10-Q 1 file001.htm FORM 10-Q

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

[X]    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2005

OR

[  ]    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                  to                 .

Commission File Number: 001-32307

Primus Guaranty, Ltd.

(Exact name of registrant as specified in its charter)


Bermuda Not Required
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer Identification No.)

Clarendon House
2 Church Street
Hamilton HM 11, Bermuda
(Address of principal executive offices, including zip code)

441-296-0519
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes   [X]    No   [ ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).     Yes   [ ]    No   [X]

As of August 5, 2005, the number of shares outstanding of the issuer's common stock, $0.08 par value, was 43,121,523.




Primus Guaranty, Ltd.
Form 10-Q
For the quarter ended June 30, 2005


Part I. Financial Information
Item 1. Financial Statements
  Consolidated Statements of Financial Condition
June 30, 2005 (Unaudited) and December 31, 2004
  3  
  Consolidated Statements of Operations (Unaudited)
Three and six months ended June 30, 2005 and 2004
  4  
  Consolidated Statements of Cash Flows (Unaudited)
Six months ended June 30, 2005 and 2004
  5  
  Notes to Consolidated Financial Statements   6  
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations
  19  
  Cautionary Note Regarding Forward-Looking Statements   32  
Item 3. Quantitative and Qualitative Disclosures about Market Risk   34  
Item 4. Controls and Procedures   35  
Part II. Other Information
Item 1. Legal Proceedings   35  
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds   35  
Item 3. Defaults upon Senior Securities   36  
Item 4. Submission of Matters to a Vote of Security Holders   36  
Item 5. Other Information   36  
Item 6. Exhibits   36  
Signatures   37  

2




Part I.    Financial Information

Item 1.    Financial Statements

Primus Guaranty, Ltd.
Consolidated Statements of Financial Condition
(dollars in 000s except per share amounts)


  June 30,
2005
December 31,
2004
  (unaudited)  
Assets
Cash and cash equivalents $ 200,852   $ 320,989  
Available-for-sale investments   286,657     161,101  
Accrued interest receivable   4,934     1,381  
Accrued premiums on credit swaps   3,287     3,349  
Premiums receivable on credit swaps   169     197  
Premiums receivable on financial guarantees   500     800  
Asset management fee receivable   39     15  
Prepaid expenses   581     868  
Unrealized gain on credit swaps, at fair value   17,531     46,517  
Fixed assets, less accumulated depreciation of $626 in 2005 and
$493 in 2004
  1,690     1,800  
Internal use software costs, less accumulated amortization of $6,800
in 2005 and $5,893 in 2004
  3,722     4,297  
Income tax receivable   279     279  
Debt issuance costs   1,133     1,125  
Total assets $ 521,374   $ 542,718  
             
Liabilities, preferred securities of subsidiary and shareholders' equity            
Accounts payable and accrued expenses $ 1,365   $ 904  
Compensation accrual   2,617     5,317  
Brokerage fees payable   37     14  
Taxes payable   184     12  
Interest payable   359     364  
Long-term debt   75,000     75,000  
Unrealized loss on credit swaps, at fair value   4,844     259  
Deferred rent payable   446     455  
Deferred financial guarantee premiums   607     806  
Deferred credit swap premiums   57     69  
Total liabilities   85,516     83,200  
Preferred securities of subsidiary   98,521     98,521  
Shareholders' equity:            
Common stock, $0.08 par value, 62,500,000 shares authorized, 43,120,064 and 42,780,033 shares issued and outstanding at June 30, 2005 and December 31, 2004, respectively   3,675     3,535  
Additional paid-in-capital   264,089     264,860  
Warrants   612     612  
Accumulated other comprehensive income   5      
Retained earnings   68,956     91,990  
Total shareholders' equity   337,337     360,997  
Total liabilities, preferred securities of subsidiary and shareholders' equity $ 521,374   $ 542,718  

See accompanying notes.

