As the year 2000 drew to a close, senior executives at leading Bermuda reinsurer RenaissanceRe were faced with a problem ? a series of lucrative reinsurance contracts were coming to an end and were unlikely to be renewed on the same favourable terms.

As a result the company, which had become well known for producing consistently strong earnings, was likely to see its profit growth slow or it could face problems paying large insurance claims that might arise.

To get around the problem, Securities and Exchange Commission prosecutors allege former RenRe chief executive officer James Stanard, former RenRe controller Marty Merritt and former vice president Michael Cash devised an elaborate scheme by which they could set aside some $25 million in earnings which could later be used to either pay claims or to boost earnings in a subsequent reporting period.

That transaction ? known as ?earnings smoothing? ? has resulted in securities fraud charges being brought against the three executives by the SEC.

The SEC frowns on ?earnings smoothing? because it misstates the true financial state of a company.

In addition, the SEC alleges that the transaction between RenRe and finite reinsurer Inter-Ocean Re was not a true reinsurance transaction because there was no transfer of risk as RenRe was guaranteed it would get its money back.

Further, the SEC alleges that the RenRe executives misled their auditors when the company?s books were examined.

Mr. Stanard and Mr. Cash deny the allegations and have vowed to fight them. Mr. Merritt agreed to cooperate with the SEC, and has consented to orders barring him from working as an accountant or serving as an officer or director of a public company. The partial settlement defers a decision on civil penalties.

According to the SEC?s 36-page complaint, which reconstructs events from 2000 to 2003 through e-mail records and reports of phone conversations, the scheme was intended to have a material impact during a future period when RenRe needed an earnings boost.

At the time of the deal, RenRe?s main business was property catastrophe reinsurance in which it provided reinsurance to insurers that might suffer losses due to catastrophes like hurricanes, tornado?s, and earthquakes.

To manage its risk, the SEC said, RenRe obtained reinsurance from other reinsurers to protect itself it had to pay out claims for large losses.

The SEC said that in least 1998 and 1999, RenRe entered into industry warranty contracts (ILW?s) ? a type of reinsurance with other insurers and reinsurers as counterparties.

These contracts entitled RenRe to recover from the ILW counterparties for insurance claims paid by RenRe to its insureds if certain industry-wide losses exceeded contractually designated levels.

?It became clear in 2000 or early 2001 that the ILW counterparties had not understood the risks underlying these contracts as well as RenRe had and the ILW counterparties had under priced the contracts to RenRe?s benefit,? the SEC said.

?The price RenRe would have to pay to enter into future ILW?s significantly rose, making these contracts less attractive economically.?

With 2000 shaping up as a strong financial year, the SEC alleges that ?two senior executives? began thinking of ways in November to protect future earnings through a project called the ?4th Quarter Challenge? and ?Project Christmas? aimed at helping ?some other company? meet earnings expectations for the fourth quarter 2000 while possibly helping RenRe?s defer earnings.

According to the SEC complaint, Mr. Cash a Bermudian with 11 years experience in the insurance industry was put to work on ?Project Christmas Present? almost immediately after joining Renaissance in 2000 as vice president-specialty reinsurance.

In January 2001, Mr. Stanard sent an e-mail entitled ?Leveling Contract.? In this email, he asked Mr. Merritt and a senior officer of Renaissance to try ?structure a ceded contract that allows us to put away $25 million?.

This e-mail, which Mr. Stanard sent to Mr. Cash and others, was the impetus for the Inter-Ocean transaction.

Mr. Cash began to develop proposals ?to smooth earnings? according to an e-mail he sent and kept Mr. Stanard and Mr. Merritt updated on his progress.

Mr. Cash and Mr. Merritt negotiated a deal with Inter-Ocean and AmRe, which managed Inter-Ocean through a subsidiary.

Both men and another RenRe official initially met with three employees of Inter-Ocean, who also had ties to AmRe, in mid-March, 2001.

Mr. Merritt and Mr. Cash also informed AmRe that RenRe?s purpose for proposing the transaction was to defer earnings, the SEC said.

