PXRE leases office space in Bermuda where our principal executive offices are located, and in Edison, New Jersey, where PXRE Reinsurance's principal offices are located. We also lease office space in Brussels, Belgium. Our properties are leased on terms and for durations that are reflective of commercial standards in the communities where these properties are located. PXRE believes the facilities it occupies are adequate for the purposes for which they are currently used and are well maintained.
================================================================================ (1) The Company was incorporated on June 1, 1999 as a Bermuda exempted company and a wholly owned subsidiary of PXRE Purpose Trust, a purpose trust established under the laws of Bermuda. On October 5, 1999, PXRE Delaware completed a reorganization pursuant to which the Company became the ultimate parent holding company of PXRE Delaware. PXRE Delaware and its subsidiaries provide property and casualty reinsurance and insurance products to a national and international marketplace. In connection with the reorganization, the Company repurchased for $1.00 per share 100% of the common shares owned by PXRE Purpose Trust and each outstanding share of PXRE Delaware common stock (other than shares held by PXRE Delaware and its subsidiaries) was converted into one common share of the Company. After the consummation of the reorganization the Company commenced carrying on the holding company functions previously conducted by PXRE Delaware.
(3) The ratios of earnings to fixed charges were determined by dividing consolidated earnings by total fixed charges. For purposes of these computations, (i) earnings consist of consolidated income before considering income taxes, fixed charges and minority interest, and (ii) fixed charges consist of interest on indebtedness, interest expense on premiums withheld under certain ceded reinsurance contracts and that portion of rentals which is deemed by PXRE's management to be an appropriate interest factor. Earnings were inadequate to cover fixed charges by $22.5 million, $22.8 million and $55.3 million for the years ended December 31, 2001, 2000, and 1999 respectively. The ratios of earnings to combined fixed charges and preferred dividends were determined by dividing consolidated earnings by total fixed charges and preferred dividends. Earnings were inadequate to cover fixed charges and preferred dividends by $22.5 million, $22.8 million and $55.3 million for the years ended December 31, 2001, 2000, and 1999 respectively.
(4) The loss, underwriting expense and combined ratios included under "Other Operating Data" have been derived from our consolidated statements of income prepared in accordance with GAAP.
PXRE Group Ltd. is an insurance holding company domiciled in Bermuda. We provide reinsurance products and services to a worldwide marketplace through our wholly owned subsidiary operations located in Bermuda, Barbados, Europe and the United States. Our primary business is catastrophe and risk excess reinsurance, which accounted for 93% of net premiums written and virtually all of our underwriting income for the year ended December 31, 2003. Our catastrophe and risk excess business includes property catastrophe excess of loss, property catastrophe retrocessional, property risk excess, marine excess and aerospace excess and pro rata reinsurance products. We also provide, to a lesser extent and on an opportunistic basis, finite reinsurance products to a small number of clients.
These favorable market conditions have driven our strong growth in net premiums written in our catastrophe and risk excess segment of 46% for the year ended December 31, 2003 as compared with the year earlier period. Our growth in 2003 builds on the prior growth in 2002 of 202% of net premiums written in the catastrophe and risk excess segment as compared with 2001.
Although pricing in the property catastrophe reinsurance market remains healthy in 2004, we expect that the pricing will remain generally flat in 2004, with modest rate decreases in certain geographic zones. As a result, we do not expect that we will be able to sustain in 2004 the significant growth rates achieved in our catastrophe and risk excess business in 2003 and 2002. We do, however, believe that we have opportunities to achieve additional growth in 2004 through the expansion of our client base and through additional penetration with existing clients.
Since the primary focus of our business is on property catastrophe reinsurance, the size of our losses during any annual period depends, to a large extent, on the number and magnitude of natural and man-made catastrophes such as hurricanes, windstorms, hailstorms, earthquakes, volcanic eruptions, fires, industrial explosions, freezes, riots and floods. This focus on short-tail, high-severity, and low frequency lines of business exposes us to short term volatility in our operating results. We have been able to successfully underwrite these products over the long term, as evidenced by our cumulative average catastrophe and risk excess loss ratio of 47.0% for the period from 1987 to December 31, 2003.
