Income (loss) before cumulative effect of accounting change and convertible preferred share dividends
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 46 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 Statement of Income and Comprehensive Income during 2004. These repurchased securities are reflected in PXRE’s December 31, 2004 Consolidated Balance Sheet under the caption “Fixed Maturities: Available-for-sale.”
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 have impacted our markets considerably and have created attractive opportunities for us.
In 2005, we believe the occurrence in 2004 and the resulting losses of hurricanes Charley, Frances, Ivan and Jeanne, as well as the typhoons that affected Japan in 2004 will drive moderate rate increases in our worldwide retrocessional business, increase or stabilize pricing in our North American property catastrophe business and moderate rate decreases in our international property catastrophe business.
During 2004, our profitability was adversely impacted by losses of $111.7, net of reinsurance and reinstatement premiums, that occurred during the third quarter arising from hurricanes Charley, Frances, Ivan and Jeanne. As a result, net income before convertible preferred share dividends declined by 76% in 2004 to $22.8 million as compared to $96.6 million in 2003, despite a 15% increase in net premiums earned in our core catastrophe and risk excess segment.
Our 2004 results were also negatively impacted net adverse development of $12.0 million in prior-year loss and loss expenses reserves, primarily arising from our exited direct casualty and finite operations. We took a number of steps during 2004 to reduce our exposure to further loss development from our exited lines segment, including the commutation of some of our largest exited casualty and exited finite contracts. As a result, the liabilities for exited lines on our balance sheet at December 31, 2004 decreased by 39% as compared to December 31, 2003. Most notably, the liabilities for our most problematic area, the exited direct casualty general liability business, decreased by 65% at December 31, 2004 as compared to December 31, 2003.
Finally, as part our normal triennial reserve review process, we retained a nationally recognized actuarial firm to perform a third party review of all of our reserves for loss and loss expense at December 31, 2004. As a result of our internal actuarial review and the third party review, management believes that our liability for loss and loss reserves as of December 31, 2004 is adequate.
Finally, PXRE records reserves for losses that have been incurred but not yet reported to PXRE, which are generally referred to as IBNR reserves. The IBNR includes both losses from events which PXRE is not aware of and losses from events which PXRE is aware of but has not yet received reports from ceding companies.
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 is due primarily to $13.7 million of adverse loss development on a finite contract with LMC which was commuted during the fourth quarter of 2004 as described in Item 3 - “Pending Legal Proceedings” above. We also experienced $19.7 million of adverse development on our 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 offset the adverse development experienced on our contract with LMC and our 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 $32.9 million below and $34.3 million above the $398.9 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 2004, the assumed premium estimate is $15.7 million, which is 5.6% of the total gross current underwriting year premium written, excluding reinstatement premiums, of $278.8 million. The estimated premium receivable included in premiums receivable, excluding reinstatement premiums was $23.5 million at December 31, 2004.
Gross and net premiums written for the years ended December 31, 2004 and 2003 were as follows:
Ceded premiums written decreased $24.5 million, or 40%, to $36.2 million for the year ended December 31, 2004 from $60.7 million for 2003, primarily as a result of a decrease of $21.1 million in ceded premiums written to Select Re under a quota share retrocessional contract that was in place in 2003 but was not renewed at January 1, 2004 and a decrease of $3.6 million in ceded premiums written related to excess of loss retrocessional catastrophe treaties.
Net premiums written for the year ended December 31, 2004 increased $31.4 million, or 11%, to $309.8 million from $278.4 million in 2003. Net premiums written in our catastrophe and risk excess segment increased $41.2 million, or 15%, for the year ended December 31, 2004 compared to 2003. The increase in this segment is due to the same factors that caused the increase in gross premiums written and decrease in ceded premiums written as explained above. Offsetting this increase, in part, was a planned decrease in our exited lines segment of $9.8 million compared to the year earlier period.
Net premiums earned for the year ended December 31, 2004 decreased $12.9 million, or 4%, to $308.1 million from $320.9 million for 2003. This decrease was a result of a planned decrease in our exited lines segment of $52.6 million compared to the year earlier period, offset by an increase in net premiums earned in the catastrophe and risk excess segment of $39.8 million, or 15%, for the year ended December 31, 2004 as compared to the corresponding prior-year period. The change in this segment is due to similar factors as those discussed above in gross and net premiums written.
