We also have entered into leases for office space in locations of our subsidiary operations. These locations include Boston, Massachusetts; Rocky Hill, Connecticut; Alpharetta, Georgia; Scottsdale, Arizona; Pasadena, California; Manhattan Beach, California and Atlanta, Georgia in the U.S. Our international offices for our subsidiaries include locations in Paris, Zurich, Singapore and Dublin.
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 twelve months ended December 31, 2008, 2007, 2006, 2005 and 2004 and the balance sheet data as of December 31, 2008, 2007, 2006, 2005 and 2004 are derived from our audited consolidated financial statements. The consolidated financial statements as of December 31, 2008, and for each of the twelve months ended December 31, 2008, 2007 and 2006, and the report thereon of KPMG Audit Plc, an independent registered public accounting firm, are included elsewhere in this report. 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.
Book value per ordinary share is based on total shareholders’ equity, excluding the aggregate value of the liquidation preferences of our preference shares, divided by the number of shares outstanding of 69,315,099, 95,209,008, 87,788,375, 85,510,673 and 81,506,503 at December 31, 2004, 2005, 2006, 2007 and 2008, respectively. In calculating the number of shares outstanding as at December 31, 2007 for this purpose, we have deducted shares delivered to us and canceled on January 22, 2008 pursuant to our accelerated share repurchase agreement.
The following is a discussion and analysis of the results of our operations for the twelve months ended December 31, 2008, 2007 and 2006 and of our financial condition at December 31, 2008. This discussion and analysis should be read in conjunction with our audited consolidated financial statements and accompanying Notes included in this report. This discussion contains forward-looking statements that involve risks and uncertainties and that are not historical facts, including statements about our 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,” “Business” and “Forward-Looking Statements” contained in Item 1A, Item 1, and Part I of this report, respectively.
The following overview of our 2006, 2007 and 2008 operating results and financial condition is intended to identify important themes and should be read in conjunction with the more detailed discussion further below.
Net income. For 2008, we reported income after taxes of $103.8 million, a $385.2 million reduction over the prior year. The reduction is due to a combination of adverse underwriting performance mainly arising from losses of $171.4 million, net of reinsurance recoveries, reinstatement premiums and tax following Hurricanes Ike and Gustav and adverse investment performance due to the turmoil in the financial markets which has resulted in losses of $97.3 million from our investment in funds of hedge funds and $59.6 million of investment impairment charges. This contrasts with 2007 which was not impacted by any significant catastrophic events while enjoying significant positive returns.
The increase in gross written premiums in 2008 was driven by a $207.9 million contribution from new underwriting teams in international insurance established in the final quarter of 2007 and during 2008. This was offset by premium reductions in a number of our established lines, in particular property treaty catastrophe, property treaty risk excess, international casualty treaty reinsurance and U.K. commercial liability insurance. We wrote less business in 2007 than in 2006 as a result of a number of factors, including: a less favorable pricing environment in many lines of business, in particular property catastrophe reinsurance, casualty treaty reinsurance, and U.K. commercial liability insurance and the re-positioning of our U.S. excess and surplus lines property insurance business. Gross written premiums in our casualty reinsurance segment were also reduced in 2007 by the relocation of our casualty facultative business from our Marlton, New Jersey office to Rocky Hill, Connecticut and a change in underwriting approach.
Reinsurance. Total reinsurance ceded in the year ended December 31, 2008 of $166.2 million was $50.9 million lower than in the corresponding period in 2007. The overall reduction was due to our ability to take advantage of favorable pricing conditions in 2007 which enabled us to purchase a number of reinsurance contracts covering a period of greater than 12 months, effectively covering the 2008 windstorm season. Costs in 2008 have also been impacted by the recognition of $13.0 million of additional reinsurance premiums to reinstate cover from our reinsurance program following Hurricane Ike. Reinsurance costs in 2007 decreased by $64.8 million compared to 2006 as we reduced our reliance on outwards reinsurance, in line with our reduction in exposure in property reinsurance.
Loss ratio. 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
The net loss ratio for the twelve months ended December 31, 2008 of 65.8% is 12.7 percentage points higher than the loss ratio for the same period in 2007 and 2006.
In 2008, the international insurance segment suffered from $45.7 million of net losses and $9.9 million of net additional reinstatement costs following Hurricanes Ike and Gustav, increasing the loss ratio by 7.9 percentage points. The 2008 loss ratio was also impacted by a net reserve strengthening of $3.9 million, due to adverse prior year deterioration in respect of California wildfires and also from shipowners’ liability, both in our marine and energy liability lines, compared to an $80.8 million reserve release in 2007. In 2007 compared to 2006 the international insurance segment included some moderate-sized losses in both the marine and aviation books, offset by prior year releases within the U.K. commercial liability account.
