The recently announced merger of Bermuda's PXRE and San Antonio,Texas-based Argonaut Group may have gotten a push from ratingagencies last year, but it was predestined to happen eventually,executives of the two firms contend.

In separate interviews, Argonaut Chief Executive Officer MarkWatson and PXRE CEO Jeffrey Radke said the merger deal creatingArgo Group International Holdings Ltd. and Peleus Re, a reinsuranceoperating unit of Argo Group, had been in informal talking stagesfor several years.

Mr. Radke said that the two CEOs knew each other well throughmutual attendance at industry functions and began to recognize afit that was “sort of striking.”

Outlining that apparent fit in very basic terms, he reportedthat a typical conversation during such meetings might have Mr.Radke saying, “You have mostly casualty. We have mostly property,”or Mr. Watson observing, “You're only in Bermuda. We're only in theUnited States.”

“Nothing much happened” until the PXRE board–following a seriesof downgrades by rating agencies in February 2006–initiated “a verypublic strategic review process,” he said.

Mr. Watson stressed that musings about the strategic benefitsexchanged with Mr. Radke were all pre-Hurricanes Katrina, Rita andWilma. “Some people think my interest was because of theirfinancial condition. Actually, to the contrary, we saw aninteresting strategic fit for both of us.”

For Argonaut, a key merger benefit will be to further diversifyan already varied specialty insurance book by adding a new segmentfrom which it will write pro-rata and property-catastrophereinsurance, Mr. Watson said.

Argonaut's existing businesses includes:

o An excess and surplus lines segment–accounting for roughlytwo-thirds of the book.

o Select Markets–offering products to selected industries on anadmitted basis through retail agent.

o Trident–a managing general agency insuring publicentities.

“The best way to look at this transaction is [to view it asadding] an additional business segment to the three we alreadyhave,” Mr. Watson told investors during a conference callannouncing the deal.

While setting up a platform in Bermuda, where Argo Group will bebased, was another deal driver for Mr. Watson's team, for PXRE thecompelling reason for the deal was diversification. The resultingbusiness mix, which the board viewed as the most attractive amongalternatives reviewed, essentially put PXRE back in business,according to Mr. Radke.

“If you go back and read the text of downgrades from Feb. 16,2006, A.M. Best especially…indicated that a lack of diversity wasthe main cause. It wasn't capital adequacy,” he said.

On that fateful day, the monoline property-cat reinsurerannounced it was raising prior loss estimates for 2005 hurricanesmore than 60 percent and that, anticipating the downgrades to come,it would explore strategic alternatives. A.M. Best delivered itsfirst cut to the “B-double-plus” rating that same day, citing adeteriorated risk-adjusted capital position and concerns aboutPXRE's risk management capability.

Mr. Radke said that by bringing “immediate diversification,” theArgonaut transaction, in turn, “immediately achieved [PXRE's] mostimportant objective–to become part of a group with an acceptablerating that will let us transact business.”

The company once known as Phoenix will metaphorically rise fromthe ashes as Peleus, which garnered an “A-minus” from A.M. Best, aday after the merger was announced. Standard & Poor's, whichdid not assign a rating to Peleus, has revised its stable outlookon Argonaut's “A-minus” to negative, citing the possibility ofmaterial increases in property-cat exposure and some risk topending class actions against PXRE.

While Mr. Watson also talks about how a new diversifyingreinsurance piece strengthens Argonaut's competitive positionrelative to other specialty insurers and allows it to be flexibleas market conditions change in various segments–”which ought toenhance profitability”–the ability to set up a platform in Bermudaalso had appeal.

“You just look at a broader spread of risk sitting in Bermudathan you do from the United States,” he said during the investorcall. That means more than just seeing a broader mix of catbusiness, according to Barbara Bufkin, Argonaut's senior vicepresident of business development, who will become president ofPeleus Re.

Amplifying Mr. Watson's remarks for NU, she said the twoexecutives have witnessed a “shift of intellectual capital” fromLondon and the United States over the last 20 years. That movement,in turn, has driven brokers to start placing business directly inBermuda.

“The distribution flow out of Bermuda is tremendous,” she said,noting this may also allow Argonaut to write some of its primaryproperty business from Bermuda. In addition, she said, “weappreciate that we can write a small conservative assumedreinsurance portfolio from Bermuda, and it may be more profitablefor us to do that than…to write it on a primary basis in the UnitedStates.”