A summary of our 2004 and 2003 net premiums written and earned by business segment is included in Note 12 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 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 investment 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, 2004 and 2003, respectively:
During 2004, we experienced net adverse development of $12.0 million for prior-year losses and loss expenses, comprised of $11.4 million cat and risk excess net favorable development and $23.4 million exited lines net adverse development. The favorable development in the cat 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 is due primarily to $13.7 million of adverse loss development on a finite contract with LMC as described in Item 3 - “Pending Legal Proceedings” above. During the fourth quarter of 2004, this contract was commuted. We also experienced $19.7 million of adverse development on our 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 offset the adverse development experienced on our contract with LMC and our 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.
During 2003, we experienced net adverse development of $44.7 million for prior-year loss and loss expenses, $21.8 million of which was due to loss development on our exited direct casualty reinsurance operations, $8.8 million adverse development from aerospace claims arising to a significant degree from our first receipt of notice that the increase in industry losses related to a 1998 air crash had resulted in the exhaustion of deductibles under three aerospace contracts between PXRE and Reliance Insurance Company and $8.2 million of development from finite contracts, $7.3 million of which related to the aggregate excess of loss reinsurance agreement with LMC noted above.
The expense ratio was 24.5% for 2004 compared with 25.6% for 2003. The commission and brokerage ratio, net of fee income, was 11.1% for 2004 compared with 13.2% for 2003, with the prior-year ratio affected by a large commission on a finite contract. The catastrophe and risk excess commission and brokerage ratio, net of fee income, was 10.8% for 2004 compared to 11.7% for 2003.
PXRE is not a party to any so-called Market Service Agreements or Placement Service Agreements, nor does PXRE engage in any of the contingent commission or other practices that we understand to be the focus of the ongoing broker compensation investigations by the Attorney General’s office of certain states including New York, as reported in the press.
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 $3.7 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 $9.7 million in 2004 from $13.4 million in 2003 as investments in hedge funds produced a return of 7.8% for the year ended December 31, 2004 compared with 11.8% 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.
PXRE recognized a tax benefit of $6.2 million in 2004 compared to a tax expense of $0.8 million in 2003. The tax benefit for the year ended December 31, 2004 differed from the U.S. statutory rate primarily due to the reinsurance business written in our Bermuda reinsurance subsidiary, as well as losses incurred from our exited lines segment which related primarily to reinsurance business written in the United States. Included in the tax benefit is $2.6 million benefit related to prior year reserves.
PXRE adopted the provisions of FIN 46 during the first quarter of 2004. The cumulative effect of this accounting pronouncement reduced net income for the year ended December 31, 2004 by $1.1 million but did not materially impact shareholders’ equity.
Gross premiums written for the year ended December 31, 2003 decreased 8% to $339.1 million from $366.8 million in 2002. This decrease in gross premiums written is primarily due to a planned decrease in our exited lines segment of $106.3 million, or 89%, compared to 2002. Partially offsetting the decrease in exited lines gross premiums written was an increase in the catastrophe and risk excess segment of $78.7 million, or 32%, compared to 2002. This increase is attributable to improved pricing, increased participation with long-standing clients and increased amounts of new business.
Net premiums written for the year ended December 31, 2003 decreased 5% to $278.4 million from $294.5 million in 2002. Net premiums written in our exited lines segment decreased $98.4 million, or 89%, compared to 2002. Partially offsetting the decrease in exited lines net premiums written was an increase in the catastrophe and risk excess segment of $82.3 million, or 45%, compared to 2002. The changes in these segments are due to the same factors as those discussed above in gross premiums written.
Gross and net premiums earned for the years ended December 31, 2003 and 2002 were as follows:
Gross premiums earned for the year ended December 31, 2003 increased 9% to $381.7 million from $349.3 million in 2002. This increase is due to an increase in the catastrophe and risk excess segment of $75.0 million, or 30%, compared to 2002. Partially offsetting this increase was a decrease in our exited lines segment of $42.6 million, or 41% compared to 2002. The changes in these segments are due to the same factors as discussed above in gross and net premiums written.