Expense ratio. 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 table below presents the contribution of the policy acquisition expenses and operating and administrative expenses to the expense ratio and the total expense ratios for the twelve months ended December 31, 2008, 2007 and 2006:
Policy acquisition expenses have decreased from $313.9 million in 2007 to $299.3 million in 2008, due primarily to a $10.6 million reduction in profit commissions payable to policyholders. The reduction in policy acquisition expenses in 2007 was largely due to the impact of the reduction in our reinsurance purchases.
Operating and administrative expenses increased by $3.3 million when compared to 2007, due mainly to a $6.8 million rise in costs in our international insurance segment resulting from our entry into new business lines, which was partially offset by a reduction in performance-related remuneration and a weakening of the British Pound against the U.S. Dollar.
Investment income. In 2008, we generated net investment income of $139.2 million, down 53.4% on the prior year (2007 - $299.0 million, 2006 - $204.4 million). The reduction was mainly due to losses from our investments in funds of hedge funds, which contributed a gain of $44.5 million in 2007 compared to a loss of $97.3 million in 2008. Net investment income increased by 46.3% in 2007 when compared to 2006 driven by rising interest rates, fixed income sector allocation changes translating into higher book yields and increases in total cash and investment balance. Our fixed income portfolio book yield reduced to 4.6% at December 31, 2008 from 5.1% at the end of 2007 (2006 - 4.5%). Total cash and investments increased from $5.9 billion at the start of 2008 to $6.0 billion at year-end (2006 - $5.2 billion). The fixed income portfolio duration decreased from 3.4 years to 3.1 years (2006 - 3.0 years) and the average credit quality of our fixed income book is “AAA”, with 88% of the portfolio being graded “AA” or higher. The average credit quality of our fixed income investment portfolio was “AA+” at the end of 2007 and “AAA” at the end of 2006.
The allocation to funds of hedge funds reduced from 9.5% of the portfolio to 5.0% at the end of 2008. These alternative investments produced an 11.4% annualized return in 2007, compared with a 17.0% annualized loss in 2008.
Change in fair value of derivatives. In the twelve months ended December 31, 2008, we recorded a reduction in the fair value of derivatives of $7.8 million (2007 - $11.4 million reduction; 2006 - $12.3 million reduction). This included a reduction of $7.8 million (2007 - $9.0 million; 2006 - $Nil) in the estimated fair value of our credit insurance contract. In the twelve months ended December 31, 2007, a charge of $2.4 million for a catastrophe swap which expired on August 20, 2007 was also included (2006 - $12.3 million).
In addition, at December 31, 2008 we held foreign currency derivative contracts to purchase $18.8 million of U.S. and foreign currencies. The foreign currency contracts are recorded as derivatives at fair value with changes recorded as a realized foreign exchange gain or loss in our statement of operations. For the twelve months ended December 31, 2008, the impact of foreign currency contracts on net income is a loss of $0.8 million (2007 - loss of $2.4 million; 2006 - $Nil). Further information on these contracts can be found in Notes 8 and 9 to the financial statements.
Other revenues and expenses. Other revenues and expenses in 2008 included $8.2 million of foreign currency exchange losses (2007 - $20.6 million gains; 2006 - $9.5 million gains) and $47.9 million of realized investment losses (2007 - $13.1 million; 2006 - $8.0 million). The increase in realized investment losses in 2008 was due to $59.6 million of charges associated with investments we believe to be other-than-temporarily impaired (2007 - $Nil; 2006 - $Nil) which were offset by $11.7 million of realized gains resulting from the sale of investments in the ordinary course of business. Interest payable was $15.6 million in 2008 (2007 - $15.7 million; 2006 - $16.9 million).
In addition to our holdings in Lehman Brothers, we recognized other-than-temporary impairments for several other securities in our investment portfolio. While such securities retained their investment grade ratings and timely continuation of interest and principal payments, they were priced at a significant discount to cost. Notwithstanding our intent and ability to hold these securities until maturity, and despite structures that indicate that a substantial amount of the securities should continue to perform in accordance with original terms, we could not assert that the recovery period would be temporary under the current accounting standards.
Dividends paid on the preference shares in 2006 were $15.6 million and the full amounts payable and paid annually in each of 2007 and 2008 were $27.7 million.
Shareholders’ equity and financial leverage. Total shareholders’ equity reduced from $2,817.6 million at the end of 2007 to $2,779.1 million as of December 31, 2008. The most significant movements were:
As at December 31, 2008, the remainder of our total shareholders’ equity was funded by two classes of preference shares with a total value as measured by their respective liquidation preferences of $430 million (2007 - $430 million) less issue costs of $10.8 million (2007 - $10.8 million).
The amounts outstanding under our senior notes were the only material debt that we had outstanding as of December 31, 2007 and 2008. Management monitors the ratio of debt to total capital, with total capital being defined as shareholders’ equity plus outstanding debt. At December 31, 2008, this ratio was 8.2% (2007 - 8.1%; 2006 - 9.4%).
