Dear friend,

If you dig deep into PXRE's 2004 annual report (on page 40, to be precise), among the long list of disclaimers nestles a very revealing paragraph on the potential threat of downgrade clauses to the company's business: "Certain of our ceded excess-of-loss reinsurance contracts require us to transfer premiums currently retained by us on a funds-withheld basis into a trust for the benefit of the reinsurers if AM Best were to downgrade us below 'A-'.

"In addition, certain of our other ceded excess-of-loss reinsurance contracts contain provisions that give the reinsurer the right to cancel the contract and require us to pay a termination fee. The amount of the termination fee would be dependent upon various factors, including the level of loss activity."

Not so great for cash flow, one would assume, but the now-beleaguered firm continues: "It is increasingly common for our assumed reinsurance contracts to contain terms that would allow our clients to cancel the contract if we are downgraded below various rating levels by one or more rating agencies, and a majority of our contracts now contain such clauses."

PXRE then spells out exactly how exposed it is: "...for example, 47% (by premium volume) of our reinsurance contracts that incepted at 1 January 2005 contained provisions allowing clients additional rights upon a decline in PXRE's ratings."

Well, that was when they had a clean AM Best rating of 'A' - two notches above the drop zone. Now, fast-forward to February of this year - by this time, PXRE was teetering on the brink with an A- rating, and the volume of business vulnerable to cancellation had shot up to 75%.

Benfield's latest Bermuda Quarterly entitled 'Shaken and Stirred' takes up the baton from here. Bemoaning "capitulation to the arbitrary view that sub-A- ratings represent an unacceptable level of counterparty risk," Benfield said that at the time of the second AM Best February downgrade, only 7.5% of these cancellation options had been exercised, "but momentum was increased after the 4Q 2005 earnings announcement."

You can say that again! I can personally testify to that momentum increasing even before the second AM Best downgrade. I was in Bermuda for the World Insurance Forum the week commencing 20 February 2006, and overheard heated broker debates on the practicality and advisability of replacing PXRE's security on recently renewed programmes, coupled with reports of brazen pitches from members of the class of 2005 to replace PXRE capacity with their own. While I was there, many incumbent reinsurers also confirmed that they had had a busy week fielding calls from clients and brokers about taking up PXRE business.

Then on the day of PXRE's results, an important attendee had to drop out of a round-table dinner I was organising at the last minute. Sources said they had spotted the man in the company of a senior broker for whom you generally drop everything when he asks you for an appointment - the experience seemed to tally with what we had all been seeing during the week.

Of course, PXRE is not the only Bermudian player to be hurled off the ratings precipice of late - Goshawk, Alea, Olympus Re and Quanta are four others left to lick their wounds. In the case of Alea and Goshawk, these wounds have been terminal, while for Quanta and PXRE, the advisers are still deliberating, and there is still a remote possibility of salvage.

But the contrast with the European players is stark. SCOR has survived its swallow dive into the 'B' list and has managed to resurface in the 'A's, while Converium's latest results showed that it has largely achieved stabilisation and might soon fulfil its stated aim of rejoining the ranks of 'acceptable' reinsurance society.

The contrast is even starker on the share-price front: as I write, SCOR and Converium's share prices are up by 38% and 37% respectively in the last 12 months, while their Bermuda-domiciled equivalents languish with an average decline of 75% in the same period.

Admittedly, the two Europeans are further down the road from their downgrade shock events than their Bermudian counterparts, but since share prices are reflections of the market's view on a company's future earnings prospects, the message is clear: the market doesn't currently believe that PXRE or Quanta have much in the way of a profitable future.

What is it about the US market that exacts an arbitrary 'A' standard when many European buyers are content with B++ or BBB?

The answer is probably to do with the nature of the business ceded, the relative strength of the brands in question, and a shorter-term and more opportunistic relationship with reinsurers on the Western side of the Atlantic, but that must be the subject of another article.

What is clear is that if you are doing business in the US on an A- rating, you are operating under extraordinary, unprecedented pressures. The consequences of failure are at best extremely unpalatable and, most likely, fatal.