The favorable results achieved in our catastrophe and risk excess segment were somewhat offset in 2003 by net adverse development of $45.8 million in prior-year loss and loss expenses reserves, primarily arising from our exited direct casualty operations. Following a reserve review during the third quarter of 2003, which included a review by a nationally recognized third party actuarial firm of the most troublesome area, the general liability line of business written by our exited casualty business, and further internal actuarial review of our loss reserve estimates during the fourth quarter of 2003, management believes that our overall liability for losses and loss expenses recorded as of December 31, 2003 is adequate.
As a property catastrophe reinsurer, our estimates of losses are inherently less reliable than for 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 future earnings and shareholders' equity.
In reserving for non-catastrophe losses from recent years, we are required to make assumptions concerning the expected loss ratio usually 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 estimated development pattern in projecting ultimate losses.
For the year ended December 31, 2002, we experienced net adverse development of $25.4 million for prior-year loss and loss expense, $16.9 million of which was due to loss development in our exited lines segment relating primarily to the 2000 and 2001 underwriting years. Adverse development of $16.2 million was primarily caused by larger than expected reported claims under our direct reinsurance contracts and corroborated by revised industry data. We ceased underwriting this business in September 2001.
The $16.2 million of adverse development attributable to PXRE's former direct operation in 2002 was primarily associated with the recent 2001 accident year ($9.9 million of adverse development) and recent 2000 accident year ($5.4 million of adverse development). As of each financial reporting date, PXRE records its best estimate of the ultimate amount of losses incurred but not yet paid.
With respect to actuarial techniques for loss reserving, PXRE places more weight on the Bornhuetter-Ferguson approach for recent accident years and, for earlier years, relies more on loss development approaches. At year-end 2000 and 2001, PXRE placed more weight on the Bornhuetter-Ferguson technique, which relied on industry loss ratios and premiums which, with hindsight, underestimated the amount of underpricing for the 1998 to 2001 underwriting years, in its actuarial analysis of the direct casualty business. When the amount of reported losses became a more reliable means for setting reserve estimates, PXRE started to place more weight on these reported losses to estimate its loss reserves and less weight on the Bornhuetter-Ferguson technique.
($000's) Low End Net High End ----------- ----------- ------------ Catastrophe and Risk Excess $ 79,750 $ 94,439 $ 110,725 Finite Business 80,055 97,420 117,218 Other Lines 4,354 4,981 5,662 Exited Lines 95,028 106,871 119,603
We regularly monitor the difference between the estimated fair value of our investments and their cost or book values to identify underperforming investments and whether declines in value are temporary in nature, or "other than temporary." If we believe a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss, net of tax, in our shareholders' equity. If we believe the decline is "other than temporary," we write down the carrying value of the investment and record a realized loss on our statement of income and comprehensive income. We formally review each quarter the unrealized losses by value, and all investments that have been in an unrealized loss position for more than six months. In assessing whether an investment is suffering a decline in value that is other than temporary we pay particular attention to those trading at 80% or less of original cost, and those investments that have been downgraded by any of the major ratings agencies, general market conditions, and the status of principal and interest payments. If we conclude that a decline is other than temporary we recognize a realized investment loss for the impairment. In 2003 and 2002, we recognized $0.2 million and $0.7 million of impairment losses, respectively.
For the year ended December 31, 2003, net income before convertible preferred share dividends was $96.6 million compared to $64.5 million for 2002. The net income per diluted common share was $4.10 for 2003 compared to $3.28 for 2002, based on diluted average shares outstanding of approximately 23.6 million in 2003 and 19.7 million in 2002.
Gross and net premiums written for 2003 and 2002 were as follows:
Year Ended December 31, -------------------------------- % Increase ($000's) 2003 2002 (Decrease) ------------- ------------- ---------- Gross premiums written $ 339,140 $ 366,768 (8)% Ceded premiums written (60,729) (72,285) (16) ------------- ------------- Net premiums written $ 278,411 $ 294,483 (5)% ============= =============
Gross premiums written for the year ended December 31, 2003 decreased 8% to $339.1 million from $366.8 million in 2002. This decrease in gross premiums written is primarily due to a planned decrease in our finite segment of $102.7 million, or 93%, compared to 2002. Partially offsetting the decrease in finite gross premiums written was an increase in the catastrophe and risk excess segment of $76.7 million, or 32%, compared to 2002. This increase is attributable to improved pricing, increased participation with long-standing clients and increased amounts of new business.
