(Loss) income before cumulative effect of accounting change and convertible preferred share dividends
Ratio of earnings to combined fixed charges and convertible preferred share dividends (3)
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within the scope of the statement as a liability or an asset in some circumstances. PXRE adopted this statement during the quarter ended September 30, 2003, however, due to certain parts of this statement being deferred by the FASB, the adoption of this statement did not have any impact on PXRE’s Consolidated Financial Statements, financial position or results of operations until the quarter ended March 31, 2004. Accordingly, as of 2004, PXRE’s capital trust pass-through securities were reclassified on its Consolidated Balance Sheet to liabilities and entitled “Subordinated debt.” In PXRE’s Consolidated Statements of Operations and Comprehensive Operations for the years ended December 31, 2005 and 2004, the interest expense related to these securities was included with “Interest expense,” whereas for the years ended December 31, 2003, 2002, 2001 it was included with “Minority interest in consolidated subsidiaries” as SFAS 150 did not permit these changes to be made retroactively.
Our counterparty credit and financial strength ratings were downgraded by the major rating agencies in February 2006 to a level that is generally unacceptable to many of our reinsurance clients. This ratings downgrade is expected to have a significant negative impact on our future results of operations and profitability. In light of the potential negative consequences of the rating downgrade, our Board of Directors has decided to explore strategic alternatives for PXRE and has retained Lazard as a financial advisor to assist in this process.
There are many possible alternatives that we are exploring which include, among others, a sale of PXRE or a sale of certain or substantially all of our assets to, or a merger with, one or more other companies, and our Board of Directors has not excluded any possibility from consideration. The Board of Directors is also considering a variety of alternate business strategies. If our Board of Directors concludes that no other alternative would be in the best interests of our shareholders, it may determine that the best alternative is to place PXRE’s reinsurance business into runoff and eventually commence an orderly winding up of PXRE operations over some period of time that is not currently determinable. If the runoff alternative is chosen, during the course of 2006 and future periods we expect to continue to pay losses and expenses as they come due and will continue to earn investment income on our investment portfolio. In pursuing any strategic alternative, the Company expects that from time to time it will enter into periods of exclusivity, for purposes of conducting diligence or otherwise investigating the merits of a particular transaction.
The implementation of any of the strategic alternatives being considered by the Board of Directors could involve substantial uncertainties and risks, including, among other things, the risk of failure in the implementation of these strategic alternatives and significant restructuring costs.
Ratings have become an increasingly important factor in establishing the competitive position of reinsurance companies. Due to these recent ratings downgrades of our reinsurance subsidiaries by A.M. Best, S&P and Moody’s, our competitive position in the reinsurance industry has suffered and it is more difficult for us to retain our reinsurance portfolio and renew many of our existing reinsurance agreements, especially since we have been downgraded from the “A” category to the “B” category. This downgrade will result in a substantial loss of business as ceding companies and brokers that place such business move to other reinsurers with higher ratings.
The foregoing discussion of our Business in Item 1 of this Annual Report on Form 10-K concerns PXRE’s business operations during 2005 and prior. As discussed above, our Board of Directors has decided to explore strategic alternatives and no assurances can be given as to what form our business will take in 2006.
As part of our year-end closing process, we reassessed our liability for claims arising from Hurricanes Katrina and Rita. As part of this year-end assessment, we determined that claims reported by clients relating to Hurricanes Katrina and Rita were significantly higher than expected, especially following a significant influx of reported claims in late November through January 2006. Our year-end assessment of Hurricane Katrina and Rita also included a review of the loss information included in the underwriting submission information provided by clients as part of the January 1, 2006 renewal process. As a result of this year-end review, we recorded an additional net liability in the fourth quarter of $238.1 million with respect to Hurricane Katrina and $48.2 million with respect to Hurricane Rita, in each case net of reinsurance recoveries on our outwards reinsurance program and the impact of inwards and outwards reinstatements and additional premiums.
A summary of the gross and net impact of Hurricanes Katrina, Rita and Wilma as of December 31, 2005 is set forth below:
Gross of reinsurance recoveries on our outwards reinsurance program and the impact of inwards and outwards reinstatements and additional premiums.
Net of reinsurance recoveries on our outwards reinsurance program and the impact of inwards and outwards reinstatements and additional premiums. No tax benefit was recorded with respect to the losses incurred from Hurricanes Katrina, Rita and Wilma as of December 31, 2005.
The new loss estimates result from the Company’s assessment of recent loss reports, as well as notifications received by the Company subsequent to the recent downgrades from two counterparties exercising their rights claimed under certain of the Company’s reinsurance contracts to cancel and commute retrocessional coverage based on ratings downgrades and material changes to the Company.
We have exhausted our retrocessional coverage with respect to Hurricane Katrina, leaving us exposed to further losses from Hurricane Katrina.
As part of our reserve review process, we retained a nationally recognized actuarial firm to perform a third party review of all of our liabilities for loss and loss adjustment expenses at December 31, 2005. As a result of our internal actuarial review and third party review, management believes that our liability for loss and loss adjustment expenses as of December 31, 2005 is adequate.
The reinsurance coverage provided by A&W I is based on a modeled loss trigger. PXRE created a series of notional portfolios of reinsurance contracts designed to closely mimic the exposures in PXRE’s assumed reinsurance portfolio. Upon the occurrence of a hurricane, windstorm or earthquake in the covered territories, the parameters of the catastrophe event are determined and modeled against the notional portfolios. If the modeled loss to the notional portfolio exceeds the attachment point for the peril at issue, then PXRE will make a recovery under the reinsurance agreement. The recovery is limited to PXRE’s ultimate net loss from the loss event. PXRE has the right to reset the notional portfolios after three years.
The second transaction was a $250.0 million collateralized transaction with Atlantic & Western Re II Limited (“A&W II”), a Cayman Island reinsurance company, which is accounted for as a derivative. It is designed to provide coverage to PXRE for second event losses in the same calendar year arising from hurricanes in the Eastern and Gulf coasts of the United States, windstorms in northern Europe and earthquakes in California. The agreement with A&W II provides two tranches of protection to PXRE for the risk that a second significant catastrophe loss arising from a hurricane in the Eastern and Gulf coasts of the United States, a windstorm in northern Europe or earthquake in California occurs following the occurrence of a first significant hurricane, windstorm or earthquake loss. The first tranche provides $125.0 million of protection from January 1, 2006 through December 31, 2006. The second tranche provides $125.0 million of protection from January 1, 2006 through December 31, 2008.
The reinsurance companies that are the counterparties to these transactions are variable interest entities under the provisions of FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46R”). The Company is not the primary beneficiary of these entities and is therefore not required to consolidate these entities in its consolidated financial statements.
The Company has also purchased additional retrocessional reinsurance coverage at various retention levels in addition to the coverage obtained in the above noted catastrophe bond transactions.
In 2005, the resulting losses of Hurricanes Charley, Frances, Ivan and Jeanne that occurred in 2004, as well as the typhoons that affected Japan in 2004, contributed to the moderate rate increases in our worldwide retrocessional business and increased or stabilized pricing in our North American property catastrophe business. We experienced moderate rate decreases in our international property catastrophe business.
We disclose our significant accounting policies in the notes to the consolidated financial statements. Several of these policies are critical to the presentation of our financial condition and results since they require management to establish estimates based on complex and subjective judgments. Our critical accounting policies include the estimation of loss and loss expenses, estimation and recognition of assumed and ceded premiums, valuation of investments and valuation of deferred tax asset.