Liquidity. Management monitors the liquidity of Aspen Holdings and of each of its Insurance Subsidiaries. With respect to Aspen Holdings, management monitors its ability to service debt, to finance dividend payments and to provide financial support to the Insurance Subsidiaries. During the period
ended December 31, 2008, Aspen Holdings received a $25.0 million dividend payment from Aspen Bermuda and a $36.5 million payment of inter-company interest in respect of an inter-company loan and a $45.0 million dividend from Aspen U.K. Holdings.
As at December 31, 2008, Aspen Holdings held $32.4 million in cash and cash equivalents which, taken together with our credit facilities and expected levels of future inter-company dividends, management considered sufficient to provide us with an appropriate level of liquidity.
At December 31, 2008, the Insurance Subsidiaries held $777.2 million in cash and cash equivalents that are readily realizable securities. Management monitors the value, currency and duration of the cash and investments within its Insurance Subsidiaries to ensure that they are individually 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, 2008 and for the foreseeable future.
As of December 31, 2008, we had in issue $331.4 million and £120.1 million in letters of credit to cedants, against which we held $604.6 million and £25.3 million of collateral. Our reinsurance receivables decreased by 7.0% from $304.7 million at December 31, 2007 to $283.3 million at December 31, 2008, mainly as a result of amounts received from our reinsurers in respect of 2005 hurricane claims. The reduction in recoveries associated with the 2005 hurricanes was offset by the recognition of $61.3 million in 2008 for recoveries from Hurricanes Ike and Gustav.
Property Reinsurance. Our property reinsurance segment is experiencing significant rate increases for U.S. peak zone catastrophe contracts with rates rising by 20% or more on renewals at January 1, 2009. We expect this upwards trend to continue throughout 2009. Rate increases on regional U.S. business, however, have seen more moderate increases. Accounts that include European wind exposure experienced rate increases of 5-10% on average. Rates on European business that is not exposed to wind perils have not moved significantly from those encountered at the end of 2007.
Casualty Reinsurance. Our U.S. casualty reinsurance business has encountered early signs of rate increases in the January 1 renewals. General and umbrella liability lines have reversed their mid-2008 double digit rate declines to a smaller single digit decrease or a flat renewal. High levels of competition continue on certain more attractive and loss free accounts, however terms and conditions continue to be reasonable. International casualty reinsurance has seen rate increases between 5% and 10% depending on the class of business and loss experience. Terms and conditions were broadly steady with small improvements. We recorded an average rate increase of 3% on renewal business across our international casualty line.
U.S. Insurance. In U.S. property insurance, rates continue to vary between 10% above and 10% below expiring premium however there are some exceptions outside of this range. For larger property accounts requiring a number of market participants, rate increases between 5% and 10% have been achieved. Property rates remain heavily bi-furcated between business exposed to catastrophes and those that are not, with the former more likely to see increases. In U.S. casualty insurance, we maintained our
In February 2009, we gave notice of redemption to our funds of hedge funds managers in respect of the remaining $286.9 million of our alternative investments. The earliest date at which these notices will take effect is June 30, 2009 and we will remain exposed to changes in the net asset value of the funds until at least that date.
premium is usually a small portion of the total premium receivable. For excess of loss contracts, the minimum and deposit premium, as defined in the contract, is generally considered to be the best estimate of the contract’s written premium at inception. Accordingly, this is the amount we generally record as written premium in the period the underlying risks incept. During the life of a contract, notifications from cedants and brokers may affect the estimate of ultimate premium and result in either increases or reductions in reported revenue. Changes in estimated adjustable premiums do not generally have a significant impact on short-term liquidity as the payment of adjustment premiums generally occurs after the expiration of a contract.
Proportional treaties (“treaty pro rata”). Estimates of premiums assumed under treaty pro rata reinsurance contracts are recorded in the period in which the underlying risks are expected to incept and are based on information provided by brokers and ceding companies and estimates of the underlying economic conditions at the time the risk is underwritten. We estimate premium receivable initially and update our estimates regularly throughout the contract term based on treaty statements received from the ceding company.
The segment for which treaty pro rata is most relevant is our property reinsurance segment in which we wrote $174.7 million in gross written premium in 2008 (2007 - $145.2 million) or 29.7% of our property reinsurance segment, of which $26.0 million was estimated (2007 - $31.0 million) and $148.7 million was reported by the cedants (2007 - $114.2 million). We estimate that the impact of a $1 million change in our estimated gross premiums written in our property treaty pro rata business would have an impact of $0.1 million on our net income before tax for our property reinsurance segment at December 31, 2008 (2007 - $0.2 million), excluding the impact of fixed costs such as reinsurance premiums and operating expenses.
We anticipate that ultimate premiums might reasonably be expected to vary by up to 5% as a result of variations in one or more of the assumptions described above, although larger variations are possible. Based on gross written premiums of $174.7 million in our property reinsurance treaty pro rata account as of December 31, 2008, a variation of 5% could increase or reduce net income before taxation by approximately $0.8 million.