As part of our efforts to return to our core catastrophe and risk business, we have intentionally de-emphasized our finite business. This business is currently focused on a limited group of cedents and on policies that do not contain significant risk transfer. Finite contracts that do not contain sufficient risk transfer are not recorded as reinsurance arrangements but are treated as deposits for accounting purposes. As such, the income related to these transactions is recorded as fee income, and liabilities, if any, are recorded as deposit liabilities. As a result, finite premiums are expected to be less than in prior periods.
Net premiums written for the year ended December 31, 2003 decreased 5% to $278.4 million from $294.5 million in 2002. Net premiums written in our finite segment decreased by $94.7 million, or 92%, compared to 2002. Partially offsetting the decrease in finite net premiums written was an increase in the catastrophe and risk excess segment of $81.6 million, or 46%, compared to 2002. The changes in these segments are due to the same factors as those discussed above in gross premiums written. Net premiums written in the exited lines segment decreased $3.7 million during the year ended December 31, 2003 compared to 2002. Since we have decided to focus on our core catastrophe and risk excess segment and have ceased writing the businesses we have classified as exited lines, we do not expect to report material premiums written and earned in the exited lines segment during 2004.
($000's) Year Ended December 31, --------------------------- % Increase 2003 2002 (Decrease) ------------ ------------ ---------- Gross premiums earned $ 381,705 $ 349,312 9% Ceded premiums earned (60,772) (79,952) (24) ------------ ------------ Net premiums earned $ 320,933 $ 269,360 19% ============ ============
Gross premiums earned for the year ended December 31, 2003 increased 9% to $381.7 million from $349.3 million in 2002. This increase is due to an increase in the catastrophe and risk excess segment of $78.1 million, or 33%, compared to 2002. Partially offsetting this increase was a decrease in our exited lines segment of $23.8 million, or 77%, and a decrease in our finite segment of $18.8 million, or 26%, compared to 2002. The changes in these segments are due to the same factors as discussed above in gross and net premiums written.
Ceded premiums earned decreased by 24% to $60.8 million for the year ended December 31, 2003 compared to $80.0 million for 2002, primarily as a result of a $15.4 million decrease in finite business ceded and cessions on the per-risk portion of the catastrophe and risk excess segment.
Net premiums earned in the year ended December 31, 2003 increased 19% to $320.9 million from $269.4 million for 2002. Net premiums earned in the catastrophe and risk excess segment increased $78.1 million, or 44%, for the year ended December 31, 2003 compared to 2002. Net premiums earned in the exited lines segment experienced a decline of $22.8 million, or 82%, for the year ended December 31, 2003 as compared to 2002. The changes in net premiums earned for the catastrophe and risk excess segment and the exited lines segment are due to the same factors as discussed above in gross and net premiums written.
A summary of our 2003 and 2002 net premiums written and earned by business segment is included in Note 12 to the Consolidated Financial Statements.
We did not experience any significant catastrophe activity in 2003. The largest losses were related to the winter storms in the Midwest and the wildfires in California, but we incurred less than $10.0 million with respect to each of these losses. The loss ratio for 2002 was affected by the 2002 European flood losses of $17.8 million. During 2003, we experienced net adverse development of $45.8 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 aggregate excess of loss reinsurance agreement referred to in Financial Condition - Liquidity - Commitment, Contingencies and Contractual Obligations. In 2002, we experienced net adverse development of $25.4 million for prior-year loss and loss expenses, $16.9 million of which was due to loss development on our exited lines segment relating primarily to the 2000 and 2001 underwriting years.
Net realized investment gains for 2003 were $2.4 million compared to gains of $9.0 million for 2002. Included in the net realized investment gains for the year ended December 31, 2002 were gains of $1.4 million realized on the repurchase of $5.2 million of our capital trust pass-through securities and gains realized on shortening of the average maturity of securities in our investment portfolio.
PXRE recognized a tax expense of $0.8 million in 2003 compared to a tax expense of $17.8 million in 2002. The tax expense for the year ended December 31, 2003 differed from the U.S. statutory rate primarily due to the significant increase in reinsurance business written in Bermuda as a percentage of our total amount written, as well as the losses incurred from our exited lines segment which related primarily to reinsurance business written in the United States.