3




Primus Guaranty, Ltd.
Consolidated Statements of Operations
(amounts in 000s except per share amounts)


  Three Months Ended
June 30,
Six Months Ended
June 30,
  2005 2004 2005 2004
  (unaudited)
Revenues                        
Net credit swap revenue $ (3,579 $ 5,865   $ (11,777 $ 2,835  
Premiums earned on financial guarantees   100     97     199     196  
Investment portfolio realized gains   23         23      
Interest income on investment portfolio   2,793     716     6,486     1,368  
Rental income       13         40  
Asset management fees   49         91      
Foreign currency revaluation   (955   (33   (1,519   (106
Total net revenues   (1,569   6,658     (6,497   4,333  
                         
Expenses                        
Employee compensation and benefits   3,406     3,861     8,602     7,284  
Professional and legal fees   796     363     1,750     778  
Fixed asset depreciation and amortization   525     485     1,041     959  
Technology and data   398     364     715     671  
Rent   186     184     376     357  
Bank and investment management fees   278     79     457     163  
Rating agency fees   84     75     155     138  
Brokerage expense   56     146     89     364  
Interest expense   497         991      
Other   249     277     541     443  
Total expenses   6,475     5,834     14,717     11,157  
Distributions on preferred securities of subsidiary   (1,127   (605   (1,775   (1,147
Income/ (Loss) before provision for income taxes   (9,171   219     (22,989   (7,971
Provision for income taxes   (9   (45   (45   (117
Net income/ (loss) available to common shares $ (9,180 $ 174   $ (23,034 $ (8,088
                         
Earnings/(loss) per common share:                        
Basic $ (0.21 $ 0.05   $ (0.53 $ (2.41
Diluted $ (0.21 $ 0.01   $ (0.53 $ (2.41
Average common shares outstanding:                        
Basic   43,108     3,527     43,160     3,353  
Diluted   43,108     34,768     43,160     3,353  

See accompanying notes.

4




Primus Guaranty, Ltd.
Consolidated Statements of Cash Flows
(dollars in 000s)


  Six months ended
June 30,
  2005 2004
  (unaudited)
Cash flows from operating activities            
Net loss $ (23,034 $ (8,088
Adjustments to reconcile net loss to net cash provided by operating activities:            
Non-cash items included in net income (loss):            
Depreciation of fixed assets   133     110  
Amortization of internal use software costs   908     850  
Stock compensation   1,534     1,385  
Net unrealized loss on credit swap portfolio   33,571     20,068  
Unrealized loss on sublease       (39
Deferred rent   (9   (7
Amortization of debt issuance costs   22      
Distributions on preferred securities of subsidiary   1,775     1,147  
Increase (decrease) in cash resulting from changes in:            
Premiums receivable on credit swaps   28     (742
Accrued premiums on credit swaps   62     (78
Deferred credit swap premiums   (12   (19
Deferred financial guarantee premiums   (199   (196
Brokerage fees payable   23     84  
Accrued interest receivable   (3,553   78  
Premiums receivable on financial guarantees   300     301  
Prepaid expenses   287     (197
Deferred IPO costs       (1,934
Asset management fee receivable   (24    
Accounts payable and accrued expenses   461     (254
Compensation accrual   (2,700   (2,432
Interest payable   (5    
Taxes payable.   172     72  
Net cash provided by operating activities   9,740     10,109  
Cash flows from investing activities            
Fixed asset purchases.   (24   (106
Net sale (purchase) of investments.   (125,551   527  
Other asset purchases   (332   (329
Net cash (used in)/ provided by investing activities   (125,907   92  
Cash flows from financing activities            
Retirement of common shares   (2,397    
Proceeds from issuance of common shares   233      
Debt issuance costs   (31    
Exercise of warrants       5,502  
Net preferred distributions of subsidiary   (1,775   (1,147
Net cash (used in)/ provided by financing activities   (3,970   4,355  
Net (decrease)/ increase in cash   (120,137   14,556  
Cash and cash equivalents at beginning of period   320,989     257,967  
Cash and cash equivalents at end of period $ 200,852   $ 272,523  
Supplemental disclosures            
Cash paid for interest $ 482   $  
Cash paid for taxes $ 4   $ 45  

See accompanying notes.

