the caption “Subordinated debt” on PXRE’s December 31, 2006 and 2005 Consolidated Balance Sheets, while PXRE’s minority investments of approximately $5.2 million in such trusts in the form of equity, which prior to March 31, 2004 were eliminated on consolidation, are reflected as assets under the caption “Other assets” with a corresponding increase in liabilities under the caption “Subordinated debt.” FIN 46R did not permit these changes to be made retroactively. In addition, gains on the repurchase of $5.2 million of PXRE’s trust preferred securities in prior periods of $1.1 million, net of tax, that were previously accounted for as extinguishments of debt, were reversed during the quarter ended March 31, 2004 and presented as a cumulative effect of an accounting change in PXRE’s Consolidated Statements of Operations and Comprehensive Operations during 2004. These repurchased securities are reflected in PXRE’s December 31, 2006 and 2005 Consolidated Balance Sheets under the caption “Fixed Maturities: Available-for-sale.”
In May 2003, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within the scope of the statement as a liability or an asset in some circumstances. PXRE adopted this statement during the quarter ended September 30, 2003; however, due to certain parts of this statement being deferred by the FASB, the adoption of this statement did not have any impact on PXRE’s Consolidated Financial Statements, financial position or results of operations until the quarter ended March 31, 2004. Accordingly, as of 2004, PXRE’s capital trust pass-through securities were reclassified on its Consolidated Balance Sheet to liabilities and entitled “Subordinated debt.” In PXRE’s Consolidated Statements of Operations and Comprehensive Operations for the years ended December 31, 2006, 2005 and 2004, the interest expense related to these securities was included with “Interest expense,” whereas for the years ended December 31, 2003 and 2002 it was included with “Minority interest in consolidated subsidiaries” as SFAS 150 did not permit these changes to be made retroactively.
At January 1, 2006, PXRE adopted the FASB SFAS No. 123R, “Share-Based Payment” (“SFAS 123R”) issued in December 2004, using the modified prospective application method. SFAS 123R establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services and for transactions in which an entity obtains employee services in share-based payment transactions. Under SFAS 123R, compensation costs are recognized for the fair value of all share-based compensation over their remaining vesting period, including the cost related to the unvested portion of all outstanding share-based compensation as of December 31, 2005. Previously, PXRE accounted for its share-based compensation plans under the recognition and measurement principles of the Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”, and related Interpretations. No share-based compensation cost related to the options granted under the plans was reflected in net income (loss) prior to the year ended December 31, 2006. PXRE’s adoption of SFAS 123R did not and has not had a material effect on net income.
In September 2006, the SEC issued Staff Accounting Bulletin (SAB) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 requires that companies assess the impact on both the balance sheet and the statement of operations when quantifying and evaluating the materiality of a misstatement. Under SAB 108, adjustment of the financial statements is required when either approach results in quantifying a misstatement that is material to a reporting period presented within the financial statements, after considering all relevant quantitative and qualitative factors. The impact on adopting SAB 108 was determined by the Company to be immaterial and does not require previously filed reports to be amended. The provisions of SAB 108 must be applied to financial statements for fiscal years ending after November 15, 2006.
Book value per share has been derived from our Consolidated Statements of Operations and Comprehensive Operations prepared in accordance with GAAP. Book value per share is the result of dividing shareholders’ equity by the sum of the common shares issued and outstanding and the number of common shares that the issued and outstanding preferred shares convert to.
On February 16, 2006, we announced that we would be increasing our estimates of the net pre-tax impact of Hurricanes Katrina, Rita and Wilma on our results of operations for the year ended December 31, 2005. We also announced our intention to explore strategic alternatives due to concerns about the hurricane losses and the resulting potential negative impact on our credit ratings. Following these announcements, in February 2006 our counterparty credit and financial strength ratings were downgraded by the major rating agencies to a level that was unacceptable to many of our reinsurance clients. These ratings downgrades have had a significant negative impact on our results of operations and profitability because they have impaired our ability to retain and renew our existing reinsurance business. In light of the negative consequences of rating downgrades, our Board of Directors determined that we should evaluate strategic alternatives to our operating approach at that time and decided to retain Lazard (which has since been succeeded by KBW) as a financial advisor to assist in the strategic exploration process.
On March 14, 2007, the Board of Directors concluded its strategic alternative evaluation process and announced that we had entered into a Merger Agreement with Argonaut. Pursuant to the terms of the Merger Agreement, Argonaut will merge into a newly formed PXRE Group Ltd. subsidiary, PXMS, Inc. Upon completion of the merger, and subject to the terms and conditions of the Merger Agreement which has been unanimously approved by the Board of Directors of both companies, Argonaut stockholders will receive subject to certain adjustments, 6.4672 PXRE common shares in exchange for each share of Argonaut common stock. Upon closing of the transaction, approximately 73% of PXRE’s outstanding common shares will be owned by former Argonaut stockholders, and approximately 27% by former holders of PXRE’s common shares and convertible voting preferred shares. Argonaut stock options and other equity awards will automatically convert upon completion of the merger into stock options and equity awards with respect to PXRE common stock, subject to adjustment to reflect the exchange ratio.
Completion of the merger, which is expected to occur in the third quarter of 2007, is subject to various conditions, including (1) receipt of approvals of the holders of PXRE and Argonaut common stock, (2) receipt of regulatory approvals, and (3) effectiveness of the Form S-4 registration statement relating to the PXRE common stock to be issued in the merger and (4) listing of the PXRE common stock on the NASDAQ.
Argonaut targets niches in which it can develop a leadership position and which Argonaut believes will generate underwriting profits. Argonaut has stated that its growth has been achieved both organically through an operational strategy focused on underwriting discipline and as a result of acquisition activity.
Concurrently with the announcement of the merger, we also announced the formation of a new Bermuda based reinsurance subsidiary, Peleus Re. Peleus Re has been rated “A-” by A.M. Best and is expected to begin writing reinsurance business. Peleus Re will focus on underwriting medium to small commercial property reinsurance risks on a pro rata and risk excess basis, and property catastrophe reinsurance risk on a controlled basis. It is also expected to reinsure casualty risks; initially through a quota share of Argonaut’s existing casualty business. Peleus Re will initially be capitalized with $213 million contributed from the existing surplus of PXRE Bermuda. PXRE Bermuda and PXRE Reinsurance will be placed into an orderly runoff, but will provide intercompany reinsurance support to Peleus Re.
Immediately following our February 16, 2006 announcement, S&P, a division of the McGraw-Hill Companies, Inc., downgraded its counterparty credit and financial strength rating on PXRE Reinsurance and PXRE Bermuda from “A-” to “BBB+” and placed these ratings on CreditWatch with negative implications. A.M. Best, an independent insurance industry rating organization, also downgraded its financial strength rating from “A-” to “B++” with a negative outlook. On February 17, 2006, Moody’s downgraded its insurance financial strength rating of PXRE Reinsurance from “Baa1” to “Baa2” and placed this rating under review for possible further downgrade.