The premium related to the unexpired portion of each policy at the end of the reporting period is included in the balance sheet as unearned premiums.
Premiums receivable. Premiums receivable are recorded as amounts due less any required provision for doubtful accounts. A significant portion of amounts included as premiums receivable, which represent estimated premiums written, net of commissions, is not currently due based on the terms of the underlying contracts. In determining whether or not any bad debt provision is necessary, we consider the financial security of the policyholder, past payment history and any collateral held. We have not made a provision for doubtful accounts in relation to assumed premium estimates. In addition, based on the above process, management believes that the premium estimates included in premiums receivable will be collectable and, therefore, we have not maintained a bad debt provision for doubtful accounts on the premiums at December 31, 2008.
As a result of the application of derivative accounting rules under SFAS 133, the contract is treated as an asset and measured at the directors’ estimate of its fair value. Changes in the estimated fair value from time to time will be included in the consolidated statement of operations. The contract is for a maximum of five years and provides 90% cover for a named panel of reinsurers up to individual defined sub-limits. The contract does allow, subject to certain conditions, for substitution and replacement of panel members if our panel of reinsurers changes. Payments are made on a quarterly basis throughout the period of the contract based on the aggregate limit, which was set initially at $477 million but is subject to adjustment.
Reserving approach. We take all reasonable steps to ensure that we have appropriate information regarding our claims exposures. However, given the uncertainty in establishing claims liabilities, it is likely that the final outcome will prove to be different from the original provision established. Prior to the selection by management of the reserves to be included in our financial statements, our actuarial
Sources of information. Claims information received typically includes the loss date, details of the claim, the recommended reserve and reports from the loss adjusters dealing with the claim. In respect of pro rata treaties we receive regular statements (bordereaux) which provide paid and outstanding claims information, often with large losses separately identified. Following widely reported loss events such as natural catastrophes and airplane crashes we adopt a proactive approach to establish our likely exposure to claims by reviewing policy listings and contacting brokers and policyholders as appropriate.
A higher degree of uncertainty is associated with setting reserves for reinsurance business owing to the longer reporting pattern and time to final settlement. Where IBNR is based on an analysis of past loss experience, the principal assumption is that past patterns of development are a reasonable proxy for current business after allowance for any changes in underlying mix of business. The process of extrapolation is by necessity one involving subjective judgment because the actuary has to take into account the impact of the changing business mix as well as changes in legislative conditions, changes in judicial interpretation of legal liability policy coverages and inflation. These factors are incorporated in the actuarial range.
Actuarial range of gross reserves. The following table sets out the actuarial range of gross reserves for each of our segments and compares it to management’s selected best estimate as at December 31, 2008.
Investments. We currently classify all of our fixed maturity investments and short-term investments as “available for sale” and, accordingly, they are carried at estimated fair value. The fair value of fixed maturity securities is estimated using quoted market prices or dealer quotes. For mortgage-backed and other asset-backed debt securities, fair value includes estimates regarding prepayment assumptions, which are based on current market conditions. Amortized cost in relation to these securities is calculated using a constant effective yield based on anticipated prepayments and estimated economic lives of the securities. When actual prepayments differ significantly from anticipated prepayments, the effective yield is recalculated to reflect actual payments to date. Changes in estimated yield are recorded on a retrospective basis, which result in future cash flows being used to determine current book value.
Although gross written premiums reduced by 6.5% in 2007 compared to 2006, net premiums written decreased by only 3.7% because ceded written premiums reduced by $64.8 million reflecting our reduced reliance on outwards reinsurance relative to 2006.
The largest percentage increase in 2007 compared to 2006 related to our property reinsurance segment and was driven primarily by reduced spending on ceded reinsurance following our decision to reduce our gross exposures.
Losses and loss adjustment expenses. In 2008, we suffered $200.2 million of losses from Hurricanes Ike and Gustav before reinstatements and tax, a $49.7 million provision against potential losses as a result of the ongoing financial crisis, a $15.7 million loss from a French pollution claim and a deterioration of $15.3 million related to California wildfires occurring in 2007. Whereas, in 2007, we suffered total losses of a smaller magnitude with a $30.1 million loss from windstorm Kyrill, $35.0 million loss from sub-prime related exposures, a $28.7 million loss from the June and July U.K. floods, an $18.1 million loss from the California wildfires, a $14.0 million marine loss resulting from a shipping collision and a $10.1 million loss from an air crash in Brazil. In 2006, we had no significant loss events, although we recognized a deterioration of $66.0 million in our 2005 hurricane loss estimates. Further information relating to movements in prior year reserves can be found below under “Reserves for Loss and Loss Adjustment Expenses.” Our insurance losses and loss adjustment expenses included paid claims of $739.4 million in 2008, $695.6 million in 2007 and $469.7 million in 2006.
Gustav contributed 25.6 percentage points to the loss ratio in property reinsurance. Prior year adjustments are discussed further in the “Reserves for Losses and Loss Adjustment Expenses” below.