Losses incurred for the year ended December 31, 2003 amounted to $157.6 million compared to $125.4 million in 2002. Our loss ratio was 49.1% for the year ended December 31, 2003 compared to 46.5% in 2002.
We did not experience any significant catastrophe activity in 2003. The largest losses were related to the winter storms in the Midwest and the wildfires in California, but we incurred less than $10.0 million with respect to each of these losses. The loss ratio for 2002 was affected by the 2002 European flood losses of $17.8 million. During 2003, we experienced net adverse development of $44.7 million for prior-year loss and loss expenses, $21.8 million of which was due to loss development on our exited direct casualty reinsurance operations, $8.8 million adverse development from aerospace claims arising to a significant degree from our first receipt of notice that the increase in industry losses related to a 1998 air crash had resulted in the exhaustion of deductibles under three aerospace contracts between PXRE Reinsurance and Reliance Insurance Company and $8.2 million of development from finite contracts, $7.3 million of which related to the aggregate excess of loss reinsurance agreement with LMC noted earlier. In 2002, we experienced net adverse development of $23.9 million for prior-year loss and loss expenses, $16.9 million of which was due to loss development on our exited lines segment relating primarily to the 2000 and 2001 underwriting years.
The expense ratio was 25.6% for 2003 compared with 31.3% for 2002. The decrease was primarily due to reduced commissions associated with finite contracts and exited lines business, offset, in part, by a fee on the commutation of a reinsurance agreement with P-1 Re Ltd., an exempted Bermuda Class 3 insurance company. The commission and brokerage ratio, net of fee income, was 13.2% for 2003, compared with 18.6% in 2002. During the year ended December 31, 2003, we incurred $4.0 million of structuring fees related to a reinsurance agreement with P-1 Re Ltd. and the subsequent commutation thereof. The operating expense ratio was 12.4% for 2003 compared with 12.7% for 2002. Other operating expenses increased 16% to $39.7 million for 2003 from $34.2 million in 2002. The increase is largely due to $3.0 million of expenses associated with hiring new underwriters and relocating other underwriters to our Bermuda office, various compensation costs of $1.2 million relating to the retirement of PXRE’s former Chief Executive Officer, Gerald L. Radke, on June 30, 2003 and his transition into a consulting role, and a $0.5 million increase in our director and officer liability insurance.
Investment income for the year ended December 31, 2003 was also affected by various finite and other reinsurance contracts where premiums payable under such contracts were retained on a funds withheld basis. In order to reduce credit risk or to comply with regulatory credit for reinsurance requirements, a portion of premiums paid under such reinsurance contracts is retained by the cedent pending payment of losses or commutation of the contract. Investment income on such withheld funds is typically for the benefit of the reinsurer and the cedent may provide a minimum investment return on such funds. We have both ceded and assumed reinsurance contracts that involve the withholding of premiums by the cedent. On assumed reinsurance contracts, cedents held premiums and accrued investment income due to us of $26.4 million and $24.9 million as of December 31, 2003 and 2002, respectively, for which we have recognized $1.7 million of investment income for both the years ended December 31, 2003 and 2002. On ceded reinsurance contracts, we held premiums and accrued investment income of $124.1 million and $122.2 million due to reinsurers as of December 31, 2003 and 2002, respectively, for which we recognized a charge to investment income of $9.1 million and $9.8 million during the year ended December 31, 2003 and 2002, respectively. On a net basis, this reduction to investment income was $2.5 million and $3.2 million for the year ended December 31, 2003 and 2002, 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 6.8% and 7.8% for the year ended December 31, 2003 and 2002, respectively, and we expect to be obligated for this contractual investment return for the life of the underlying liabilities, which is expected to be six years as of December 31, 2003 on a weighted average basis.
year ended December 31, 2003. PXRE incurred minority interest expense of $10.5 million related to PXRE’s capital trust pass-through securities during the year ended December 31, 2003 (see “- Liquidity” below for a full description of the capital trust pass-through securities). In 2002, PXRE only incurred $8.6 million of minority interest expense on the capital trust pass-through securities. Minority expense on the capital trust pass-through securities increased because $62.5 million of additional capital trust pass-through securities were issued during the year ended December 31, 2003.