Reinsurance and PXRE Bermuda from “BBB-” to “BB+” and then withdrew these ratings; and Moody’s downgraded its insurance financial strength rating of PXRE Reinsurance from “Baa3” to “Ba2” and then withdrew this rating.
On March 15, 2007, Peleus Re received a rating of “A-” from A.M. Best. Our existing reinsurance subsidiaries, PXRE Bermuda and PXRE Reinsurance were also re-rated “B+” by A.M. Best on March 15, 2007.
We incurred 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. Our profitability in 2006 was attributable to the low level of insured catastrophe activity, offset by the significant reduction in our premium volume due to cancellation and inability to renew expiring policies in the wake of our ratings downgrades. The primary cause of the 2005 net loss was the net impact on our financial position and results of operations 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. See below, Management’s Discussion and Analysis of Financial Condition and Results of Operations - Losses and Loss Expenses.
Pursuant to a Share Purchase Agreement dated as of September 29, 2005, we agreed to issue and sell 375,000 Series D Preferred Shares in a private placement exempt from registration under the Securities Act of 1933. The Series D Preferred Shares were mandatorily exchangeable for common shares upon the shareholders’ approval of the exchange. The private placement closed on October 7, 2005. The gross proceeds from the private placement were $375.0 million and proceeds, net of agents’ discounts and commissions and offering expenses, were $359.3 million. The Series D Preferred Shares were mandatorily exchanged into 34,090,906 common shares following the affirmative vote of the Company’s shareholders at a special general meeting held on November 18, 2005 approving the exchange of the Series D Preferred Shares and the authorization of an additional 300.0 million of our common shares. Shortly after the exchange, S&P affirmed our “A-” financial strength rating and assigned us a stable outlook.
In 2006, the Company purchased $482.3 million of single event reinsurance and catastrophe bond protection, including catastrophe bonds accounted for as reinsurance and as a derivative. This compares to $245.5 million purchased in 2005. Additionally, the amount of coverage available upon the occurrence of a second catastrophe event in 2006 was $275.0 million, compared to the 2005 amount of $25.0 million. This increased limit purchased increased ceded premiums over prior periods, exclusive of reinstatement and additional premiums. Our risk management program for our 2006 assumed reinsurance portfolio forecast that we would have significant gross premiums written during 2006.
In order to better protect PXRE against the risk of another severe catastrophe event or the occurrence of multiple significant catastrophe events, we sponsored two catastrophe bond transactions that closed during the fourth quarter of 2005. The first transaction was a $300.0 million collateralized reinsurance agreement with Atlantic & Western Re Limited (“A&W I”), a Cayman Island reinsurance company. This reinsurance coverage was designed to protect PXRE from extreme catastrophe losses arising from hurricanes in the Eastern and Gulf coasts of the United States, windstorms in northern Europe and earthquakes in California. This reinsurance provided two layers of protection over the next 5 years to PXRE. The first layer provides $200.0 million of coverage for losses arising from hurricanes in the Eastern and Gulf coasts of the United States, windstorms in northern Europe and earthquakes in California. The second layer provided $100.0 million of coverage for losses arising from hurricanes in the Eastern and Gulf coasts of the United States and windstorms in northern Europe.
On November 8, 2005, A&W I financed the reinsurance coverage through the issuance and sale of $300.0 million in catastrophe bonds pursuant to Rule 144A under the Securities Act of 1933.
The A&W II coverage is based on a modeled loss trigger. PXRE created a series of notional portfolios of reinsurance contracts designed to closely mimic the 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 the coverage is activated. Upon the occurrence of a second catastrophe event in the covered territories during the same calendar year, the parameters of the catastrophe event are determined and modeled against the notional portfolios. If the modeled loss to the notional portfolio for the second event exceeds the attachment point for the peril at issue, then PXRE will make a recovery under the agreement. The recovery is based on modeled losses and, unlike A&W I, is not limited to PXRE’s ultimate net losses from the loss event.
Initial estimates are as of quarter-end immediately following an event. Property Claims Services (“PCS”) is a division of the Insurance Services Office (“ISO”).
Our methods for establishing loss and loss expense liabilities vary depending upon the nature of the losses, which can generally be divided into three categories: (1) non-catastrophe losses in our catastrophe and risk excess segment, (2) catastrophe losses in our catastrophe and risk excess segment, and (3) losses in our exited lines segment. The Company generally considers reserves for each of these categories to be “mature” as follows (1) for non-catastrophe losses in our catastrophe and risk excess segment, generally anywhere between eighteen and thirty-six months after the accident year, (2) for catastrophe losses in our catastrophe and risk excess segment, generally anywhere between six to twelve months after the event occurs, and (3) losses in our exited lines segment, depending upon the nature of the underlying business, generally anywhere from five to seven years after the accident year.
In reserving for non-catastrophe losses in our catastrophe and risk excess segment, we use three different methods to estimate IBNR reserves: the loss ratio method; the incurred Bornhuetter-Ferguson method, which we refer to as the BF method; and the incurred loss development method, the latter two of which are “loss development approaches.” Initially, at the inception of an accident year, when there is little reported loss information, we use the loss ratio method. This method computes IBNR, as the product of an expected loss ratio and assumed earned premium minus reported loss to date. 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. As the accident year matures further and reported loss activity begins to emerge (usually at the end of the second or third quarter following the loss) we change to the BF method.
Concurrently, our underwriting team performs a thorough contract by contract analysis to identify potential changes to the expected loss estimates including IBNR by contract. With respect to the 2005 Hurricanes, our underwriters’ estimates were subject to a high level of uncertainty. Specifically for Hurricane Katrina, this high level of uncertainty arose 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. In order to address these uncertainties, at that time, for contracts exposed to Hurricane Katrina losses in our most volatile lines of business (retrocessional and direct and facultative reinsurance) we posted reserves for a significant percentage of occurrence limits as of December 31, 2005. These lines of business represented approximately 60% of our gross loss amount on Hurricane Katrina. The underwriters’ knowledge of the clients’ underlying books of business is considered in establishing loss estimates by contract. The combination of catastrophe modeling and underwriting review of affected contracts then forms the basis of our initial loss estimates for catastrophe losses.
In light of the limited loss data available from clients in the wake of catastrophes, our actuary uses our most current internally generated catastrophe loss development factors to assess the reasonableness and adequacy of our catastrophe loss reserves in the immediate wake of a catastrophe. These significant catastrophe loss development factors reflect the historical variability of prior catastrophe loss reserves in the industry and PXRE’s specific experience.