As a property catastrophe reinsurer, incurred losses are inherently more volatile than those of primary insurers and reinsurers of risks that have an established historical pattern of losses. In addition, with respect to insured events that occur near the end of a reporting period, as well as with respect to our retrocessional book of business, the significant delay in losses being reported to insurance carriers, reinsurers and finally retrocessionaires require us to make estimates of losses based on limited information from our clients, industry loss estimates and our own underwriting data. Because of the uncertainty in the process of estimating our losses from insured events, there is a risk that our liabilities for losses and loss expenses could prove to be inadequate, with a consequent adverse impact on our earnings and shareholders’ equity in future periods.
As of December 31, 2005, our estimate of ultimate incurred gross loss and loss expenses arising from the 2005 hurricanes are $1,014.5 million, consisting of $771.0 million arising from Hurricane Katrina, $68.9 million arising from Hurricane Rita and $174.6 million arising from Hurricane Wilma.
As part of our year-end closing process, we reassessed our ultimate liability for loss and loss expenses arising from Hurricanes Katrina, Rita and Wilma. As of September 30, 2005, we had estimated that our ultimate incurred gross loss and loss expenses were $556.4 million arising from Hurricane Katrina and $20.8 million arising from Hurricane Rita. In addition, on November 9, 2005, we had announced that our preliminary estimate of the net impact from Hurricane Wilma was between $75.0 million and $90.0 million, net of reinsurance, reinstatement premiums and tax.
Our initial loss estimates for each of the hurricanes was based, in part, on insured industry loss estimates for each event, catastrophe modeling, preliminary discussions with clients and a review of potentially exposed contracts by our underwriters. In our year-end assessment of the liability for the 2005 hurricane losses, we determined that claims reported by clients relating to Hurricanes Katrina and Rita were significantly higher than expected, especially following a significant influx of reported claims from late November 2005 to February 2006. In part, the additional claims arose from a reassessment by clients of their original loss estimates for the hurricane events. For example, various clients, who advised our underwriters in the immediate wake of the hurricanes that they did not expect to experience significant losses to the reinsurance contracts in the upper layers of their reinsurance programs, reassessed their losses and submitted notices of claim for the contracts that they had previously indicated would not be impacted by the catastrophes.
In addition, in reviewing underwriting information provided by clients during December as part of the January 1, 2006 renewal process, we found that certain clients were anticipating higher losses from Hurricanes Katrina and Rita than had been reported through the formal claims channels.
Approximately 77% of the $262.7 million increase in our prior estimates of gross incurred loss arising from Hurricanes Katrina and Rita is attributable to our property retrocessional contracts and property catastrophe contracts written to protect direct and facultative books of business underwritten by clients. This business is predominately made up of cedents from the London market, including various Lloyd’s syndicates. The claims estimation process for both 	retrocessional business and direct and facultative business originating in the London market is subject to limited information concerning the actual loss incurred in the immediate aftermath of major catastrophes and slow loss reporting. In the case of retrocessional business, we and our cedents are several layers removed from the underlying claims and the claims adjustment process. Loss information therefore tends to be less reliable and slower reporting in the immediate aftermath of a hurricane, than is the case, for example, with our North American property catastrophe excess of loss business where we deal directly with the cedent companies who are adjusting the claims.
Direct and facultative business typically involves the reinsurance of books of excess and surplus lines binding authorities: in the typical case, a Lloyd’s syndicate will grant various managing general agents authority to bind excess and surplus lines commercial property risks on the syndicate’s behalf. Since our client, the Lloyd’s syndicate, is dependent on a third party to report loss involvement for risks under the binding authority agreements, they have less immediate information regarding losses in the immediate aftermath of a hurricane than in other lines of business. In the case of Hurricane Katrina, this was most apparent in our clients’ expectations regarding the extent of their exposure to commercial flood losses on their Gulf coast business.
Specifically for Hurricane Katrina, our estimates are subject to a high level of uncertainty arising out of extremely complex and unique causation and coverage issues, including the appropriate attribution of losses to wind or flood damage as opposed to other perils such as fire, business interruption or civil commotion. The underlying personal lines policies generally contain exclusions for flood damage; however, water damage caused by wind may be covered. We expect that causation and coverage issues may not be resolved for a considerable period of time and may be influenced by evolving legal and regulatory developments.
In reserving for non-catastrophe losses for recent periods, we are usually required to make assumptions concerning the expected loss ratio for broad lines of business, but sometimes on an individual contract basis. We consider historical loss ratios for each line of business and utilize information provided by our clients and estimates provided by underwriters and actuaries concerning the impact of pricing and coverage changes. As experience emerges, we will revise our prior estimates concerning pricing adequacy and non-catastrophe loss potential for our coverages and we will eventually rely solely on our indicated loss development patterns to estimate ultimate losses.
In addition, the risk for recent underwriting years includes the increased casualty exposures assumed by us through our casualty and finite businesses. Unlike property losses that tend to be reported more promptly and usually are settled within a shorter time period, casualty losses are frequently slower to be reported and may be determined only through the lengthy, unpredictable process of litigation. Moreover, given our limited experience in the casualty and finite businesses, we do not have established historical loss development patterns that can be used to establish these loss liabilities. We must therefore rely on the inherently less reliable historical loss development patterns reported by our clients and industry loss development data in calculating our liabilities. PXRE’s loss reserve estimation process takes into consideration the facts and circumstances related to reported losses; however, for immature accident years, reported casualty losses are relatively insignificant when compared to ultimate losses. As such, it is difficult to determine how facts and circumstances related to early-notified claims will impact future reported losses. When reported losses grow to a magnitude at which they suggest a trend, PXRE can, and does, re-estimate loss reserves.
PXRE derives almost all of its business from reinsurance intermediaries. As a result, the ceding company reports claims to the intermediary and the intermediary in turn reports the data to all the reinsurers included in the underlying program. Controls in place require that certain claims must be approved by the underwriter or a member of senior management to validate the loss data before payment is made. The underwriter, based on his knowledge and judgment, may question the broker or ceding company if he did not expect a loss of a certain magnitude to impact a certain layer. Since many of PXRE’s losses are from events that are well known, such as large hurricanes and earthquakes, the underwriter may in fact expect losses to certain layers and therefore would not question the accuracy of such loss reports. If the underwriter does question the loss data, PXRE may perform audits at the underlying ceding company in order to determine the accuracy of the amounts ceded. PXRE’s risk management and underwriting systems provide a list of impacted or potentially impacted contracts by peril and by geographic zone. This assists PXRE in determining the completeness of losses, as we will contact intermediaries and the ceding companies for which we believe underlying contracts are impacted subsequent to an event to request information.
Currently, PXRE does not have any backlog related to the processing of assumed reinsurance information. When a large loss occurs, the Company shifts personnel from various functions to assist the claims personnel in the processing and evaluation of claims data.
During 2005, we experienced net adverse development of $23.9 million for prior-year losses and loss expenses, consisting of $17.3 million of adverse development on our catastrophe and risk excess segment and $6.6 million of adverse development on our exited lines segment. The $17.3 million of prior-year catastrophe and risk excess losses were primarily related to re-estimation of the 2004 storm losses following additional claim reports from cedents. Prior year losses in the exited lines segment increased because of higher than expected reported claims.
