Argo Group International Holdings Ltd (ARGO) 2006 Q2 法說會逐字稿

Good day, and welcome, everyone, to the PXRE Group Ltd. second-quarter 2006 earnings results conference call. As a reminder, today's call is being recorded.

At this time, I would like to turn the call over to Jamie Tully.

Thank you, operator. Representing the Company today are Jeff Radke, President and Chief Executive Officer, and Bob Myron, the Company's Chief Financial Officer.

Before Jeff begins, I will read the following Safe Harbor statement. Statements made during the conference call that are not based on historical facts are forward-looking statements. These statements are made in reliance on the Safe Harbor provisions of the Private Securities Reform Act of 1995, and are subject to uncertainties and risks. It should be noted that PXRE's future results may differ materially from those anticipated and discussed in the forward-looking statements. Some of the factors that could cause or contribute to such differences have been described in the news release issued yesterday and PXRE's annual report on Form 10-K and other filings with the SEC. We refer you to those sources for additional information.

Lastly, I would like to point out that the remarks made during the conference call are based on information and understandings that are believed to be accurate as of today's date, August 8, 2006. Because of the time-sensitive nature of this information, it is PXRE's policy to limit the archived replay of this conference call to a period of 30 days. This call is the property of PXRE. Any distribution, transmissions, broadcasts or rebroadcasts in any form without the express written consent of the Company is prohibited.

With those announcements complete, I will turn the call over to Jeff Radke.

Thank you, Jamie, and good morning. Today, I will comment on the portfolio of business, provide an update on our strategic review process and then turn the call over to Bob Myron to comment on the financials.

The exposure in our portfolio continues to drop as we head into the peak of the US windstorm season. The portfolio has been reduced in terms of premium by 82% since January 1st. More important than premium, zonal aggregate exposures, a critical metric of what impact a catastrophe could have on PXRE's balance sheet, have been significantly reduced. Our maximum gross zonal exposure as of July 1st was $240 million, compared to $475 million on May 5th. This is before reductions for traditional reinsurance in our catastrophe bonds.

The appropriate reduction from these hedges is difficult to measure with any certainty, as they vary from zone to zone, and in the case of catastrophe bonds, respond to a modeled portfolio rather than PXRE's actual portfolio. Furthermore, we expect substantially all of this exposure to expire by January 1, 2007.

The Board's process of reviewing strategic alternatives continues. To maximize value for shareholders, the Board has followed a broad but disciplined approach. It is important to note that the review is ongoing, and that the timing of any potential transaction may reflect several factors. Such factors include the seasoning of PXRE's exposures to Katrina, Rita and Wilma, as well as the expiration or commutation of in-force contracts over the balance of 2006.

Regardless of the outcome of the strategic review, we hope to increase shareholder value through commutations of our existing reinsurance liabilities. To date, we have been successful in commuting various reinsurance contracts, and we have begun commutation negotiations with a number of our major cedents in an effort to expedite the ultimate settlement of our reinsurance loss reserves. The Board has elected to await the outcome of the seasoning of reserves, expiration of exposures and the US hurricane season before making a decision on the resumption of our common share dividends.

Finally, Lazard's engagement letter with the Company is expiring, and the lead banker who has been assisting us at Lazard has resigned from that firm. The Board is therefore engaging Keefe, Bruyette & Woods to provide investment banking advice as the strategic process continues.

In summary, we continue to focus intently on maximizing value for all our shareholders, through our portfolio management and our review of capital and corporate structure alternatives. Bob, would you please offer some further detail on the financials?

Yes and good morning, everyone. I will discuss several items during my remarks, including our results for the quarter, the investment portfolio and then some commentary on the remainder of the balance sheet.

First, the results for the quarter. The level of the terminations and nonrenewals, as mentioned by Jeff, had a significant impact on our top line during the quarter. We had approximately $32.6 million of gross premium earned and $15.3 million of net premiums earned. It should be noted that given the significance of July 1st as a renewal date for property/catastrophe business, our net earned premiums during the remaining quarters of 2006 are expected to be meaningfully lower on a percentage basis than they were in Q2.

Net premiums written in the quarter were negative $27.9 million, due to the cancellations and nonrenewals. In addition, one large North American pro rata contract was terminated on a cutoff basis during the quarter, which resulted in a reduction of written premium of $18.1 million, compared to the same period in 2005. There was no significant catastrophe activity during the quarter. Alongside this, we experienced slightly favorable development on our March 31, 2006 loss reserves in the amount of $7.5 million, and we have had $10.1 million of overall favorable reserve development since December 31, 2005.

