(Loss) income before income taxes, cumulative effect of accounting change and convertible preferred share dividends
In January 2003, the FASB issued FASB Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest Entities” (“FIN 46R”), which requires consolidation of all “Variable Interest Entities” (“VIEs”) by the “primary beneficiary,” as these terms are defined in FIN 46R. The adoption of this statement during the quarter ended March 31, 2004, resulted in PXRE deconsolidating the five special purpose trusts which issued PXRE’s trust preferred securities. As a result, the subordinated loans from the trusts are reflected as liabilities under the caption “Subordinated debt” on PXRE’s December 31, 2005 and 2004 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, 2005 and 2004 Consolidated Balance Sheets under the caption “Fixed Maturities: Available-for-sale.”
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 $697.6 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 $704.6 million and $22.5 million for the years ended December 31, 2005 and 2001 respectively.
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 or other reinsurance related expense 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, 2005 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 is catastrophe and risk excess reinsurance, which accounted for substantially all of our net premiums written for the year ended December 31, 2005. Our catastrophe and risk excess business includes property catastrophe excess of loss and pro-rata, property catastrophe retrocessional, property risk excess and marine excess and aerospace excess reinsurance products.
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. We also first announced our intention to explore strategic alternatives due to concerns about potential negative impact on our credit ratings.
Immediately following this announcement, 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. A.M. Best also downgraded its financial strength rating on these entities 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.
On February 23, 2006, S&P further downgraded its counterparty credit and financial strength rating on PXRE Reinsurance and PXRE Bermuda from “BBB+” to “BBB-” where they remain on CreditWatch with negative implications. On February 24, 2006, A.M. Best further downgraded its financial strength rating on these entities from “B++” to “B+” with a negative implication. On February 28, 2006, Moody’s further downgraded its insurance financial strength rating of PXRE Reinsurance from “Baa2” to “Baa3” and placed this rating under review for possible further downgrade. See Item 1 - Business: Ratings.
It is increasingly common for our assumed reinsurance contracts to contain terms that would allow our clients to cancel the contract if we are downgraded below various rating levels by one or more rating agencies. Whether a client would exercise such rights would depend, among other things, on the reasons for such a downgrade, the extent of the downgrade, the prevailing market conditions, and the pricing and availability of replacement reinsurance coverage. We cannot predict in advance how many of our clients will actually exercise such rights or the effect such cancellations will have on our financial condition or future prospects, but, depending on the number of contracts involved, such an effect could be materially adverse. As of January 1, 2006, more than 75% of our business (by premium volume) is subject to contractual provisions allowing clients additional rights upon a decline in PXRE’s ratings or capital. As of March 13, 2006, we had received notice of cancellation from approximately 33% of our clients, calculated using premiums with respect to in-force business as of January 1, 2006, and it is anticipated that this percentage will increase.
We incurred a net loss before convertible preferred share dividends of $697.6 million in the year ended December 31, 2005. 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. See below, Management’s Discussion and Analysis of Financial Condition and Results of Operations - Losses and Loss Expenses.
In order to address the capital lost as a result of Hurricanes Katrina and Rita, avoid further rating agency downgrades and position PXRE to take advantage of expected reinsurance market opportunities, the Board of Directors implemented a capital raising plan that resulted in the Company receiving net proceeds of $474.0 million from two separate transactions as described below.
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 common shares. Shortly after the exchange, S&P affirmed our “A-” financial strength rating and assigned us a stable outlook.
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 of $8 billion to $12 billion in Florida. As of December 31, 2005, the net impact of Hurricane Wilma was $138.0 million, after reinsurance recoveries on our outwards reinsurance program and the impact of inwards and outwards reinstatements and additional premiums.
The following table summarizes the change in the gross and net impact of Hurricanes Katrina and Rita from September 30, 2005.
Before reinsurance recoveries on our outwards reinsurance program and the impact of inwards and outwards reinstatements and additional premiums.
Net of reinsurance recoveries on our outwards reinsurance program and after the impact of inwards and outwards reinstatements and additional premiums.
Reflects the reversal of tax benefits recorded as of September 30, 2005 with respect to Hurricane Katrina following the Company’s determination to record a valuation allowance against income tax recoverables for all but $6.3 million of such recoverables as of December 31, 2005. This was done due to the uncertainty with regard to the ultimate realization of the Company’s income tax recoverables following the Company’s recent ratings downgrades.
As of December 31, 2005, we have paid less than 10% of our net incurred loss amounts with respect to Hurricanes Katrina, Rita and Wilma. 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 Loss and Loss Expenses.
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 new reinsurance coverage is designed to protect PXRE from extreme catastrophe losses arising from hurricanes in the Eastern and Gulf coasts of the United States, windstorms in northern Europe and earthquakes in California. This reinsurance provides two layers of protection over the next 5 years to PXRE. The first layer provides $200.0 million of coverage for losses arising from hurricanes in the Eastern and Gulf coasts of the United States, windstorms in northern Europe and earthquakes in California. The second layer provides $100.0 million of coverage for losses arising from hurricanes in the Eastern and Gulf coasts of the United States and windstorms in northern Europe.