In addition, in reviewing underwriting information provided by clients during December 2005 as part of the January 1, 2006 renewal process, we found that certain clients were anticipating higher losses from Hurricanes Katrina and Rita than had been reported through the formal claims channels.
If clients report increased losses this may not result in a linear increase in PXRE’s assumed loss position as the Company’s IBNR may cover such increases. In addition, the results are showing limited amounts of development at the various FGU percentages presented for certain lines of business due to the fact that as ground up losses are increased, an increasing number of underlying contracts have reached their contractual limits. Additionally, total losses are shown excluding risk excess business as this line primarily involves commercial exposures and is not expected to experience material development due to adverse personal lines litigation results in Louisiana, Mississippi and Alabama.
We have a system of controls in place that assists us in evaluating the completeness of the data received from cedents. PXRE derives almost all of its business from reinsurance intermediaries. As a result, the ceding company reports claims to the intermediary and the intermediary in turn reports the data to all the reinsurers included in the underlying program. Controls in place require that certain claims must be approved by the underwriter or a member of senior management to validate the reported loss data before recorded as a case reserve. The underwriter, based on his knowledge and judgment, may question the broker or ceding company if he did not expect a loss of a certain magnitude to impact a certain layer. Because many of PXRE’s losses are from events that are well known, such as large hurricanes and earthquakes, the underwriter may in fact expect losses to pierce certain layers and therefore would not question the accuracy of such loss reports. If the underwriter does question the loss data, PXRE may perform audits at the underlying ceding company in order to determine the accuracy of the amounts ceded. PXRE’s risk management and underwriting systems provide a list of impacted or potentially impacted contracts by peril and by geographic zone. This assists PXRE in determining the completeness of losses, as we will contact intermediaries and the ceding companies for which we believe underlying contracts are impacted subsequent to an event to request information.
The following chart sets forth the allocation of our net liabilities for unpaid losses and loss expenses between case reserves and IBNR reserves as of December 31, 2006:
On an overall basis, the low and high ends of our selected range of reasonable net loss and loss expense reserves are $33.6 million below and $49.8 million above the $567.9 million best estimate. The range around the overall estimate is not the sum of the ranges about the component segments due to the impact of diversification when the reserve levels are considered in total. The impact of diversification reflects the fact that not all lines with very low correlations are expected to develop well or poorly at the same time.
The low and high ends of a range of reasonable net loss and loss expense liabilities around the best estimate displayed in the table below with respect to each segment are shown in the following table as of December 31, 2006. This range was produced using two different methods, one for the 2005 Hurricanes (KRW) and one for the remainder of our carried loss and loss expense liabilities.
Our premiums on reinsurance business assumed are recorded as earned evenly over the contract period based upon estimated subject premiums. PXRE’s assumed premium is comprised of both minimum and deposit premium and an estimate of premium. Minimum and deposit premium is billed and collected in accordance with the provisions of the contracts and is usually billed quarterly or semi-annually. A premium estimate is also recorded if the estimate of the ultimate premium is greater than the minimum and deposit premium. The final or ultimate premium for most contracts is the product of the provisional rate and the ceding company’s subject net earned premium income (“SNEPI”). Because this portion of the premium is reasonably estimable, the Company records and recognizes it as revenue over the period of the contract in the same manner as the minimum and deposit premium. The key assumption related to the premium estimate is the estimate of the amount of the ceding company’s SNEPI, which is a significant element of PXRE’s overall underwriting process. Because of the inherent uncertainty in this process, there is the risk that premiums and related receivable balances may turn out to be higher or lower than reported.
We record an allowance for doubtful accounts that we believe approximates the exposure for all potential uncollectible assets, after considering other balances that mitigate the exposure.
The premiums on reinsurance business ceded are recorded as incurred evenly over the contract period. Certain ceded reinsurance contracts contain provisions requiring us to pay additional premiums or reinstatement premiums in the event that losses of a significant magnitude are ceded under such contracts. Under GAAP, we are not permitted to establish reserves for these potential additional premiums until a loss occurs that would trigger the obligation to pay such additional or reinstatement premiums. As a result, the net amount recoverable from our reinsurers in the event of a loss may be reduced by the payment of additional premiums and reinstatement premiums. Frequently, the impact of such premiums will be offset by additional premiums and reinstatement premiums payable to us by our clients on our assumed reinsurance business. No assurance can be given; however, that assumed reinstatement and additional premiums will offset ceded reinstatement and additional premiums. For example, in the case of the September 11, 2001 terrorist attacks, our net premiums earned during 2001 were reduced by $26.3 million as a result of net additional premiums and reinstatement premiums. In the case of Hurricanes Katrina, Rita and Wilma our net premiums earned were increased by $43.9 million in 2005 as a result of net additional premiums and reinstatement premiums.
Assumed reinstatement premiums that reinstate coverage are written and earned at the time the associated loss event occurs. Under the contract terms of certain of our excess of loss contracts, reinstatement premiums are mandatorily due PXRE following a ceding company’s loss, based on pre-defined contract terms. Terms principally include a pro-rata amount of the original contract premium relative to the proportion of the contractual limit exhausted by the associated loss, without respect to time remaining in the term of the original limit, that is, the amount due is 100% as to time and pro-rata as to amount. Less frequently, terms can vary to incorporate a percentage of the original premium that is more or less than the original premium or can be pro-rata as to time remaining in the term of the original limit.
Ceded additional premiums are less uniform in their terms than assumed reinstatement premiums. The single largest additional premium in 2005, accounting for 80% of the additional premium written and earned for the year ended December, 2005 events, was triggered by an event in excess of $165.0 million of losses incurred.
Assumed reinstatement premiums receivable, net of commission and brokerage, associated with our case reserves and incurred but not reported loss and loss expense liabilities, as reflected in “Premiums receivable, net” in the Consolidated Balance Sheets, are as follows:
Additional ceded premiums occur less frequently, and were incurred by the Company in 2005 due to the significance of the losses from Hurricanes Katrina and Wilma. In 2005, these ceded losses were full limit losses, resulting in additional ceded premiums. These additional ceded premiums are not expected to vary from the estimate in 2005.
Deferred tax assets and liabilities reflect the expected tax consequences of temporary differences between carrying amounts and the tax bases of PXRE’s United States subsidiaries assets and liabilities. At December 31, 2006, PXRE had a deferred tax asset net of deferred income tax liability of $50.3 million, offset by a valuation allowance of $50.3 million. Management reviewed the net deferred tax asset as of December 31, 2006, and as a result of the ratings downgrades of PXRE that occurred subsequent to December 31, 2005, and the related uncertainty with respect to the amount of future taxable income that will be generated by the Company, have concluded that the full valuation allowance established at December 31, 2005 continues to be required for the entire deferred tax asset as of December 31, 2006.