5




Primus Guaranty, Ltd.
Notes to Consolidated Financial Statements
June 30, 2005

1.    Organization and Basis of Presentation

Primus Guaranty, Ltd. ("Primus Guaranty" or the "Company"), is a Bermuda holding company and the 100% owner of Primus (Bermuda), Ltd. ("Primus Bermuda"), also a Bermuda holding company. The Company considers its legal domicile to be where it is incorporated, Bermuda. Primus Bermuda is the 100% owner of Primus Group Holdings, LLC ("Primus Group Holdings"), a Delaware limited liability company. Primus Group Holdings has two principal operating subsidiaries: Primus Financial Products, LLC ("Primus Financial"), and Primus Asset Management, Inc. ("Primus Asset Management"). Primus Financial is a Delaware limited liability company that maintains a long-term counterparty credit rating of AAA from Standard & Poor's Rating Services ("S&P") and Aaa from Moody's Investors Service, Inc. ("Moody's" and, together with S&P, the "Rating Agencies"). Primus Financial is primarily a provider of credit risk protection in the form of credit swaps, covering single name, investment grade corporate and sovereign financial obligations. Primus Financial also sells credit protection referencing portfolios containing obligations of multiple reference entities, or tranches. Primus Asset Management is a provider of administrative and technology support to Primus Financial and an asset manager for Primus Financial and third parties.

Primus Financial and Primus Asset Management function as separate entities from Primus Group Holdings. Additionally, the obligations of Primus Financial are not the obligations of Primus Bermuda, Primus Group Holdings, or any other of its affiliates, and vice versa. Primus Asset Management wholly owns Primus Re, Ltd. ("Primus Re"), a Bermuda company that operates as a financial guarantee insurance company and is licensed as a Class 3 Insurer under the Insurance Act of 1978 of Bermuda.

The accompanying unaudited consolidated financial statements of Primus Guaranty, Ltd. have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the periods presented are not necessarily indicative of the results that may be expected for any other interim period or for the year ended December 31, 2005. The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances have been eliminated.

The consolidated financial statements represent a single reportable segment, as defined in Statement of Financial Accounting Standards ("SFAS") No. 131, Disclosures about Segments of an Enterprise and Related Information.

The consolidated financial statements are presented in U.S. dollar equivalents. At June 30, 2005 and December 31, 2004, Primus Financial's credit swap activities were conducted in U.S. dollars and Euros.

Certain 2004 amounts have been reclassified to be consistent with the 2005 presentation.

2.    Summary of Significant Accounting Policies

Credit swaps

Credit swaps are over-the-counter ("OTC") derivative financial instruments and are recorded at fair value in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. Obtaining the fair value (as such term is defined in SFAS No. 133) for such instruments requires the use of management judgment. These instruments are valued using pricing models based on the net present value of expected future cash flows and observed prices for other OTC transactions

6




Primus Guaranty, Ltd.
Notes to Consolidated Financial Statements
June 30, 2005

bearing similar risk characteristics. The fair value of these instruments appears on the consolidated statement of financial condition as unrealized gains or losses on credit swaps. The Company does not believe that its credit swaps fall outside the scope of the guidance of SFAS No. 133 paragraph 10d, as amended by SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, because there is no contractual requirement that the protection purchaser be exposed to the underlying risk.

Net credit swap revenue includes realized and unrealized gains and losses on credit swaps and net premiums earned.

Premiums are taken into income as they are earned over a specified time period. Accrued premiums on credit swaps represent premiums earned but not yet payable by Primus Financial's counterparty. Premiums receivable on credit swaps represents premiums that are both earned by and payable to Primus Financial.

Financial Guarantee-Insurance Contracts

The Company has undertaken a limited amount of financial guarantee business through its subsidiary, Primus Re. Financial guarantees are insurance contracts that contingently require the guarantor to make payments to the guaranteed party. The Company designs its guarantee contracts to qualify as non-derivatives in accordance with the scope exception under paragraph 10d of SFAS 133 as amended by SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. This scope exception requires that the guaranteed party be exposed to loss both at inception and over the life of the contract, incurrence of loss must be a precondition for payment under the contract, and these losses are based on payments to be made solely to reimburse the guaranteed party for failure of the debtor to satisfy its required payment obligations under a nonderivative contract, either at pre-specified payment dates or accelerated payment dates as a result of the occurrence of an event of default (as defined in the financial obligation covered by the guarantee contract) or notice of acceleration being made to the debtor by the creditor. Thus, the Company accounts for its financial guarantee contracts in accordance with SFAS No. 60, Accounting and Reporting by Insurance Enterprises. This requires that premiums are deferred and recognized over the life of the contract and that losses are recorded in the period that they occur based on an estimate of the ultimate cost of losses incurred.