The A&W II coverage is based on a modeled loss trigger. PXRE created a series of notional portfolios of reinsurance contracts designed to closely mimic the exposures in PXRE’s assumed reinsurance portfolio. Upon the occurrence of a hurricane, windstorm or earthquake in the covered territories, the parameters of the catastrophe event are determined and modeled against the notional portfolios. If the modeled loss to the notional portfolio exceeds the attachment point for the peril at issue, then the coverage is activated. Upon the occurrence of a second catastrophe event in the covered territories during 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 is not limited to PXRE’s ultimate net losses from the loss event.
On December 21, 2005, A&W II financed the coverage through the issuance of $250.0 million in catastrophe bonds pursuant to Rule 144A under the Securities Act of 1933.
Our ability and willingness to generate significant premium growth are highly dependent upon the premium pricing levels in the reinsurance market. 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 have historically caused cyclical increases and declines in premium rates.
Considerable increases in pricing as well as improved terms and conditions for the insurance industry have occurred since 2000 as a result of large losses from catastrophic events (including the events of September 11, 2001), recognized industry-wide reserve deficiencies, poor investment performance and the continued exit of insurance industry players. These conditions had impacted our markets considerably and had created attractive opportunities for us. These favorable market conditions have driven our strong growth in net premiums written in our catastrophe and risk excess segment since 2001.
Pricing in our catastrophe and risk excess business was healthy during 2004 following the significant rate increases experienced in 2002 and 2003. During 2004, pricing was generally flat to up slightly in our North American property catastrophe and worldwide retrocessional businesses. We experienced single-digit rate decreases in our international property catastrophe business in 2004.
In the wake of significant industry losses arising from Hurricanes Katrina, Rita and Wilma, we are experiencing significant improvements in premium rates and terms of coverage in our property retrocessional business and North American property catastrophe reinsurance and risk excess businesses. We are also experiencing moderate rate increases and term improvements in our international property catastrophe reinsurance and risk excess businesses.
Since the primary focus of our business is on property catastrophe reinsurance, the size of our losses during any annual period depends, to a large extent, on the number and magnitude of natural and man-made catastrophes such as hurricanes, windstorms, hailstorms, earthquakes, volcanic eruptions, fires, industrial explosions, freezes, riots and floods. This focus on short-tail, high-severity and relatively low-frequency lines of business exposes us to short-term volatility in our operating results. Given our focus on catastrophe coverages, there is significant uncertainty with respect to the size or scope of losses we might experience in 2006.
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. As an event matures, we rely more and more on our client’s reported losses combined with both Company and industry event specific historical reporting patterns to project ultimate losses for the event. This process can cause our ultimate estimates to differ significantly from initial projections. The French storm Martin that occurred on December 27, 1999 presents an example of these potential uncertainties. Initially, we based our reserves to a significant degree on industry estimates of the total loss, which were approximately $1.0 billion. In 2001, the cost was estimated to be $2.5 billion by SIGMA, a widely used industry publication. Our gross loss estimate at December 31, 1999 for this event was $31.3 million. Our gross loss estimate for French storm Martin at December 31, 2005 was $68.9 million. Thus, the original industry loss estimate increased by 150%, and our loss estimate has increased by 120%.
During the course of our year-end assessment, we increased our estimate of the ultimate incurred gross loss and loss expenses arising from Hurricane Katrina by $214.6 million and from Hurricane Rita by $48.1 million, in each case as compared to the gross incurred loss recorded as of September 30, 2005.
As of December 31, 2005, we have paid less than 10% of our net incurred loss amounts with respect to Hurricanes Katrina, Rita and Wilma. Accordingly, our estimate of the ultimate liability arising from these catastrophes is based on preliminary claims notices received from clients, catastrophe modeling, a review of exposed reinsurance contracts, discussions with numerous clients and a review of the underwriting information provided by clients with reinsurance contracts that renewed as of January 1, 2006. Although these events are still too immature to rely solely on historical reporting patterns to project ultimate net loss, our estimates fall within a reasonable actuarial range produced by these methods for Hurricanes Katrina and Rita. Hurricane Wilma is too premature to place any substantial reliance on the reported loss method.
In developing our best estimate, we have also assumed flood damage exclusions contained in our cedent’s underlying insurance policies will be effective. We understand that various lawsuits have been filed seeking to invalidate such flood damage exclusions on various grounds, including a suit filed by the Attorney General for the State of Mississippi. If such lawsuits were to successfully invalidate the underlying flood damage exclusions, our liabilities for losses and loss expenses relating to Hurricane Katrina could prove to be inadequate, with a consequent adverse impact on our earnings and shareholders’ equity in future periods.
There is an additional risk of uncertainty in PXRE’s estimation of loss 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, since 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.