There was no material development in our reserves for Katrina, Rita and Wilma during the quarter. Accordingly, our loss and loss expenses on our income statement of $850,000 for the quarter consisted principally of $8.4 million of IBNR booked against Q2 earned premium amounts, offset by the $7.5 million of positive development just mentioned.

We also engaged a nationally recognized actuarial firm to review our groupwide loss reserves as of June 30, 2006. Their loss estimates for the 2005 hurricanes, as well as for the remainder of our reserves, was consistent with our carried reserves. On an overall basis, their best estimate was less than 1% different than our internal estimates on $797 million of net reserves.

Net investment income was $13.2 million for the quarter. This was principally driven by an annualized invested asset return rate of 5.1% from our fixed-income and short-term portfolio, offset by a return for the quarter of -1.4% from our significantly reduced hedge fund portfolio.

During the quarter, and as a result of uncertainties associated with our ongoing strategic alternative analysis, we recorded $3.3 million of other-than-temporary impairments on longer-duration fixed-income securities held in our Bermuda operating company. This had no impact on overall shareholders' equity or book value per share.

During the quarter, we recorded $2.3 million of other reinsurance-related expense. As previously advised, this cost represents the quarterly expense for our second cat bond transaction, A&W Re II, which was accounted for as a derivative. Given the transaction's derivative nature, the annual expense for this transaction is not expensed on a pro rata basis over the year. Rather, the quarterly expense is linked to the timing of the underlying exposure periods. We expect to expense the annual costs, including amortization of operating costs, as follows, for the remainder of 2006, as previously advised -- Q3, approximately $4.8 million, and Q4, approximately $7.1 million. These amounts, as always, of course, assume there are no loss recoveries under the transaction.

Operating expenses were $0.9 million more compared to the same period in the prior year, principally due to legal and financial advisory fees.

Now, to the investment portfolio. As of June 30, 2006, our fixed-income portfolio had a duration of 1.3 years, and overall was rated AAA. As shown on the face of our balance sheet, we have $603.4 million of our total fixed-income portfolio in short-term instruments. We have elected to keep such a large percentage of our fixed-income portfolio in short-term due to the shape of the yield curve, to allow us to continue to meet the needs of our counterparties, to maximize our financial flexibility in the context of our strategic alternative review and to maximize liquidity in order to facilitate commutations.

As communicated to you last quarter, in February 2006 we executed redemption orders on our entire hedge fund portfolio. As of June 30, 2006, we have $40.3 million of hedge funds still on our balance sheet, reduced from $148.2 million at December 31, 2006.

Additionally, we have received approximately $18 million of additional redemption proceeds during the month of July 2006. The balance of the hedge fund portfolio after those redemptions is expected by March 31, 2007 or shortly thereafter. Pending the outcome of our strategic alternative review, we do not have any plans to reinvest in hedge fund assets.

Now, to the remaining captions on the balance sheet. With respect to loss reserves during the quarter ended June 30, 2006, we paid approximately $139.3 million of net losses. With respect to the payout of loss reserves, based on historical patterns, an experience we have seen on KRW to date, we expect to have paid 26% of the June 30, 2006 loss reserves by the end of this year and 59% by December 31, 2007.

As of June 30th, 2006, we have paid $309.3 million in net claims from Katrina, Rita and Wilma. During the second quarter, we commuted a number of Exited Lines contracts, which, combined with loss payments in the normal course of business, reduced net reserves from Exited Lines from $87 million to $47.4 million or approximately 46%.

With respect to premium receivables, the balance at June 30, 2006 of $124 million is principally comprised of approximately $106 million of reinstatement premiums due on losses incurred. This asset contains little counterparty credit risk, due to contractual offset losses. The remainder of the balance of the premium receivables relates to other amounts due to us in the normal course of business, and we don't expect any material issues with respect to recoverability of these assets.

On to reinsurance recoverables on paid and unpaid losses. These balances stand at $52.8 million at June 30, 2006, a decrease of $59.1 million since year end and a decrease of $29.7 million since March 31st. Approximately 94% of these recoverables that are on the balance sheet at June 30th are either fully collateralized or reside with entities rated A- or higher by A.M. Best or S&P.

With respect to other assets, the balance of $58.5 million principally consists of a receivable in the amount of $21.2 million on a ceded deposit contract which is 100% collateralized as of June 30th. That receivable will be paid to us in full by August 31, 2006. Also in that balance is the fair value of the derivative asset for the A&W Re II transaction in the amount of $12.9 million, our investment in our building that we occupy in Bermuda of $8.4 million and other small balances.