During 2003, we experienced net adverse development of $44.7 million for prior-year loss and loss expenses, $21.8 million of which was due to loss development on our exited direct casualty reinsurance operations, $8.8 million adverse development from aerospace claims arising to a significant degree from our first receipt of notice that the increase in industry losses related to a 1998 air crash had resulted in the exhaustion of deductibles under three aerospace contracts between PXRE and Reliance Insurance Company and $8.2 million of development from finite contracts, $7.3 million of which related to the LMC XOL Contract noted above.
Loss and loss expense liabilities as estimated by PXRE’s actuaries and recorded by management in the statement of financial position as of December 31, 2005 were as follows:
We record an allowance for doubtful accounts that we believe approximates the exposure for all potential uncollectible assets.
We utilize the valuations provided to us by managers of our hedge funds and other privately held fixed income and equity securities in preparing our financial statements. The carrying values used in such financial statements may not reflect the value we receive when liquidating our investment in a hedge fund or other privately held security. If liquidity is by redemption, the valuations supplied quarterly by the manager of the hedge fund or other privately held security will generally be the values used by the manager to set the redemption prices. However, to the extent a manager has discretion in pricing holdings, should substantial redemptions occur in a limited period of time, that discretion may be used to price at lower values than would otherwise be used, thus reducing the redemption price. If liquidation of our investment occurs by virtue of a liquidation of a hedge fund or other privately held securities, we may receive substantially less than the valuation method used by the manager because the valuation method used by the manager is unlikely to use liquidation values. Accordingly, the estimated fair value of our hedge fund and other privately held investments does not necessarily represent the amount that could be realized upon future sale, including in the event we need liquidity to fund catastrophic losses.
Deferred tax assets and liabilities reflect the expected tax consequences of temporary differences between carrying amounts and the tax bases of PXRE’s United States subsidiaries assets and liabilities. At December 31, 2005, PXRE had a deferred tax asset net of deferred income tax liability of $51.4 million, offset by a valuation allowance of $51.4 million. Management reviewed the net deferred tax asset as of December 31, 2005, and as a result of the ratings downgrades of PXRE that occurred subsequent to December 31, 2005, and the related uncertainty with respect to the amount of future taxable income that will be generated by the Company, have concluded that a valuation allowance of $51.4 million is required for the entire deferred tax asset as of December 31, 2005.
In 2006 and subsequent periods, PXRE’s management will evaluate this valuation allowance on an ongoing basis and will make any necessary adjustments to it based upon any changes in management’s expectations of future taxable income.
Net loss per diluted common share was $21.65 for 2005 compared to net income per diluted common share of $0.82 for 2004, based on diluted average shares outstanding of approximately 32.5 million in 2005 and 27.7 million in 2004. As the Company incurred a loss from continuing operations, in accordance with SFAS No. 128, “Earnings Per Share,” for 2005 it did not include 11.0 million of average shares that are anti-dilutive (as shown in Note 10 to the Consolidated Financial Statements) in determining the denominator for its calculation of net loss per diluted common shares.
Gross and net premiums written for the years ended December 31, 2005 and 2004 were as follows:
The increase in both ceded premiums written and ceded premiums earned during the year ended December 31, 2005 was driven by $107.8 million of reinstatement and additional premiums related to Hurricanes Katrina, Rita and Wilma compared to an insignificant amount in 2004.
Losses and loss expenses incurred amounted to $1,011.5 million in 2005 compared to $226.3 million in 2004. The loss ratio was 260.5% for 2005 compared to 73.5% for 2004. The increase in losses and loss expenses incurred and our loss ratio was attributable to Hurricanes Katrina, Rita and Wilma that occurred during 2005.
The net impact of Hurricanes Katrina, Rita and Wilma in 2005 was $806.9 million. The net impact of the losses arising from Hurricanes Katrina, Rita and Wilma is summarized in the following table:
Current year net losses incurred of $987.6 million is mainly due to the 2005 hurricanes which amounted to $638.0 million from Hurricane Katrina, $68.9 million from Hurricane Rita and $143.9 million from Hurricane Wilma.
The operating expense ratio was 9.3% for 2005 compared with 13.4% for 2004. The decrease is the result of increased net premiums earned and decreased operating costs in 2005. Operating expenses for the year ended December 31, 2005 decreased $5.1 million, or 12%, to $36.2 million from $41.3 million in 2004 as a result of a 10% reduction in personnel and the curtailment of the Company’s retirement plans during 2004 and decreases in various operating expenses such as costs associated with Sarbanes-Oxley Section 404 compliance and consulting costs.
Net realized investment losses for 2005 were $14.7 million compared to net realized investment losses of $0.2 million for 2004. The increase in net realized investment losses relates to the write down of $11.8 million of investment securities due to other than temporary impairment following the downgrade of PXRE’s credit ratings in February 2006 and the sale of PXRE Limited, the sole member of PXRE Lloyd’s Syndicate 1224, during the fourth quarter of 2005.
Management has reviewed PXRE’s deferred tax asset and due to uncertainty with respect to the amount of future taxable income that will be generated following the downgrade of PXRE’s credit rating in February 2006, has concluded that a full valuation allowance of $51.4 million is required for all of its deferred tax asset, $48.9 million of which relates to tax benefits that otherwise would have been, with respect to 2005, or have been, with respect to years prior to 2005, recognized in the Consolidated Statements of Operations in 2005 and prior periods. The remainder relates to the tax consequences of temporary differences in Other Comprehensive Operations.
PXRE adopted the provisions of FIN 46R during the first quarter of 2004. The cumulative effect of this accounting pronouncement reduced net income for the year ended December 31, 2004 by $1.1 million but did not materially impact shareholders’ equity.
Gross premiums earned for the year ended December 31, 2004 decreased $30.4 million, or 8%, to $351.3 million from $381.7 million in 2003. The decrease in gross premiums earned was a result of a planned decrease in our exited line segment of $53.8 million compared to the year earlier period, offset by an increase in gross premiums earned in our catastrophe and risk excess segment of $23.4 million, or 7%, to $344.7 million in 2004 compared to $321.3 million in 2003. Gross reinstatement premiums earned related to the catastrophe and risk excess business increased by $27.0 million to $35.2 million in 2004 from $8.2 million in 2003. The change in this segment was due to similar factors as those discussed above in gross premiums written.
Ceded premiums written decreased $24.5 million, or 40%, to $36.2 million for the year ended December 31, 2004 from $60.7 million for 2003, primarily as a result of a decrease of $21.1 million in ceded premiums written to Select Reinsurance Ltd. (“Select Re”) under a quota share retrocessional contract that was in place in 2003 but was not renewed at January 1, 2004 and a decrease of $3.6 million in ceded premiums written related to excess of loss retrocessional catastrophe treaties.
Net premiums written for the year ended December 31, 2004 increased $31.4 million, or 11%, to $309.8 million from $278.4 million in 2003. Net premiums written in our catastrophe and risk excess segment increased $41.2 million, or 15%, for the year ended December 31, 2004 compared to 2003. The increase in this segment was due to the same factors that caused the increase in gross premiums written and decrease in ceded premiums written as explained above. Offsetting this increase, in part, was a planned decrease in our exited lines segment of $9.8 million compared to the year earlier period.