Argonaut's current portfolio is about 85 percent casualty and 15percent property, she said. Initially, 70 percent of Peleus Re'sbusiness will be a quota-share of Argonaut Group, she noted,characterizing the remaining 30 percent as predominately propertyopen-market business–split among primary, risk-excess andproperty-cat reinsurance segments. She also foresees opportunitiesfor Argo to increase the amount of customized program business itparticipates in via Peleus in Bermuda.

Acting as a reinsurer is not a completely new experience forArgonaut, which derived roughly $80 million, or 8 percent of 2006net premiums, from assumed reinsurance–a figure that's expected torise to 15 percent.

As for the composition of the current reinsurance book, Ms.Bufkin explained that some of Argonaut's public-entity business isdone on a pooling basis, adding that the group also has smallparticipations in the programs of some “business partners.” Shedeclined to name them, but confirmed that they include reinsurers,insurers and production partners.

Both she and Mr. Watson said Argo will continue to pursue suchquota-share opportunities. An overall goal is to use capitaleffectively by writing risks in Bermuda that are not correlatedwith U.S. business, Mr. Watson explained.

“We will not be competing with our Bermuda business partners inthe reinsurance business, but hopefully this will give us anopportunity to do more business together,” he said during theinvestor call.

In a later interview, Mr. Watson explained how thewell-diversified Argonaut might uncover uncorrelated businessopportunities–noting, for example, that while Argonaut's currentproperty-cat insurance book is U.S.-based, it reinsures twopartners writing worldwide risks.

“There are a number of specialty companies we've discussedjoint-venturing with” in lines that Argonaut doesn't write, headded–noting, for example, that Argonaut took a quota-share ofHouston-based HCC's directors and officers book in past years, andis still taking a share of HCC's energy program.

Distinguishing Peleus from PXRE, Ms. Bufkin said PXRE wrote verylarge accounts and a lot of retrocessional business–and neither isin the business plan going forward.

Both Mr. Radke and Mr. Watson have experience leaving pastbusiness plans behind. For Mr. Watson, a turnaround at Argonautbegan when he took the helm in 1999, transforming a Californiaworkers' compensation insurer into a diversified specialtyorganization–turning to the type of business he knew best, havingworked for his father in a previous position at Titan Holdings.(For more on Argonaut's history, see NU, Oct. 16, 2006.)

Mr. Radke (who took the CEO reins from his father, Gerald Radke,in 2003) also decided to shed what turned out to be a problemcasualty book–this one a reinsurance book–during his tenure aspresident a few years earlier. Shutting it down had the effect ofreturning PXRE to a core property-cat book, but that wasn't themotivation, the younger Mr. Radke said.

“Slightly before 9/11, we came to the conclusion that ourattempt to diversify… just flat out wasn't working,” he said. “Mypersonal view…is that we just didn't have sufficient size,” headded, noting that while property customers were comfortable withPXRE “from a credit risk perspective,” the same wasn't true on theliability side.

Stopping short of calling it adverse selection, he said, “weweren't seeing a broad cross-section of business [and] couldn'twrite what we wanted.”

Mr. Radke doesn't believe the same type of scenario will playout for the larger Argo with respect to the higher property volumeit will now try to take on. Like salt in a recipe, “you only need apinch of property-cat” in a business mix, because profit marginsare potentially so large, he said.

Like the rest of the industry, both PXRE and Argonaut struggledto deal with the unfavorable runoff of casualty business they wrotein the 1990s–a parallel that gives Mr. Watson confidence movingforward.

Responding to analysts who dwell on the potential downside of“merging with a company that has balance sheet issues,” he coaxes alook at Argonaut's background and experience–”background meaningwe've had similar issues, and experience meaning we've shown anability to deal with them.”

Both men repeatedly describe Argo as an insurance operationwriting a small amount of reinsurance–a seemingly unique strategytoday, but one that had some traction decades ago when insurerslike CNA, St. Paul and Chubb had reinsurance operations.

Mr. Watson and Ms. Bufkin both reject such comparisons. Thebusiness plans of those insurers called for them to operate thoseunits as “traditional” reinsurers. “That's not our game plan atall,” Mr. Watson said, alluding to partnerships he discussedearlier. “If I elaborate more, I'll give away our strategicadvantage.”

Ms. Bufkin noted that those insurers experimented withreinsurance operations from U.S. platforms, contrasting a “positiveregulatory environment available in Bermuda” today and a currentfocus on capital management.

Mr. Radke noted that Argo's predominant focus on insurance willallow it the “luxury to sit back and decide” on an optimal businessmix without worrying about top-line objectives for reinsurance.