During 2004, we experienced net adverse development of $12.0 million for prior-year losses and loss expenses, comprised of $11.4 million catastrophe and risk excess net favorable development and $23.4 million exited lines net adverse development. The favorable development in the catastrophe and risk excess business was primarily related to case reserve takedowns from past significant catastrophes, such as the 2002 European floods. The $23.4 million net adverse development related to exited lines was due primarily to $13.7 million of adverse loss development related to an adverse litigation outcome concerning one aggregate excess of loss reinsurance contract (the “LMC XOL Contract”) that was commuted during the fourth quarter of 2004 following an adverse ruling in litigation. We also experienced $19.7 million of adverse development on our exited direct casualty reinsurance operations. The primary cause of the adverse development was higher than expected reported losses in 2004. Favorable development in other exited lines partially offset the adverse development experienced on the LMC XOL Contract and our exited direct reinsurance operations. During the third and fourth quarters of 2004, we completed commutations of two of the largest exited direct general liability reinsurance programs, the first resulting in a $2.0 million reduction in incurred losses and the second in a $1.0 million increase in incurred losses.
On an overall basis, the low and high ends of a range of reasonable net loss reserves are $124.2 million below and $160.6 million above the $1,212.5 million best estimate displayed above. Note that 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 low and high ends of a range of reasonable net loss reserves around the best estimate displayed in the table above with respect to each segment are as follows:
For 2005, gross premiums written were $542.3 million. This amount includes premium estimates of $168.8 million, $153.8 million of which were from reinstatement premiums. The estimated premium receivable included in premiums receivable, is $206.0 million, including reinstatement premiums of $182.9 million.
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.
Fair values for our investments in hedge funds and other privately held fixed income and equity 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.
Hedge funds and other limited partnership investments are accounted for under the equity method whereby both the investment income and any change in the fair value are recorded through the net investment income line of the Consolidated Statements of Operations and Comprehensive Operations. The fair value of hedge funds approximates redemption values. Foreign denominated fixed maturities are accounted for as part of a trading portfolio, whereby both the investment income and a portion of the change in the fair value are recorded through the net investment income line of the Consolidated Statements of Operations and Comprehensive Operations.
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 year ended December 31, 2005, PXRE recorded $11.8 million in other than temporary impairment charges. The other than temporary impairment charges recorded in the current year relate to investments that the Company may not have the ability to hold to maturity or have sold subsequent to year end to pay claims and meet the Company’s short term obligations as a result of the ratings downgrades of PXRE subsequent to year end. In 2004 and 2003, we recognized $0.1 million and $0.2 million, respectively, of impairment losses on investment securities whose value had fallen below 80% of face value for more than six months.
Gross and net premiums earned for the years ended December 31, 2005 and 2004 were as follows:
The increase in both gross premiums written and gross premiums earned for the year ended December 31, 2005 was primarily driven by reinstatement premiums of $159.5 million in 2005, including $151.7 million of reinstatement premiums from Hurricanes Katrina, Rita and Wilma, compared to $35.1 million of reinstatement premiums in 2004 which were primarily a result of the 2004 Florida hurricanes and Asian typhoons. Before the effects of reinstatement premiums, PXRE experienced growth in gross premiums written and gross premiums earned of 23% and 16%, respectively, as a result of new business written and rate increases on the renewal of contracts that were impacted by losses from the 2004 Florida hurricanes and Asian typhoons.
Before the effects of reinstatement premiums, PXRE experienced growth in net premiums written and net premiums earned of 29% and 23%, respectively, as a result of new business written and rate increases on the renewal of contracts that were impacted by losses from the 2004 Florida hurricanes and Asian typhoons.
A summary of our 2005 and 2004 net premiums written and 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 or other reinsurance related expense on underwriting results. The ratios discussed below have been calculated on a GAAP basis.
During 2004, we experienced net adverse development of $12.0 million for prior-year losses and loss expenses, comprised of $11.4 million catastrophe and risk excess net favorable development and $23.4 million exited lines net adverse development. The favorable development in the catastrophe and risk excess business was primarily related to case reserve takedowns from past significant catastrophes, such as the 2002 European floods. The $23.4 million net adverse development related to exited lines was due primarily to $13.7 million of adverse loss development on the LMC XOL Contract. During the fourth quarter of 2004, this contract was commuted. We also experienced $19.7 million of adverse development on our exited direct casualty reinsurance operations. The primary cause of the adverse development was higher than expected reported losses in 2004. Favorable development in other exited lines partially offset the adverse development experienced on the LMC XOL Contract and our exited direct reinsurance operations. During the third and fourth quarters of 2004, we completed commutations of two of the largest exited direct general liability reinsurance programs, the first resulting in a $2.0 million reduction in incurred losses and the second in a $1.0 million increase in incurred losses.