The Company does not actively offer financial guarantee insurance. Rather, it is an alternative the Company has available when a counterparty requests an insurance contract instead of a credit swap. Generally, a counterparty's choice of a financial guarantee insurance contract versus a credit swap is determined by economic terms available in the marketplace as well as regulatory and accounting considerations. Also, the purchaser of an insurance contract cannot submit a claim for payment unless it has an insurable loss, whereas the purchaser of a credit swap need not have actual exposure to the underlying risk.

Insurance Premiums Earned and Receivable and Related Expenses

In exchange for providing financial guarantee protection to counterparties, Primus Re receives premiums over the life of the contract. The amount expected over the life of the policy is reflected in the statement of financial condition and will be reduced as payments are received quarterly in advance.

Although Primus Re provides insurance and purchases off-setting credit swaps through "separate accounts" under a private act, those accounts of Primus Re are not deemed to be separate accounts under SOP 03-01, Accounting & Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts for Separate Accounts, since investment performance is not passed through to the contract holder.

7




Primus Guaranty, Ltd.
Notes to Consolidated Financial Statements
June 30, 2005

Policy acquisition costs include only those expenses that relate primarily to, and vary with, premium production. Such costs generally include compensation of employees involved in underwriting and policy issuance functions, certain rating agency fees, state premium taxes and certain other underwriting expenses. No costs have been deferred by the Company as of June 30, 2005, as any such amounts have been immaterial.

Deferred Financial Guarantee Premiums

Unearned premiums related to the financial guarantee protection provided are used to establish the liability at inception. This liability is reflected in income on a straight-line basis over the period the risk protection is provided.

Unpaid Losses and Loss Expenses on Financial Guarantees

Liabilities for unpaid losses and loss expenses include the accumulation of individual case estimates for claims reported as well as estimates of incurred but not reported claims and estimates of loss settlement expenses on the obligations it has insured. Estimates will be based upon historical industry loss experience modified for current trends as well as prevailing economic, legal and social conditions. Any changes in estimates are reflected in operating results in the period in which the estimates changed. At June 30, 2005 and at December 31, 2004, the Company had no loss reserves recorded.

Income Taxes

Income tax expense is computed in accordance with the requirements of SFAS No. 109, Accounting for Income Taxes, which prescribes the asset and liability approach to accounting for income taxes. The asset and liability approach requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities.

Employee Compensation Plans

In 2003, the Company adopted the fair value approach on a prospective basis for recording stock-based employee compensation in accordance with the fair value method prescribed by SFAS No. 123, Accounting for Stock-based Compensation, as amended by SFAS No. 148, Accounting for Stock Based Compensation—Transition and Disclosure. Compensation expense is recognized based on the fair value of stock options, performance shares, restricted shares and restricted share units ("RSU") granted over the related vesting period. The fair value of the stock options granted is determined through the use of an option-pricing model.

Recently Issued Accounting Standards

In May 2005, the FASB issued SFAS 154, Accounting Changes and Error Corrections – a replacement of APB Opinion No. 20 and FASB Statement No. 3. This statement requires retrospective application to prior periods' financial statements of changes in accounting principle. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of SFAS 154 is not expected to have a significant impact on the Company's financial statements.

In December 2004, the FASB issued SFAS 123R, which replaces SFAS 123 and supersedes APB 25. SFAS 123R eliminates the choice of alternative accounting methods, and requires that all entities follow the fair value based method of SFAS 123. Public entities will be required to apply Statement 123R at the beginning of the first fiscal year beginning after June 15, 2005. The adoption of SFAS 123R is not expected to have a significant impact on the Company's financial statements.