Total includes 3.9% of increased KRW reserves ($66.0 million) although this is partially offset elsewhere in the 2006 income statement by additional net earned premiums of $14.1 million.
Expenses. We monitor the ratio of expenses to gross earned premium (the “gross expense ratio”) as a measure of the cost effectiveness of our business acquisition, operating and administrative processes. The table below presents the contribution of the policy acquisition expenses and operating and administrative expenses to the gross expense ratios and the total net expense ratios for the twelve months ended December 31, 2008, 2007 and 2006. We also show the effect of reinsurance purchased which impacts the reported net expense ratio by expressing the expenses as a proportion of net earned premiums.
attributable to our investment in new business lines offset by a reduction in accruals for bonus and long-term incentive charges, in addition to a weakening of the British Pound against the U.S. Dollar.
Changes in the acquisition and operating expense ratios to gross earned premiums, and the impact of reinsurance on net earned premiums by segment for each of the twelve months ended December 31, 2008, 2007 and 2006 are shown in the following tables:
Net investment income. Net investment income consists primarily of interest on fixed income securities and cash, and the change in the value of funds of hedge funds investments, and is stated after deduction of expenses relating to the management of our investments. The allocation to funds of hedge funds reduced from 9.5% of the portfolio to 5.0% at year-end as a result of the redemption of $177.2 million of these alternative investments at December 31, 2008.
remaining decrease in investment income resulted from lower reinvestment yields due to a reduction of interest rates, particularly in the second half of 2008.
In addition to our holdings in Lehman Brothers, we recognized provisions for other than temporary impairments of several other securities in our investment portfolio that were not in default at December 31, 2008. While such securities retained their investment grade ratings and timely continuation of interest and principal payments, they were priced at a significant discount to cost. Notwithstanding our intent and ability to hold these securities until maturity, and despite structures that indicate that a substantial amount of the securities should continue to perform in accordance with original terms, we could not assert that the recovery period would be temporary under the current accounting standards.
Income/(loss) before tax. In 2008, income before tax was $140.2 million and comprised $74.8 million of underwriting profit, $139.2 million in net investment income, $8.2 million of net exchange losses, $15.6 million of interest payable, $47.9 million of realized investment losses and $2.1 million of changes in the fair value of derivatives and other expenses. In 2007, income before tax was $574.0 million and comprised $295.1 million of underwriting profit, $299.0 million in net investment income, $20.6 million of net exchange gains, $15.7 million of interest payable, $13.1 million of realized investment losses and $11.9 million of changes in the value of derivatives and other expenses. The significant reduction in income in 2008 compared to 2007 was due principally to the impact of investment losses as a result of the financial crisis and a smaller underwriting profit due to greater losses incurred in the year, including losses from Hurricane Ike. In 2006, income before tax was $470.4 million and comprised $295.6 million of underwriting profit, $204.4 million in net investment income, $9.5 million of net exchange gains, $16.9 million of interest payable and $22.2 million of other expenses.
The increase in income in 2007 compared to 2006 was driven by the increase in investment income due to the recognition of $44.5 million of gains from our investment in funds of hedge funds.
Income tax expense. Income tax expense decreased to $36.4 million in 2008 from $85.0 million in 2007 and $92.3 million in 2006. The effective tax rate in 2008 was 26.0% compared to 14.8% in 2007 and to 19.6% in 2006. The increase in tax rate for 2008 was mainly driven by the distribution of insurance and investment-related losses within the group in the fourth quarter of 2008. The decrease in effective tax rate for 2007 compared to 2006 was due to a greater portion of the Company’s profits being derived from our Bermudian operations.
Management measures segment results on the basis of the combined ratio, which is obtained by dividing the sum of the losses and loss expenses, acquisition expenses and operating and administrative expenses by net premiums earned. Indirect operating and administrative expenses are allocated to segments based on each segment’s proportional share of gross earned premiums. As a relatively new company, our historical combined ratio may not be indicative of future underwriting performance. We do not manage our assets by segment; accordingly, investment income and total assets are not allocated to the individual segments.
The following tables summarize gross and net premiums written and earned, underwriting results, and combined ratios and reserves for each of our four business segments for the twelve months ended December 31, 2008, 2007 and 2006.
Losses and loss adjustment expenses. The net loss ratio for 2008 was 59.1% compared to 39.7% in 2007 due to the recognition of $140.5 million, net of recoveries, of Hurricanes Ike and Gustav losses partially mitigated by a $23.6 million increase in prior year releases compared to 2007. The segment has also experienced a high incidence of risk losses which have contributed to the increase in the loss ratio. In 2007, the loss ratio decreased to 39.7% from 43.2% in 2006. In 2007, the property reinsurance segment suffered from a series of modest catastrophe losses, including: $25.5 million from windstorm Kyrill, $28.7 million from the June and July U.K. flood and $18.1 million of losses from the California wildfires. Prior year reserve movements increased the 2007 loss ratio by 2.2 percentage points from 37.5% which is broadly in line with the loss ratio in 2006.