Gross premiums written $ 366,768 $ 290,213 26% Ceded premiums written (72,285) (135,735) (47) ------------- -------------- Net premiums written $ 294,483 $ 154,478 91% ============= ==============
Gross and net premiums earned for 2002 and 2001 were as follows:
Year Ended December 31, ------------------------------- % Increase ($000's) 2002 2001 (Decrease) ------------- ------------- ----------
Gross premiums earned $ 349,312 $ 293,442 19% Ceded premiums earned (79,952) (131,317) (39) ------------- ------------- Net premiums earned $ 269,360 $ 162,125 66% ============= =============
Gross premiums earned for the year ended December 31, 2002 increased 19% to $349.3 million from $293.4 million in 2001. The catastrophe and risk excess segment increased $65.5 million, or 39%, while the finite segment increased $31.5 million, or 78%, compared to 2001. Offsetting these increases was a decrease in our exited lines segment of $43.6 million, or 58%, compared to the prior year. The changes in these segments are due to the same factors as discussed above in gross premiums written.
Net premiums earned for 2002 increased 66% to $269.4 million from $162.1 million for 2001. The catastrophe and risk excess segment increased $115.6 million, or 191% on a net earned basis while the finite segment increased $24.7 million, or 76% on a net earned basis versus the prior year. The exited lines segment experienced a decrease of $37.3 million, or 57% on a net earned basis during 2002 compared to 2001. The changes in net premiums earned for these segments are due to the same factors as discussed above in gross premiums written.
A summary of our 2002 and 2001 net premiums written and earned by business segment is included in Note 12 to the Consolidated Financial Statements.
The following table summarizes the loss ratio, expense ratio and combined ratio for the years ended December 31, 2002 and 2001, respectively:
The expense ratio was 30.6% for 2002 compared with 33.4% for 2001. This decrease was largely due to an increase in premiums earned. The commission and brokerage ratio, net of fee income, was 18.6% for 2002, compared with 15.2% in 2001. The operating expense ratio was 12.0% for 2002 compared with 18.3% for 2001.
Other operating expenses increased 10% to $32.5 million for 2002 from $29.6 million in 2001. The increase primarily reflects incentive compensation expense that varies with return on equity, to be paid under PXRE's Restated Employee Annual Incentive Bonus Plan and $1.3 million of costs incurred in connection with the establishment of a reinsurance facility with P-1 Re Ltd.
On January 29, 1997, PXRE Capital Trust I ("PXRE Capital Trust"), a Delaware statutory trust and a wholly-owned subsidiary of PXRE Delaware, issued $100.0 million principal amount of its 8.85% TRUPS due February 1, 2027 in an institutional private placement. Proceeds from the sale of these securities were used to purchase PXRE Delaware's 8.85% Junior Subordinated Deferrable Interest Debentures due February 1, 2027 (the "Subordinated Debt Securities"). On April 23, 1997, PXRE Delaware and PXRE Capital Trust completed the registration with the SEC of an exchange offer for these securities and the securities were exchanged for substantially similar securities (the "Capital Securities"). Distributions on the Capital Securities (and interest on the related Subordinated Debt Securities) are payable semi-annually, in arrears, on February 1 and August 1 of each year, commencing August 1, 1997. On or after February 1, 2007, PXRE Delaware has the right to redeem the Subordinated Debt Securities, in whole at any time or in part from time to time, subject to certain conditions, at call prices of 104.180% at February 1, 2007, declining to 100.418% at February 1, 2016, and 100% thereafter. During 2002 we purchased $5.2 million TRUPS and recognized a gain of $1.4 million.
On May 15, 2003, PXRE Capital Statutory Trust II, a Connecticut statutory trust and subsidiary of the Company, sold $17.5 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 option 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 October 29, 2003, PXRE Capital Statutory Trust V, a Connecticut statutory trust and a subsidiary of the Company, sold $20.0 million principal amount of capital trust pass-through securities due October 29, 2033. The securities bear interest payable quarterly at an initial rate of 7.70% until October 29, 2008, and thereafter at an annual rate of 3 month LIBOR plus 3.85% reset quarterly. The Company has the right to redeem the securities at any quarterly interest payment date after October 29, 2008 at 100%. The Company used the net proceeds to provide additional capital to PXRE Bermuda.
Dividends declared to common shareholders were $2.9 million in both 2003 and 2002. Book value per common share was $22.24 at December 31, 2003 after considering convertible preferred shares.
