Everyone has noticed the never-ending soft market in insurance, and waiting for these stocks to return to book value can be like watching paint dry. But given the pick-up in catastrophic events, the general economy, and inflation expectations, maybe a turn is not too far off.

If so, Aspen Insurance Holdings is likely to perform well. The company has compounded total book value per share at 12.5% per annum from 2002 through Q4'10, most of it a soft market. It currently trades at 0.77x Q1'11 diluted book value per share, at the median low multiple over the past eight years (Aspen currently has an immaterial amount of intangible assets).

Given that this is a high quality insurance company (as we'll see below), when it re-rates we could see upside of ~25% IRR over the next couple of years.

Business Background

Aspen is a Bermuda insurer and reinsurer incorporated in May 2002 and IPO'd in December 2003. For the year 2010 business was spread into property and casualty (35% of gross written premiums), marine, energy and transportation (47.6%) and financial and professional lines (17.4%). The financial portion includes credit and default risks on project and trade transactions, political and terrorism risks, kidnap and ransom.

Insurance and reinsurance were about evenly split with insurance at 44% of GWP and reinsurance comprising 56%. A lot more detail on exposures can be found in the latest 10-K: http://www.sec.gov/Archives/edgar/data/1267395/000095012311018156/u10184e10vk.htm

ROE Targets & Reserves

The company is focused on generating ROEs better than the 3-year Treasury plus 8%. Executive compensation is tied to ROE as well, with option awards increasing as higher targets are reached. I'm not sure this is the best way to do it, but it's probably not the worst. Over the past four years ROE has averaged 13.6%.

A more relevant metric is reserve releases. An insurer with conservative underwriting will reserve more than it needs up front, and release those reserves when fewer claims come in than planned. Aspen has had reserve releases every year it's been in business (see page 23 of the above 10-K for details).

Management

It's easy to write sloppy business in insurance because losses are always in the future and premium checks are so alluring. As Buffett and Munger say, with any financial company you must really look at management's DNA. Insurance companies can easily game earnings by over or under reserving, thereby manipulating book value. Since Aspen has proven to be well reserved since its IPO, I like to know if the folks who've responsibly led the company since then are still around today. And that is indeed the case.

The executives with longest tenure are:

• Christopher O'Kane, CEO, who owns 1.3m shares (with the company since pre-IPO);
• Julian Cusack, former CFO and now CEO of Aspen Bermuda and Chief Risk Officer, with 255k shares (since pre-IPO);
• James Few, Chief Underwriting Officer with 189.5k shares (6 years);
• Brian Boornazian, CEO of Aspen Re with 153k shares (4 years)

This portion of the IPO prospectus is relevant to management quality:

Our Chief Executive Officer Christopher O'Kane and Chief Financial Officer Julian Cusack lead a team of over 50 underwriting and risk management professionals, many of whom have worked together as a team since 1996 in the insurance and reinsurance industry. Our underwriting teams apply sophisticated quantitative approaches to pricing and risk selection. For the years 1999, 2000, 2001 and 2002, the combined ratios for the Initial Lines of Business that they wrote at Syndicate 2020 were 78%, 71%, 174% (including 103 percentage points due to September 11th-related claims) and 93%, respectively, compared with average combined ratios (weighted by net premiums written) of 112%, 112%, 128% and 107%, respectively, for the Standard & Poor's Top 25 Reinsurance Groups Ranked by Net Reinsurance Premiums Written for the years 1999, 2000, 2001 and 2002.

Risks

Aspen is ready to lose up to 25% of shareholder's equity from a single catastrophic event having the probability of occurring more than once in 250 years. Since these things seem to happen much more often than expected, this may be a cause for concern. As O'Kane mentioned in the Q1 '11 conference call, the New Zealand earthquake happened on a fault line that was not part of the modeling for this particular risk, and the Japanese earthquake was of a magnitude (9) not contemplated by any insurance model. The bottom line: risk underwriting is a very imperfect science. An active hurricane season may further ding book value per share.

Potential Return

If Aspen is able to grow book value 10% per year over the next two years - which is below what it's done since the IPO, and likely given a hardening market (see catalysts, below) - then book value should increase to $44.35 per share. At book value, this would provide a 2-year IRR of 25%. Good insurance companies typically trade above book value, so there's further upside possibility. Finally, given management's stock ownership, and a market cap ~$2 bn, this company could be an attractive acquisition for a larger insurer.

Aspen's Q1 conference call had some interesting nuggets. O'Kane mentioned that one of the main model vendors released, in March, a new model for wind exposure for eastern and southeastern US. When Aspen ran this through their client portfolio, modeled losses were 50-100% greater than previously assumed. This model is used by 80% of all primary insurers. If it is widely adopted, it will dramatically increase the capital requirements and pricing across the industry.

As a result of Q1's catastrophe losses and the aforementioned model changes, Aspen expects up to 35% of the business it intends to write this year could be subject to "meaningful positive price change."

?   Inflation expectations should push up renewal rates

?   Pick-up in the economy leads to more underwriting demand

?   Higher interest rates provide more investment income

?   Industry consolidation / acquisitions (or getting acquired)