Policy acquisition, operating and administrative expenses. Policy acquisition expenses have reduced by $12.4 million in 2008 mainly due to the reduction in written premiums. The acquisition expense ratio has also decreased due to the reduction in ceded earned premiums in the year as we have continued our reduced reliance on reinsurance. Operating and administrative expenses have remained static year on year; however, our underlying cost base in 2008 has increased due to the operating costs of our Zurich branch and through incremental salary increases which have been offset by reductions in performance-related compensation. Total expenses in 2007 increased by 2.4% to $182.7 million from
Our casualty reinsurance segment is written mainly on a treaty basis with a small proportion of facultative risks. The casualty treaty reinsurance is primarily written 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 cedants located mainly in the United States, the United Kingdom, Europe and Australia. We also write some structured reinsurance contracts out of Aspen Bermuda. For a more detailed description of this segment, see Part I, Item 1, “Business - Business Segments - Casualty Reinsurance.”
Losses and loss adjustment expenses increased by $46.5 million in 2007 compared to 2006 due mainly to the recognition of $35.0 million of losses from U.S. sub-prime exposures. This comprised $20.0 million of reserves in addition to $15.0 million of losses resulting from our normal expectations of reserving within this segment. The loss ratio for casualty reinsurance increased by 4.3 percentage points to 69.9% in 2007 from 58.3% in 2006, as a result of these sub-prime related losses. The loss ratio was also impacted by a reduction in prior year reserve releases from $60.3 million in 2006 to $31.8 million in 2007.
Our international insurance segment mainly comprises marine hull, marine and specialty liability, energy, non-marine transportation liability, aviation, professional liability, excess casualty, financial institutions, financial and political risk, management and technology liability, U.K. commercial property (including construction) and U.K. commercial liability insurance. The commercial liability line of business consists of U.K. employers’ and public liability insurance. Our specialty reinsurance lines of business include aviation, marine and other specialty reinsurance. For a more detailed description of this segment, see Part I, Item 1, “Business - Business Segments - International Insurance.”
$3.1 million mainly due to energy property insurance which experienced reducing rates until the September hurricanes and U.K. commercial liability insurance due to continuing rate pressure. Gross written premiums have also been adversely impacted by exchange rate movements between the British Pound and the U.S. Dollar. The decrease in gross written premiums in 2007 of 3.0% over 2006 was due to a number of factors including the then prevailing less favorable pricing environment in some lines of business, in particular the aviation and U.K. commercial liability insurance classes. This was partially offset by increases in premiums from the energy insurance business.
Operating and administrative expenses increased by $7.2 million compared to 2007 mainly due to increases in personnel costs associated with the establishment of our Dublin branch, direct costs of the new underwriting teams and our entry into Lloyd’s. This was partially offset by a reduction in accruals for performance-related compensation and favorable movements in the exchange rate between the U.S. Dollar and British Pound applied to Sterling denominated expenses.
Gross written premiums decreased by 20.2% in 2007 compared to 2006 due primarily to the repositioning of our U.S. commercial property account and the non-renewal of a number of poorly performing contracts.
Fixed maturities. At December 31, 2008 the average credit quality of our fixed income book is “AAA,” with 96% of the portfolio being graded “A” or higher. At December 31, 2007 the average credit quality of our fixed income book was “AA+”, with 89% of the portfolio being graded “A” or above.
Our fixed income portfolio duration decreased marginally from 3.4 years in 2007 to 3.1 years during 2008.
Other-than-temporary impairment. We review all of our fixed maturities and short term investments for potential impairment each quarter based on criteria including issuer-specific circumstances, credit ratings actions and general macro-economic conditions. The process of determining whether a decline in value is “other-than-temporary” requires considerable judgment. As part of the assessment process we also evaluate our ability and intent to hold any fixed maturity security in an unrealized loss position until its market value recovers to amortized cost. Once a security has been identified as other-than-temporarily impaired, the amount of any impairment is determined by reference to that security’s estimated fair value and recorded as a charge to realized losses included in earnings.
For a discussion of our valuation techniques within the fair value hierarchy of SFAS 157, please see Note 6 of the audited financial statements for the twelve months ended December 31, 2008 included elsewhere in this report.
Reserves by segment. The following presents our loss reserves by business segment as at December 31, 2008 and 2007:
The gross reserves may be further analyzed between outstanding or reported claims and IBNR as at December 31, 2008 and 2007, as follows:
Prior year loss reserves. In the twelve months ended December 31, 2008, 2007 and 2006, there was an overall reduction of our estimate of the ultimate claims to be paid. An analysis of this reduction by segment is as follows:
Property Reinsurance: The $12.1 million reserve release in this segment was predominantly due to favorable development on the catastrophe line of business. The most significant elements related to reductions in loss estimates for the 2007 U.K. floods and estimated recoveries from enforcing subrogation rights in respect of California wildfires.