The Company did not receive any of the proceeds from the sale of shares by Phoenix. Net proceeds to the Company, from the sale of the common shares sold by the Company, were approximately $20.4 million. We used the net proceeds from the sale of common shares for general corporate purposes, including contributions to the capital of PXRE Bermuda to support growth in its business.
On January 22, 2004, the underwriters of the above mentioned share offering exercised in-full the over-allotment option to purchase 0.3 million additional common shares at $21.75 per share. As a result of the exercise of the option, the Company received additional net proceeds of approximately $6.8 million, resulting in total net proceeds from the offering of approximately $27.2 million. We again used the net proceeds for general corporate purposes, including contributions to the capital of PXRE Bermuda. After giving effect to the sale of the over-allotment shares, a total of 2.5 million shares were sold in the offering.
Net cash flows provided by operations were $154.3 million in 2003 compared to $139.4 million in 2002 primarily due to the effects of timing of collection of receivables and reinsurance recoverables and payments of losses. Because of the nature of the coverages we provide, which typically can produce infrequent losses of high severity, it is not possible to accurately predict our future cash flows from operating activities. As a consequence, cash flows from operating activities may fluctuate, perhaps significantly, between years.
Net cash used by investing activities were $184.3 million in 2003 compared to $226.5 million in 2002 due primarily to purchases of securities for investment partially offset by proceeds received on sale or maturity of investments.
We do not have any material off-balance sheet arrangements. We do have the following commitments, contingencies and contractual obligations.
As noted under Capital Resources, we expect to be able to meet the contractual obligations over 2004 with the dividend paying capacity of the Company's subsidiaries. PXRE Reinsurance and PXRE Bermuda expect to be able to meet their contractual obligations over 2004 with operating and investing cash flows.
Other commitments and pledged assets include: (a) letters of credit amounting to $17.3 million, which are secured by cash and securities amounting to $19.6 million, (b) securities with a par value of $10.7 million on deposit with various state insurance departments in order to comply with insurance laws, (c) securities with a fair value of $57.8 million deposited into a trust for the benefit of a cedent in connection with a finite reinsurance transaction, (d) funding commitments to certain limited partnerships of $0.9 million included in the table above, (e) a commitment to lend a further $0.2 million to finance the construction of an office building that we intend to use as our headquarters in Bermuda, included in the table above and (f) a contingent liability amounting to $3.1 million under the 1992 Restated Employee Annual Incentive Bonus Plan.
In connection with the capitalization of PXRE Lloyd's Syndicate 1224, PXRE Reinsurance has placed on deposit a $30.6 million par value U.S. Treasury security as collateral for Lloyd's. In addition, cash and invested assets amounting to $9.2 million at December 31, 2003, are restricted from being paid as a dividend until the run-off has been completed.
In April 2000, PXRE Reinsurance entered into an aggregate excess of loss retrocessional reinsurance agreement with a U.S. based cedent. In the agreement, PXRE Reinsurance reinsured a portfolio of treaties underwritten by a former business unit of the cedent, which had been divested. Pursuant to this excess of loss retrocessional agreement, PXRE Reinsurance agreed to indemnify the cedent for losses in excess of a 75% paid loss ratio on this underlying portfolio of treaties up to a 100% paid loss ratio, subject to an aggregate limit of liability of $50.0 million. The latest loss reports related to the agreement provided by the cedent forecast an ultimate net loss ratio in excess of 100%, which could result in a full limit loss to PXRE.
Although the ultimate outcome of the litigation cannot presently be determined, management believes that PXRE Reinsurance's claims are meritorious and intends to vigorously prosecute its suit. As of December 31, 2003, we have recorded $34.4 million of loss reserves related to the agreement. If our lawsuit is unsuccessful, we could potentially incur additional losses under the agreement of up to $10.2 million on an after-tax basis.
As a reinsurer of property catastrophe-type coverages in the worldwide marketplace, our operating results in any given period depend to a large extent on the number and magnitude of natural and man-made catastrophes such as hurricanes, windstorms, hailstorms, earthquakes, volcanic eruptions, fires, industrial explosions, freezes, riots and floods. For example, the terrorist attacks on September 11, 2001 resulted in a $35.3 million net loss, after tax, in the third quarter of 2001, which subsequently decreased to a $32.1 million net loss, after tax, by December 31, 2003. While we may, depending on market conditions, purchase catastrophe retrocessional coverage for our own protection, the occurrence of one or more major catastrophes in any given period could nevertheless have a material adverse impact on our results of operations and financial condition and result in substantial liquidation of investments and outflows of cash as losses are paid.