According to an internal AmRe email, RenRe asked AmRe not to ?widely broadcast? its proposal ?given the nature of the transaction?.

Mr. Cash played a significant role in drafting both the assignment agreement and the reinsurance agreement and signed the reinsurance agreement with Inter-Ocean on RenRe?s behalf, whIle Merritt signed the assignment agreement, the SEC said.

Mr. Cash initially wanted to have different counterparties on each agreement. RenRe originally proposed entering into the assignment agreement with Inter-Ocean and the reinsurance agreement with AmRe, in part because Mr. Cash initially wanted to mislead RenRe?s auditors into thinking that the agreements were unrelated, according to the complant.

RenRe entered into both parts of the transaction with Inter-Ocean, which then ceded its obligations under the reinsurance portion of the transaction to AmRe through a separate retrocession agreement.

A retrocession agreement is one in which a reinsurer cedes its obligations under an insurance policy or agreement to another reinsurer.

The SEC claims Mr. Stanard was kept apprised of the progress of the negotiations, which were also discussed at several senior staff meetings.

The assignment agreement, RenRe purported to transfer $50 million of the recoverables under the ILWs to Inter-Ocean in exchange for a payment of $30 million.

At the same time the agreement provided a mechanism for RenRe to recover from Inter-Ocean at a later date the remaining $20 million (plus $7.3 million it paid Inter-Ocean as a supposed premium, less certain fees and costs).

?The two agreements in reality provided no economic benefit to either party other than a substantial fee, not expressly reflected in the contracts that RenRe paid Inter-Ocean for its role in the transaction,? the SEC said.

?The SEC believe the entire Inter-Ocean transaction was a sham and should not have been accounted for at all.?

?RenRe should have recognised the ILW recoverables as income in the first quarter of 2001, when the company became aware of its entitlement to them and the amount was probable and reasonably estimable.?

?Instead, the company sought to reduce the impact from the ILW recoverables on its earnings by assigning them to Inter-Ocean. But the assignment agreement was not bona fide and should not have been given accounting effect.?

?Even if RenRe wished to account for the transaction, it should have treated the assignment and premium as a loan to or deposit with Inter-Ocean of approximately $26 million, with $1.1 million of expenses for transaction fees and costs, and a later recovery of the principal and investment returns.?

The SEC said RenRe did not account for the transaction in this manner, because proper accounting treatment would not have permitted RenRe to defer $26 million of income.

The SEC also alleges that Mr. Merritt misrepresented certain facts to RenRe?s outside auditors and concealed several other key facts that might have led the auditors to conclude that the transaction was a sham.

?The goal from the beginning was to structure a transaction that fooled RenRe?s outside auditors into thinking it was a bona fide reinsurance deal,? the complaint said.

To reinforce its claim that Mr. Stanard knew the transaction was a sham, the SEC said that in April 2001, Mr. Stanard and the chief executive officer of AmRe participated in a conference call in which the RenRe chief executive ?wanted to make it clear to his counterpart at AmRe that RenRe would get its money back under the reinsurance agreement?.

During the conference call, Mr. Stanard walked AmRe?s CEO through the assignment and reinsurance agreements, explained that the triggers in the reinsurance agreement would be met by RenRe and made clear that RenRe would make a claim for a full recovery under the reinsurance agreement, the SEC said.

?Both sides intended the transaction to look like a real assignment and reinsurance agreement but with no actual risk transfer.

?Inter-Ocean assumed no reinsurance risk because RenRe could not receive more from Inter-Ocean under the reinsurance agreement than it had already paid Inter-Ocean in premiums or by the transfer of the ILW recoverables under the assignment agreement.?

?RenRe assumed no risk, because the reinsurance agreement provided an assured mechanism for it to recover the money it had transferred to Inter-Ocean.?

?The reinsurance agreement merely provided a means for RenRe fraudulently to defer recognising $26 million until such time as RenRe made a claim under the reinsurance agreement.?

The SEC said RenRe should have recorded the expected $50 million in recoverables as income in the first quarter of 2001 because it used an accrual method of accounting.