The expense ratio was 21.9% for 2005 compared with 24.5% for 2004. The commission and brokerage ratio, net of fee income, was 12.6% for 2005 compared with 11.1% for 2004. The increase in the commission and brokerage ratio is primarily attributable to the increase in ceded reinstatement and additional premium amounts incurred in connection with the Company’s ceded reinsurance program as a result of Hurricanes Katrina, Rita and Wilma. While these ceded reinstatement and additional premium amounts decreased earned premium, they did not decrease brokerage expenses on assumed reinsurance business, thus causing our commission and brokerage ratio to increase. In addition, commission and brokerage includes costs associated with reinsurance protection through a collateralized catastrophe bond transaction of $3.6 million.
Net investment income for the year ended December 31, 2005 increased $19.1 million, or 73%, to $45.3 million from $26.2 million for 2004. This increase was primarily due to a $13.8 million increase in income from our fixed maturity and short-term investment portfolios resulting from the increase in the average invested balance due to cash flows from financing activities, including the $474.0 million of net proceeds from the two equity offerings which were completed in the fourth quarter of 2005 and net proceeds of $98.2 million from a common share offering in the fourth quarter of 2004. Additionally, the book yield of our fixed maturity and short-term investment portfolios increased to 3.7% for the year ended December 31, 2005 from 3.2% for the year ended December 31, 2004. Lastly, investment income related to our hedge fund portfolio increased to $11.9 million in 2005 from $8.7 million in 2004 as investments in hedge funds produced a return of 8.5% for the year ended December 31, 2005 compared with 7.1% for the year ended December 31, 2004.
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 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.
Gross premiums written for the year ended December 31, 2004 increased $6.9 million, or 2%, to $346.0 million from $339.1 million in 2003. Gross premiums written in our core catastrophe and risk excess segment increased $17.9 million, or 6%, compared to 2003 due to increased business written and reinstatement premiums associated with catastrophe losses that occurred during the third quarter of 2004, namely Hurricanes Charley, Frances, Ivan and Jeanne. Gross reinstatement premiums written related to the catastrophe and risk excess business increased by $27.0 million to $35.2 million in 2004 from $8.2 million in 2003. Offsetting the increase in the catastrophe and risk excess segment, in part, was a planned decrease in our exited lines segment of $11.0 million compared to the year earlier period.
Losses and loss expenses incurred amounted to $226.3 million in 2004 compared to $157.6 million in 2003. The loss ratio was 73.5% for 2004 compared to 49.1% for 2003 largely due to $136.4 million in incurred losses, net of reinsurance, from Hurricanes Charley, Frances, Ivan and Jeanne that occurred during the third quarter of 2004. As noted in the discussion under “- Premiums” above, these Florida hurricanes triggered $24.8 million of reinstatement premiums earned during the third quarter of 2004, which somewhat offset the impact of the hurricane losses on net income. We did not experience any significant catastrophe activity in 2003. The largest losses in 2003 were related to the winter storms in the Midwest and the wildfires in California, but we incurred less than $10.0 million with respect to each of these losses.
Net investment income for the year ended December 31, 2004 decreased 3% to $26.2 million from $26.9 million for 2003, primarily as a result of a $3.8 million decrease in income from our hedge fund portfolio, offsetting an increase in income from our fixed maturity and short-term investment portfolios resulting from the increase in the average invested balance due to cash flows from operations and financing. Investment income related to our hedge fund portfolio decreased to $8.7 million in 2004 from $12.5 million in 2003 as investments in hedge funds produced a return of 7.1% for the year ended December 31, 2004 compared with 11.1% for the year ended December 31, 2003. The book yield of our fixed maturity and short-term investment portfolios decreased to 3.2% for the year ended December 31, 2004 from 3.6% for the year ended December 31, 2003.
Net realized investment losses for 2004 were $0.2 million compared to net realized investment gains of $2.4 million for 2003.
The primary sources of liquidity for our principal operating subsidiaries have historically been net cash flows from operating activities (including interest income from investments), the maturity or sale of investments, borrowings, capital contributions and advances. Funds are applied primarily to the payment of claims, operating expenses, income taxes and to the purchase of investments. Premiums are typically received in advance of related claim payments.
As of the result of our recent ratings downgrades and the resulting level of contract terminations from our assumed book of business, positive cash flows associated with the receipt of reinsurance premiums is likely to decrease substantially in 2006. 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 50% of such proceeds are expected to be received by April 30, 2006, approximately 80% by July 31, 2006, and 100% by March 31, 2007. As a result of these steps, we believe we have sufficient liquidity to meet the currently foreseen needs of our counterparties.
On October 7, 2005, PXRE completed the public offering of 8,843,500 of its 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. Net proceeds to the Company from the common share offering, after deducting estimated expenses and underwriter’s discounts and commissions, were approximately $114.7 million.
Pursuant to a Share Purchase Agreement dated as of September 29, 2005, PXRE 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 common shares.
PXRE contributed the $474.0 million net proceeds of the public offering and the private placement to PXRE Bermuda to support the underwriting of reinsurance business during subsequent renewal periods.