8




Primus Guaranty, Ltd.
Notes to Consolidated Financial Statements
June 30, 2005

3.    Cash and Cash Equivalents

The Company and its subsidiaries invest only in obligations of the United States of America or direct debt obligations of U.S. Agencies (including government-sponsored enterprises) rated AAA and Aaa by the respective Rating Agencies, commercial paper rated A-1 and P-1 by the respective Rating Agencies and money market funds.

All outstanding obligations in this category mature within 90 days.

4.    Available-for-Sale Investments

Available-for-sale investments included obligations of the United States of America or direct debt obligations of U.S. Agencies (including government-sponsored enterprises) rated AAA and Aaa by the respective Rating Agencies. Available-for-sale investments have original maturities or maturities at time of purchase greater than 91 days. At June 30, 2005, no investment has an original maturity or maturity at time of purchase of greater than 3 years.

Available-for-sale investments are reported in the balance sheet at their fair value. Changes in fair value are reported in other comprehensive income in shareholders' equity.

During the second quarter of 2005, interest income was adjusted to reflect a reduction attributable to the fourth quarter of 2004 (in the amount of $126,000) and the first quarter of 2005 (in the amount of $466,000), as the amortization of purchased premium on certain investment securities was not charged against interest income for such periods. The unrecorded amortization was not material to net income (loss) in either of the previous periods.

5.     Credit Swap Revenues and Portfolio

Net credit swap revenue, as presented in the consolidated statement of operations, comprises changes in the fair value of credit swaps, realized gains or losses on the termination of credit swaps and premium income or expense. The realized gains and losses on credit swaps represent realized gains and losses on unwound or assigned credit swaps. The realization of gains or losses on credit swaps will generally result in a reduction in unrealized gains or losses and accrued premium at the point in time realization occurs.

In exchange for providing credit protection to its counterparties, Primus Financial receives premium payments as a series of fixed cash flows. Premiums are taken into income as they are earned over a specified time period. Accrued premiums on credit swaps represent premiums earned but not yet payable by Primus Financial's counterparty. Premiums receivable on credit swaps represents premiums that are both earned by and payable to Primus Financial. When Primus Financial purchases credit protection from its counterparties, Primus Financial pays premiums as a series of fixed cash flows. The premium expense is recognized ratably over the life of the transaction as a component of net credit swap revenue.

Under the terms of Primus Financial's operating guidelines, derivatives transactions can only include credit swaps. Credit swaps are derivative transactions that obligate one party to the transaction (the "Seller") to pay an amount to the other party to the transaction (the "Buyer") should one of a specified group of events ("Credit Events") be incurred by an unrelated third party (the "Reference Entity") specified in the contract. The amount to be paid by the Seller will either be (a) the notional amount of the transaction, in exchange for which the Seller must be delivered a defined obligation of the Reference Entity (called physical settlement), or (b) the difference between the current market value of a defined obligation of the Reference Entity and the notional amount of the transaction (called cash settlement). In exchange for incurring the potential of a Credit Event-generated loss, the Seller will receive a fixed premium for the term of the contract (or until the occurrence of a Credit Event). The fixed premium is generally paid quarterly in arrears over the term of the transaction.

9




Primus Guaranty, Ltd.
Notes to Consolidated Financial Statements
June 30, 2005

Nearly all transactions entered into between the Buyer and the Seller are subject to an ISDA master agreement executed by both parties. The master agreement allows for the consolidation of the market exposures and termination of all transactions between the Buyer and Seller in the event a Default (as defined by the master agreement) is incurred by either party.

Primus Financial is primarily a Seller of credit swaps, although it may also buy credit swaps. Credit swaps purchased to off-set risks do not qualify as hedges in accordance with SFAS No. 133. In addition, Primus Financial is permitted to purchase credit swaps in order to seek short-term market appreciation as a limited percentage of its overall portfolio (represented as Credit Swaps Purchased as short-term investments in the tables below). The company's operating guidelines and board authorization limit the notional amount of credit swaps purchased for this purpose to seven and a half percent of the notional amount of credit swaps sold.

