In September, 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (“SFAS 158”), an amendment of SFAS No. 87, 88, 106 and 132R. This statement represents the completion of the first phase in the FASB’s postretirement benefits accounting project and requires an entity to recognize in its statement of financial position an asset for a defined benefit postretirement plan’s overfunded status or a liability for a plan’s underfunded status, measure a defined benefit postretirement plan’s assets and obligations that determine its funded status as of the end of the employer’s fiscal year and recognize changes in the funded status of a defined benefit postretirement plan in comprehensive income in the year in which the changes occur. The statement does not change the amount of net periodic benefit cost included in net income or address the various measurement issues associated with postretirement benefit plan accounting. PXRE adopted the portion of the statement which requires recognition of the funded status of a defined benefit postretirement plan and the disclosure requirements as of December 31, 2006. The adoption of this statement resulted in PXRE recording a charge of $0.7 million in “Accumulated other comprehensive loss” in its Consolidated Balance Sheet as of December 31, 2006. The requirement to measure plan assets and benefit obligations as of the date of the employer’s fiscal year-end balance sheet is effective for fiscal years ending after December 15, 2008.
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 $691.7 million and $22.5 million for the years ended December 31, 2005, and 2001 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 $698.7 million and $22.5 million for the years ended December 31, 2005 and 2001 respectively.
The 2004 net income per diluted common share for the year ended December 31, 2004 and the net income per diluted common share for the three months ended June 30, 2006 and September 30, 2006 have been adjusted for immaterial errors with respect to the anti-dilutive nature of convertible preferred share dividends and therefore the amounts presented herein do not agree with previously issued consolidated financial statements.
The loss, expense and combined ratios included under “Other Operating Data” have been derived from our Consolidated Statements of Operations and Comprehensive Operations prepared in accordance with GAAP. The underwriting results of a property and casualty insurer are discussed frequently by reference to its loss ratio, expense ratio and combined ratio. The loss ratio is the result of dividing losses and loss expenses incurred by net premiums earned. The expense ratio is the result of dividing underwriting expenses (including amortization of expenses previously deferred, commission and brokerage, net of fee income, and the operating expenses) by net premiums earned. The combined ratio is the sum of the loss ratio and the
expense ratio. A combined ratio less than 100% indicates underwriting profits and a combined ratio greater than 100% indicates underwriting losses. The combined ratio does not reflect the effect of net investment income, other reinsurance related expense or other fee income on underwriting results.
The following discussion and analysis is comprised of an overview of the Company, critical accounting policy disclosures, comparisons of operating results between periods, a discussion of our financial condition and results of operations at December 31, 2006 and disclosure of certain risks and uncertainties. This discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes included in this filing. This filing contains forward-looking statements that involve risks and uncertainties. Actual results may vary materially from the results described or implied by these forward-looking statements.
PXRE Group Ltd. is an insurance holding company organized in Bermuda. We provide reinsurance products and services to a worldwide marketplace through our wholly owned subsidiary operations located in Bermuda, Europe and the United States. Our primary business has been catastrophe and risk excess reinsurance, which accounted for substantially all of our net premiums written for the year ended December 31, 2006.
Since the downgrade and withdrawal of our credit ratings in early 2006, we have not underwritten any material new reinsurance contracts or renewed any of our expiring reinsurance contracts. During 2006, most of our clients exercised their contractual rights to terminate their reinsurance contracts with us as a result of the decline in our ratings and capital. In order to manage our peak zone catastrophe exposures, the Company had also selectively allowed extra-contractual cancellations on certain contracts that do not contain cancellation provisions triggered by rating downgrades. As of January 1, 2007, virtually all of our in-force assumed reinsurance contracts had expired and we have no remaining material exposure to future catastrophe events at that date.
We had net income before convertible preferred share dividends of $28.5 million in 2006 compared to a net loss before convertible preferred share dividends of $697.6 million in 2005. The primary cause of the 2005 net loss was the net impact of catastrophe losses arising from
Hurricanes Katrina, Rita and Wilma of $806.9 million, after reinsurance recoveries on our outwards reinsurance program and the impact of inwards and outwards reinstatements and additional premiums. The Company had $84.5 million in net premiums earned during the year ended December 31, 2006, as compared to $388.3 million in the prior year.
Upon completion of the merger, PXRE will be renamed “Argo Group International Holdings, Ltd.” and its common shares will be delisted from the New York Stock Exchange and relisted on the NASDAQ.
The merger agreement contains certain termination rights for both us and Argonaut. Under certain circumstances, including those relating to competing business combination proposals, termination of the merger agreement could obligate PXRE to pay a termination fee of $20 million.
Argonaut underwrites specialty commercial insurance in niche areas of the property and casualty insurance market. Argonaut offers property and casualty insurance products through eleven wholly-owned insurance companies. Collectively, the insurance subsidiaries are admitted to write insurance in all fifty states and in the District of Columbia, Guam and the U.S. Virgin Islands and are authorized to write insurance on a surplus lines basis in all fifty states.
The Board of Directors believes that the merger with Argonaut and resumption of reinsurance business through Peleus Re will provide shareholders with an expected return that is superior to both the potential value that shareholders would have realized if the Board of Directors had elected to pursue other non-runoff alternatives considered during the strategic evaluation process or the potential value that shareholders were likely to realize if the Company were to be liquidated after the conclusion of an orderly runoff and winding up process.
On February 22, 2006, we announced our financial results for the quarter ended December 31, 2005. We also announced a further increase in our estimates of the net pre-tax impact of Hurricanes Katrina, Rita and Wilma. See Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Comparison of 2005 with 2004 - Losses and Loss Expenses.
Subsequently in February 2006, S&P further downgraded its counterparty credit and financial strength rating on PXRE Reinsurance and PXRE Bermuda from “BBB+” to “BBB-”. A.M. Best further downgraded its financial strength rating on these entities from “B++” to “B+” with a negative implication. 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. See Item 1 - Business: Ratings.