As we underwrite risks from a large number of insurers based on information generally supplied by reinsurance brokers, we may develop a concentration of exposure to loss in certain geographic areas prone to specific types of catastrophes. For example, we are significantly exposed to losses arising from hurricanes in the southeastern United States, earthquakes in California, the midwest United States and Japan, and to windstorms in northern Europe. We have developed systems and software tools to monitor and manage the accumulation of our exposure to such losses and have established guidelines for maximum tolerable losses from a single event or multiple catastrophic events based on historical data. However, no assurance can be given that these maximums will not be exceeded in some future catastrophe.
In particular, we compete with reinsurers that provide property-based lines of reinsurance, such as ACE Tempest Reinsurance Ltd., Arch Reinsurance Ltd., AXIS Reinsurance Company, Converium Reinsurance (North America), Inc., Endurance Specialty Insurance Ltd., Everest Reinsurance Company, IPCRe 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. Competition varies depending on the type of business being insured or reinsured and whether we are in a leading position or acting on a following basis.
Our success is dependent upon our ability to assess accurately the risks associated with the businesses that we insure and reinsure. Claim reserves represent estimates involving actuarial and statistical projections, at a given point in time, of our expectations of the ultimate settlement and administration costs of claims incurred. We utilize actuarial models as well as historical insurance industry loss development patterns to assist in the establishment of appropriate claim reserves. In our casualty and finite business, given our limited experience we do not have established historical loss development patterns that can be used to establish these loss liabilities. For these lines, we rely on loss development patterns that have been estimated from industry or client data, which may not accurately represent the true development pattern for the business we wrote. For property lines, reserves may differ from ultimate settlement values due to the infrequency of some types of catastrophe losses, the incompleteness of information in the wake of a major catastrophe and delay in receiving that information. Actual claims and claim expenses paid may deviate, perhaps substantially, from the reserve estimates reflected in our financial statements.
The property catastrophe reinsurance market is highly sensitive to the ratings assigned by the rating agencies. If either of S&P or A.M. Best were to downgrade us, such downgrade would likely have a material negative impact on our ability to expand our reinsurance portfolio and renew all of our existing reinsurance agreements, especially if we were to be downgraded more than one level from the "A" category to the "B" category. In 1999, we were downgraded from A+ to A, which downgrade was considered by us to have no material effect on our core short tail property business. Although impossible to quantify, we believe the downgrade did have some impact on our ability to expand the direct casualty reinsurance business that we have since discontinued.
The three most significant risks inherent in our hedge fund portfolio are liquidity risk, credit risk and market risk:
We market our reinsurance products worldwide exclusively through reinsurance brokers. Four, five and four brokerage firms accounted for 78%, 84%, and 60% of our gross premiums written for the years ended December 31, 2003, 2002, and 2001, respectively. Approximately 27%, 21%, 16%, and 15% of gross premiums written in fiscal year 2003 were arranged through Benfield Greig Ltd., the worldwide branch offices of Guy Carpenter & Company, Inc. (a subsidiary of Marsh & McLennan Companies, Inc.), Willis Re. Inc., and Aon Group Ltd., respectively. Loss of all or a substantial portion of the business provided by these brokers could have a material adverse effect on our business.
PXRE Bermuda is not licensed or admitted as an insurer in any jurisdiction other than Bermuda. Because many jurisdictions do not permit insurance companies to take credit for reinsurance obtained from unlicensed or non- admitted insurers on their statutory financial statements unless appropriate security mechanisms are in place, we anticipate that our reinsurance clients will typically require PXRE Bermuda to post a letter of credit or other collateral. If we are unable to arrange for security on commercially reasonable terms, PXRE Bermuda could be limited in its ability to write business for certain of our clients.