International Insurance. The international insurance segment has been impacted by $3.9 million of net reserve strengthening during 2008. The reserve strengthening was attributable to deterioration in respect of a loss related to the 2007 California wildfires and also from shipowner’s liability losses, both written in our marine and specialty liability account. This was partially offset by favorable development in our U.K. commercial and property lines.
Property Reinsurance. Property reinsurance deteriorated by $11.5 million in 2007, approximately $10.0 million of which was attributable to Hurricanes Katrina, Rita and Wilma. The methodology used to determine the hurricanes’ ultimate losses was to review each cedant’s position with respect to its reported claims and establish an expected IBNR utilizing information from that client. In setting our loss estimates for Hurricane Katrina, we had taken account of evolving litigation relating to coverage and quantum issues and included additional provisions where appropriate. Because of ongoing litigation, there remains significant uncertainty as to our ultimate costs of Hurricane Katrina.
Casualty Reinsurance. The lines contributing to the casualty reinsurance reserves release of $31.8 million, were $12.1 million attributed to international casualty, $31.4 million to U.S. casualty less $11.7 million of reserve strengthening for casualty facultative and structured business. Although claims in these lines may take several years to emerge, the experience to date compared with our starting loss ratios and expected patterns have generally been better than expected at the aggregate level.
Casualty Reinsurance. During 2006, the most significant contributions to the casualty reinsurance reserves release of $60.3 million, were $27.8 million attributed to international casualty and $28.6 million to U.S. casualty. Claims in these lines may take several years to emerge. Nonetheless, the experience through December 31, 2006 compared with our starting loss ratios and expected patterns have been better than expected.
International Insurance. Reserve releases of $32.7 million for international insurance were spread across several lines of which the largest contributors being U.K. commercial liability of $28.7 million,
U.S. Insurance. U.S. insurance reserves were increased by $0.8 million in 2006 due to the deterioration on the property account offsetting favorable development on the casualty account.
Management monitors the ratio of debt to total capital, with total capital being defined as shareholders’ equity plus outstanding debt. At December 31, 2008, this ratio was 8.2% (2007 - 8.1%, 2006 - 9.4%).
Our Preference Shares are classified in our balance sheet as equity but may receive a different treatment in some cases under the capital adequacy assessments made by certain rating agencies. Such securities are often referred to as ‘hybrids’ as they have certain attributes of both debt and equity. We also monitor the ratio of the total of debt and hybrids to total capital and this stands at 22.1% as of December 31, 2008 (2007 - 21.8%, 2006 - 25.3%).
On February 6, 2008, the Company’s Board authorized a new share repurchase program for up to $300 million of ordinary equity. The authorization covers the period through March 1, 2010.
On May 13, 2008, we entered into a share purchase agreement with one of the Company’s founding shareholders, Candover Investments plc, its subsidiaries and funds under management and Halifax EES Trustees International Limited, as trustees to a Candover employee trust, to repurchase a total of 4,080,800 ordinary shares for a total purchase price of $100 million. The ordinary shares were purchased and cancelled on May 18, 2008.
Liquidity is a measure of a company’s ability to generate cash flows sufficient to meet short-term and long-term cash requirements of its business operations. Management monitors the liquidity of Aspen Holdings and of each of its Insurance Subsidiaries and arranges credit facilities to enhance short-term liquidity resources on a stand-by basis.
As at December 31, 2008 and 2007, Aspen Holdings held $32.4 million and $17.9 million, respectively, in cash and cash equivalents which, taken together with dividends declared or expected to be declared by subsidiary companies and our credit facilities, management considered sufficient to provide Aspen Holdings liquidity at such time.
During the period ended December 31, 2008, Aspen Bermuda and Aspen U.K. Holdings paid Aspen Holdings dividends of $25.0 million and $45.0 million, respectively. In the twelve months ended December 31, 2007, Aspen Bermuda and Aspen U.K. Holdings paid Aspen Holdings a dividend of $125.0 million and $17.0 million respectively. Aspen Holdings also received interest of $36.5 million (2007 - $28.6 million) from Aspen U.K. Holdings in respect of an inter-company loan.
Insurance subsidiaries. As of December 31, 2008, the Insurance Subsidiaries held approximately $777.2 million (2007 - $633.5 million) in cash and short-term investments that are readily realizable securities. Management monitors the value, currency and duration of cash and investments held by its
Liquidity risks are managed by making regular forecasts of the timing and amount of expected cash outflows and ensuring that we maintain sufficient balances in cash and short-term investments to meet these estimates. Notwithstanding this policy, if these cash flow forecasts are incorrect, we could be forced to liquidate investments prior to maturity, potentially at a significant loss. Historically, we have not had to liquidate investments to maintain sufficient levels of liquidity.