In April, 2006, after finding that operational ratings below the critical “A” category provided little value for a reinsurer, we announced that we had requested that the major credit rating agencies withdraw their financial strength and claims paying ratings of the Company and its operating subsidiaries. In the wake of this request, A.M. Best downgraded its financial strength ratings of PXRE Reinsurance and PXRE Bermuda from “B+” to “B” and withdrew these ratings; S&P downgraded its counterparty credit and financial strength rating on PXRE
Ratings have become an increasingly important factor in establishing the competitive position of reinsurance companies. Due to these ratings downgrades and withdrawal in 2006 of the operational ratings of our reinsurance subsidiaries by A.M. Best, S&P and Moody’s, our competitive position in the reinsurance industry has suffered, with ceding companies and brokers having moved business to other reinsurers with higher ratings. As of December 31, 2006, virtually all of the Company’s reinsurance contracts had either been cancelled, non-renewed or expired.
The foregoing discussion of our Business in Item 1 of this Annual Report on Form 10-K concerns PXRE’s business operations during 2006 and prior. As discussed above, our Board of Directors entered into a Merger Agreement with Argonaut. For a discussion of Argonaut’s business, see Argonaut’s Annual Report of Form 10-K for the period ended December 31, 2006, which was filed with the SEC on March 1, 2007.
Industry sources have estimated that Hurricane Katrina, which struck the United States on August 30, 2005, caused insured industry losses from $41 billion to $60 billion. Hurricane Rita, which struck Texas on September 24, 2005, caused another $4 billion to $7 billion in insured industry losses according to these same industry sources. As a result of these hurricanes, we reported a net loss before convertible preferred share dividends of $317.3 million during the quarter ended September 30, 2005.
On September 29, 2005, S&P downgraded both the counterparty credit and financial strength ratings of our reinsurance subsidiaries from “A” (Strong) to “A-” (Strong) and announced that this rating would remain on credit watch negative. A.M. Best also downgraded the financial strength rating of our reinsurance subsidiaries from “A” (Excellent) to “A-” (Excellent) on September 30, 2005 and announced that this rating would remain under review with negative implications.
On October 7, 2005, we also completed a public offering of 8,843,500 of our common shares including 1,153,500 shares sold upon exercise of the underwriter’s over-allotment option in full, at a public offering price of $13.25 per share. Credit Suisse First Boston LLC acted as sole underwriter in the offering. Net proceeds to the Company from the common stock offering, after deducting estimated expenses and underwriter’s discounts and commissions, were approximately $114.7 million.
We contributed the net proceeds of both offerings to PXRE Bermuda to support the underwriting of reinsurance business during subsequent renewal periods.
Shortly after the completion of the foregoing capital raising transactions, Hurricane Wilma occurred, making landfall in Mexico on October 21, 2005 and Florida on October 24, 2005. Industry sources have estimated that Hurricane Wilma caused insured industry losses from $8 billion to $12 billion in Florida. As of December 31, 2005, the net impact of Hurricane Wilma on our financial position and results of operations was $138.0 million, after reinsurance recoveries on our outwards reinsurance program and the impact of inwards and outwards reinstatements and additional premiums.
The new loss estimates resulted from the Company’s assessment of new loss reports, as well as notifications received by the Company subsequent to the ratings 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.
Approximately ninety-five percent of our projected net ultimate incurred loss for Hurricanes Katrina, Rita and Wilma has been formally reported to us as paid or case reserves. However, as of December 31, 2006, we have paid less than 60% of our net incurred loss amounts with respect to these hurricanes. Accordingly, the liability for loss and loss expenses incurred with respect to Hurricanes Katrina, Rita and Wilma represents management’s best estimate of our ultimate liability for claims arising from these catastrophes. Our estimation of loss and loss expense liability involves significant uncertainties and is based on complex and subjective judgments. Because of the uncertainty in the process of estimating our losses from catastrophe events, there is a risk that our liability for losses and loss expenses could prove to be inadequate, with a consequent adverse impact on our future earnings and shareholders’ equity. See below, Update on Critical Accounting Policy Disclosures - Estimation of Losses and Loss Expenses.
Our incurred loss for these events represents our best estimate, which is primarily based on claims notices, modeling, a review of affected contracts by our underwriters and discussions with our clients; however, some of our cedents who have incurred losses from multiple events, may have the ability to choose which losses to cede, and as such, in future periods they may reallocate losses among the 2005 events.
The reinsurance coverage provided by A&W I was based on a modeled loss trigger. PXRE created a series of notional portfolios of reinsurance contracts designed to closely mimic the expected 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 exceeded the attachment point for the peril at issue, then PXRE would have made a recovery under the reinsurance agreement. The recovery was limited to PXRE’s ultimate net loss from the loss event. PXRE has the right to reset the notional portfolios after three years.
In order to have realized any benefit from the coverage provided under the A&W I reinsurance agreement, PXRE would need to incur significant losses from a catastrophe event. Since the downgrades and withdrawal of PXRE’s credit ratings in early 2006, PXRE has not underwritten any new reinsurance contracts or renewed any of its expiring reinsurance contracts. Effective as of January 1, 2007, virtually all of PXRE’s in-force assumed reinsurance contracts had expired and PXRE has no remaining material exposure to future catastrophe events. The Board of Directors of PXRE Group Ltd. concluded that it was unlikely that PXRE Group Ltd. would ultimately pursue a strategic alternative that would allow PXRE to utilize the coverage available under the A&W I reinsurance agreement in light of the extremely high attachment point under such reinsurance agreement. Accordingly, on February 8, 2007, PXRE did not pay the premium due to A&W I. The non-payment is expected to result in an event of default under the A&W I reinsurance agreement, which will trigger the early commutation of such reinsurance agreement. As a result of the early commutation of the Reinsurance Agreement, PXRE recorded termination charges of approximately $17.6 million in its December 31, 2006 consolidated financial statements. This amount is reflected as a reduction to net premium earned in the Company’s consolidated statement of operations and comprehensive operations for the year ended December 31, 2006.
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 coverage provided $250.0 million of protection for the period from January 1, 2006 to December 31, 2006 and provides $125.0 million for the period from January 1, 2007 to December 31, 2008.
On December 21, 2005, A&W II financed the coverage through the issuance and sale of $250.0 million in catastrophe bonds pursuant to Rule 144A under the Securities Act of 1933.