If PXRE were to implement the merger with Argonaut resulting in a change of control, utilization of the net operating loss carry-forward included in deferred tax assets would be limited in future periods.
Gross and net premiums written for the years ended December 31, 2006 and 2005 were as follows:
The decrease in both gross premiums written and gross premiums earned for the year ended December 31, 2006 was due to the cancellation and non-renewal of the majority of our reinsurance portfolio following our ratings downgrades in February 2006. In addition, during the year ended December 31, 2005 reinstatement premiums of $159.5 million, including $151.7 million of gross reinstatement premiums from Hurricanes Katrina, Rita and Wilma, were written and earned compared to negative gross written and gross earned reinstatement premiums of $1.7 million for the year ended December 31, 2006. See Management’s Discussion and Analysis “Critical Accounting Policy Disclosures - Estimation and Recognition of Premiums.”
The decrease in both net premiums written and net premiums earned during 2006 was a result of the decrease in gross premiums written and gross premiums earned of $403.5 million and $354.6 million, respectively, which were primarily a result of the cancellation and non-renewal of the majority of our reinsurance contracts as well as reinstatement premiums written and earned from Hurricanes Katrina, Rita and Wilma in 2005, offset, in part, by the decrease in ceded premiums written and ceded premiums earned of $50.1 million and $50.8 million, respectively that were incurred in 2005 primarily in connection with Hurricanes Katrina, Rita and Wilma.
A summary of our 2006 and 2005 net premiums written and net premiums earned by business segment is included in Note 13 to our Consolidated Financial Statements.
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 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 ratios discussed below have been calculated on a GAAP basis.
The following table summarizes the loss ratio, expense ratio and combined ratio for the years ended December 31, 2006 and 2005, respectively:
Losses and loss expenses incurred amounted to $12.4 million in 2006 compared to $1,011.5 million in 2005. The loss ratio was 14.7% for 2006 compared to 260.5% for 2005. The decrease in our loss ratio was due to the absence of any significant property catastrophe losses during 2006 compared to net losses and loss expenses incurred of $850.8 million from Hurricanes Katrina, Rita and Wilma which occurred in 2005. In addition, there was net favorable development of $10.4 million on prior year losses during 2006 compared to $23.9 million of adverse development for prior year losses in 2005.
Net favorable development of $10.4 million for prior-year losses and loss expenses was comprised of $16.3 million of favorable development in the catastrophe and risk excess segment and $5.9 million of adverse development in the exited lines segment. The $16.3 million of prior-year favorable development in the catastrophe and risk excess segment was primarily related to favorable reported loss activity on our prior-year non-significant catastrophe losses. During 2006, there was approximately $0.5 million of adverse development to our estimate of net losses and loss expenses for Hurricanes Katrina, Rita and Wilma. Prior year losses in the exited lines segment increased because of higher than expected reported claims.
There was $22.8 million of net incurred losses from current-year losses and loss expenses during 2006 associated with non-significant catastrophe loss activity.
The expense ratio was 73.7% for 2006 compared with 21.9% for 2005. The commission and brokerage ratio, net of fee income, was 22.4% for 2006 compared with 12.6% for 2005. The increase in the commission and brokerage ratio, net of fee income, is primarily attributable to the increase in ceded premium amounts which decreased net premiums earned without decreasing brokerage expenses, thus causing our commission and brokerage ratio to increase.
Investment income for the year ended December 31, 2006 was affected by various 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. On September 30, 2006, one remaining ceded reinsurance contract was commuted and the underlying funds withheld balances were settled with the reinsurers that were parties to this contract. Prior to this commutation and as of December 31, 2005, we held premiums and accrued investment income of $86.4 million due to reinsurers. On this ceded reinsurance contract we recognized a reduction to gross investment income of $4.7 million and $6.7 million during the years ended December 31, 2006 and 2005, respectively. On a net basis, this reduction to investment income was $1.4 million and $3.0 million for the years ended December 31, 2006 and 2005, respectively, representing the difference between the stated investment return under such contracts and the overall yield achieved on our total investment portfolio for the period. The weighted average contractual investment return on the funds held by PXRE is 7.1% and 7.7% for the years ended December 31, 2006 and 2005, respectively. As a result of the commutation, in future periods the Company will not experience a reduction to gross or net investment income with respect to this contract.
Management has reviewed PXRE’s deferred tax asset and due to uncertainty with respect to the amount of future taxable income that will be generated following the downgrade of PXRE’s credit rating in February 2006, has concluded that a full valuation allowance of $50.3 million is required for all of its deferred tax asset, $48.5 million of which relates to tax benefits that otherwise would have been, with respect to 2005, or have been, with respect to years prior to 2005, recognized in the Consolidated Statements of Operations in 2005 and prior periods. The remainder relates to the tax consequences of temporary differences in Other Comprehensive Operations.
For the year ended December 31, 2005, net loss before convertible preferred share dividends was $697.6 million compared to net income before convertible preferred share dividends of $22.8 million for 2004. The primary cause of this 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. Our net income in 2004 was materially impacted by losses arising from the occurrence of Hurricanes Charley, Frances, Ivan and Jeanne.
A summary of our 2005 and 2004 net premiums written and net premiums earned by business segment is included in Note 13 to our Consolidated Financial Statements.
The following table summarizes the loss ratio, expense ratio and combined ratio for the years ended December 31, 2005 and 2004, respectively:
The 2005 current year net losses incurred of $987.6 million is mainly due to the 2005 hurricanes which amounted to $638.0 million from Hurricane Katrina, $68.9 million from Hurricane Rita and $143.9 million from Hurricane Wilma.
During 2005, we experienced net adverse development of $23.9 million for prior-year losses and loss expenses, consisting of $17.3 million of adverse development on our catastrophe and risk excess segment and $6.6 million of adverse development on our exited lines segment. The $17.3 million of prior-year catastrophe and risk excess losses 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.
investment income of $6.7 million and $8.0 million during the years ended December 31, 2005 and 2004, respectively. On a net basis, this reduction to investment income was $3.0 million and $3.4 million for the years ended December 31, 2005 and 2004, respectively, representing the difference between the stated investment return under such contracts and the overall yield achieved on our total investment portfolio for the period. The weighted average contractual investment return on the funds held by PXRE is 7.7% and 7.4% for the years ended December 31, 2005 and 2004, respectively, and we expect to be obligated for this contractual investment return for the life of the underlying liabilities, which is expected to be one year as of December 31, 2005 on a weighted average basis.