On December 16, 2003, the Company completed an offering of 2.2 million of its common shares at $21.75 per share. Of the 2.2 million shares sold, 1.1 million were offered by PXRE and 1.1 million were offered by Phoenix Life Insurance Company (“Phoenix”), one of the Company’s common shareholders.
The Company did not receive any of the proceeds from the sale of shares by Phoenix. Net proceeds to the Company, from the sale of the common shares sold by the Company, were approximately $20.4 million. We used the net proceeds from the sale of common shares for general corporate purposes, including contributions to the capital of PXRE Bermuda to support growth in its business. On January 22, 2004, the underwriters exercised in-full the overallotment option to purchase 0.3 million additional common shares at $21.75 per share. As a result of the exercise of the option, the Company received additional net proceeds of approximately $6.3 million, resulting in total net proceeds from the offering of approximately $26.7 million. We again used the net proceeds for general corporate purposes, including contributions to the capital of PXRE Bermuda. After giving effect to the sale of the overallotment shares, a total of 2.5 million shares were sold in the offering.
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, 2005, obligations to PXRE Capital Trust amount to $102.6 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 and $3.4 million in 2005 and 2004, respectively. Book value per common share was $6.01 at December 31, 2005 after considering convertible preferred shares.
As a result of the losses arising from Hurricanes Katrina, Rita and Wilma, the realizable value of the Company’s assets ($2.1 billion) no longer exceeds the aggregate of its liabilities ($1.7 billion) its issued share capital ($130.4 million) and its share premium account ($550.0 million). As a result of this deficiency, the Company is currently prohibited by Bermuda law from paying dividends or making distributions from its contributed surplus account to its shareholders.
Because of the nature of the coverages we provide, which typically can produce infrequent losses of high severity, it is not possible to accurately predict our future cash flows from operating activities. As a consequence, cash flows from operating activities may fluctuate, perhaps significantly, between individual quarters and years.
PXRE is subject to large losses, including natural perils such as hurricanes and earthquakes. Since the timing and amount of losses from such exposures is unknown, the Company invests its assets so that should an event occur, it would have sufficient liquidity to pay claims on the underlying contracts. This strategy is evidenced by the overall 1.7 year duration of the Company’s fixed income and short-term investments as of December 31, 2005. Due to this relatively short duration portfolio, the Company does not believe realized losses resulting from selling securities before anticipated will have a material adverse impact on its financial position. Should an event actually occur such as the occurrence of Hurricane Katrina in the third quarter of 2005, PXRE dedicates assets, including cash equivalents and other short-term investments, in such a manner that cash is always on hand to pay claims. 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. 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 50% of such proceeds are expected to be received by April 30, 2006, approximately 80% by July 31, 2006, and 100% by March 31, 2007. As a result of these steps, we believe we have sufficient liquidity to meet the currently foreseen need of our counterparties.
The second transaction was a $250.0 million collateralized transaction with A&W II, a Cayman Island reinsurance company, which is accounted for as a derivative. It is designed to provide coverage to PXRE for second event losses in the same calendar year arising from hurricanes in the Eastern and Gulf coasts of the United States, windstorms in northern Europe and earthquakes in California. The agreement with A&W II provides two tranches of protection to PXRE for the risk that a second significant catastrophe loss arising from a hurricane in the Eastern and Gulf coasts of the United States, a windstorm in northern Europe or earthquake in California occurs following the occurrence of a first significant hurricane, windstorm or earthquake loss. The first tranche provides $125.0 million of protection from January 1, 2006 through December 31, 2006. The second tranche provides $125.0 million of protection from January 1, 2006 through December 31, 2008. The annual premium payments with respect to the A&W II facility are $15.6 million in 2006 and $7.9 million in 2007 and 2008, respectively.
The reinsurance companies that are counterparties to these transactions are variable interest entities under the provisions of FIN 46R. The Company is not the primary beneficiary of these entities and is therefore not required to consolidate these entities in its consolidated financial statements.
The downgrade in the ratings of our reinsurance subsidiaries by rating agencies will materially and negatively impact our business and results of operations.
Our counterparty credit and financial strength ratings have now been downgraded to a level that is generally unacceptable to many of our reinsurance clients. Ratings have become an increasingly important factor in establishing the competitive position of reinsurance companies. Due to these recent ratings downgrades of our reinsurance subsidiaries by A.M. Best, S&P and Moody’s, our competitive position in the reinsurance industry has suffered and it is more difficult for us to retain our existing clients, expand our reinsurance portfolio and renew many of our existing reinsurance agreements, especially since we have been downgraded from the “A” category to the “B” category. This downgrade could result in a substantial loss of business as ceding companies and brokers that place such business move to other reinsurers with higher ratings. We cannot give any assurance regarding whether or to what extent the rating agencies may further downgrade our ratings.
The current financial strength ratings of PXRE Bermuda and PXRE Reinsurance are:
These 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). Our ratings may be revised or revoked at the sole discretion of the rating agencies.