If the Board of Directors elects to pursue a strategic alternative that materially changes PXRE’s catastrophe risk profile, we may seek to assign or novate PXRE’s rights and obligations under the A&W II collateralized catastrophe facility 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 the 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 this collateralized catastrophe facility, PXRE could incur material termination fees and liabilities. If the A&W II facility is terminated prior to the end of the scheduled termination date, these fees could be as much as $5.8 million, and PXRE is obligated to make all premium payments up to the date of termination.
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. If the Board of Directors elects to pursue a strategic alternative that materially changes PXRE’s catastrophe risk profile, the Company will also need to evaluate its obligations under two multi-year ceded reinsurance contracts that provide the Company with reinsurance protection against catastrophic events in 2007 and 2008. In this regard, the Company will need to evaluate whether it is likely that catastrophe loss exposure assumed by PXRE in 2007 and 2008 has the potential to result in losses that exceed the retention level under these ceded reinsurance protections. The Company is currently obligated to cede reinsurance premiums of $15.0 million per annum in each of 2007 and 2008 under these multi-year contracts.
As a reinsurer, we generated income primarily through the premiums from clients who purchased our reinsurance contracts and the investment income generated by our portfolio of invested assets. Our primary expenses are the losses incurred under our reinsurance contracts, commissions and brokerage paid to reinsurance brokers who place reinsurance contracts with us, our general operating expenses such as salaries and rent, and interest expense on our debt. The two largest variables that determine the profitability of our business from period to period are generally the amount of premiums generated and the size of losses incurred.
We disclose our significant accounting policies in the Notes to the Consolidated Financial Statements. Certain of these policies are critical to the portrayal 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 losses and loss expenses, estimation and recognition of premiums, valuation of investments and valuation of deferred tax asset.
In establishing our loss and loss expense liabilities, PXRE records reserves as management’s best estimate of liabilities as of the balance sheet date. Management believes that the Company’s estimated liability for unpaid losses and loss expenses as of December 31, 2006 is adequate. Since year-end 2004, all of our loss and loss expense estimates have been reviewed annually by an independent internationally recognized actuarial firm, and their conclusions have not, in any period, been materially different than those of the Company.
The most significant uncertainty in our reserves involves our estimates of catastrophe losses. In reserving for catastrophe losses, our estimates are influenced by underwriting information provided by our clients, industry catastrophe models, industry loss estimates and our internal analyses of this information. This reserving approach can cause significant development from initial loss estimates in the immediate wake of a catastrophe event due to the limited information available to us as a reinsurer and retrocessionaire regarding the actual underlying losses. This process can cause our ultimate estimates to differ significantly from initial projections.
Historically, there has been significant variability in the development of catastrophe losses during the twelve month period immediately following the catastrophe event with such variability reducing after the initial twelve month period. To further illustrate the variability of setting catastrophe loss estimates, the following chart outlines the changes in the initial loss estimates for recent costly catastrophes in the United States over a three-year period based on industry insured loss:
We establish loss and loss expense liabilities (to cover expenses related to settling claims, including legal and other fees) to provide for the ultimate cost of settlement and administration of claims for losses, including claims that have been reported to us by our reinsureds and claims for losses that have occurred but have not yet been reported to us.
For reported losses, we establish reserves (liabilities for formally reported claims) when we receive notice of the claim, which we refer to as case reserves. It is our general policy to establish liabilities for reported losses in an amount equal to the liability set by the reinsured. In certain but infrequent instances, such as the receipt of inconsistent, incorrect or inadequate supporting documentation, we will conduct an investigation to determine if the amount established by the reinsured is appropriate or if it should be adjusted in the form of an additional case reserve.
PXRE also records reserves for losses that have been incurred but not yet reported, which are referred to as IBNR reserves. For IBNR reserves, a variety of methods have been developed in the insurance industry and are generally accepted for use in determining the appropriate provision for such liabilities. In general, these methods involve the extrapolation of reported loss data to estimate ultimate losses. Our loss calculation methods generally rely upon a projection of ultimate losses based upon the historical patterns of reported loss development.
The BF method is a premium based method of computing IBNR which blends the loss ratio method with the loss development method. The BF method computes IBNR for an accident year as the product of expected loss (earned premium multiplied by an expected loss ratio) and an expected percentage of unreported losses. This expected percentage of unreported loss is a function of the loss development factors developed by our corporate actuaries from our annual analysis of the Company’s historical loss development patterns by line of business. As experience emerges and accident years mature further (generally eighteen to thirty-six months after the accident year given the short-tailed nature of these property reinsurance lines) we transition to the incurred loss development method, which relies solely on our clients’ reported loss information and indicated historical loss development patterns to estimate ultimate losses.
Other alternate loss reserving methods developed in the insurance industry include the paid loss development method and the paid Bornhuetter-Ferguson method. We do not use these methods to establish our IBNR reserves. We believe that incurred loss methods are more reliable because they rely on a much larger, more stable and credible source of information, which is not influenced by the occurrence of one or more large payments. We do, however, use these alternate loss reserving methods to evaluate the reasonableness of the IBNR reserves that we establish using the incurred loss methods.
Our loss development factors and expected loss ratios are monitored regularly and updated as appropriate but at least once a year. These are the key assumptions that materially affect our estimates for reserves for losses and loss expenses. The expected loss ratio is primarily established for each line of business based on the Company’s historical loss ratios. In determining the expected loss ratio, we also consider information provided by our clients and estimates provided by our underwriters and actuaries concerning the impact of pricing and coverage changes. Loss development factors are developed from our annual analysis of our Company’s historical loss development patterns by line of business. These key assumptions did not materially change from December 31, 2005 to December 31, 2006.
In reserving for catastrophe losses in our catastrophe and risk excess segment, there is initially little reported loss information in the immediate wake of a catastrophe event, as was the case with the 2005 Hurricanes, Katrina, Rita and Wilma (“KRW”). The loss estimation process begins with the identification of events with characteristics similar to the recent catastrophe (geographic location, wind speed, damageability etc.), which then results in a list of the expected losses by contract from our proprietary risk management system. Third party modeling software is embedded in our proprietary risk management system.