U.S. reinsurance trust fund. For its U.S. reinsurance activities, Aspen U.K. has established and must retain a multi-beneficiary U.S. trust fund for the benefit of its U.S. cedants so that they are able to take financial statement credit without the need to post cedant-specific security. The minimum trust fund amount is $20 million plus a minimum amount equal to 100% of Aspen U.K.’s U.S. reinsurance liabilities, which were $939.3 million at December 31, 2008 and $810.2 million at December 31, 2007. At December 31, 2008, the total value of assets held in the trust was $1,092.5 million (2007 - $1,180.2 million).
Canadian trust fund. Aspen U.K. has established a Canadian trust fund with a Canadian bank to secure a Canadian insurance license. As at December 31, 2008, the balance held in trust was Can$203.6 million (2007 - Can$159.9 million).
Consolidated cash flows for the twelve months ended December 31, 2008. Total net cash flow from operating activities in 2008 was $530.5 million (2007 - $774.0 million), a reduction of $243.5 million from 2007 due largely to an increase in claims payments. For the twelve months ended December 31, 2008, our cash flows from operations provided us with sufficient liquidity to meet our operating requirements. We paid net claims of $739.4 million in 2008 and made net investments in the amount of $255.3 million in market securities during the period. We paid ordinary and preference share dividends of $77.9 million, and $100.3 million was used to repurchase ordinary shares. At December 31, 2008, we had a cash and cash equivalents balance of $809.1 million. The increase in cash is in response to volatile market conditions allowing increased flexibility to deploy cash to longer duration portfolios as we expect yields to rise and spreads to remain wide over the short-term.
Consolidated cash flows for the twelve months ended December 31, 2007. Total net cash flow from operating activities in 2007 was $774.0 million (2006 - $723.2 million), an increase of $50.8 million from 2006. For the twelve months ended December 31, 2007, our cash flows from operations provided us with sufficient liquidity to meet our operating requirements. We paid net claims of $695.6 million in 2007 and made net investments in the amount of $426.1 million in marketable securities during the period. We paid ordinary and preference share dividends of $80.7 million, and $100.3 million was used to repurchase ordinary shares. At December 31, 2007, we had a cash and cash equivalents balance of $651.4 million.
Consolidated cash flows for the twelve months ended December 31, 2006. Total net cash flow from operating activities in 2006 was $723.2 million, a reduction of $65.9 million from 2005. Net paid claims were $469.7 million in 2006 with $934.5 million of net investment in market securities during the period. We paid ordinary and preference share dividends of $71.8 million, and raised $225.4 million from preference share offerings, $200.8 million of which was used to repurchase ordinary shares. At December 31, 2006, we had a cash and cash equivalents balance of $495.0 million.
The facility can be used by any of the Borrowers to provide funding for our Insurance Subsidiaries, to finance the working capital needs of the Company and our subsidiaries and for general corporate purposes of the Company and our subsidiaries. The revolving credit facility provides for a $250 million sub-facility for collateralized letters of credit. The facility will expire on August 2, 2010. As of December 31, 2008, no borrowings were outstanding under the credit facilities, though we had $209.3 million and $84.6 million of outstanding collateralized and uncollateralized letters of credit, respectively. The fees and interest rates on the loans and the fees on the letters of credit payable by the Borrowers increase based on the consolidated leverage ratio of the Company.
The following table summarizes our contractual obligations (other than our obligations to employees, our Perpetual PIERS and our Perpetual Preference Shares) under long-term debt, operating leases and reserves relating to insurance and reinsurance contracts as of December 31, 2008:
The long term debt obligations disclosed above does not include the $15 million annual interest payable on our outstanding senior notes.
In estimating the time intervals into which payments of our reserves for losses and loss adjustment expenses fall, as set out above, we have utilized 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 relatively short time in which we have operated, thereby providing limited Company-specific
Ajax Re is a variable interest entity under the provisions of Financial Accounting Standards Board (“FASB”) interpretation No. 46(R). We have a variable interest in the entity, however we are not the primary beneficiary of the entity and therefore we are not required to consolidate its results into our consolidated financial statements. For further details on the Ajax Re transactions please see Note 8 to the audited financial statements for the twelve months ended December 31, 2008 included elsewhere in this report.
On September 15, 2008, Lehman Brothers filed for bankruptcy, which is a termination event under the swap. Ajax Re terminated the swap on September 16, 2008. As a result, without the benefit of the total return swap, the extent of the actual reinsurance cover in the event of a California earthquake provided by Ajax Re will be limited to the market value of the collateral held by Ajax Re, that in light of current financial market conditions, we expect the market value of this collateral is substantially less than the $100 million of original reinsurance cover. Nevertheless, we remain within our risk tolerances without the benefit of this reinsurance cover.
We also seek to take into account the projected impact of inflation on the likely actions of central banks in the setting of short-term interest rates and consequent effects on the yields and prices of fixed interest securities. As of February 2009, we consider that although inflation is currently low, in the medium-term there is a risk that inflation, interest rates and bond yields will rise with the result that the market value of certain of our fixed interest investments may reduce.