The Company and PXRE Delaware rely primarily on dividend payments from PXRE Bermuda and PXRE Reinsurance, respectively, to pay its operating expenses, to meet its debt service obligations and to pay dividends. During 2004, PXRE Reinsurance paid $42.5 million in dividends. As approved by the Insurance Department of the State of Connecticut, PXRE Reinsurance distributed capital of $57.5 million and $100.0 million in the third and fourth quarters of 2004, respectively. PXRE Bermuda did not pay dividends. These dividends were primarily used to meet interest payments on trust preferred securities, increase the capital of PXRE Bermuda and pay dividends to the Company’s shareholders. Based on the statutory surplus as of December 31, 2004, the aggregate dividends that are available to be paid during 2005, without prior regulatory approval, by PXRE Reinsurance and PXRE Bermuda are $22.5 million and $236.7 million, respectively. We anticipate that this available dividend capacity will be sufficient to fund our liquidity needs during 2005.
The A1 Preferred Shares, B1 Preferred Shares and C1 Preferred Shares will be mandatorily convertible into Class A Common Shares, Class B Common Shares and Class C Common Shares, respectively, on March 31, 2005. These shares were originally scheduled to convert on April 4, 2005, but in the interest of presenting a balance sheet reflecting the conversion on March 31, 2005, PXRE reached an agreement with the preferred shareholders to convert four days early. All the remaining Preferred Shares will be mandatorily convertible into Convertible Common Shares on April 4, 2008. At December 31, 2004, there were 10,174 A1, B1 and C1 Preferred Shares and 6,213 A2, B2 and C2 Preferred Shares. Notwithstanding the foregoing, on any conversion date, to the extent necessary to prevent the initial purchasers of Preferred Shares and their affiliates from owning more than 49.9% of the capital shares of the Company following conversion, we shall have the right (but not the obligation) to make a cash payment in lieu of Convertible Common Shares equal to the fair market value of the Convertible Common Shares that would have been received in excess of the 49.9% limitation in connection with any conversion, plus an additional tax gross up amount to take into account in appropriate circumstances the difference between the federal income tax rate on long-term capital gains and the federal ordinary income tax rate that might apply to the recipient on the receipt of a cash payment in lieu of Convertible Common Shares. If the A2 Preferred Shares, B2 Preferred Shares and C2 Preferred Shares are not voluntarily converted on or prior to the third anniversary of their issuance, an annual 8% dividend, payable in cash, will accrue until these Preferred Shares are converted.
On May 15, 2003, PXRE Capital Statutory Trust II, a Connecticut statutory trust and subsidiary (non-consolidated) of the Company, sold $18.0 million principal amount of capital trust pass-through securities due May 15, 2033. The securities bear interest payable quarterly at an initial rate of 7.35% until May 15, 2008, and thereafter at an annual rate of 3 month LIBOR plus 4.1% reset quarterly. The Company has the option right to redeem the securities at any quarterly interest payment date after May 15, 2008 at 100%. The Company used the net proceeds of the sale to repay the balance of $10.0 million outstanding under its credit agreement, and to provide additional capital to PXRE Bermuda.
On October 29, 2003, PXRE Capital Statutory Trust V, a Connecticut statutory trust and a subsidiary (non-consolidated) of the Company, sold $20.6 million principal amount of capital trust pass-through securities due October 29, 2033. The securities bear interest payable quarterly at an initial rate of 7.70% until October 29, 2008, and thereafter at an annual rate of 3 month LIBOR plus 3.85% reset quarterly. The Company has the right to redeem the securities at any quarterly interest payment date after October 29, 2008 at 100%. The Company used the net proceeds to provide additional capital to PXRE Bermuda.
On December 16, 2003, the Company completed an offering of 2.2 million of its common shares at $21.75 per share, pursuant to a Shelf Registration on Form S-3, filed in 2003 for up to $150.0 million of securities. 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 over-allotment option to purchase 0.3 million additional common shares at $21.75 per share. As a result of the exercise of the option, the Company received additional net proceeds of approximately $6.8 million, resulting in total net proceeds from the offering of approximately $27.2 million. We again used the net proceeds for general corporate purposes, including contributions to the capital of PXRE Bermuda. After giving
Net cash used by investing activities were $205.7 million in 2004 compared to $184.3 million in 2003 due primarily to purchases of securities for investment partially offset by proceeds received on sale or maturity of investments.