The results of this initial process are updated when additional information is available. This information comes in the form of publicly available announcements, informal contact with brokers and/or clients, submission data and formal claim notices. As catastrophic events mature and reporting loss methods become more credible (usually six to twelve months after the event) actuarial methods implementing historical patterns can be assigned more credibility. In evaluating the loss estimates for catastrophic events, our actuaries utilize our internal database to establish projected reporting patterns and payment patterns. This database includes data dating back to the 1980’s consisting of well over one hundred catastrophic events, of which over twenty are hurricanes. Our actuary also employs industry patterns from the Reinsurance Association of America, an insurance industry organization. Using this information, we have developed loss development factors for significant catastrophes. Our internal significant catastrophe loss development factors are analyzed as appropriate and at least once per year to reflect updated industry benchmarks and changes in PXRE’s specific loss history. The volume of reported loss activity in interim quarterly periods is monitored by the Company to determine consistency with expected loss activity based on PXRE and industry historical patterns. For individual storms, PXRE specific loss development factors are applied to reported losses to estimate IBNR reserves. However these may be weighted with industry factors or judgmental adjustments for individual significant catastrophes based upon the nature of the particular catastrophe and the underwriters’ knowledge.
This catastrophe reserving process can cause our ultimate estimates to differ significantly from initial projections. For example, as part of our year-end closing process for the year ended December 31, 2005, we reassessed our ultimate liability for losses and loss expenses arising from Hurricanes Katrina, Rita and Wilma. During the course of our 2005 year-end assessment, we increased our estimate of the ultimate incurred gross losses and loss expenses arising from Hurricane Katrina by $214.6 million to $771.0 million and from Hurricane Rita by $48.1 million to $68.9 million, in each case as compared to the gross incurred losses recorded as of September 30, 2005. Our initial loss estimates for each of the hurricanes were 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 2005 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.
A number of our clients have already exhausted all coverage available for losses arising from Hurricane Katrina. If other clients were to incur widespread additional losses as a result of settlements or adverse litigation results involving the flood vs. wind controversy, it is possible that our current best estimate for Hurricane Katrina will be exceeded. The “remaining limits” table below displays the potential impact to PXRE as of December 31, 2006 should the aggregate amount of losses reported by our clients from the ground up (“FGU”) from all cedents that still have remaining limits increase uniformly by various percentages:.
In reserving for losses on our exited lines segment, there is great uncertainty due to its composition of casualty and finite businesses, which produce losses that are slower to be reported and paid than the property losses of our catastrophe and risk excess segment. 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 estimate these loss liabilities. We must therefore rely on the historical loss development patterns reported by our clients and industry loss development data in estimating our liabilities including IBNR. Accident years for this segment take a longer period of time to “mature” than for our catastrophe and risk excess segment, therefore, we primarily utilize the loss ratio method and BF method to establish our initial exited lines loss estimates including IBNR. When the amount of reported losses become a more reliable means for setting reserve estimates, generally five to seven years after the relevant accident year, PXRE places more weight on these reported losses to estimate its loss reserves including IBNR and less weight on the BF method.
There is an additional risk of uncertainty in PXRE’s estimation of losses due to the fact that PXRE writes only reinsurance business and no insurance business. As a result, losses, unearned premiums and premiums written are all recorded based on reports received from the ceding companies. PXRE does not receive loss information from the underlying insureds; however, because the Company’s reinsurance business focuses on short-tail lines such as property catastrophe, retrocessional property catastrophe, risk-excess and aerospace, the delay from the time of the underlying loss to the report date to PXRE is not as significant a risk as it would be if the Company underwrote a significant amount of casualty business. However, 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, a delay in losses being reported to insurance carriers, reinsurers and finally retrocessionaires may require us to make estimates of losses based on limited information from our clients, industry loss estimates and our own underwriting data.
Net Loss and Loss Expense Liabilities Range at December 31, 2006
For the remainder of our carried loss and loss expense liabilities, we used a statistical model to simulate a range of results about our best estimates assuming probability distributions believed to reasonably reflect potential for favorable and unfavorable loss development. The simulation results indicate that a five percent probability exists that the net loss reserves will be below the low estimate and a five percent probability exists that the net loss reserves will be above the high estimate. However, no assurance can be given that our ultimate losses will not be significantly different than the simulation.
The low end and high end of the range of reasonable net loss and loss expense reserves around the best estimate have decreased from December 31, 2005 principally because of the reduction in the Company’s net loss reserve amount due to the payment of claims during the year ended December 31, 2006, as well as the passage of time since the occurrences of Hurricanes Katrina, Rita and Wilma and the resulting increase in formal loss reports and decrease in actuarial variability surrounding the best estimate.
The estimated premium receivable, net of commission and brokerage, included in “Premiums receivable, net” on the Consolidated Balance Sheets at December 31, 2006 of $93.3 million, is $75.1 million, including assumed reinstatement premiums of $69.5 million.
Assumed reinstatement and additional premiums written and earned during the years ended December 31, 2006 and 2005, as reflected in the Consolidated Statements of Operations and Comprehensive Operations, were as follows:
We accrue assumed reinstatement premiums based upon contract terms applied to the amount estimated to settle ultimate incurred losses. The primary factor that could affect our estimate of assumed reinstatement premiums is management’s best estimate of ultimate incurred losses. See “Critical Accounting Policy Disclosures - Estimation of Losses and Loss Expenses” with regards to the uncertainty, historical accuracy and sensitivity of this estimate. While premiums stated relative to limit (“rates on line”) have an effect on the estimate of assumed reinstatement premiums, those associated with case reserves are based on actual contract rate on line terms, and those estimates associated with IBNR are based on weighted average rate on line terms of the book of business for a given underwriting year by line of business. Therefore the primary factor that could change our estimate of assumed reinstatement premium is management’s best estimate of ultimate incurred losses and the mix of treaties along with their respective rate on lines that ultimately incur losses. Assumed reinstatement premiums receivable are settled on a net basis when loss payments are made to cedents. Accordingly, there is an insignificant amount of credit risk associated with this asset as of any given period end date.
Fair values for our investments in hedge funds and other privately held fixed income securities generally are established on the basis of the valuations provided monthly or quarterly by the managers of such investments. These valuations generally are determined based upon the valuation criteria established by the governing documents of such investments or utilized in the normal course of such manager’s business. Such valuations may differ significantly from the values that would have been used had readily available markets existed.
We utilize the valuations provided to us by managers of our hedge funds and other privately held fixed income 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 or loss payments.