PXRE U.S. Subsidiaries. PXRE Delaware and PXRE Reinsurance are subject to regulation under the insurance statutes of various U.S. states, including Connecticut, the domiciliary state of PXRE Reinsurance. The regulation and supervision to which PXRE Reinsurance is subject relates primarily to the standards of solvency that must be met and maintained, licensing requirements for reinsurers, the nature of and limitations on investments, deposits of securities for the benefit of a reinsured, methods of accounting, periodic examinations of the financial condition and affairs of reinsurers, the form and content of reports of financial condition required to be filed, reserves for losses and other matters. In general, such regulation is for the protection of the reinsureds and policyholders, rather than investors.
Barbados. PXRE Barbados is subject to regulation under Barbados' Insurance Act, 1996. Under the Barbados Act, PXRE Barbados may only pay a dividend out of the realized profits of the company and may not pay a dividend unless (a) after payment of the dividend it is able to pay its liabilities as they become due, and (b) the realizable value of its assets is greater than the aggregate value of its liabilities and (c) the stated capital accounts are maintained in respect of all classes of shares.
As a registered Bermuda Class 3 insurer, PXRE Bermuda is subject to regulation and supervision in Bermuda. Bermuda insurance statutes, regulations and policies of the BMA require PXRE Bermuda to, among other things:
o maintain a principal office and appoint and maintain a principal representative in Bermuda; and
o provide for the performance of certain periodic examinations of PXRE Bermuda and its financial condition.
Under Bermuda law, non-Bermudians (other than spouses of Bermudians) may not engage in any gainful occupation in Bermuda without the specific permission of the appropriate government authority. The Bermuda government will issue a work permit for a specific period of time, which may be extended upon showing that, after proper public advertisements, no Bermudian (or spouse of a Bermudian) is available who meets the minimum standards for the advertised position. The Bermuda government has a policy that limits the duration of work permits to six years, subject to certain exemptions for key employees. Substantially all of our key officers, including our Chief Executive Officer, Chief Financial Officer, most executive vice presidents and key reinsurance underwriters are working in Bermuda under work permits that will expire over the next three years. The Bermuda government could refuse to extend these work permits. If any of our senior executive officers were not permitted to remain in Bermuda, our operations could be disrupted and our financial performance could be adversely affected.
We and our Bermuda subsidiaries may become subject to Bermuda taxes in the future.
We and our non-U.S. subsidiaries intend to operate our business in a manner that will not cause us to be treated as engaged in a trade or business in the United States (and, in the case of those non-U.S. companies qualifying for treaty protection, in a manner that will not cause us to be doing business through a permanent establishment in the United States) and, thus, will not subject us to U.S. federal corporate income taxes or branch profits tax (other than withholding taxes on certain U.S. source investment income, dividends from PXRE Delaware to PXRE Barbados and excise taxes on insurance or reinsurance premiums). However, because there is uncertainty as to the activities that constitute being engaged in a trade or business within the United States, and what constitutes a permanent establishment under the applicable tax treaties, there can be no assurances that the U.S. Internal Revenue Service ("IRS") will not contend successfully that we or our non-U.S. subsidiary is engaged in a trade or business, or carrying on business through a permanent establishment in the United States.
Although it is not anticipated that we or any of our non-U.S. subsidiaries are or will be classified as a FPHC for U.S. federal income tax purposes, if we or any of our non-U.S. subsidiaries are classified as a FPHC, a United States person that directly or indirectly owns our common shares would be subject to adverse tax consequences.
Each U.S. Holder (as defined in Section 7701(a)(30) of the Internal Revenue Code of 1986, as amended (the "Code")) of a foreign corporation that is a CFC for an uninterrupted period of 30 days or more during a taxable year, and who owns, directly or indirectly through foreign entities, on the last day of the CFC's taxable year, at least 10% of the total combined voting power of all classes of shares of the CFC entitled to vote, must include in its gross income for U.S. federal income tax purposes its pro rata share of the CFC's "subpart F income," even if the subpart F income is not distributed. A foreign corporation is considered a CFC if "10% U.S. Shareholders" own (directly, indirectly through foreign entities or by attribution by application of the constructive ownership rules (i.e., "constructively")) more than 50% of the total combined voting power of all classes of voting stock of such foreign corporation or the total value of all stock of such corporation. A "10% U.S. Shareholder" is a U.S. Holder who owns (directly, indirectly through foreign entities or constructively) at least 10% of the total combined voting power of all classes of stock entitled to vote of the foreign corporation. For purposes of taking into account insurance income, a CFC also includes a foreign insurance company in which more than 25% of the total combined voting power of all classes of stock (or more than 25% of the total value of the stock) is owned by 10% U.S. Shareholders, on any day during the taxable year of such corporation, if the gross amount of premiums or other consideration for the reinsurance or the issuing of insurance or annuity contracts exceeds 75% of the gross amount of all premiums or other consideration in respect of all risks.