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. A portion of the invested assets is notionally allocated to a Primary Capital Portfolio. The guidelines of this portfolio are designed in such a manner that securities are available to pay claims from a potential loss. For example, the securities, which are of high credit quality, have a duration that approximates the duration of the cash outflows of past large losses incurred by PXRE. The purpose of the Primary Capital Portfolio is to maintain a pool of assets whose underlying durations and maturities approximate that of the potential future cash outflows. Should an event actually occur, PXRE may dedicate assets, including cash equivalents and other short-term investments, in such a manner that cash is always on hand to pay claims.
As of December 31, 2004, other commitments and pledged assets include (a) LOCs of $8.1 million which are secured by cash and securities amounting to $23.2 million, (b) cash and securities amounting to $9.8 million were on deposit with various state insurance departments and overseas banks in order to comply with insurance laws, (c) securities with a fair value of $64.5 million deposited in a trust for the benefit of a cedent in connection with certain finite reinsurance transactions, (d) funding commitments to certain limited partnerships of $0.3 million, (e) a commitment to lend a further $0.1 million to finance the completion of the construction of an office building that we currently use as our headquarters in Bermuda, (f) a contingent liability amounting to $1.0 million under the Restated Employee Annual Incentive Bonus Plan, (g) commitments under the capital trust pass-through securities discussed above, and (h) commitment fees of $0.2 million per annum under a Letter of Credit Facility Agreement, dated June 25, 2004, between PXRE Bermuda and Barclays Bank PLC.
As a reinsurer of property catastrophe-type coverages in the worldwide marketplace, our operating results in any given period depend to a large extent on the number and magnitude of natural and man-made catastrophes such as hurricanes, windstorms, hailstorms, earthquakes, volcanic eruptions, fires, industrial explosions, freezes, riots and floods. For example, the four Florida hurricanes in the third quarter of 2004 resulted in pre-tax losses of $111.7 million, net of reinsurance recoverables and reinstatement premiums for that quarter. While we may, depending on market conditions, purchase catastrophe retrocessional coverage for our own protection, the occurrence of one or more major catastrophes in any given period could nevertheless have a material adverse impact on our results of operations and financial condition and result in substantial liquidation of investments and outflows of cash as losses are paid.
As we underwrite risks from a large number of insurers based on information generally supplied by reinsurance brokers, we may develop a concentration of exposure to loss in certain geographic areas prone to specific types of catastrophes. For example, we are significantly exposed to losses arising from hurricanes in the southeastern United States, earthquakes in California, the Midwest United States and Japan, and to windstorms in northern Europe. We have developed systems and software tools to monitor and manage the accumulation of our exposure to such losses and have established guidelines for maximum tolerable losses from a single event or multiple catastrophic events based on historical data. However, no assurance can be given that these maximums will not be exceeded in some future catastrophe.
We compete with numerous companies, many of which have substantially greater financial, marketing and management resources. The level of competition has increased in the wake of the September 11, 2001 terrorist attacks with the formation of a number of large and well-capitalized Bermuda reinsurance companies. In addition, a number of our pre-existing competitors were successful in raising substantial levels of additional capital. Although we increased our capital as well since the September 11th attacks, we remain smaller than most of our competitors.
In particular, we compete with reinsurers that provide property-based lines of reinsurance, such as ACE Tempest Reinsurance Ltd., Arch Reinsurance Ltd., Aspen Insurance Holdings Limited, AXIS Reinsurance Company, Endurance Specialty Insurance Ltd., Everest Reinsurance Company, IPC Re Limited, Lloyd’s of London syndicates, Montpelier Reinsurance Ltd., Munich Reinsurance Company, Partner Reinsurance Company Ltd., Platinum Underwriters Reinsurance, Inc., Renaissance Reinsurance Ltd., Swiss Reinsurance Company and XL Re Ltd. Competition varies depending on the type of business being insured or reinsured and whether we are in a leading position or acting on a following basis.