We regularly monitor the difference between the estimated fair values 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 other comprehensive operations as a separate component of 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 in our Consolidated Statements of Operations and Comprehensive Operations. 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. During the years ended December 31, 2006 and 2005, PXRE recorded $7.3 million and $11.8 million, respectively, in “other than temporary” impairment charges. The “other than temporary” impairment charges recorded in 2006 and 2005 relate to investments that the Company may not have the ability to hold to maturity or recovery as a result of the ratings downgrades of PXRE in February 2006. In 2004 we recognized $0.1 million of impairment losses on investment securities whose value had fallen below 80% of face value for more than six months.
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.
For the year ended December 31, 2006, net income before convertible preferred share dividends was $28.5 million compared to net loss before convertible preferred share dividends of $697.6 million for 2005. Our net income in 2006 reflected the absence of any significant loss events during 2006 as well as net favorable development on our reserves for prior years. This was offset by a $303.8 million, or 78%, decrease in net premiums earned during 2006 as compared to 2005 due to the cancellation and non-renewal of many of our reinsurance contracts due to our ratings downgrades in February 2006. The primary cause of the net loss in 2005 was the net impact of catastrophe losses arising from Hurricanes Katrina, Rita and Wilma of $806.9 million, after reinsurance recoveries on our outwards reinsurance program and the impact of inwards and outwards reinstatements and additional premiums.
Net income per diluted common share was $0.33 for 2006, compared to net loss per diluted common share of $21.65 for 2005, based on diluted average shares outstanding of approximately 72.0 million in 2006 and 32.5 million in 2005. In accordance with SFAS No. 128, “Earnings Per Share,” for 2006 and 2005 it did not include 5.1 million and 11.0 million of average shares, respectively that are anti-dilutive (as shown in Note 10 to the Consolidated Financial Statements) in determining the denominator for its calculation of net income (loss) per diluted common shares.
Gross and net premiums earned for the years ended December 31, 2006 and 2005 were as follows:
During 2005, we experienced net adverse development of $23.9 million for prior-year losses and loss expenses, comprised 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 was 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.
The operating expense ratio was 51.3% for 2006 compared with 9.3% for 2005. The increase in the operating expense ratio can be attributed to the decrease in net premiums earned and an increase in operating costs in 2006. Other operating expenses increased $7.2 million, or 20%, to $43.4 million for 2006 from $36.2 million in 2005 largely as a result of an increase in fees to attorneys and financial advisors, which have been incurred as a result of our ratings downgrades, the Board of Directors’ decision to explore strategic alternatives for the Company and class action securities lawsuits filed against the Company during the second quarter of 2006.
In the fourth quarter of 2005, PXRE sponsored a catastrophe bond transaction which was determined to be a derivative and recorded at fair value. During 2006 the increase of $16.9 million in other reinsurance related expense was due to the change in fair value of this derivative, principally due to the passage of one year of the transaction’s risk coverage for calendar year 2006.
Net investment income for the year ended December 31, 2006 increased $15.4 million, or 34%, to $60.7 million from $45.3 million for 2005. This increase was primarily due to a $20.2 million increase in income from our fixed maturity and short-term investment portfolios, offset, in part, by a $6.6 million decrease in income from our hedge funds. The average invested balances in our fixed maturity and short-term investment portfolio increased due to cash flows from proceeds from a public offering and private placement of $474.0 million in the fourth quarter of 2005 as discussed in Note 8 to the Consolidated Financial Statements as well as from the proceeds from the redemptions of hedge fund investments during 2006. The net return of the fixed maturity and short-term investment portfolios, excluding realized and unrealized capital gains, increased to 4.9% for 2006, on an annualized basis, compared to 3.7% for 2005 due to improved yields throughout the portfolio, but particularly within our short-term portfolio. Investment income related to our hedge fund portfolio decreased to $5.2 million in 2006 from $11.9 million in 2005. Investments in hedge funds produced a return of 9.1% for the year ended December 31, 2006 compared with 8.5% for the year ended December 31, 2005. Subsequent to, and as a result of the ratings downgrades in February 2006, redemption orders were executed for all of the Company’s hedge fund investments and as a result income from hedge funds is expected to continue to decrease in future periods as we receive the proceeds from our various hedge funds.
Net realized investment losses for 2006 were $7.8 million. The losses were primarily the result of the write down of $7.3 million of investment securities due to other than temporary impairment following the downgrades of PXRE’s credit ratings in February 2006.
Net realized investment losses for 2005 were $14.7 million. The losses were primarily the result of the write down of $11.8 million of investment securities due to other than temporary impairment following the downgrades 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.
PXRE recognized a tax expense of $0.6 million in 2006 compared to a tax expense of $5.9 million in 2005. The tax expense in 2006 related to prior year alternative minimum tax.
Net loss per diluted common share was $21.65 for 2005 compared to net income per diluted common share of $0.59 for 2004, based on diluted average shares outstanding of approximately 32.5 million in 2005 and 15.0 million in 2004. In accordance with SFAS No. 128, “Earnings Per Share,” for 2005 and 2004 the Company did not include 11.0 million and 12.8 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) income per diluted common shares.
All of the Company’s reinsurance recoverable related to Hurricanes Katrina, Rita and Wilma are either fully collateralized or reside with entities presently rated “A” or higher.
Investment income for the year ended December 31, 2005 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 for which we have recognized $0.9 million of investment income for the year ended December 31, 2004. On ceded reinsurance contracts, we held premiums and accrued investment income of $86.4 million due to reinsurers as of both December 31, 2005 and 2004 for which we recognized a charge to
PXRE recognized a tax expense of $5.9 million in 2005 compared to a tax benefit of $6.2 million in 2004, reflecting the proportion of business reinsured by PXRE Reinsurance relative to the consolidated PXRE Group for Hurricanes Katrina, Rita and Wilma.
Book value per common share was $6.41 at December 31, 2006 after considering convertible preferred shares.
Net cash provided by investing activities were $436.5 million in 2006 compared to net cash flows used by investing activities of $490.5 million in 2005. This increase was primarily due to the sale of investment securities in order to meet the Company’s currently foreseen liquidity needs. As discussed above, in February 2006 we sold approximately $490.5 million of fixed income securities held by PXRE Bermuda, and additionally executed redemption orders for all of the Company’s hedge fund investments. Because of the nature of the coverages we provided, 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 individual quarters and years.