The SEC said also the company could have booked an allowance (or reserve) for whatever small portion of the total $55 million of recoverables to which it was entitled that it legitimately decided it would not collect.

Any such allowance necessarily would have taken into account the $42 million RenRe had received by the time it entered into the assignment agreement. RenRe booked neither the $50 million of income nor any related allowance in the first quarter of 2001.

Instead, the SEC. said RenRe entered into the assignment agreement transferring to Inter-Ocean $50 million of the recoverables in exchange for a $30 million premium.

Although this assignment agreement was not executed until April 23,2001, after the close of the first quarter, RenRe accounted for the assignment by posting a credit of $30 million to income in the first quarter of 2001, reflecting only the amount Inter-Ocean paid for the recoverables.

This resulted in the company?s deferral of $20 million of income from the recoverables and as the recoverables were received in 2001, RenRe did not report them as income, but recorded them in, among other things, a temporary holding account.

The SEC said: ?RenRe sidestepped its own accounting policies and GAAP (Generally Accepted Accounting Principles) in an effort to defer income.?

On July 3 1,2001, during the third quarter, RenRe paid Inter-Ocean a $7.3 million ?premium? pursuant to the reinsurance agreement.

RenRe accounted for the payment as a premium expense, apportioned over the third and fourth quarters of 2001.

This treatment of the purported premium did not comply with GAAP either, the SEC said, because GAAP only allows a premium payment to a reinsurer to be treated as an expense if the reinsurance contract includes a ?genuine transfer of risk?.

In the absence of genuine risk, the reinsured must treat the premium payment as a deposit ? in essence, a loan to the reinsurer to be repaid at a later date through the riskless reinsurance recovery.

?RenRe transferred no risk at all to Inter-Ocean because it fully expected ? and agreed with Inter-Ocean ? that it would receive a complete recovery of the amounts it had paid Inter-Ocean. RenRe nevertheless treated the $7.3 million ?premium? payment to Inter-Ocean as an expense, instead of a deposit.?

?The excess $20 million in recoverables that RenRe assigned to Inter- Ocean under the assignment agreement was ultimately placed in the trust account for RenRe?s benefit (minus the fees and costs paid to Inter-Ocean) and therefore the $20 million was also a deposit of cash with Inter-Ocean in the third quarter of 2001.

On September 25,2002, RenRe made a claim under the reinsurance agreement for the full amount in the trust.

RenRe then received from Inter-Ocean approximately $16.6 million in the fourth quarter of 2002, $9.7 million in the first quarter of 2003, and $91,000 in the fourth quarter of 2003.

To account for these recoveries, RenRe originally recorded $25 million of income in the third quarter of 2002, to reflect its accrual of at least that amount based on its third quarter claim to Inter-Ocean for the trust?s contents.

It recorded an additional $1.3 million of income in the first quarter of 2003, to reflect receipt of $1.3 million more than the $25 million it accrued in the third quarter of 2002.

Finally the SEC said, in the fourth quarter of 2003, it recorded $91,000 of income to reflect receipt of $91,000 more than it had previously accrued.

?The company treated these recoveries as reinsurance recoveries, even though the reinsurance agreement did not transfer any risk to Inter-Ocean.?

?This treatment enabled RenRe to record the recoveries as income in 2002, rather than as the return of a deposit given to Inter-Ocean in 2001 under the assignment and risk-free reinsurance agreements.?

?The end result was the improper deferral of more than $26 million of income from 2001 to 2002 and 2003.?

On March 3 1,2005, RenRe restated its financial results for 2001,2002, and 2003 in its Form 10-K for the year ended December 31,2004.

The restatement reversed both components of the transaction, as if the transaction had not occurred at all.

The net effect was to increase the company?s net income by $26.4 million in 2001 and decrease its net income by $25 million in 2002 and $1.4 million in 2003. Because the transaction cost the company $863,000 in transaction fees and costs to Inter-Ocean ($1.1 million in fees and costs offset by investment returns on the trust principal), RenRe restated that amount as an operating expense in the third quarter of 2001.