The Company and PXRE Delaware rely primarily on dividend payments and capital distributions from PXRE Bermuda and PXRE Reinsurance to pay its operating expenses, to meet its debt service obligations and to pay dividends. In the wake of losses incurred as a result of Hurricanes Katrina, Rita and Wilma which occurred in 2005, PXRE Reinsurance has an accumulated deficit and, therefore, may not declare and pay any dividend without regulatory approval. Based on the total statutory capital of PXRE Bermuda as of December 31, 2006, the aggregate capital distribution that is available to be paid during 2007, without prior regulatory approval is $104.6 million. Since our ratings downgrades in February 2006, we have been actively communicating with the BMA and we do not intend to make any further dividends or capital distributions without prior notification to the BMA. See Item I - Business: Regulation. PXRE Bermuda paid a capital distribution of $27.0 million to the Company during 2006. PXRE Reinsurance did not pay any dividends in 2006. We anticipate that this dividend and capital distribution capacity (with notification to the BMA) will be sufficient to fund our liquidity needs during 2007.
Following our February 2006 ratings downgrades and the resulting level of contract terminations from our assumed book of business, in conjunction with paid losses primarily from Hurricanes Katrina, Rita and Wilma, resulted in net cash used by operating activities. Subsequent to, and as a result of, the downgrades, 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. The proceeds of the sales of the fixed income securities were all received by the first week of March 2006 and were reinvested in commercial paper and other short term investments. With respect to the proceeds of the sales of the hedge fund investments, approximately 92% of such proceeds were received by December 31, 2006. The remainder is expected to be received by June 30, 2007. As a result of these steps, we believe we have sufficient liquidity to meet the currently foreseen needs of our counterparties.
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. 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.
On November 23, 2004, PXRE completed a public offering of 5.2 million of its common shares at $23.75 per share, consisting of 3.7 million shares offered by the Company and 1.5 million shares offered by certain selling shareholders. On December 2, 2004, the underwriters exercised in-full the overallotment option to purchase 0.8 million additional common shares, consisting of 0.7 million shares from the Company and 0.1 million shares from the selling shareholders. After giving effect to the sale of the overallotment shares, a total of 6.0 million shares were sold in the offering.
The Company did not receive any of the proceeds from the sale of shares by the selling shareholders. The selling shareholders converted 2,208 preferred shares, including accrued dividends, to 1.6 million common shares sold in the public offering, including the overallotment. Net proceeds to the Company from the sale of common shares sold by the Company were approximately $98.2 million, including the overallotment. PXRE used its net proceeds for general corporate purposes, including contributions to the capital of PXRE Bermuda to support growth in its business.
On April 4, 2002, the Company raised $150.0 million of additional capital through the issuance of 15,000 Convertible Voting Preferred Shares (the “Preferred Share Investment”). As of December 31, 2006, 5,813 Preferred Shares were issued and outstanding. The Preferred Shares are entitled to receive, when, as and if declared by our Board of Directors and to the extent of funds legally available for the payment of dividends, cumulative dividends per share at the rate per annum of 8% of the sum of the stated value on each share plus any accrued and unpaid dividends thereon, payable on a quarterly basis. Commencing in the second quarter of 2005, the dividends paid on such convertible voting preferred shares are paid in cash, rather than in additional convertible voting preferred shares. No dividends were paid in the first quarter of 2006 and therefore overdue dividends were accrued at 10% per annum from April 1, 2006 until paid on May 30, 2006. Dividends to preferred shareholders, paid in cash, during 2006 and 2005 amounted to $4.9 million and $3.7 million, respectively, and paid in kind during 2005 amounted to $3.4 million.
On March 31, 2005, 5,840.6 Series A1 convertible voting preferred shares, 3,143.6 Series B1 convertible voting preferred shares and 1,393.6 Series C1 convertible voting preferred shares were mandatorily converted into 4.4 million class A convertible voting common shares, 2.4 million class B convertible voting common shares and 1.0 million class C convertible voting common shares, respectively. The conversion was effected based upon a conversion price of $13.27, which conversion price was agreed between the Company and holders of the Company’s convertible voting preferred shares pursuant to a letter agreement dated as of March 31, 2005. All the remaining convertible preferred shares mandatorily convert on April 4, 2008. At December 31, 2006, there were no A1, B1 and C1 Preferred Shares and 5,813 A2, B2 and C2 Preferred Shares outstanding. As the A2 Preferred Shares, B2 Preferred Shares and C2 Preferred Shares were not voluntarily converted on or prior to the third anniversary of their issuance, an annual 8% dividend, payable in cash, will accrue until these Preferred Shares are converted.
On January 29, 1997, PXRE Capital Trust I (“PXRE Capital Trust”), a Delaware statutory trust and a wholly-owned subsidiary (non-consolidated) of PXRE Delaware, issued $103.1 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”). At December 31, 2006, obligations to PXRE Capital Trust amount to $102.7 million. 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.
Dividends declared to common shareholders were $16.8 million in 2005. There were no dividends to common shareholders declared in 2006.
The Board of Directors does not intend to declare dividends on our common shares during the pendency of its evaluation of strategic alternatives.
Net cash flows used by operations were $434.2 million in 2006 compared to net cash flows provided by operations of $27.3 million in 2005 primarily due to an increase in net paid losses, mainly attributable to Hurricanes Katrina, Rita and Wilma, and the decrease in premiums collected as a result of the cancellation and non-renewal of contracts as a result of our ratings downgrades in February 2006.
PXRE has three letter of credit (“LOC”) facilities that allow it to provide LOCs to its ceding companies if such LOC is required under the terms of the contract. All of the facilities require the Company to provide collateral in the form of fixed maturity securities or cash to the issuing bank as security for outstanding LOCs. The first is a $110.0 million committed facility with Barclays Bank plc under which the Company pays the issuing bank an annual standby commitment fee of 0.15% per annum. The second is a $200.0 million committed facility with Citibank Ireland Financial Services plc under which the Company pays the issuing bank an annual standby commitment fee of 0.10% per annum. The third is an uncommitted facility with Merrill Lynch that allows for LOCs to be issued subject to satisfactory collateral being provided to the issuing bank by the Company. There is no commitment fee for the third facility. The Company must transfer eligible assets to collateral accounts prior to each respective bank issuing an LOC. Since eligible assets include fixed income investments, such securities need not be sold in order to qualify as eligible collateral. As of December 31, 2006, the Company has pledged assets with a fair value of $329.5 million to support outstanding letters of credit. 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.
The A&W II coverage is based on a modeled loss trigger. PXRE created a series of notional portfolios of reinsurance contracts designed to closely mimic the 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 the coverage is activated. Upon the occurrence of a second catastrophe event in the covered territories during that calendar year, the parameters of the catastrophe event are determined and modeled against the notional portfolios. If the modeled loss to the notional portfolio for the second event exceeds the attachment point for the peril at issue, then PXRE will make a recovery under the agreement. The recovery is based on modeled losses and, unlike A&W I, is not limited to PXRE’s ultimate net loss from the loss event.