The property catastrophe reinsurance market is highly sensitive to the ratings assigned by the rating agencies. If either of S&P or A.M. Best were to downgrade us, such downgrade would likely have a material negative impact on our ability to expand our reinsurance portfolio and renew all of our existing reinsurance agreements, especially if we were to be downgraded more than one level from the “A” category to the “B” category. In 1999, we were downgraded from A+ to A, which downgrade was considered by us to have no material effect on our core short tail property business. Although impossible to quantify, we believe the downgrade did have some impact on our ability to expand the direct casualty reinsurance business that we have since discontinued.
A decline in our ratings may require us to transfer premiums retained by us into a beneficiary trust.
Recent investigations of broker placement and compensation practices initiated by the Attorney General’s office of certain states including New York, together with recently filed class action lawsuits initiated against such broker entities and certain reinsurance companies have challenged the legality of certain activities conducted by these brokers and companies. Various brokers with whom we do business are included within these investigations and lawsuits. The investigations and suits challenge, among other things, the appropriateness of setting fees paid to brokers based on the volume of business placed by a broker with a particular insurer or reinsurer; the payment of contingent fees to brokers by insurers or reinsurers because of an alleged conflict of interest arising from such fee arrangements; the nondisclosure by brokers to their clients of contingent fees paid to them by insurers and reinsurers, bid rigging and tying the receipt of direct insurance to placing reinsurance through the same broker. Because these investigations and suits have only recently been commenced, it is not possible to determine their ultimate impact upon the broker reinsurance market and reinsurers, including us. However, because of our reliance on the broker reinsurance market for future business, any governmental actions or judicial decisions which had the effect of impairing the broker reinsurance market could materially impact our ability to underwrite business. In addition, to the extent that any of the arrangements into which we routinely enter with our brokers were determined to be unlawful, we could be fined or otherwise penalized. Further, to the extent that any of the brokers with whom we do business suffer financial difficulties as a result of the investigations or proceedings, we could suffer increased credit risk. See “Our reliance on reinsurance brokers exposes us to their credit risk” below.
Finite risk reinsurance contracts are highly customized and typically involve complicated structural elements. GAAP governs whether or not a contract should be accounted for as reinsurance. Contracts that do not meet these GAAP requirements may not be accounted for as reinsurance and are required to be accounted for as deposits. As reported recently in the press, certain finite insurance and reinsurance arrangements are coming under scrutiny by the New York Attorney General’s Office, the Securities and Exchange Commission and other governmental authorities. According to the press, investigators have asserted that the contracts in question were accounted for in an improper or fraudulent manner.
We sold finite reinsurance prior to June 30, 2004, and from time to time, have purchased finite reinsurance. Any claim challenging the appropriateness of the accounting treatment of the finite contracts we underwrote or purchased could result in negative publicity, costs and, in the event of any regulatory or judicial decision being entered against us, ultimately fines and penalties, all of which could have a material adverse effect on our business and results of operations.
Historically, insurers and reinsurers have experienced significant fluctuations in operating results due to competition, frequency and severity of catastrophic events, levels of capacity, general economic conditions and other factors. The supply of insurance and reinsurance is related to prevailing prices, the level of insured losses and the level of industry surplus which, in turn, may fluctuate in response to changes in rates of return on investments being earned in the insurance and reinsurance industry. As a result, the insurance and reinsurance business historically has been a cyclical industry characterized by periods of intense price competition due to excessive underwriting capacity as well as periods when shortages of capacity permitted favorable premium levels. Our recent, and anticipated, growth relates in part to improved industry pricing, but the supply of insurance and reinsurance may increase, either by capital provided by new entrants or by the commitment of additional capital by existing insurers or reinsurers, which may cause prices to decrease. Any of these factors could lead to an adverse effect on our profits. In addition to these considerations, changes in the frequency and severity of losses suffered by insureds and insurers may affect the cycles of the insurance and reinsurance business significantly, and we expect to experience the effects of such cyclicality.
PXRE Bermuda. PXRE Bermuda is a registered 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.