With respect to the other liabilities caption, the balance of $34 million principally consists of the offsetting fair value liability for the A&W Re II transaction that I just mentioned, contingent commissions payable of $8 million, $4.3 million of accrued interest expense on trust preferred debt, unearned fee income on assumed deposit contracts and a series of other small balances.

Our shareholders' equity as of June 30, 2006 stands at $504.5 million. Combined with $167.1 million of trust preferred debt, we have approximately $672 million of total capital as of June 30th. Fully-diluted book value per share as of June 30, 2006 is $6.51.

Fully-diluted shares outstanding are approximately 77.5 million as of June 30th. This amount is comprised of issued shares outstanding of approximately 72.4 million and convertible preferred shares that convert to 5.1 million common shares at the June 30, 2006 conversion price of $11.36.

Statutory surplus of our Bermuda entity was approximately $555.9 million at June 30, 2006. Statutory surplus of our US entity was approximately $133.5 million at June 30, 2006.

That concludes my prepared remarks. With that, we will now take any questions.

(OPERATOR INSTRUCTIONS). [Casey Creager], Nomura.

I don't know if in your comments, you broke out on the operating expenses the expenses attributable to the financial and legal advice. Is there a way to split out in more detail the operating expense?

The amounts are not terribly significant relative to the balance as a whole. The legal fees for the quarter were approximately $1 million, and the financial advisory fees incurred were approximately $700,000.

I think that's fees and other expenses, just to be clear, on the financial advisory pieces.

Yes.

Can then you, as a follow-up, can you comment on where you're sort of trying to pinpoint the run rate on the operating expenses, given some of the commutations and some of the shrinking of the balance sheet?

I'm afraid this isn't going to be a very satisfying answer, but the fact of the matter is we are seeking to achieve the lowest possible expense level that correlates to a public company with a clean Sarbanes-Oxley opinion, et cetera. As a result, the exact expense level projected out over two or more quarters is very difficult for us to ascertain. A lot of it depends on how well we do on commutations and how much sort of transaction load is left.

So, difficult to call, but the concept or the approach that the Board and management is taking is exactly as I outlined, which is right-size the human resources of the Company to match the objective, which is retain that clean Sarbanes-Oxley opinion and produce the appropriate financial filings for a public company.

Then, on the financial advisor switching, did this individual go to the new firm that you have engaged, or --?

I guess I'm comfortable saying no, he did not. So it was a switch of firms.

In other words, did you lose momentum in your process by switching financial advisors?

Sort of by definition, the answer to that question is a matter of opinion. I guess my opinion is that we will not lose significant momentum.

(OPERATOR INSTRUCTIONS). [Aviva Schneider], Silver Point Capital.

Could you comment a little bit on what is happening with the exposure in your US subsidiary, with the business being canceled?

The US had effectively -- well, the US entity had very little business as of January 1st. I believe that substantially all of that exposure has been canceled. However, keep in mind, as we discussed on our last earnings call, the US company does write a reinsurance with limits of $40 million, which support PXRE Insurance Ltd., the Bermuda reinsurance company. So substantially all of New Jersey's ongoing live exposure is represented by that intercompany $40 million limit.

He is making reference to the Connecticut regulated entity, US.

Could you refresh us on what the terms of that contract were?

I think what has been disclosed is pretty simple and straightforward, being it's $40 million of limit, excess of $150 million retention on a per-occurrence basis. I'm going to look to Bob -- do you remember reinstatement provision?

No reinstatements and $7 million of premium.

Brian Smith, USAA.

Could you comment on your exposures? In your press release, you say that there's a significant amount of exposures remaining. But, based on your comments, it sounds like they have been reduced dramatically.

I think both are true. They have been reduced substantially, dramatically, whatever word you want to use. But, at the same token, our largest zonal exposure stands at $240 million, and relative to a $504 million equity base, we perceive that to be meaningful. So smaller, but still meaningful.

Would it be accurate to say that as of January 1, 2007, you would have almost no exposures remaining? Assuming a runoff is completed at that point, tell me if I'm wrong, but if that's the case, how do you plan on winding things up?

I will separate your question into three parts, I think. We do expect that substantially all of our exposure will be expired or gone by January 1, 2007. If the Board determines that runoff is in the best interests of shareholders, the process of runoff, assuming that no runoff specialist is involved, if we do organic runoff, the process would be right-sizing the staff so that, as I answered in the first question, so that we have enough for the transaction flow, maximize commutation activity such that the reserve certainty and payout are as quick as possible. Then the distribution of funds to shareholders would be largely governed by statutory restrictions, both in Bermuda and in Connecticut.