The decline in our ratings and reduction in our surplus will allow clients to terminate their contracts with us and, with respect to ceded reinsurance, may require us to transfer premiums retained by us into a beneficiary trust.
It is common for our assumed reinsurance contracts to contain terms that would allow our clients to cancel the contract if we are downgraded below various rating levels by one or more rating agencies or if our surplus is materially reduced.
Typically such cancellation clauses are triggered if A.M. Best or S&P were to downgrade us below “A-.” Whether a client will exercise such rights will depend, among other things, on the reasons for such a downgrade, the extent of the downgrade, the prevailing market conditions, the degree of unexpired coverage, and the pricing and availability of replacement reinsurance coverage. We cannot predict in advance whether and how many of our clients would actually exercise such rights or what effect such cancellations would have on our financial condition or future prospects, but such an effect could potentially be materially adverse. The recent downgrade, below “A-” by both S&P and A.M. Best, therefore, could result in a substantial loss of business if insurers, ceding companies and/or brokers that place such business move to other insurers and reinsurers with higher ratings. Based on premium volume, more than 75% of our reinsurance contracts in-force at January 1, 2006 contain such clauses. As of March 13, 2006, we had received notice of cancellation from approximately 33% of our clients, calculated using premiums with respect to in-force business as of January 1, 2006, and it is anticipated that this percentage will increase.
Certain of our ceded excess of loss reinsurance contracts may require us to transfer premiums currently retained by us on a funds withheld basis into a trust for the benefit of the reinsurers if A.M. Best were to downgrade us below “A-.” In addition, certain of our other ceded excess of loss reinsurance contracts contain provisions that give the reinsurer the right to cancel or commute the contract and require us to pay a termination fee. The amount of the termination fee would be dependent upon various factors, including level of loss activity.
Our counterparty credit and financial strength ratings were downgraded by the major rating agencies in February 2006 to a level that is generally unacceptable to many of our reinsurance clients. This ratings downgrade is expected to have a significant negative impact on our financial condition, future results of operations and profitability. In light of the potential negative consequences of the rating downgrade, our Board of Directors has decided to explore strategic alternatives for PXRE and has retained Lazard as a financial advisor to assist in this process.
There are many possible alternatives that we are exploring which include, among others, a sale of PXRE, a sale of certain or substantially all of our assets, a merger with one or more other companies and a variety of alternate business strategies. Our Board of Directors has not excluded any possibility from consideration. 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 one of the other strategic alternatives under consideration, 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.
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 a liquidation, we may not receive any material amounts for the sale or other disposition of our assets. Further, in a 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.
If the Board of Directors elects to pursue a strategic alternative that does not involve the continuation of meaningful property catastrophe reinsurance business, there is a risk that the Company could incur material charges or termination fees in connection with our collateralized catastrophe facilities.
The first facility, A&W I, provides $300.0 million of collateralized catastrophe protection for a term that commenced on November 9, 2005 and is scheduled to terminate on November 15, 2010, unless terminated earlier. The annual premium payments due with respect to A&W I during its term are approximately $26.0 million. PXRE has the right to terminate the A&W I facility without penalty during the fifth year of the facility’s term. If the A&W I facility is terminated prior to such period, PXRE could be obligated to pay significant early terminations fees that could be as much as $17.5 million.
The second facility, A&W II, provides $250.0 million of collateralized catastrophe protection in two tranches. The first $125.0 million tranche commenced on January 1, 2006 and is scheduled to terminate on December 31, 2006. The second $125.0 million tranche commenced on January 1, 2006 and is scheduled to terminate on December 31, 2008. The annual premium payments with respect to the A&W II facility are $15.6 million in 2006 and $7.9 million in 2007 and 2008, respectively. 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 $11.4 million.
Our ability to continue to operate our business and to identify, evaluate and complete any strategic alternative are dependent on our ability to retain our management and other key employees, and we may not be able to do so.
The market price of our common stock has declined and may decline further as a result of our announcements of increased loss estimates for losses due to Hurricanes Katrina, Rita and Wilma and the ratings downgrades we have experienced.
Recent adverse events have affected the market price of our common shares, which may lead to securities litigation, administrative proceedings or both being brought against us.
Companies that experience material adverse events, such as having their financial strength ratings downgraded by rating agencies or their material contracts terminated, often experience significant market fluctuations that affect the prices of their securities and result in litigation, administrative proceedings or both. 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 risk that significant individual lawsuits and securities class action litigation may be brought against us or that regulators may institute administrative proceedings against us, or both. As of March 13, 2006, we are not aware of any such litigation or administrative proceedings. While we would contest vigorously any such action, legal and administrative proceedings of this type are often expensive and can 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. In addition, the existence of significant litigation or administrative proceedings against us, or the perceived probability of such actions, could have a material adverse effect on the market price of our common shares and other securities.
Our actual losses from Hurricanes Katrina, Rita and Wilma may exceed our best estimate as a result of, among other things, the receipt of additional information from clients, the attribution of losses to coverages that for the purpose of our estimates we assumed would not be exposed, and inflation in repair costs due to the limited availability of labor and materials, in which case our financial results could be further materially adversely affected.