We believe that because of the anticipated dispersion of our share ownership, provisions in our organizational documents that limit voting power and other factors, no U.S. person who owns our shares directly or indirectly through one or more foreign entities should be treated as owning (directly, indirectly through foreign entities or constructively) 10% or more of the total voting power of all classes of our shares. However, due to the attribution provisions of the Code regarding determination of beneficial ownership, there is a risk that the IRS could assert that one or more of our non-U.S. subsidiaries are CFCs and that U.S. holders of our common shares who own 10% or more of the value of our common shares should be treated as owning 10% or more of the total voting power of all classes of our shares notwithstanding the reduction of voting power discussed above.
If the RPII of any of our non-U.S. insurance subsidiaries were to equal or exceed 20% of such company's gross insurance income in any taxable year and direct or indirect insureds (and persons related to such insureds) own (or are treated as owning directly or indirectly through entities) 20% or more of our voting power or value, then a U.S. person who owns our shares (directly or indirectly through foreign entities) on the last day of the taxable year would be required to include in its income for U.S. federal income tax purposes such person's pro rata share of such non-U.S. insurance subsidiary's RPII for the entire taxable year, determined as if such RPII were distributed proportionately only to U.S. persons at that date regardless of whether such income is distributed. 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, and we do not expect the direct or indirect insureds of the non-U.S. insurance subsidiaries (and related persons) to directly or indirectly own 20% or more of either the voting power or value of our common shares, but we cannot be certain 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 holder's share of the corporation's undistributed earnings and profits that were accumulated during the period that the holder owned the shares (whether or not such earnings and profits are attributable to RPII). In addition, such a holder will be required to comply with certain reporting requirements, regardless of the amount of shares owned by the holder. These RPII rules should not apply to dispositions of our common 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 subsidiaries is uncertain.
If we are classified as a passive foreign investment company ("PFIC"), your taxes would increase.
Although it is not anticipated that we will be classified as a PFIC for U.S. income tax purposes, if we are classified as a PFIC, it would have material adverse tax consequences for U.S. persons that directly or indirectly own our common shares, including subjecting such U.S. persons to a greater tax liability than might otherwise apply and subjecting such U.S. persons to tax on amounts in advance of when tax would otherwise be imposed. There are currently no regulations regarding the application of the PFIC provisions to an insurance company. New regulations or pronouncements interpreting or clarifying these rules may be forthcoming. We cannot predict what impact, if any, such guidance would have on persons subject to U.S. federal income tax that directly or indirectly own our common shares.
The anti-dilution protections afforded to the preferred shareholders could have a material dilutive effect on our common shareholders. Each preferred share, in whole or in part, is convertible at any time at the option of the holder into convertible common shares for that series according to a formula set forth in the description of stock filed as an exhibit to this form 10-K. The convertible common shares are, in turn, convertible into common shares on a one-for-one basis. The number of convertible common shares per preferred shares issuable upon any conversion will be determined by dividing a liquidation preference for the series equal to the aggregate original purchase price of the preferred share plus accrued but unpaid dividends thereon, by the conversion price then in effect. The conversion price is subject to adjustment to avoid dilution in the event of recapitalization, reclassification, stock split, consolidation, merger, amalgamation or other similar event or an issuance of additional common shares in a private placement below the fair market value or in a registered public offering below 95% of fair market value or without consideration. In addition, the conversion price is subject to adjustment for certain loss and loss expense development on reserves for losses incurred on or before September 30, 2001 and for any liability or loss arising out of pending material litigation on December 10, 2001. As of March 1, 2004, the outstanding preferred shares were ultimately convertible into 12,100,347 common shares, or 47.7% of our outstanding common shares on a fully converted basis and using the adjusted conversion price of $14.23 in effect as of December 31, 2003. However, because the conversion price for the preferred shares is subject to adjustment for a variety of reasons, including if we have certain types of adverse loss development, the number of our common shares into which the preferred shares are ultimately convertible and, accordingly, the amount of dilution experienced by our common shareholders, could increase.