Sorry. I would sort of a last piece. In that is trust preferred debt, both at the US holding company level and at the Bermuda holding company level. Obviously, in conjunction with the runoff, the funds from the operating companies would have to go to those trust preferreds, as the terms of each of those securities requires.

Do you have any kind of estimated timeframe over which that might be completed?

We do not, and the reason we do not is it depends heavily on two things, which are out of our control -- how many commutations we are able to secure and, finally, the decisions of the various regulators. Because it so far outside our control, I think us hazarding a guess is probably inappropriate.

Jonathan Starr, Flagg Street Capital.

How should we be thinking about the premium run rate? Can you give us some idea kind of where you ended the quarter at?

I think that you should think of the premium being dramatically reduced from here on out for the rest of the year. The gross earned, if you will, so sort of the assumed premium, will be dramatically reduced. We don't have those numbers in front of us, right, Bob?

Right.

So I think you can feel comfortable that they will be reduced by a significant percentage.

From the Q2 run rate?

Correct.

So the gross earned, and that's even on a gross basis -- what about the difference in gross and net? Should that stay about flat on an absolute basis?

Yes, I think it should. There's information in the public -- our filings and what we disclosed in this respect, but if you exclude this first cat bond transaction, which has a run rate of about $6.6 million per quarter, we had ceded reinsurance costs of $17.2 million in Q2. Then I separately, in my comments, disclosed the amount of the costs of the second cat bond transaction. So if you can kind of put all those pieces together, so to speak, there will be no meaningful change in that through the last two quarters of the year.

Did that not run off at all? I assumed you would take on some reinsurance in the June/July renewal season, typically. Do you not have any runoff?

We didn't. Our reinsurance portfolio is largely January 1st.

Is there a real value to that -- is a lot of that reinsurance actually set even above the $240 million loss amount, or is there --?

No, sir. We have sufficient exposure to collect under our traditional reinsurances. What can be said is that the probability of loss is lower for those reinsurers than either party thought it would be, when we entered into the transaction on January 1st. However, if you want to try and think about some sort of rough mark to market, however, at January 1st, when we bought that retrocessional protection, prices were substantially -- and let me do a middle-off-the-road guess of 40% -- substantially less than what they are today.

So it's not as if they're actually above your limits?

Correct.

Is any of it above your limit? Is any of it just completely wasted, or --?

It is possible that a portion of the first cat bond transaction, A&W I, it's possible that a portion of that bond could not be recovered.

Is it safe to say the reinsurance you would have, when it kicks in, would kick in at a much stronger level than your current size of your book, just because the premium has been reduced so dramatically but the reinsurance has not been reduced?

I'm sorry. Could I ask you to rephrase it? Unless, Bob, did you understand --?

Yes. I think, if I understood your question correctly, it would have a pretty significant impact on -- it could have a pretty significant impact on the book should it kick in, because I think what you are alluding to is we bought that program on a much larger exposure base. While the assumed exposure has decreased substantially as the result of the terminations and nonrenewals, there has not been a commensurate reduction in the ceded exposure purchase, so to speak. Does that answer your question?

Yes, that does. Is (multiple speakers) how you would mark that to market?

Could I just interject something there, just to make sure that we are even-handed? Bob, I think, outlined well the good news, which is the amount of reinsurance we purchase relative to the gross aggregate we assume is larger now, that from a risk reduction standpoint, that is the good news.

I think it's worth noting that because of the reduced book -- and now I'm speaking of premium -- the retentions, the dollar retentions, some of them flow, some of them remain the same. So if you look at the whole package of premiums minus net loss, that may not work in our favor, in small to moderate-sized losses. Are you with me?

Right. You are basically saying you did some at a much higher -- some did not ratchet down (multiple speakers) premium?

Right. So the fact -- to oversimplify things, if we have a very, very large catastrophe, our ceded program will have an unusually large benefit. If we have a small to medium-sized catastrophe, our retrocessional program will have a smaller-than-usual benefit.

Right. But some of the retrocessional insurance you bought did come down?

Did ratchet, yes. That's right, but the other piece of the puzzle is how much premium we have, and obviously the premium is dramatically reduced.

Right, but it doesn't ratchet down with premium? That's not how it works?

I guess with premium comes exposure, and the ratchet down is on the exposure. I guess what I'm highlighting is, at the end of the day, in a small to medium-sized loss, if you look at the net retained premium versus the net retained loss, that that could be less attractive, because the gross book has decreased so much.

I understand. Does this make you think, between that and the cat bonds that you have -- which certainly now, if you were to have them hit, would be significant compared to the size of your current book of business that you would be losing. Did it make you think to maybe get rid of some of the cat bonds?