Net premiums earned for the year ended December 31, 2004 decreased $12.9 million, or 4%, to $308.1 million from $320.9 million for 2003. This decrease was a result of a planned decrease in our exited lines segment of $52.6 million compared to the year earlier period, offset by an increase in net premiums earned in the catastrophe and risk excess segment of $39.8 million, or 15%, for the year ended December 31, 2004 as compared to the corresponding prior-year period. The change in this segment was due to similar factors as those discussed above in gross and net premiums written.
A summary of our 2004 and 2003 net premiums written and earned by business segment is included in Note 13 to our Consolidated Financial Statements.
The expense ratio was 24.5% for 2004 compared with 25.6% for 2003. The commission and brokerage ratio, net of fee income, was 11.1% for 2004 compared with 13.2% for 2003, with the prior-year ratio affected by a large commission on a finite reinsurance contract. The catastrophe and risk excess commission and brokerage ratio, net of fee income, was 10.8% for 2004 compared to 11.7% for 2003.
Investment income for the year ended December 31, 2004 was also affected by various finite and other reinsurance contracts where premiums payable under such contracts were retained on a funds withheld basis. In order to reduce credit risk or to comply with regulatory credit for reinsurance requirements, a portion of premiums paid under such reinsurance contracts is retained by the cedent pending payment of losses or commutation of the contract. Investment income on such withheld funds is typically for the benefit of the reinsurer and the cedent may provide a minimum investment return on such funds. We have both ceded and assumed reinsurance contracts that involve the withholding of premiums by the cedent. On assumed reinsurance contracts, cedents held premiums and accrued investment income due to us of $0.0 million and $26.4 million as of December 31, 2004 and 2003, respectively, for which we have recognized $0.9 million and $1.7 million of investment income for the years ended December 31, 2004 and 2003, respectively. On ceded reinsurance contracts, we held premiums and accrued investment income of $86.4 million and $124.1 million due to reinsurers as of December 31, 2004 and 2003, respectively, for which we recognized a charge to investment income of $8.0 million and $9.1 million during the year ended December 31, 2004 and 2003, respectively. On a net basis, this reduction to investment income was $3.4 million and $2.5 million for the year ended December 31, 2004 and 2003, respectively, representing the difference between the stated investment return under such contracts and the overall yield achieved on our total investment portfolio for the period. The weighted average contractual investment return on the funds held by PXRE is 7.4% and 6.8% for the year ended December 31, 2004 and 2003, respectively.
Interest expense, including minority interest expense in consolidated subsidiaries, increased to $14.4 million for 2004 from $13.0 million in 2003. This increase was due to $3.1 million of additional interest on $64.4 million of trust preferred securities which were issued during the course of 2003 and as such had a full year’s worth of interest expense associated with them during 2004, offset by the non-recurrence of $1.3 million of expense reflected in 2003 from an interest rate swap that became ineffective as a hedging instrument during the quarter ended March 31, 2003 as well as the paydown of $30.0 million of bank debt in 2003. As discussed in Note 2 to our Consolidated Financial Statements, following the implementation of SFAS 150 and FIN 46R during the quarter ended March 31, 2004, the interest on trust preferred securities is now shown as interest expense, whereas it was previously recorded as minority interest in consolidated subsidiaries.
PXRE recognized a tax benefit of $6.2 million in 2004 compared to a tax expense of $0.8 million in 2003. The tax benefit for the year ended December 31, 2004 differed from the U.S. statutory rate primarily due to the reinsurance business written in our Bermuda reinsurance subsidiary, as well as losses incurred from our exited lines segment which related primarily to reinsurance business written in the United States. Included in the tax benefit is $2.6 million benefit related to prior-year reserves.
The Company and PXRE Delaware rely primarily on dividend payments from PXRE Bermuda and PXRE Reinsurance to pay its operating expenses, to meet its debt service obligations and to pay dividends. During 2005, PXRE Bermuda and PXRE Reinsurance did not pay any dividends. In the wake of losses incurred as a result of Hurricanes Katrina, Rita and Wilma, PXRE Reinsurance has an accumulated deficit and, therefore, may not declare and pay any dividends without regulatory approval during 2006. Based on the statutory surplus of PXRE Bermuda as of December 31, 2005, the aggregate dividends that are available to be paid during 2006, without prior regulatory approval are $161.1 million. We anticipate that this available dividend capacity will be sufficient to fund our liquidity needs during 2006.
On March 31, 2005, 5,840.6 Series A1 convertible voting preferred shares, 3,143.6 Series B1 convertible voting preferred shares and 1,393.6 Series C1 convertible voting preferred shares were mandatorily converted into 4.4 million class A convertible voting common shares, 2.4 million class B convertible voting common shares and 1.0 million class C convertible voting common shares, respectively. The conversion was effected based upon a conversion price of $13.27, which conversion price was agreed between the Company and holders of the Company’s convertible voting preferred shares pursuant to a letter agreement dated as of March 31, 2005. All the remaining convertible preferred shares mandatorily convert on April 4, 2008. At December 31, 2005, there were no A1, B1 and C1 Preferred Shares and 5,813 A2, B2 and C2 Preferred Shares outstanding. As the A2 Preferred Shares, B2 Preferred Shares and C2 Preferred Shares were not voluntarily converted on or prior to the third anniversary of their issuance, an annual 8% dividend, payable in cash, will accrue until these Preferred Shares are converted.
On May 15, 2003, PXRE Capital Statutory Trust II, a Connecticut statutory trust and subsidiary (non-consolidated) of the Company, sold $18.0 million principal amount of capital trust pass-through securities due May 15, 2033. The securities bear interest payable quarterly at an initial rate of 7.35% until May 15, 2008, and thereafter at an annual rate of 3 month LIBOR plus 4.1% reset quarterly. The Company has the right to redeem the securities at any quarterly interest payment date after May 15, 2008 at 100%. The Company used the net proceeds of the sale to repay the balance of $10.0 million outstanding under its credit agreement, and to provide additional capital to PXRE Bermuda.
On May 23, 2003, PXRE Capital Trust III, a Delaware statutory trust and a subsidiary (non-consolidated) of the Company, sold $15.5 million principal amount of capital trust pass-through securities due May 23, 2033. The securities bear interest payable quarterly at a rate of 9.75%. The Company has the right to redeem the securities at call prices of 104.875% on May 23, 2008, declining to 100.975% on May 23, 2012 and 100% on May 23, 2013 or thereafter. The Company used the net proceeds to provide additional capital to PXRE Bermuda.
On November 6, 2003, PXRE Capital Trust VI, a Delaware capital trust and a subsidiary (non-consolidated) of the Company, sold $10.3 million principal amount of capital trust pass-through securities due September 30, 2033. The securities bear interest payable quarterly at an initial rate of 7.58% until September 30, 2008, and thereafter at an annual rate of 3 month LIBOR plus 3.90% reset quarterly. The Company has the right to redeem the securities at any quarterly interest payment date after September 30, 2008 at 100%. The Company used the net proceeds to provide additional capital to PXRE Bermuda.