If the merger with Argonaut is not consummated and our Board of Directors concludes that no other feasible 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. If runoff is chosen, the only sources of liquidity for our principal operating subsidiaries will be the maturity or sale of investments, as we will no longer expect to have net positive cash flows from operating activities, borrowings, capital contributions or advances. As of December 31, 2006, we have $671.2 million of short term investments and $532.9 million of other invested assets. The overall duration of the Company’s fixed income and short-term investment strategy is 1.1 years. Based upon our current estimates of losses and loss expenses and other liabilities on our December 31, 2006 consolidated balance sheet, we believe we have sufficient liquidity to meet the currently foreseen needs of our counterparties should we elect to go into runoff, however the nature and timing of cash flows could be highly uncertain in this scenario.
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, 2006 and future commitments.
Loss and loss expense reserves represent management’s best estimate of the ultimate cost of settling the underlying reinsurance claims. As more fully discussed in “Critical Accounting Policy Disclosures - Estimation of Losses and Loss Expenses” above, the estimation of loss and loss expense reserves is based on various complex and subjective judgments. Actual losses and loss expenses paid may deviate, perhaps substantially, from the reserve estimates reflected in our consolidated financial statements. Similarly, the timing for payment of our estimated losses is not fixed and is not determinable on an individual or aggregate basis. The assumptions used in estimating the likely payments due by periods are based on the Company’s historical claims payment experience, but due to the inherent uncertainty in the process of estimating the timing of such payments, there is a risk that the amounts paid in any such period can be significantly different than the amounts disclosed above.
As noted under “- Capital Resources” above, we expect to be able to meet the contractual obligations over 2007 with the dividend paying capacity of the Company’s subsidiary, PXRE Bermuda. PXRE Reinsurance and PXRE Bermuda expect to be able to meet their contractual obligations over 2007 with operating and investing cash flows.
As of December 31, 2006, other commitments and pledged assets include (a) LOCs of $239.3 million which are secured by cash and securities with a fair value of $329.5 million, (b) securities amounting to $9.7 million on deposit with various state insurance departments in order to comply with insurance laws, (c) cash and securities with a fair value of $53.9 million deposited in a trust for the benefit of a cedent in connection with certain deposit liabilities, (d) funding commitments to certain limited partnerships of $0.2 million, (e) commitments under the capital trust pass-through securities discussed above, and (f) commitment fees of $0.4 million per annum under the two committed LOC facilities discussed above. Subsequent to December 31, 2006 and as of February 28, 2007, the Company believes that approximately $89.5 million of this collateral is eligible to be released from the underlying collateral trusts that support the outstanding LOCs.
If the Board of Directors elects to pursue a strategic alternative that materially changes PXRE’s catastrophe risk profile, the Company will also need to evaluate its obligations under two multi-year ceded reinsurance contracts that provide the Company with reinsurance protection against catastrophic events in 2007 and 2008. In this regard, the Company will need to evaluate whether it is likely that catastrophe loss exposure assumed by PXRE in 2007 and 2008 has the potential to result in losses that exceed the retention level under these ceded reinsurance protections. The Company is currently obligated to cede reinsurance premiums of $15.0 million per annum in each of 2007 and 2008 under these multi-year contracts.
Moreover, A.M. Best’s rating of Peleus Re assumes that the merger will be consummated. If the merger is not consummated, there can be no assurance that we will be able to maintain Peleus Re’s current “A-” rating or be able to continue writing reinsurance business.
Ratings have become an increasingly important factor in establishing the competitive position of reinsurance companies. Due to the ratings downgrades and withdrawal of the operational ratings of our reinsurance subsidiaries by A.M. Best, S&P and Moody’s, our competitive position in the reinsurance industry has suffered and we have been unable to retain or renew our reinsurance portfolio.
Ratings are not evaluations directed to investors in our securities (including investors in our common shares) or a recommendation to buy, sell or hold our securities (including our common shares). Ratings may be revised or revoked at the sole discretion of the rating agencies.
If the merger is not consummated, we may not be able to identify or implement a strategic alternative for PXRE.
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. These ratings downgrades have had a significant negative impact on our results of operations and profitability. We have not written any new reinsurance business or renewed any expiring reinsurance business since the downgrades occurred. In light of the negative consequences of the rating downgrades, our Board of Directors decided to retain Lazard (who has since been succeeded by KBW) as a financial advisor to assist in the process of exploring strategic alternatives, which resulted in the proposed merger with Argonaut.
If the merger with Argonaut is not consummated, the Board of Directors would likely re-commence its strategic evaluation process, but we may not be able to identify or complete any of these alternatives that our Board of Directors finds to be in the shareholders’ best interests. Even if we are successful in identifying and completing a merger or sale of PXRE or some other strategic alternative, we cannot provide any assurance about the financial impact or timing of the implementation of any such strategic alternatives or that any individual shareholder will determine that such strategic alternative is in his, her or its best interests.
If the merger is not consummated and our Board of Directors concludes that no other feasible 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.
Alternatively, a program of individual commutations could be pursued with a similar result. Following either a scheme or individual commutation program, PXRE would be placed into liquidation as a solvent entity (a voluntary liquidation approved by shareholders). In the event that PXRE were to become insolvent, the Company would have to be liquidated under the supervision of the Bermuda Supreme Court during which a court appointed liquidator of PXRE may or may not pursue a scheme of arrangement to shorten the time otherwise required to wind up PXRE’s business.
In a winding up or liquidation as described above, a liquidator would be appointed and would sell or otherwise dispose of our remaining assets, pay our existing liabilities, including contingent obligations (which would have to be estimated in advance of payment) and distribute net proceeds, if any, to our shareholders in one or more liquidating distributions. In liquidation, we may not receive any material amounts for the sale or other disposition of our assets. Further, in liquidation, we will have significant obligations, including the costs incurred by the independent liquidator appointed and the work required to estimate liabilities and realize assets. Additionally, if we do not generate sufficient revenue to support our continued operations, we will be required to reduce our cash balance to support our continued operations and the amount of any liquidation proceeds available for distribution to our shareholders would thereby be reduced. Accordingly, the amount and timing of distributions, if any, to shareholders in a liquidation cannot be determined because such would depend on a variety of factors, including the amount of proceeds received from any asset sales or dispositions, the time and amount required to resolve outstanding obligations and the amount of any reserves for future contingencies. If PXRE were to become insolvent, there will be no distributions payable to our shareholders.