Yes, I think we continue to explore the best way and the best time to manage the catastrophe bonds. By manage, we can novate, we could transfer -- there are several other transactions that are possible.

What we found in our initial review is that parts of the protection that the catastrophe bond provides were easily transferable, and parts were not. We believed it was more prudent to retain the protection, especially from A&W II, for this year because, while the exposure has reduced by a large percentage, it is still substantial, especially if you think of multiple events.

Following the wind season, the management and the Board are going to have to make a determination as to what is the most effective way to address those catastrophe bonds, because we will not have the exposure to utilize them. We won't want them as a hedge.

Right. Understood. On the commutations, we saw Tower made an announcement that they took a loss on it. Are you generally doing these at gains? Is that part of why the prior-year reserve's development was favorable?

Well, the second part first. The ones that we have done thus far have been at, overall, a gain. That is in part why we had favorable development. Looking forward, I guess we would expect, but certainly it's not a foregone conclusion, nor is in a requirement that they be at gains.

Jay Yang, Perry Capital.

Just a quick question about the IBNR of $8.4 million. Given that you had revenues or earned premiums, net premiums of $15 million, that struck me as a bit high. Could you give us some more color on that?

It's actually based upon the gross earned premium number of $32.6 million. It's calculated based upon sort of historical attritional loss ratios, excluding major catastrophic events. So it's like a loss ratio method, so to speak, of booking reserves against earned premium.

In terms of the maximum zonal exposure, the remaining $240 million -- would you expect almost all of that to run off on January 1, or is it a more linear progression between now and January 1?

No, you're right. It's a cliff at January 1. That is not to say that there isn't anything that expires. 10/1 will be meaningful, to a certain extent. But it is very much a cliff at January 1st.

Finally, I think you mentioned, you pointed out that your maximum zonal exposure was $475 million on 5/5 and $240 million on July 1. Can we infer from that that gross earned premiums would be down roughly 50% in the third quarter versus the second quarter?

To fill the dead air, I'm going to talk while I think about whether that would work. I think that that's a dangerous assumption, at least in part, because these maximum zonal exposures are in-force numbers rather than premium earning, which, as you know, is sort of pro rata over time. So I guess what I would say is directionally, obviously, you have to be right. But, because the terms of the reinsurances that we sold are not all 1/1, it's not necessarily algebraically linear.

Also, the fact that we have less exposure than we told you we might at July 1st demonstrates the fact that we have been able to get more cancellations than we could count on. Now, that seems to be continuing, as counter-intuitive as that is. Obviously, to the extent we can't predict cancellations, we can't predict earned premium. So the yardstick in the broadest sense is right, but I would urge you to use caution in assuming any precision.

Ron Bobman, Capital Returns.

Could you split out what the commutation gains were for the quarter, please?

That is not detail that we're going to provide in the disclosures here or in the 10-Q.

I think it's -- how would I answer that? I know or I believe that it's counterproductive for that information to be disclosed, for competitive reasons, for shareholders. I would also say that, given where the Company is, if there was a theme involved in those numbers, i.e., if those numbers -- if the gain on the commutation was masking something else, we would want to disclose that from a caution standpoint.

I can definitely understand the implications for revealing the commutation info, I guess, as it impacts your ability to negotiate commutations going forward. But I'm also trying to really garner an estimate as to how good your KRW loss estimates are really holding up, and you are netting the two, if I understand this correctly, and thus not making it evident to us as to (multiple speakers).

Okay, that wasn't the intention. So why don't we address the KRW?

The favorable development on the overall level loss reserves -- I wouldn't want you to interpret that to be driven by the commutation amounts.

Oh, I incorrectly was doing that.

Yes. I think what Jeff was trying to say is if the commutations were giving a result that was meaningfully different than (indiscernible) excluding the commutations I think we would make disclosure of that.

Right. So let me -- I have now confused myself, so let me try and unravel all of that. While we don't want to disclose exactly what the gain on commutations for the quarter were, they were not meaningful in the overall positive development. Because they were a gain, they obviously were a component, but they weren't a meaningful component.

What sort of disclosure on the KRW reserves itself do you have in front of you? The KRW reserves, which I think is a question in the forefront of everyone's mind -- the takeaway is that the gross loss reserves were essentially unchanged. However, we did have a benefit where our ceded reinsurance increased due to increases in the industry loss estimates. Is that clear?

Is that like you buying an ILW?

Yes, exactly. So the rumor was right. They just had it in the wrong direction.

Gentlemen, there are no further questions in the queue. Let me turn the call back over to you, please.

Thank you very much. We will be talking to you next quarter. Thank you.

That does conclude the conference for today. Thank you for your participation. You may now disconnect.