As a result of the losses arising from Hurricanes Katrina, Rita and Wilma, for Bermuda corporate law purposes, the realizable value of the Company’s assets ($2.1 billion) no longer exceeds the aggregate of our liabilities ($1.7 billion), our issued share capital ($130.4 million) and our share premium account ($550.0 million). As a result of this deficiency, we are currently prohibited by Bermuda corporate law from paying dividends or making distributions from our contributed surplus account to our shareholders.
In order that the Company can continue to have the flexibility to pay dividends to shareholders, the Board determined that it is in the best interests of the Company to reduce the share premium account to zero and allocate $550.0 million to the Company’s contributed surplus account. This reduction of our share premium account and reallocation to the contributed surplus account requires the approval of our shareholders to be effective. At our next Annual General Meeting of Shareholders, the Company intends to ask shareholders to approve a proposal to reduce our share premium account and transfer the $550.0 million balance to our contributed surplus account. If our shareholders do not approve this proposal, we may be restricted by Bermuda corporate law from declaring or paying dividends to our shareholders. Even if our shareholders approve this proposal and we are once again permitted by law to declare and pay dividends, we cannot guarantee that the Company will pay dividends to our shareholders at any time in the future, or that future losses or other events could not once again impair our ability to pay dividends to our shareholders.
As we underwrite risks from a large number of insurers based on information generally supplied by reinsurance brokers, we may develop a concentration of exposure to loss in certain geographic areas prone to specific types of catastrophes. For example, we are significantly exposed to losses arising from hurricanes in the southeastern United States, earthquakes in California, the midwestern United States and Japan, and to windstorms in northern Europe. We have developed systems and software tools to monitor and manage the accumulation of our exposure to such losses and have established guidelines for maximum tolerable losses from a single event or multiple catastrophic events based on historical data. However, these risk limits were exceeded in Hurricane Katrina and no assurance can be given that these maximums will not be exceeded in some future catastrophe.
Moreover, in purchasing reinsurance coverage to protect PXRE during 2006, we assumed that such gross premiums written would be available to offset smaller losses and; as a result most of the reinsurance coverage purchased by PXRE is designed to protect PXRE against larger catastrophe events. Therefore, although our aggregate exposures may be reduced due to widespread cancellations of our assumed reinsurance contracts, we may be overexposed to the risk of losses arising from smaller catastrophe events since our reinsurance protections may not respond to such small catastrophe events.
Finally, in underwriting our 2006 assumed reinsurance portfolio, we sought to build a portfolio that was balanced with respect to geographic region, peril and level of loss exposure. Since we have no control over which of our clients will cancel their reinsurance contracts, there is a significant risk that our remaining reinsurance portfolio will be unbalanced and overexposed to loss for certain geographic areas, perils and loss exposure levels.
We compete with numerous companies, many of whom have higher 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 recently 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 recent ratings downgrade and the material negative financial impact of the losses arising from Hurricanes Katrina, Rita and Wilma, 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.
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.
To the extent that the funds generated by our ongoing operations and existing capitalization are insufficient to fund future operating requirements, liquidity needs, growth expectations and cover claim payments, we may need to raise additional funds through financings. Any equity or debt financing, if available at all, may be on terms that are not favorable to us or may be dilutive to our shareholders. In addition, substantial sales of our equity in the public market, or the perception that such sales could occur, could adversely affect the market price of our common shares. If we cannot obtain adequate capital, our business, operating results and financial condition could be adversely affected in a material manner.
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 “A2” or “A” or better by Moody’s or S&P. The average credit rating of the fixed maturities and short-term investments at December 31, 2005 is “AA+.” 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.
We market our reinsurance products worldwide exclusively through reinsurance brokers. Four brokerage firms accounted for approximately 80%, 78% and 78% of our gross premiums written in each of the years ended December 31, 2005, 2004 and 2003, respectively. Approximately 31%, 25%, 13% and 11% of gross premiums written in fiscal year 2005 were arranged through Benfield Greig Ltd., the worldwide branch offices of Guy Carpenter & Company, Inc. (a subsidiary of Marsh & McLennan Companies, Inc.), Aon Group Ltd. and Willis Re. Inc., respectively.
Each of these brokers have security guidelines that generally impose various limitations and restrictions on the placement of reinsurance contracts with a reinsurer with a financial strength rating of less than “A-,” including requiring a client’s written consent prior to the placement of any reinsurance contract with a reinsurer with a sub-par credit rating. Loss of all or a substantial portion of the business provided by these brokers could have a material adverse effect on our business.
The impact of investigations of broker fee and placement arrangements could adversely impact our ability to write more business.
We have exhausted our retrocessional coverage with respect to Hurricane Katrina, leaving us exposed to further losses.
Recoveries under portions of our collateralized catastrophe facilities 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 these facilities.