During the fourth quarter of 2005, PXRE entered into a collateralized catastrophe facility that currently provides $125.0 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 merger is not consummated, and the Board of Directors elects to pursue a strategic alternative that materially changes PXRE’s catastrophe risk profile, the Company will also need to evaluate its obligations under two multi-year ceded reinsurance contracts that provide the Company with reinsurance protection against catastrophic events in 2007 and 2008. In this regard, the Company will need to evaluate whether it is likely that catastrophe loss exposure assumed by PXRE in 2007 and 2008 has the potential to result in losses that exceed the retention level under these ceded reinsurance protections. The Company is currently obligated to cede reinsurance premiums of $15.0 million per annum in each of 2007 and 2008 under these multi-year contracts.
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 consummating the merger or in identifying, evaluating and completing any other strategic alternative. If we are unable to do so for at least the time necessary to consummate the merger or identify and implement an alternative selected strategy, our continued business operations and our ability to identify, evaluate and complete a strategic alternative could be materially and adversely affected.
Adverse events in 2006 have negatively affected the market price of our common shares, which may lead to further securities litigation, administrative proceedings or both being brought against us.
Reserving for losses includes significant estimates, which are also subject to inherent uncertainties.
Our estimate of the ultimate incurred gross loss and loss expenses arising from Hurricanes Katrina, Rita and Wilma of $1,023.5 million as of December 31, 2006 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 60% of our net incurred loss with respect to Hurricanes Katrina, Rita and Wilma as of December 31, 2006. 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.
If our clients were to incur widespread additional losses as a result of settlements or adverse litigation results involving the flood vs. wind controversy, it is possible that our current best estimate for Hurricane Katrina will be exceeded.
Because of potential exposure to catastrophes in the future, our financial results may vary significantly from period to period.
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, Hurricanes Katrina, Rita and Wilma resulted in a net impact of $806.9 million, after reinsurance recoveries on our outwards reinsurance program and the impact of inwards and outwards reinstatements and additional premiums as of December 31, 2005. 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.
Demand for reinsurance depends on numerous factors, including the frequency and severity of catastrophic events, levels of capacity, general economic conditions and underwriting results of primary property insurers. The supply of reinsurance is related to prevailing prices, recent loss experience and levels of surplus capacity. All of these factors fluctuate and may contribute to price declines generally in the reinsurance industry. Premium rates or other terms and conditions of trade may vary in the future. If any of these factors were to cause the demand for reinsurance to fall or the supply to rise, our profitability could be adversely affected if we resume underwriting.
In February 2006, $490.5 million of fixed maturity investments were liquidated and the proceeds were invested in cash equivalents. As of December 31, 2006, $671.2 million of our invested assets were in short term investments. This could have a material negative impact on our future income from our investment portfolio.
Risks Related to our Hedge Fund Investments. We are exposed to potential losses from the risks inherent in our portfolio of hedge funds. The three most significant risks inherent in our hedge fund portfolio are liquidity risk, credit risk and market risk:
Credit risk exists in the hedge fund portfolio where hedge funds are net long in a particular security, or group of correlated securities. Where a hedge fund is net long in a security that defaults, or suffers an adverse credit event, we are exposed to loss. Our exposure to any individual hedge fund is limited to the carrying value of the investment, and we invest in a diversified portfolio of hedge funds that utilize different strategies and markets to reduce this risk. However, different hedge funds in the portfolio may be net long in the same or correlated securities at the same time, which could have an adverse effect on the value of the portfolio and thus our financial condition.
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 few years, 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.
We sold finite reinsurance prior to June 30, 2004, and from time to time, have purchased finite reinsurance to which we are a party. Although we have received no request for information or documents in connection with the investigations with respect to any finite reinsurance we sold or purchased from time to time, certain of our customers or reinsurers have been asked to provide or have provided documents and information in the framework of these investigations with respect to reinsurance contracts to which we are a party. Any claim challenging the appropriateness of the accounting treatment of the finite contracts we underwrote or purchased could result in negative publicity, costs and, in the event of any regulatory or judicial decision being entered against us, ultimately fines and penalties, all of which could have a material adverse effect on our business and results of operations.
Although our functional currency is the U.S. dollar, premium receivables and loss reserves include business denominated in currencies other than U.S. dollars. We are exposed to the possibility of significant claims in currencies other than U.S. dollars. We may, from time to time, experience losses resulting from fluctuations in the values of these non-U.S. currencies, which could adversely affect our operating results. While we hold positions denominated in foreign currencies to mitigate, in part, the effects of currency fluctuations on our results of operations, we currently do not hedge our currency exposures before a catastrophic event that may produce a claim.
Retrocessional reinsurance subjects us to credit risk and may become unavailable on acceptable terms.
Based on our current estimate of losses related to Hurricane Katrina, we have exhausted our retrocessional protection with respect to this event, meaning that we have no retrocessional coverage available should our Hurricane Katrina losses prove to be greater than currently estimated. We cannot be sure that retrocessional coverage will be available to us on acceptable terms, or at all, in the future. Our business, results of operations and financial condition could be materially adversely impacted by additional losses related to Hurricane Katrina.
During the fourth quarter of 2005, PXRE entered into a collateralized facility that provides $125.0 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. The coverage under the facility is based on a modeled loss trigger. PXRE created a series of notional portfolios of reinsurance contracts designed to closely mimic the expected 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 agreement. If such a hurricane, windstorm or earthquake were to occur, there is a risk that the actual losses incurred by PXRE could exceed the modeled loss to the notional portfolios and that the actual benefit of this facility could be substantially less than expected.
As of March 7, 2007, we have $310.0 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 if we resume underwriting. 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.