The Company was incorporated in Bermuda and is subject to the Bermuda Companies Act 1981 (the “Companies Act”). Under the Companies Act, even though we are solvent and able to pay our liabilities as they become due, we may not declare or pay dividends or make distributions from our contributed surplus if there are reasonable grounds for believing either that we are, or would after the payment, be, unable to pay our liabilities as they become due, or that the realizable value of our assets would thereby be less than the sum of our liabilities and our issued share capital (par value) and our share premium account. Under the Companies Act, when a company issues shares, the aggregate paid in par value of the issued shares comprises the Company’s share capital account. When shares are issued at a “premium”, that is, where the actual sum paid for a share exceeds the par value of the share, the amount paid in excess of the par value must be allocated to and maintained in a capital account called the “share premium account.” The Companies Act requires shareholder approval prior to any reduction of our share capital or share premium accounts. Bermuda law also provides that we maintain a contributed surplus account, to which we must allocate, amongst other things, shareholder capital which is unrelated to any share subscription. Currently, there is $325.2 million in our contributed surplus account.
In order that the Company can continue to have the flexibility to pay dividends to shareholders, the Board determined that it is in the best interests of the Company to reduce the share premium account to zero and allocate $550.0 million to the Company’s contributed surplus account. This reduction of our share premium account and reallocation to the contributed surplus account requires the approval of our shareholders to be effective. The Company intends to ask shareholders to approve a proposal to reduce our share premium account and transfer the $550.0 million balance to our contributed surplus account at our next General Meeting of shareholders. Assuming our shareholders give the required approval at the next General Meeting, the reallocated capital will remain part of our capital structure available for the benefit of our creditors and shareholders. Future dividends and distributions may then be made by the Board within the limits prescribed by Bermuda law, without restriction for the value of the historical share premium account.
If shareholders approve the foregoing proposal, the Board of Directors will evaluate whether to resume paying dividends and the appropriate level of such dividends as part of its evaluation of strategic alternatives.
Net cash flows provided by operations were $27.3 million in 2005 compared to $45.3 million in 2004 primarily due to an increase in net paid losses which was mainly attributable to the 2004 Florida hurricanes and Hurricanes Katrina, Rita and Wilma. Partially offsetting these decreases in operating cash flows was an increase in premium collected.
We do not have any material off-balance sheet arrangements. We do have the following commitments, contingencies and contractual obligations. Payments due by period in the following table reflect liabilities recorded at December 31, 2005.
As of December 31, 2005, other commitments and pledged assets include (a) LOCs of $284.3 million which are secured by cash and securities with a fair value of $405.7 million, (b) securities amounting to $9.9 million on deposit with various state insurance departments in order to comply with insurance laws, (c) securities with a fair value of $61.6 million deposited in a trust for the benefit of a cedent in connection with certain finite reinsurance transactions, (d) funding commitments to certain limited partnerships of $0.3 million, (e) a contingent liability amounting to $0.9 million under the Restated Employee Annual Incentive Bonus Plan and other compensation, (f) commitments under the capital trust pass-through securities discussed above, and (g) commitment fees of $0.8 million per annum under the two committed LOC facilities discussed above.
In connection with the capitalization of PXRE Lloyd’s Syndicate 1224, PXRE Reinsurance has on deposit $1.3 million par value of securities as collateral for Lloyd’s which are due to be released prior to June 30, 2006, following the sale in 2005 of PXRE Limited, the sole capital provider to PXRE Lloyd’s Syndicate 1224 and reinsurance to close of the liabilities of PXRE Lloyd’s Syndicate 1224 into a Lloyd’s syndicate controlled by Chaucer.
In order to better protect PXRE against the risk of another severe catastrophe event or the occurrence of multiple significant catastrophe events, we sponsored two catastrophe bond transactions that closed during the fourth quarter of 2005. The first transaction was a $300.0 million collateralized reinsurance agreement with A&W I, a Cayman Island reinsurance company. This new reinsurance coverage is designed to protect PXRE from extreme catastrophe losses arising from hurricanes in the Eastern and Gulf coasts of the United States, windstorms in northern Europe and earthquakes in California over the next 5 years. This reinsurance provides two layers of protection over the next 5 years to PXRE. The first layer provides $200.0 million of coverage for losses arising from hurricanes in the Eastern and Gulf coasts of the United States, windstorms in northern Europe and earthquakes in California. The second layer provides $100.0 million of coverage for losses arising from hurricanes in the Eastern and Gulf coasts of the United States and windstorms in northern Europe. The amount of annual disbursements to be made by the Company for this transaction are approximately $26.0 million.
The A&W II coverage is based on a modeled loss trigger. PXRE created a series of notional portfolios of reinsurance contracts designed to closely mimic the exposures in PXRE’s assumed reinsurance portfolio. Upon the occurrence of a hurricane, windstorm or earthquake in the covered territories, the parameters of the catastrophe event are determined and modeled against the notional portfolios. If the modeled loss to the notional portfolio exceeds the attachment point for the peril at issue, then the coverage is activated. Upon the occurrence of a second catastrophe event in the covered territories during that calendar year, the parameters of the catastrophe event are determined and modeled against the notional portfolios. If the modeled loss to the notional portfolio for the second event exceeds the attachment point for the peril at issue, then PXRE will make a recovery under the agreement. The recovery is based on modeled losses and is not limited to PXRE’s ultimate net loss from the loss event.
PXRE Delaware files U.S. income tax returns for itself and all of its direct or indirect U.S. subsidiaries that satisfy the stock ownership requirements for consolidation. PXRE Delaware is party to a tax allocation agreement concerning filing of consolidated federal income tax returns pursuant to which each of these U.S. subsidiaries makes tax payments to PXRE Delaware in an amount equal to the federal income tax payment that would have been payable by the relevant U.S. subsidiary for the year if it had filed a separate income tax return for that year. PXRE Delaware is required to provide payment of the consolidated federal income tax liability for the entire group. If the aggregate amount of tax payments made in any tax year by one of these U.S. subsidiaries is less than (or greater than) the annual tax liability for that U.S. subsidiary on a stand-alone basis for that year, the U.S. subsidiary will be required to make up the deficiency to PXRE Delaware (or will be entitled to receive a credit if payments exceed the separate return tax liability of that U.S. subsidiary).
Our future results of operations involve a number of risks and uncertainties, some of which are discussed below.
In the aftermath of Hurricane Katrina, each of the major rating agencies placed the credit ratings of our reinsurance subsidiaries on CreditWatch negative or the equivalent, and S&P and A.M. Best initially downgraded their ratings from “A” to “A-.” On February 16, 2006, A.M. Best downgraded its financial strength rating from “A-” to “B++” with a negative outlook. On February 24, 2006, A.M. Best further downgraded its financial strength rating from “B++” to “B+” with negative implications. On February 16, 2006, S&P downgraded its counterparty credit and financial strength rating on PXRE Reinsurance and PXRE Bermuda from “A-” to “BBB+” and placed these ratings on CreditWatch with negative implications. On February 23, 2006 S&P further downgraded its counterparty credit and financial strength rating on PXRE Reinsurance and PXRE Bermuda from “BBB+” to “BBB-” where they remain on CreditWatch with negative implications. On February 17, 2006, Moody’s downgraded its insurance financial strength rating of PXRE Reinsurance from “Baa1” to “Baa2” and placed this rating under review for possible further downgrade. On February 28, 2006, Moody’s further downgraded its insurance financial strength rating of PXRE Reinsurance from “Baa2” to “Baa3” and placed this rating under review for possible further downgrade.
• A.M. Best: “B+” (Very good), sixth highest of fifteen rating levels; and
We may not be able to identify or implement strategic alternatives for PXRE.