During the fourth quarter of 2005, PXRE entered into two collateralized facilities that provide $550.0 million of aggregate protection against losses arising from hurricanes in the Eastern and Gulf coasts of the United States, windstorms in northern Europe and earthquakes in California. The coverage under both facilities is based on a modeled loss trigger. PXRE created a series of notional portfolios of reinsurance contracts designed to closely mimic the exposures in PXRE’s assumed reinsurance portfolio. Upon the occurrence of a hurricane, windstorm or earthquake in the covered territories, the parameters of the catastrophe event are determined and modeled against the notional portfolios. If the modeled loss to the notional portfolio exceeds the attachment point for the peril at issue, then PXRE will make a recovery under the 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 these facilities could be substantially less than expected.
At December 31, 2005, the Company had issued letter of credits in the amount of $284.3 million which are secured by cash and securities with a fair value of $405.7 million.
General. 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.
PXRE U.S. Subsidiaries. PXRE Delaware and PXRE Reinsurance are subject to regulation under the insurance statutes of various U.S. states, including Connecticut, the domiciliary state of PXRE Reinsurance. The regulation and supervision to which PXRE Reinsurance is subject relates primarily to the standards of solvency that must be met and maintained, licensing requirements for reinsurers, the nature of and limitations on investments, deposits of securities for the benefit of a reinsured, methods of accounting, periodic examinations of the financial condition and affairs of reinsurers, the form and content of reports of financial condition required to be filed, reserves for losses and other matters. In general, such regulation is for the protection of the reinsureds and policyholders rather than investors.
provide for the performance of certain periodic examinations of PXRE Bermuda and its financial condition.
Under Bermuda law, non-Bermudians (other than spouses of Bermudians or holders of permanent residence certificates) may not engage in any gainful occupation in Bermuda without the specific permission of the appropriate government authority. The Bermuda government will issue a work permit for a specific period of time, which may be extended upon showing that, after proper public advertisements, no Bermudian (or spouse of a Bermudian or holder of a permanent residence certificate) is available who meets the minimum standards for the advertised position. The Bermuda government has a policy that limits the duration of work permits to six years, subject to certain exemptions for key employees. A significant number of our key officers, including our Chief Executive Officer, an executive vice president and key reinsurance underwriters are working in Bermuda under work permits that will expire over the next two years. The Bermuda government could refuse to extend these work permits. If any of our senior executive officers were not permitted to remain in Bermuda, our operations could be disrupted and our financial performance could be adversely affected.
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 that resulted in a change of control will require regulatory approval.
potential shareholder litigation and regulatory investigations relating to the recent decline in our share price, ratings downgrade and catastrophe losses;
changes in financial estimates and recommendations by securities analysts concerning us or the reinsurance industry generally;
the material facts as to such interested director’s relationship or interests were disclosed or were known to the board of directors and the board of directors in good faith authorized the transaction by the affirmative vote of a majority of the disinterested directors;
the transaction was fair as to the corporation as of the time it was authorized, approved or ratified. Under Delaware law, such interested director could be held liable for a transaction in which such director derived an improper personal benefit.
a holder of our common shares would be able to enforce, in the courts of Bermuda, judgments of United States courts against persons who reside in Bermuda based upon the civil liability provisions of the United States federal securities laws;
The anti-dilution protection afforded to the holders of our outstanding preferred shares could cause substantial dilution to the holders of our common shares. The sale, following conversion, of substantial amounts of our common shares by the holders of the preferred shares could cause the market price of our common shares to decline significantly.
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. 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.
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 13, 2006, the outstanding convertible common shares and preferred shares were ultimately convertible into 5.1 million common shares, or 6.6% 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.
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.
Dividends paid by PXRE Delaware to PXRE Ireland may not be eligible for benefits under the U.S.-Ireland income tax treaty.
PXRE Delaware is a Delaware corporation wholly owned by PXRE Ireland. Under U.S. federal income tax law, dividends paid by a U.S. corporation to a non-U.S. shareholder are generally subject to a 30% withholding tax, unless reduced by treaty. The income tax treaty between the Republic of Ireland and the United States (the “Irish Treaty”) reduces the rate of withholding tax on certain dividends to 5%. Were the IRS to contend successfully that PXRE Ireland is not eligible for benefits under the Irish Treaty, any dividends paid by PXRE Delaware to PXRE Ireland would be subject to the 30% withholding tax. Such a result could have a material adverse effect on our financial condition and results of operations.
Due to the attribution provisions of the Code regarding determination of beneficial ownership, there is a risk that the IRS could assert that we or one or more of our non-U.S. subsidiaries are CFCs and that U.S. holders of our shares who own 10% or more of the value of our shares should be treated as owning 10% or more of the total voting power of us and/or our non-U.S. subsidiaries, notwithstanding the reduction of voting power discussed above.
If the RPII of any of our non-U.S. insurance subsidiaries were to equal or exceed 20% of such company’s gross insurance income in any taxable year and direct or indirect insureds (and persons related to such insureds) own, 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.