual rent for each of the leases will each be subject to 5-yearly upwards-only rent reviews. There are no contractual provisions in any of the leases allowing us to terminate any of the leases prior to expiration of the 15-year contractual terms.
Reference is made to Part IV, 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.