If our Board of Directors concludes that no other strategic alternative would be in the best interests of our shareholders, it may determine that the best course of action is to place the reinsurance operations of PXRE into runoff and eventually commence an orderly winding up and liquidation of PXRE operations over some period of time that is not currently determinable.
If our Board of Directors concludes that no other strategic alternative would be in the best interests of our shareholders, it may determine that the best course of action is to place the reinsurance operations of PXRE into runoff. Once in run-off there are various options available to bring PXRE's business to a conclusion including pursuing an arrangement with its policyholders in which it estimates and pays out all existing and contingent liabilities with a view to liquidating PXRE in accordance with a procedure which is approved by a statutory majority of policyholders. Under Bermuda law this is referred to as a solvent scheme of arrangement and is, in effect, a global commutation of PXRE’s business.
As part of its evaluation of potential strategic alternatives, the Board of Directors is also evaluating the continuing utility of PXRE’s two collateralized catastrophe facilities. During the fourth quarter of 2005, PXRE entered into two collateralized catastrophe facilities that provide $550.0 million of aggregate protection against losses arising from hurricanes in the Eastern and Gulf coasts of the United States, windstorms in northern Europe and earthquakes in California.
If the Board of Directors elects to pursue a strategic alternative that materially changes PXRE’s catastrophe risk profile, the Board of Directors may elect to explore the assignment or novation of PXRE’s rights and obligations under the collateralized catastrophe facilities to another insurance or reinsurance company. There can be no assurance that any other insurance or reinsurance company would be willing to accept such an assignment or novation, that note holders who funded the facilities would consent to such an assignment or novation, or that the cost of such an assignment or novation would not have a material adverse impact on PXRE. If PXRE was not able to successfully assign or novate its rights and obligations under these collateralized catastrophe facilities, PXRE could incur material termination fees and liabilities.
We may have difficulty retaining our management and other key employees on whom we will depend to continue to operate our business and to assist in identifying, evaluating and completing any strategic alternative. If we are unable to do so for at least the time necessary to identify and implement a selected strategy, our continued business operations and our ability to identify, evaluate and complete a strategic alternative could be materially and adversely affected.
The closing market price of our common stock has declined from a high of $27.11 per common share at February 16, 2005 to a low of $3.01 at March 7, 2006. On March 13, 2006, the closing price per share of our common stock as reported on The New York Stock Exchange was $3.24 per share. We believe that the market price of our common stock has been significantly and adversely affected by the losses due to Hurricanes Katrina, Rita and Wilma and the downgrade in our ratings. We also believe that there is a risk that our common stock price may decline further in the future as a result of our decision to evaluate strategic alternatives. In addition, we believe that many of the other risk factors listed in this report may have a material adverse effect on our results of operations and financial condition and contribute to fluctuations in our common stock price.
Our estimate of the ultimate incurred gross loss and loss expenses arising from Hurricanes Katrina, Rita and Wilma of $1,014.5 million as of December 31, 2005 is based mainly on modeling, a review of exposed reinsurance contracts, claims notices received from clients, discussions with clients and loss information provided by clients to underwriters as part of the underwriting submissions received in connection with the January 2006 renewal process. Although we have begun to receive loss notices with respect to Hurricanes Katrina, Rita and Wilma, we have paid less than 10% of our net incurred loss with respect to Hurricanes Katrina, Rita and Wilma as of December 31, 2005. In addition, our estimates are subject to a high level of uncertainty arising out of extremely complex and unique causation and coverage issues, including the appropriate attribution of losses to wind or flood damage as opposed to other perils such as fire, business interruption or civil commotion. The underlying policies generally contain exclusions for flood damage; however, water damage caused by wind may be covered. We expect that causation and coverage issues may not be resolved for a considerable period of time and may be influenced by evolving legal and regulatory developments.
In developing our best estimate, we have also assumed flood damage exclusions contained in our cedents’ underlying insurance policies will be effective. We understand that various lawsuits have been filed seeking to invalidate such flood damage exclusions on various grounds, including a suit filed by the Attorney General for the State of Mississippi. If such lawsuits were to successfully invalidate the underlying flood damage exclusions, our liabilities for losses and loss expenses relating to Hurricane Katrina could prove to be inadequate, with a consequent adverse impact on our future earnings and shareholders’ equity.
Without the approval by our shareholders of a proposal to reduce our share premium account and reallocate certain capital to our contributed surplus account, we may be restricted by law from declaring or paying dividends to our shareholders in the future.
Over 75% of our assumed reinsurance contracts in-force as of January 1, 2006, based on premium volume, contain special termination provisions that allow our clients to cancel such contracts based on our recent ratings downgrade and/or loss of surplus. As of March 13, 2006, we had received notice of cancellation from approximately 33% of our clients, calculated using premiums with respect to in-force business as of January 1, 2006, and it is anticipated that this percentage will increase.
Our risk management program for our 2006 assumed reinsurance portfolio assumed that we would have significant gross premium written during 2006. It was assumed that such premium income would offset losses arising from small or medium catastrophe events. For example, during 2004, we incurred material losses from Hurricanes Charley, Frances, Ivan and Jeanne, but still experienced a loss ratio of 65.9% in our catastrophe and risk excess segment due to the significant volume of premium written during 2004. If many or all of our clients exercise their special cancellation rights, we will have significantly less premium income to offset smaller catastrophe losses.
We compete with reinsurers that provide property-based lines of reinsurance, such as ACE Tempest Reinsurance Ltd., Arch Reinsurance Ltd., Aspen Insurance Holdings Limited, AXIS Reinsurance Company, Endurance Specialty Insurance Ltd., Everest Reinsurance Company, IPC Re Limited, Lloyd’s of London syndicates, Montpelier Reinsurance Ltd., Munich Reinsurance Company, Partner Reinsurance Company Ltd., Platinum Underwriters Reinsurance, Inc., Renaissance Reinsurance Ltd., Swiss Reinsurance Company and XL Re Ltd. A number of reinsurers were also formed in Bermuda in the wake of Hurricanes Katrina, Rita and Wilma in 2005 and we expect them to provide additional competition.
Our invested assets consist primarily of debt instruments with fixed maturities, short-term investments, a diversified portfolio of hedge funds and, to a lesser extent, interests in mezzanine bond and equity limited partnerships. At December 31, 2005, 90.8% of PXRE’s investment portfolio consisted of fixed maturities and short-term investments and 9.2% consisted of hedge funds and other investments.
Our invested assets are subject to market-wide risks and fluctuations as well as to risks inherent in particular securities. Although we seek to preserve our capital, we have invested in a portfolio of hedge funds and other privately held securities. These investments are designed to provide diversification of risk; however, such investments entail substantial risks. There can be no assurance that our investment objectives will be achieved, and results may vary substantially over time. In addition, although we seek to employ investment strategies that are not correlated with our reinsurance exposures, losses in our investment portfolio may occur at the same time as underwriting losses and, therefore, exacerbate such losses’ adverse effect on us. While our primary objective is capital preservation, all our portfolios have a degree of risk. See “Investments.”
Risks Related to our Fixed Maturity Investments. We are exposed to potential losses from the risks inherent in our fixed maturity investments. The two most significant risks inherent in our fixed income portfolio are interest rate risk and credit risk:
We invest in hedge funds that trade in securities using strategies that are generally market neutral. The hedge fund investments do not generally benefit from rising equity or bond markets, and have demonstrated historically low correlation of returns to equity market indices. However, the hedge funds may maintain leveraged net long positions, and this can expose us to market risks.
