Argonaut-PXRE Explain Merger Strategy

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

In separate interviews, Argonaut Chief Executive Officer Mark Watson and PXRE CEO Jeffrey Radke said the merger deal creating Argo Group International Holdings Ltd. and Peleus Re, a reinsurance operating unit of Argo Group, had been in informal talking stages for several years.

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

Outlining that apparent fit in very basic terms, he reported that 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 the United States.”

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

Mr. Watson stressed that musings about the strategic benefits exchanged with Mr. Radke were all pre-Hurricanes Katrina, Rita and Wilma. “Some people think my interest was because of their financial condition. Actually, to the contrary, we saw an interesting strategic fit for both of us.”

For Argonaut, a key merger benefit will be to further diversify an already varied specialty insurance book by adding a new segment from which it will write pro-rata and property-catastrophe reinsurance, Mr. Watson said.

Argonaut's existing businesses includes:

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

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

o Trident–a managing general agency insuring public entities.

“The best way to look at this transaction is [to view it as adding] an additional business segment to the three we already have,” Mr. Watson told investors during a conference call announcing the deal.

While setting up a platform in Bermuda, where Argo Group will be based, was another deal driver for Mr. Watson's team, for PXRE the compelling reason for the deal was diversification. The resulting business mix, which the board viewed as the most attractive among alternatives 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 was the main cause. It wasn't capital adequacy,” he said.

On that fateful day, the monoline property-cat reinsurer announced it was raising prior loss estimates for 2005 hurricanes more than 60 percent and that, anticipating the downgrades to come, it would explore strategic alternatives. A.M. Best delivered its first cut to the “B-double-plus” rating that same day, citing a deteriorated risk-adjusted capital position and concerns about PXRE's risk management capability.

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

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

While Mr. Watson also talks about how a new diversifying reinsurance piece strengthens Argonaut's competitive position relative to other specialty insurers and allows it to be flexible as market conditions change in various segments–”which ought to enhance profitability”–the ability to set up a platform in Bermuda also had appeal.

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

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

“The distribution flow out of Bermuda is tremendous,” she said, noting this may also allow Argonaut to write some of its primary property business from Bermuda. In addition, she said, “we appreciate that we can write a small conservative assumed reinsurance portfolio from Bermuda, and it may be more profitable for us to do that than…to write it on a primary basis in the United States.”

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

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

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

Both she and Mr. Watson said Argo will continue to pursue such quota-share opportunities. An overall goal is to use capital effectively by writing risks in Bermuda that are not correlated with U.S. business, Mr. Watson explained.

“We will not be competing with our Bermuda business partners in the reinsurance business, but hopefully this will give us an opportunity to do more business together,” he said during the investor call.

In a later interview, Mr. Watson explained how the well-diversified Argonaut might uncover uncorrelated business opportunities–noting, for example, that while Argonaut's current property-cat insurance book is U.S.-based, it reinsures two partners writing worldwide risks.

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

Distinguishing Peleus from PXRE, Ms. Bufkin said PXRE wrote very large accounts and a lot of retrocessional business–and neither is in the business plan going forward.

Both Mr. Radke and Mr. Watson have experience leaving past business plans behind. For Mr. Watson, a turnaround at Argonaut began when he took the helm in 1999, transforming a California workers' compensation insurer into a diversified specialty organization–turning to the type of business he knew best, having worked 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 problem casualty book–this one a reinsurance book–during his tenure as president a few years earlier. Shutting it down had the effect of returning PXRE to a core property-cat book, but that wasn't the motivation, the younger Mr. Radke said.

“Slightly before 9/11, we came to the conclusion that our attempt to diversify… just flat out wasn't working,” he said. “My personal view…is that we just didn't have sufficient size,” he added, noting that while property customers were comfortable with PXRE “from a credit risk perspective,” the same wasn't true on the liability side.

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

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

Like the rest of the industry, both PXRE and Argonaut struggled to deal with the unfavorable runoff of casualty business they wrote in the 1990s–a parallel that gives Mr. Watson confidence moving forward.

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

Both men repeatedly describe Argo as an insurance operation writing a small amount of reinsurance–a seemingly unique strategy today, but one that had some traction decades ago when insurers like CNA, St. Paul and Chubb had reinsurance operations.

Mr. Watson and Ms. Bufkin both reject such comparisons. The business plans of those insurers called for them to operate those units as “traditional” reinsurers. “That's not our game plan at all,” Mr. Watson said, alluding to partnerships he discussed earlier. “If I elaborate more, I'll give away our strategic advantage.”

Ms. Bufkin noted that those insurers experimented with reinsurance operations from U.S. platforms, contrasting a “positive regulatory environment available in Bermuda” today and a current focus on capital management.

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