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 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 facility 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 the 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 of a tranche, PXRE could be obligated to pay significant early termination fees that could be as much as $5.8 million, and PXRE is obligated to make all premium payments up to the date of termination.
There are significant risks and uncertainties associated with our proposed merger with Argonaut. For example, the merger may not be consummated, or may not be consummated in the third quarter of 2007 as currently anticipated, as a result of a number of factors, including, without limitation, the inability to obtain governmental approvals of the merger on the proposed terms or the failure of either company to obtain stockholder approval for the merger. If the combined company is not able to combine successfully the businesses of Argonaut and PXRE, the anticipated benefits from the merger may not be realized fully or at all or may take longer to realize than expected. For example, it is possible that the integration process could result in the loss of key employees or in complications in combining Argonaut’s and PXRE’s operations.
If the merger with Argonaut is not completed, unless the Board of Directors identifies and implements a different operating strategic solution, we will not write or earn any material premiums in the future and, as a result, we expect to incur material operating losses, since our remaining revenue is insufficient to cover our projected operating and other expenses.
In the aftermath of Hurricane Katrina, each of the major rating agencies placed the credit ratings of our reinsurance subsidiaries on CreditWatch negative or the equivalent, and S&P and A.M. Best initially downgraded their ratings from “A” to “A-.” On February 16, 2006, A.M. Best downgraded its financial strength rating from “A-” to “B++” with a negative outlook. In February, 2006, A.M. Best further downgraded its financial strength rating from “B++” to “B+” with negative implications and S&P downgraded its counterparty credit and financial strength rating on PXRE Reinsurance and PXRE Bermuda from “A-” to “BBB+” and placed these ratings on CreditWatch with negative implications. Thereafter, S&P further downgraded its counterparty credit and financial strength rating on PXRE Reinsurance and PXRE Bermuda from “BBB+” to “BBB-”. Moody’s downgraded its insurance financial strength rating of PXRE Reinsurance from “Baa1” to “Baa2” and placed this rating under review for possible further downgrade. Subsequently, 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.
If the merger is not consummated, unless we are able to implement a strategic alternative that would allow us to provide clients with an acceptably rated counterparty, we do not anticipate being able to underwrite any material amount of new reinsurance business in 2007 and would therefore not be able to generate any material amount of net premiums earned during 2007. The reduction in premium income has and will have a material adverse effect on our future operating results, liquidity and financial condition. Net premiums earned were our primary source of revenue for the years ended December 31, 2006 and 2005, accounting for 61% and 92% of our revenue, respectively. In 2006 and 2005, revenue from non-premium sources was not sufficient to offset operating expenses and interest expenses. We therefore expect to incur net operating losses in future periods unless we are successful in executing a strategic alternative other than runoff. If such operating losses were to occur, this would result in a decline in our shareholders’ equity.
In almost one year of considering potential strategic alternatives, the Argonaut merger was found by our Board of Directors to be the most suitable strategic alternative available. If we are not able to consummate this merger, we may not be able to identify or implement a strategic alternative that is as attractive as Argonaut is in the future.
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. Once in runoff there are various options available to bring PXRE’s business to a conclusion including pursuing an arrangement with its policyholders in which it estimates and pays out all existing and contingent liabilities with a view to liquidating PXRE in accordance with a procedure which is approved by a statutory majority of policyholders. Under Bermuda law this is referred to as a solvent scheme of arrangement and is, in effect, a global commutation of PXRE’s business.
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 Board of Directors may elect to explore the assignment or novation of PXRE’s rights and obligations under the 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 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., which could be as much as $5.8 million and PXRE is obligated to make all premium payments up to the date of termination.
Our ability to continue to operate our business, consummate the merger and to identify, evaluate and complete any other strategic alternative are dependent on our ability to retain our management and other key employees, and we may not be able to do so.
We have recently experienced material adverse events, including the downgrading of our ratings in February 2006, and the market price of our common shares has declined materially and may continue to do so, regardless of our financial condition or our ability to meet our contractual and financial obligations. Due to the decline in the market price of our common shares, there is a continued risk that individual lawsuits and securities class action litigation may be brought against us or that regulators may institute administrative proceedings against us, or both. Several class action lawsuits have been filed against PXRE Group Ltd. and certain of our officers on behalf of a putative class consisting of investors who purchased our publicly traded securities between July 28, 2005 and February 16, 2006. The complaints allege, among other things, that we made false and misleading statements regarding loss estimates in violation of the federal securities laws (collectively, the “Securities Litigation”). We anticipate that additional lawsuits relating to the recent decline in our share price may be filed against us and/or certain of our current and former officers and directors in the future. It is also possible that administrative proceedings or regulatory proceedings could be commenced against us in the future (“Future Proceedings”).
The Securities Litigation and any Future Proceedings could be expensive and could divert management’s attention and other resources away from other matters. Any such diversion of management’s attention or other resources could negatively and materially impact our business. We cannot predict the timing of any trials with respect to the Securities Litigation or Future Proceedings. We are not currently able to estimate legal defense costs or the amount of any damages that we may be required to pay in connection with the Securities Litigation or Future Proceedings. The Securities Litigation, which could continue for a significant period, is currently at a very early stage and we have very little information as to the course it will take. In view of the inherent difficulty of predicting the outcome of litigation, particularly where there are many claimants and the claimants seek indeterminate damages, we are unable to predict the outcome of these matters and at this time cannot reasonably estimate the possible loss or range of loss with respect to the Securities Litigation or Future Proceedings.
We have not established any reserves for any potential liability relating to the Securities Litigation, other than $1.0 million for legal fees. We have insurance coverage with respect to claims such as the Securities Litigation, but it is not currently possible to determine whether such insurance coverage will be adequate to cover our defense costs and any losses.
In reserving for catastrophe losses, our estimates are influenced by underwriting and loss information provided by our clients, industry catastrophe models and our internal analyses of this information. As an event matures, we rely more and more on our development patterns by type of event as well as contract information to project ultimate losses for the event. This process can cause our ultimate estimates to differ significantly from initial projections.