Because we depend on a few reinsurance brokers for a large portion of revenue, loss of business provided by any one or more of them could adversely affect us.
Investigations of broker placement and compensation practices initiated by the Attorney General’s office of certain states including New York, together with recently filed class action lawsuits initiated against such broker entities and certain reinsurance companies, have challenged the legality of certain activities conducted by these brokers and companies. Various brokers with whom we do business are included within these investigations and lawsuits. The investigations and suits challenge, among other things, the appropriateness of setting fees paid to brokers based on the volume of business placed by a broker with a particular insurer or reinsurer; the payment of contingent fees to brokers by insurers or reinsurers because of an alleged conflict of interest arising from such fee arrangements; the nondisclosure by brokers to their clients of contingent fees paid to them by insurers and reinsurers, bid rigging and tying the receipt of direct insurance to placing reinsurance through the same broker. Because these investigations and suits have not all been completed or resolved, it is not possible to determine their ultimate impact upon the broker reinsurance market and reinsurers, including us. However, because of our reliance on the broker reinsurance market for future business, any governmental actions or judicial decisions which have the effect of impairing the broker reinsurance market could materially impact our ability to underwrite business. In addition, to the extent that any of the arrangements into which we routinely enter with our brokers were determined to be unlawful, we could be fined or otherwise penalized. Further, to the extent that any of the brokers with whom we do business suffer financial difficulties as a result of the investigations or proceedings, we could suffer increased credit risk. See “Our reliance on reinsurance brokers exposes us to their credit risk” below.
Finite risk reinsurance contracts are highly customized and typically involve complicated structural elements. GAAP governs whether or not a contract should be accounted for as reinsurance. Contracts that do not meet these GAAP requirements may not be accounted for as reinsurance and are required to be accounted for as deposits. As reported in the past year, certain finite insurance and reinsurance arrangements are coming under scrutiny by the New York Attorney General’s Office, the Securities and Exchange Commission and other governmental authorities. According to the press, investigators have asserted that the contracts in question were accounted for in an improper or fraudulent manner.
Our reliance on reinsurance brokers exposes us to their credit risk.
In order to limit the effect of large and multiple losses upon our financial condition, we buy reinsurance for our own account. This type of insurance is known as retrocessional reinsurance. From time to time, market conditions have limited, and in some cases have prevented, reinsurers from obtaining the types and amounts of reinsurance which they consider adequate for their business needs. Accordingly, we may not be able to obtain our desired amounts of retrocessional reinsurance. In addition, even if we are able to obtain such retrocessional reinsurance, we may not be able to negotiate terms as favorable to us as in prior years. In difficult market conditions, pricing for our retrocessional reinsurance products may improve, but conversely, obtaining retrocessional reinsurance for our own account on favorable terms can become more difficult.
A retrocessionaire’s insolvency or its inability or unwillingness to make payments under the terms of a retrocessional reinsurance treaty with us could have a material adverse effect on us. Therefore, our retrocessions subject us to credit risks because the ceding of risk to retrocessionaires does not relieve us of our liability to our clients. In the event that we cede business to a retrocessionaire, we must still pay on claims of our cedent even if we are not paid by the retrocessionaire.
As of March 1, 2006, we have $650.0 million committed letter of credit facilities and an uncommitted facility that allows for letters of credit to be issued subject to satisfactory collateral being provided to the issuing bank by the Company.
Historically, insurers and reinsurers have experienced significant fluctuations in operating results due to competition, frequency and severity of catastrophic events, levels of capacity, general economic conditions and other factors. The supply of insurance and reinsurance is related to prevailing prices, the level of insured losses and the level of industry surplus which, in turn, may fluctuate in response to changes in rates of return on investments being earned in the insurance and reinsurance industry. As a result, the insurance and reinsurance business historically has been a cyclical industry characterized by periods of intense price competition due to excessive underwriting capacity as well as periods when shortages of capacity permitted favorable premium levels. Our recent growth from January 1, 2002 through December 31, 2005 relates in part to improved industry pricing, but the supply of insurance and reinsurance may increase, either by capital provided by new entrants or by the commitment of additional capital by existing insurers or reinsurers, which may cause prices to decrease. Any of these factors could lead to an adverse effect on our profits. In addition to these considerations, changes in the frequency and severity of losses suffered by insureds and insurers may affect the cycles of the insurance and reinsurance business significantly, and we expect to experience the effects of such cyclicality.
PXRE Bermuda. PXRE Bermuda is registered as a Class 4 Bermuda insurance and reinsurance company. Among other matters, Bermuda statutes, regulations and policies of the BMA, require PXRE Bermuda to maintain minimum levels of statutory capital, surplus and liquidity, to meet solvency standards, to obtain prior approval of ownership and transfer of shares and to submit to certain periodic examinations of its financial condition. These statutes and regulations may, in effect, restrict PXRE Bermuda’s ability to write insurance and reinsurance policies, to make certain investments and to distribute funds.
The offshore insurance and reinsurance regulatory environment has become subject to increased scrutiny in many jurisdictions, including the United States and various states within the United States. Compliance with any new laws or regulations regulating offshore insurers or reinsurers could have a material adverse effect on our business. In addition, although PXRE Bermuda does not believe it is or will be in violation of insurance laws or regulations of any jurisdiction outside Bermuda, inquiries or challenges to PXRE Bermuda’s insurance or reinsurance activities may still be raised in the future.
Changes in the laws and regulations to which our insurance and reinsurance subsidiaries are subject or the interpretation of these laws and regulations could have a material adverse effect on our business or results of operations.
Generally, Bermuda insurance statutes and regulations applicable to PXRE Bermuda are less restrictive than those that would be applicable if it were governed by the laws of any state in the United States. In the past, there have been congressional and other initiatives in the United States regarding proposals to supervise and regulate insurers domiciled outside the United States. If in the future PXRE Bermuda becomes subject to any insurance laws of the United States or any state thereof or of any other jurisdiction, we cannot assure you that PXRE Bermuda would be in compliance with those laws or that coming into compliance with those laws would not have a significant and negative effect on PXRE Bermuda’s business.
We have recently experienced material adverse events, including significant losses in 2005 and the downgrading of our ratings in February 2006. As a result, regulators having jurisdiction over one or more of our insurance subsidiaries could institute inquiries or proceedings against them. Any such regulatory action could impact our ability to write insurance business in some jurisdictions. In addition, the approval of insurance regulators would be required for the implementation of strategic alternatives that we may pursue, particularly any one involving a change of control of such subsidiaries. A significant delay or the denial of any required regulatory approval could negatively impact our ability to put into effect a strategic alternative that we consider beneficial to our business, which could have a material adverse impact on our results of operations and financial condition. In addition, this could have a material adverse effect on the market price of our securities.
the results of the Board of Directors’ exploration of strategic alternatives and the implementation of, or failure to implement, the strategic alternative selected by the Board of Directors;
We are a holding company with no operations or significant assets other than the capital stock of our subsidiaries. We effected an internal reorganization of our subsidiaries on March 15, 2005. The purpose of the reorganization was to consolidate all of our non-Bermudian subsidiaries under a newly formed holding company established in Ireland, PXRE Ireland. PXRE Ireland is a wholly owned subsidiary of PXRE Bermuda. In the reorganization, PXRE Reinsurance (Barbados) Ltd. distributed all of the common shares of PXRE Delaware to PXRE Bermuda. PXRE Bermuda then contributed the common shares of PXRE Delaware and the common shares of PXRE Europe to PXRE Ireland.