Barbados. PXRE Barbados is subject to regulation under Barbados’ Insurance Act, 1996. Under the Barbados Act, PXRE Barbados may only pay a dividend out of the realized profits of the company and may not pay a dividend unless (a) after payment of the dividend it is able to pay its liabilities as they become due, and (b) the realizable value of its assets is greater than the aggregate value of its liabilities and (c) the stated capital accounts are maintained in respect of all classes of shares.
As a registered Bermuda Class 4 insurer, PXRE Bermuda is subject to regulation and supervision in Bermuda. Bermuda insurance statutes, regulations and policies of the BMA require PXRE Bermuda to, among other things:
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. Substantially all of our key officers, including our Chief Executive Officer, Chief Financial Officer, and key reinsurance underwriters are working in Bermuda under work permits that will expire at various times over the next five years. The Bermuda government could refuse to extend these work permits. If any of our senior executive officers were not permitted to remain in Bermuda, our operations could be disrupted and our financial performance could be adversely affected.
We and/or our non-U.S. subsidiaries could be subject to U.S. federal income tax on a portion of our income that is earned from U.S. sources if we or our non-U.S. subsidiaries are considered to be a personal holding company (or a “PHC”) for U.S. federal income tax purposes. This status will depend on whether more than 50% of our shares could be deemed to be owned by five or fewer individuals and on whether at least 60% of our or our subsidiaries adjusted ordinary gross income is “personal holding company income” (“PHCI threshold”), as determined for U.S. federal income tax purposes. We believe, based upon information made available to us regarding our existing shareholder base, that neither we nor any of our subsidiaries should be considered a PHC. Additionally, we intend to operate our business to minimize the possibility that we will meet the PHCI threshold. However, due to the lack of complete information regarding our ultimate share ownership, we cannot be certain that we will not be characterized as a PHC, or that the amount of U.S. federal income tax that would be imposed if it were not the case would be minimal.
If we are classified as a foreign personal holding company (“FPHC”), your taxes would increase.
Although it is not anticipated that we or any of our non-U.S. subsidiaries will be classified as a FPHC for U.S. federal income tax purposes, if we or any of our non-U.S. subsidiaries are classified as a FPHC, a United States person that directly or indirectly owns our common shares would be subject to adverse tax consequences.
However, due to the attribution provisions of the Code regarding determination of beneficial ownership, there is a risk that the IRS could assert that one or more of our non-U.S. subsidiaries are CFCs and that U.S. holders of our common shares who own 10% or more of the value of our common shares should be treated as owning 10% or more of the total voting power of all classes of our shares notwithstanding the reduction of voting power discussed above.
If we or a non-U.S. subsidiary is determined to have “related party insurance income” (“RPII”), you may be subject to U.S. taxation on your pro rata share of such income.
A number of multinational organizations, including the European Union, the Organization for Economic Cooperation and Development (“OECD”), the Financial Action Task Force and the Financial Stability Forum (“FSF”), have all recently identified some countries as not participating in adequate information exchange, engaging in harmful tax practices or not maintaining adequate controls to prevent corruption, such as money laundering activities. Recommendations to limit such harmful practices are under consideration by these organizations, and a report published on November 27, 2001 by the OECD at the behest of FSF titled “Behind the Corporate Veil: Using Corporate Entities for Illicit Purposes,” contains an extensive discussion of specific recommendations. The OECD has threatened non-member jurisdictions that do not agree to cooperate with the OECD with punitive sanctions by OECD member countries, though specific sanctions have yet to be adopted by OECD member countries. It is as yet unclear what these sanctions will be, who will adopt them and when or if they will be imposed. In a June 26, 2000 report, Bermuda was not listed as a tax haven jurisdiction by the OECD because it previously signed a letter committing itself to eliminating harmful tax practices by the end of 2005 and to embrace international tax standards for transparency, exchange of information, and the elimination of regimes for financial and other services that attract businesses with no substantial domestic activity. We cannot assure you, however, that the action taken by Bermuda would be sufficient to preclude all effects of the measures or sanctions described above, which, if ultimately adopted, could adversely affect Bermuda companies such as us.
In April 2002, we privately placed Series A, Series B and Series C preferred shares to 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 interests 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.
Consolidated Statements of Income and Comprehensive Income for the years ended December 31, 2004, 2003 and 2002