In developing our best estimate for Hurricane Katrina, we have also assumed flood damage exclusions contained in our cedent’s underlying insurance policies will be effective. We understand that various lawsuits are pending seeking to invalidate such flood damage exclusions on various grounds. If such lawsuits were to successfully invalidate the underlying flood damage exclusions or if the court or a jury were to find that an insurer had not adequately established that a loss was attributable to flood rather than wind, our liabilities for losses and loss expenses relating to Hurricane Katrina could prove to be inadequate, with a consequent adverse impact on our earnings and shareholders’ equity in future periods. Based on reports in the press, we understand that State Farm, one of the nation’s largest insurers, has been engaging in various settlement discussions concerning claims involving the controversies over the flood exclusion. We do not reinsure State Farm, but it is unclear at this time how any potential settlements by State Farm would impact or influence our cedents.
We operate in a highly competitive environment and no assurance can be given that we will be able to compete effectively in this environment.
We compete with numerous companies, many of whom have credit ratings and substantially greater financial, marketing and management resources. Our ability to compete against such companies was substantially impaired when 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. In light of our ratings downgrades and the material negative financial impact of the losses arising from Hurricanes Katrina, Rita and Wilma, our competitive position in the reinsurance industry has suffered and we have been unable to retain our reinsurance portfolio and renew any of our existing reinsurance agreements. No assurance can be given that we will be able to continue to compete successfully in the reinsurance markets in which we have historically operated.
If we complete the merger or another strategic alternative we will compete with reinsurers that provide property-based lines of reinsurance, such as ACE Tempest Reinsurance Ltd., Arch Reinsurance Ltd., Aspen Insurance Holdings Limited, AXIS Reinsurance Company, Endurance Specialty Insurance Ltd., Everest Reinsurance Company, IPC Re Limited, Lloyd’s of London syndicates, Montpelier Reinsurance Ltd., Munich Reinsurance Company, Partner Reinsurance Company Ltd., Platinum Underwriters Reinsurance, Inc., Renaissance Reinsurance Ltd., Swiss Reinsurance Company and XL Re Ltd. A number of reinsurers were also formed in Bermuda in the wake of Hurricanes Katrina, Rita and Wilma in 2005 that are providing additional competition.
Our future capital requirements depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover losses. Our capital needs may also be impacted by the strategic alternative path that the Board of Directors ultimately determines to pursue.
Our investment portfolio is subject to significant market and credit risks which could result in an adverse impact on our financial position or results.
Our invested assets consist primarily of debt instruments with fixed maturities, short-term investments and, to a lesser extent, hedge funds and interests in mezzanine bond and equity limited partnerships. At December 31, 2006, 98.7% of PXRE’s investment portfolio consisted of fixed maturities and short-term investments and 1.3% consisted of hedge funds and other investments.
Our principal fixed maturity market risk exposure is to changes in U.S. interest rates. Changes in interest rates may affect the fair value of our fixed maturity portfolio and borrowings (in the form of trust preferred securities). Our holdings subject us to exposures in the treasury, municipal, and various asset-backed sectors. Changes in interest rates could also cause a potential underperformance in our exited finite coverages and shortfalls in cash flows necessary to pay fixed rate amounts due to exited finite contract counterparties.
We are also exposed to potential losses from changes in probability of default and from defaulting counterparties with respect to our investments. A majority of our investment portfolio consists of fixed maturities and short-term investments rated “A” or “A2” or better by Moody’s or S&P. The average credit rating of the fixed maturities and short-term investments at December 31, 2006 is “AAA.” Our investment portfolio also contains privately held fixed maturities that are not traded on a recognized exchange. A deterioration in the credit quality of our investments or our inability to liquidate any of our privately held investments promptly could have an adverse effect on our financial condition.
Liquidity risk exists in the hedge fund portfolio because there are delays between giving notice to redeem a hedge fund investment and receiving proceeds. In February 2006, redemption orders were placed with our hedge funds in the amount of $150.0 million. At December 31, 2006, the Company had $12.8 million in hedge funds subject to redemption notices. The redemption terms are defined in the offering documents and generally require notice periods and time scales for settlement. We remain at risk during the notice period, which typically specifies a month or quarter end reference point at which to calculate redemption proceeds. The risk also exists that a hedge fund may be unable to meet its redemption obligations. A hedge fund may be faced with excessive redemption notices and illiquid underlying investments.
We have exited the finite reinsurance business, but claims in respect of finite reinsurance could have an adverse effect on our results of operations.
If we complete the merger or implement another strategic alternative, we are likely to continue to rely on such brokers and assume this risk.
Recoveries under our collateralized catastrophe facility are triggered by modeled loss to a notional portfolio, rather than our actual losses arising from a catastrophe event, which creates a potential mismatch between the risks assumed through our inwards reinsurance business and the protection afforded by this facility.
At December 31, 2006, the Company had issued letters of credit in the amount of $239.3 million which are secured by cash and securities with a fair value of $329.5 million.
PXRE Bermuda. PXRE Bermuda is registered as a Class 4 Bermuda insurance and reinsurance company. Among other matters, Bermuda statutes, regulations and policies of the BMA, require PXRE Bermuda to maintain minimum levels of statutory capital, surplus and liquidity, to meet solvency standards, to obtain prior approval of ownership and transfer of shares and to submit to certain periodic examinations of its financial condition. These statutes and regulations may, in effect, restrict PXRE Bermuda’s ability to write insurance and reinsurance policies, to make certain investments and to distribute funds. By agreement with the BMA, PXRE Bermuda may not underwrite any new reinsurance business without the prior consent of the BMA.
In recent years, the U.S. insurance regulatory framework has come under increased federal scrutiny, and some state legislators have considered or enacted laws that may alter or increase state regulation of insurance and reinsurance companies and holding companies. Moreover, the NAIC, which is an association of the insurance commissioners of all 50 states and the District of Columbia, and state insurance regulators regularly reexamine existing laws and regulations.
In addition to the above, PXRE Bermuda has agreed to submit to additional regulatory oversight by the BMA effective March 12, 2007. Please refer to the section entitled “Business: Regulation - Bermuda ” for a full discussion of this matter.
We do not presently intend that PXRE Bermuda will be admitted to do business in any jurisdiction in the United States, the United Kingdom or elsewhere (other than Bermuda). However, we cannot assure you that insurance regulators in the United States, the United Kingdom or elsewhere will not review the activities of PXRE Bermuda, or related companies or its agents and claim that PXRE Bermuda is subject to such jurisdiction’s licensing requirements. If any such claim is successful and PXRE Bermuda must obtain a license, we may be subject to taxation in such jurisdiction. (In certain circumstances, PXRE may be subject to tax in a jurisdiction even if it is not licensed by such jurisdiction. See “Risks Related to Taxation.”) In addition PXRE Bermuda is subject to indirect regulatory requirements imposed by jurisdictions that may limit its ability to provide insurance or reinsurance. For example, PXRE Bermuda’s ability to write insurance or reinsurance may be subject, in certain cases, to arrangements satisfactory to applicable regulatory bodies. Proposed legislation and regulations may have the effect of imposing additional requirements upon, or restricting the market for, alien insurers or reinsurers with whom domestic companies place business.