General. Assuming the consummation of the transaction contemplated under the Merger Agreement entered into by the Company and Argonaut, and therefore the resumption of our operations,our insurance and reinsurance subsidiaries may not be able to obtain or maintain necessary licenses, permits, authorizations or accreditations in locales where we currently engage in business or in new locales, or may be able to do so only at significant cost. In addition, we may not be able to comply fully with, or obtain appropriate exemptions from, the wide variety of laws and regulations applicable to insurance or reinsurance companies or holding companies. Failure to comply with or to obtain appropriate authorizations and/or exemptions under any applicable laws could result in restrictions on our ability to do business or certain activities that are regulated in one or more of the jurisdictions in which we operate and could subject us to fines and other sanctions, which could have a material adverse effect on our business.
maintain a principal office and appoint and maintain a principal representative in Bermuda; and
We have 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 merger and its implementation or for the implementation of any other 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.
Our stock price and trading volume may be subject to significant fluctuations. Our stock price and trading volume may fluctuate in response to a number of events and factors, including:
The Companies Act, which applies to us, differs in certain material respects from laws generally applicable to U.S. corporations and their shareholders. Set forth below is a summary of certain significant provisions of the Companies Act which includes, where relevant, information on modifications thereto adopted pursuant to our bye-laws, applicable to us, which differ in certain respects from provisions of Delaware corporate law. Because the following statements are summaries, they do not discuss all aspects of Bermuda law that may be relevant to us and our shareholders.
As a Bermuda company, we may enter into certain business transactions with our significant shareholders, including asset sales, in which a significant shareholder receives, or could receive, a financial benefit that is greater than that received, or to be received, by other shareholders with prior approval from our board of directors but without obtaining prior approval from our shareholders. Amalgamations require the approval of the board of directors and, except in the case of amalgamations with and between wholly-owned subsidiaries, a resolution of shareholders approved by the affirmative vote of shareholders holding a majority of the voting power of the then outstanding shares entitled to vote. If we were a Delaware corporation, we would need, subject to certain exceptions, prior approval from shareholders holding at least two-thirds of our outstanding common stock not owned by such interested shareholder to enter into a business combination (which, for this purpose, includes mergers and asset sales of greater than 10% of our assets that would otherwise be considered transactions in the ordinary course of business) with an interested shareholder for a period of three years from the time the person became an interested shareholder, unless we opted out of the relevant Delaware statute.
Our bye-laws provide, as permitted by Bermuda law, that the board of directors may delegate any of its powers to committees that the board appoints, and those committees may consist partly or entirely of non-directors. Delaware law allows the board of directors of a corporation to delegate many of its powers to committees, but those committees may consist only of directors.
Further, we have been advised that there is no treaty in effect between the United States and Bermuda providing for the enforcement of judgments of United States courts, and there are grounds upon which Bermuda courts may not enforce judgments of United States courts. Because judgments of United States courts are not automatically enforceable in Bermuda, it may be difficult for our shareholders to recover against us based on such judgments.
The rights and protections afforded to the holders of our outstanding preferred shares could have a material negative impact on the holders of our common shares.
In April 2002, we privately placed Series A, Series B and Series C convertible preferred shares with several private equity investors. These investors have the right to nominate four directors for election to the board of directors, and were granted demand and other registration rights. These investors also have the ability to veto certain corporate actions being considered in the context of our review of strategic alternatives, including, among other things, (i) the sale or merger of the Company, (ii) the sale of more than 25% of the Company’s assets, (iii) the expansion into other lines of business, (iv) the payment of extraordinary dividends, and (v) the voluntary liquidation, dissolution or winding up of the Company.
The interest of the preferred share investors may differ materially from the interests of our common shareholders, and these investors could take actions or make decisions that are not in the best interests of our common shareholders.
In addition, 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. 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 shares 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 12, 2007, the outstanding convertible common shares and preferred shares were ultimately convertible into 5.2 million common shares, or 6.7% of our outstanding common shares on a fully converted basis. 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.
Furthermore, upon conversion, sales of substantial amounts of common shares by these investors, or the perception that these sales could occur, could adversely affect the market price of the common shares, as well as our ability to raise additional capital in the public equity markets at a desirable time and price.
If you acquire 10% or more of our shares and we or our non-U.S. subsidiaries are classified as a controlled foreign corporation (“CFC”), your taxes could increase.
Each United States person (as defined in Section 957(c) of the U.S. Internal Revenue Code of 1986, as amended (the “Code”)) who (i) owns (directly, indirectly through foreign persons, or constructively by application of certain attribution rules (“constructively”)) 10% or more of the total combined voting power of all classes of stock of a foreign corporation at any time during a taxable year (such person, a “10% United States Shareholder”), and (ii) owns (directly or indirectly through foreign persons) shares of such foreign corporation on the last day of such taxable year, 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, if such foreign corporation has been a CFC for an uninterrupted period of 30 days or more during such taxable year. A foreign corporation is considered a CFC if 10% United States Shareholders own (directly, indirectly through foreign entities, or 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. 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 (directly, indirectly or constructively) by 10% United States Shareholders, on any day during the
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 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 shares.
The reinsurance agreements between us and our U.S. subsidiaries may be subject to recharacterization or other adjustment for U.S. federal income tax purposes, which may have a material adverse effect on our financial condition and results of operations.
Under Section 845 of the Code, the IRS may allocate income, deductions, assets, reserves, credits and any other items related to a reinsurance agreement among certain related parties to the reinsurance agreement, recharacterize such items, or make any other adjustment, in order to reflect the proper source, character or amount of the items for each party. No regulations have been issued under Section 845 of the Code. Accordingly, the application of such provisions to us and our subsidiaries is uncertain and we cannot predict what impact, if any, such provisions may have on us and our subsidiaries.
The tax laws and interpretations regarding whether a company is engaged in a U.S. trade or business or whether a company is a CFC or PFIC or has RPII, are subject to change, possibly on a retroactive basis. There are currently no regulations regarding the application of the PFIC rules to an insurance company. Additionally, the regulations regarding RPII are still in proposed form. New regulations or pronouncements interpreting or clarifying such rules will likely be forthcoming from the IRS. We are not able to predict if, when or in what form such guidance will be provided and whether such guidance will be applied on a retroactive basis.
If completed, our proposed merger with the Argonaut Group, Inc., may have adverse U.S. federal income tax consequences on us under certain circumstances.