We rely primarily on cash dividends from PXRE Reinsurance, PXRE Ireland and PXRE Bermuda to pay our operating expenses, including debt service payments, shareholder dividends, if any, income taxes and other obligations that may arise from time to time. We expect future dividends and other permitted payments from these subsidiaries to be our principal source of funds to pay expenses and dividends. The payment of dividends by our reinsurance subsidiaries to us is limited under Bermuda law, Irish law and under certain insurance statutes of various U.S. states in which they are licensed to transact business. PXRE Reinsurance is subject to state regulatory restrictions that limit the maximum amount of annual dividends or other distributions, including loans or cash advances, available to stockholders without prior approval of the Insurance Commissioner of the State of Connecticut. As of January 1, 2006, PXRE Reinsurance cannot pay any dividends without the prior approval of the Insurance Commissioner of the State of Connecticut.
Bermuda insurance laws require PXRE Bermuda to maintain certain measures of solvency and liquidity, and further limit the amount by which we can reduce surplus without prior regulatory approval. Cash dividend payments to be made by us on our preferred shares and common shares or interest payments on our debt securities may also be affected by any inability to rely on payments from our subsidiaries.
Some aspects of our corporate structure and insurance regulations may discourage third-party takeovers and other transactions and may result in the entrenchment of incumbent management.
Under our bye-laws, subject to certain exceptions and to waiver by our board of directors on a case by case basis, no transfer of our shares is permitted if such transfer would result in a shareholder owning, directly or indirectly, more than 9.9% of the voting power of our outstanding shares, including our common shares, or more than 9.9% of the outstanding shares of any class of our share capital. Ownership is broadly defined in our bye-laws. We may refuse to register any such transfer on our share transfer records. A transferee will be permitted to promptly dispose of any of our shares purchased which violate the restriction and as to the transfer of which registration is refused.
The provisions described above may have the effect of making more difficult or discouraging unsolicited takeover bids from third parties. To the extent that these effects occur, shareholders could be deprived of opportunities to realize takeover premiums for their shares and the market price of their shares could be depressed. In addition, these provisions could also result in the entrenchment of incumbent management.
The rights of shareholders under Bermuda law are not as extensive as the rights of shareholders in many U.S. jurisdictions. Class actions and derivative actions are generally not available to shareholders under the laws of Bermuda. However, the Bermuda courts ordinarily would be expected to follow English case law precedent, which would permit a shareholder to commence an action in our name to remedy a wrong done to us where an act is alleged to be beyond our corporate power, is illegal or would result in the violation of our memorandum of association or bye-laws. Furthermore, consideration would be given by the court to acts that are alleged to constitute a fraud against the minority shareholders or where an act requires the approval of a greater percentage of our shareholders than actually approved it. The winning party in such an action generally would be able to recover a portion of attorneys’ fees incurred in connection with such action. Our bye-laws provide that shareholders waive all claims or rights of action that they might have, individually or in our right, against any director or officer for any act or failure to act in the performance of such director’s or officer’s duties, except with respect to any fraud or dishonesty of such director or officer. Class actions and derivative actions generally are available to shareholders under Delaware law for, among other things, breach of fiduciary duty, corporate waste and actions not taken in accordance with applicable law. In such actions, the court has discretion to permit the winning party to recover attorneys’ fees incurred in connection with such action.
Under Bermuda law and our bye-laws, we may indemnify our directors, officers or any other person appointed to a committee of the board of directors (and their respective heirs, executors or administrators) to the full extent permitted by law against all actions, costs, charges, liabilities, loss, damage or expense incurred or sustained by such person by reason of any act done, concurred in or omitted in the conduct of our business or in the discharge of his/her duties; provided that such indemnification shall not extend to any matter in which any of such persons is found, in a final judgment or decree not subject to appeal, to have committed fraud or dishonesty. Under Delaware law, a corporation may indemnify a director or officer of the corporation against expenses (including attorneys’ fees), judgments, fines and amounts paid in settlement actually and reasonably incurred in defense of an action, suit or proceeding by reason of such position if (i) such director or officer acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the corporation and (ii) with respect to any criminal action or proceeding, such director or officer had no reasonable cause to believe his conduct was unlawful.
Our shareholders may have difficulty effecting service of process on us or enforcing judgments against us in the United States.
We are incorporated pursuant to the laws of Bermuda and our business is based in Bermuda. In addition, certain of our directors and officers reside outside the United States, and all or a substantial portion of our assets and the assets of such persons are located in jurisdictions outside the United States. As such, we have been advised that there is doubt as to whether:
In addition, any RPII that is includible in the income of a U.S. tax-exempt organization may be treated as unrelated business taxable income. The amount of RPII earned by the non-U.S. insurance subsidiaries (generally, premium and related investment income from the direct or indirect insurance or reinsurance of any direct or indirect U.S. holder of common shares or any person related to such holder) will depend on a number of factors, including the geographic distribution of the non-U.S. insurance subsidiaries’ business and the identity of persons directly or indirectly insured or reinsured by the non-U.S. insurance subsidiaries. We believe that the gross RPII of each non-U.S. insurance subsidiary did not in prior years of operation and is not expected in the foreseeable future to equal or exceed 20% of such subsidiary’s gross insurance income. Additionally, we do not expect the direct or indirect insureds of our non-U.S. insurance subsidiaries (and persons related to such insureds) to directly or indirectly own 20% or more of either the voting power or value of our shares. No assurance can be given that this will be the case because some of the factors that determine the existence or extent of RPII may be beyond our knowledge and/or control.
The RPII rules provide that if a U.S. person disposes of shares in a foreign insurance corporation in which U.S. persons own 25% or more of the shares (even if the amount of RPII is less than 20% of the corporation’s gross insurance income and the ownership of its shares by direct or indirect insureds and related persons is less than the 20% threshold), any gain from the disposition will generally be treated as ordinary income to the extent of the U.S. person’s share of the corporation’s undistributed earnings and profits that were accumulated during the period that the U.S. person owned the shares (whether or not such earnings and profits are attributable to RPII). In addition, such U.S. person will be required to comply with certain reporting requirements, regardless of the amount of shares owned by the U.S. person. These RPII rules should not apply to dispositions of our shares because we will not ourselves be directly engaged in the insurance business. The RPII provisions, however, have never been interpreted by the courts or the U.S. Treasury Department in final regulations, and regulations interpreting the RPII provisions of the Code exist only in proposed form. It is not certain whether these regulations will be adopted in their proposed form or what changes or clarifications might ultimately be made thereto or whether any such changes, as well as any interpretation or application of RPII by the IRS, the courts or otherwise, might have retroactive effect. The U.S. Treasury Department has authority to impose, among other things, additional reporting requirements with respect to RPII. Accordingly, the meaning of the RPII provisions and the application of those provisions to us and our non-U.S. subsidiaries are uncertain.
If we are classified as a passive foreign investment company (“PFIC”), your taxes would increase.
Consolidated Statements of Operations and Comprehensive Operations for the years ended December 31, 2005, 2004 and 2003