Recent adverse events impacting our business that have led us to consider strategic alternatives could lead to regulatory inquiries and adoption of any course of action, including that contemplated under the Merger Agreement, that resulted in a change of control will require regulatory approval.
news reports relating to our business and trends in our markets;
acquisitions and financings by us or others in our industry; and
sales or acquisitions of substantial amounts of our common stock by our directors and executive officers or principal shareholders, or the perception that such sales could occur.
In addition, in recent years the stock market has experienced extreme price and volume fluctuations. This volatility has had a significant effect on the market prices of securities issued by many companies for reasons unrelated to their operating performance. These broad market fluctuations may materially adversely affect our stock price, regardless of our operating results.
We are a holding company and if our subsidiaries do not make dividend payments to us, we may not be able to pay dividends or other obligations.
We rely primarily on cash dividends from PXRE Reinsurance, PXRE Ireland and PXRE Bermuda to pay our operating expenses, including debt service payments, shareholder dividends, if any, income taxes and other obligations that may arise from time to time. We expect future dividends and other permitted payments from these subsidiaries to be our principal source of funds to pay expenses and dividends. The payment of dividends by our reinsurance subsidiaries to us is limited under Bermuda law, Irish law and under certain insurance statutes of various U.S. states in which they are licensed to transact business. PXRE Reinsurance is subject to state regulatory restrictions that limit the maximum amount of annual dividends or other distributions, including loans or cash advances, available to stockholders without prior approval of the Insurance Commissioner of the State of Connecticut. As of January 1, 2007, PXRE Reinsurance cannot pay any dividends without the prior approval of the Insurance Commissioner of the State of Connecticut.
Our bye-laws provide for a classified board of directors. The directors of the class elected at each annual general meeting hold office for a term of three years, with the term of each class expiring at successive annual general meetings of shareholders. Under our bye-laws, the vote of 66 2/3% of the outstanding shares entitled to vote and the approval of a majority of the board is required to amend bye-laws regarding appointment and removal of directors, remuneration, powers and duties of the board, indemnification of directors and officers, director’s interests and the procedures for amending bye-laws.
In addition, our ownership of U.S. subsidiaries can, under applicable state insurance company laws and regulations, delay or impede a change of control of us. Under applicable insurance regulations, any proposed purchase of 10% or more of our voting securities would require the prior approval of the relevant insurance regulatory authorities.
Under Bermuda law and our bye-laws, a transaction entered into by us, in which a director has an interest, will not be voidable by us, and such director will not be liable to us for any profit realized pursuant to such transaction, provided the nature of the interest is disclosed at the first opportunity at a meeting of directors, or in writing to the directors. In addition, our bye-laws allow a director to be taken into account in determining whether a quorum is present and to vote on a transaction in which that director has an interest following a declaration of the interest pursuant to the Companies Act provided that the director is not disqualified from doing so by the chairman of the meeting. Under Delaware law, such transaction would not be voidable if:
such material facts were disclosed or were known to the shareholders entitled to vote on such transaction and the transaction was specifically approved in good faith by vote of the majority of shares entitled to vote thereon; or
a holder of our common shares would be able to enforce, in the courts of Bermuda, judgments of United States courts based upon the civil liability provisions of the United States federal securities laws; and
a holder of our common shares would be able to bring an original action in the Bermuda courts to enforce liabilities against us or our directors or officers, as well as our independent accountants, who reside outside the United States based solely upon United States federal securities laws.
We and our Bermuda subsidiaries may become subject to Bermuda taxes after 2016.
Bermuda currently imposes no income tax on corporations. We have obtained an assurance from the Bermuda Minister of Finance, under The Exempted Undertakings Tax Protection Act 1966 of Bermuda, that if any legislation is enacted in Bermuda that would impose tax computed on profits or income, or computed on any capital asset, gain or appreciation, or any tax in the nature of estate duty or inheritance tax, then the imposition of any such tax will not be applicable to us or our Bermuda subsidiaries until March 28, 2016. We cannot assure you that we or our Bermuda subsidiaries will not be subject to any Bermuda tax after that date.
We and our non-U.S. subsidiaries have and intend to continue 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, we and our non-U.S. subsidiaries will not be subject to U.S. federal income taxes or branch profits tax (other than withholding taxes on certain U.S. source investment income 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 IRS will not contend successfully that we or a non-U.S. subsidiary of ours is engaged in a trade or business, or carrying on business through a permanent establishment, in the United States.
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 cannot assure you that we or our non-U.S. subsidiaries will not be classified as CFCs. We believe that because of the anticipated dispersion of our common share ownership, provisions in our organizational documents that limit voting power and other factors, no United States person who (i) owns our shares (directly, indirectly through one or more foreign entities or constructively), (ii) does not own (directly or indirectly through one or more foreign entities or constructively) our preferred shares and (iii) has not received a waiver from our board of directors of provisions in our organizational documents that limit voting power, 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.
If we or a non-U.S. subsidiary is determined to have “related person insurance income” (“RPII”), you may be subject to U.S. taxation on your pro rata share of such income.
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, 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. Additionally, we do not expect the direct or indirect insureds of our non-U.S. insurance subsidiaries (and persons related to such insureds) to directly or indirectly own 20% or more of either the voting power or value of our shares. No assurance can be given that this will be the case because some of the factors that determine the existence or extent of RPII may be beyond our knowledge and/or control.
Under recently enacted “inversion” rules, if a non-U.S. corporation acquires substantially all the assets of a U.S. corporation (including by acquiring the stock of the U.S. corporation) and if, after the acquisition, the shareholders of the U.S. corporation own at least 60 percent of the vote or value of the stock of the non-U.S. corporation, any income or gain recognized by the U.S. corporation on certain transfers of assets or licenses of property to related foreign persons may not be offset by net operating losses, foreign tax credits, or other tax attributes of the U.S. corporation. Based on the structure of the proposed merger transaction, these rules will apply to Argonaut.
In addition, the inversion rules provide that if, after the acquisition, the shareholders of the U.S. corporation own at least 80 percent of the vote or value of the stock of the non-U.S. corporation, the non-U.S. corporation will be treated as a United States corporation for tax purposes. If this rule applies following the merger with Argonaut, we would be subject to U.S. federal income tax on our worldwide income. Based on the structure of the proposed merger transaction, we believe that we will not be treated as a U.S. corporation taxable in the United States on its worldwide income. There can be no assurances, however, that the IRS will not contend successfully that we should be considered a U.S. corporation under the inversion rules.
Consolidated Statements of Operations and Comprehensive Operations for the years ended December 31, 2006, 2005 and 2004