As a general rule, when the Company sells credit protection, it intends to maintain the transaction until maturity. However, there are two sets of circumstances in which the Company could elect to terminate transactions prior to maturity, and the Company monitors its portfolio on a continuing basis to assess whether those circumstances are present.

First, whenever the Company receives new information suggesting that the credit quality of the underlying risk has deteriorated to a material degree, the Company considers the possibility of terminating the transaction, usually at a loss, to avoid the larger loss that could result if the credit swap were to remain in place until a credit event occurs. The principal factor that governs the Company's decision regarding termination in these circumstances is whether the Company believes that the underlying risk has become substantially greater than the level of risk the Company would choose to assume in entering into a new sale of credit default protection.

Second, the Company may also elect to terminate a transaction for which it has an unrealized gain based on one or more of the following considerations: the likelihood of further gains arising from the position, its view as to whether the capital dedicated to the position would be profitably reallocated, its total exposure to a particular Reference Entity, the total size of its portfolio in relation to its capital and the total size of its swap positions and exposures with a particular counterparty which might be reduced so that the counterparty may enter into additional swaps with the Company.

The Company terminates (or offsets) a credit swap in any one of three ways. The Company may negotiate an agreed termination through the original counterparty (an unwind). The Company may negotiate an assignment and novation of its rights and obligations under the credit swap to a third party (an assignment). As an alternative to terminating a transaction, the Company may enter into an equal and opposite transaction with a third party under which the Company purchases credit default protection on terms that match the terms of the original transaction (an offset). In this last case, both sides of the position may subsequently be unwound or assigned.

In the event of an unwind or assignment, the Company pays or receives a cash settlement negotiated with the counterparty or assignee, based on the fair value of the credit swap contract and the accrued premium on the swap contract at the time of negotiation. The amounts the Company pays or receives are recorded as a realization of fair value and as a realization of accrued premiums in the period in which the termination occurs.

The primary risks inherent in the Company's activities are (a) that Reference Entities specified in its credit swap transactions will incur Credit Events (Credit Events may include any or all of the following: bankruptcy, failure to pay, repudiation or moratorium, and modified or original restructuring) that will require Primus Financial to make payments to the Buyers of the transactions, (b) where Primus Financial is a Buyer of a credit swap and a Credit Event occurs, the Seller fails to make payment to the Company, and (c) that Buyers of the transactions from Primus Financial will default on their required premium payments at times when the fair value of the underlying transactions are positive to Primus Financial. Since inception, none of these events had occurred.

10




Primus Guaranty, Ltd.
Notes to Consolidated Financial Statements
June 30, 2005

The Company distinguishes among credit swaps sold – single name, credit swaps sold – tranche, credit swaps purchased as short-term investments and credit swaps purchased to offset the credit risk on credit swaps previously sold. Credit swaps sold – single name refers to credit swap protection relating to a single reference entity. Credit swaps sold – tranche refers to credit swap protection referencing portfolios containing obligations of multiple reference entities, and we began selling protection of this type during the second quarter of 2005. All credit swaps purchased refer to credit swap protection on single name reference entities.

The tables below present the components of credit swap revenues for the three and six months ended June 30, 2005 and 2004, in thousands.

Net credit swap revenues/ (losses) for the three months ended June 30, 2005


  Premium
income/
(expense)
Realized
gains
Realized
(losses)
Change in
unrealized
gains/(losses)
Total
Credit swaps sold – single name $ 12,653   $ 470   $ (3,019 $ (14,765 $ (4,661
Credit swaps sold – tranche   96             467     563  
Credit swaps purchased as short-term investments   (329   635     (23   219     502  
Credit swaps purchased to offset credit risk on certain swaps sold   (23           40     17  
Total $ 12,397   $ 1,105   $ (3,042 $ (14,039 $ (3,579

Net credit swap revenues/ (losses) for the six months ended June 30, 2005


  Premium
income/
(expense)
Realized
gains
Realized
(losses)
Change in
unrealized
gains/(losses)
Total
Credit swaps sold – single name $ 24,281   $ 589   $ (3,019 $ (34,728 $ (12,877
Credit swaps sold – tranche   96             467     563  
Credit swaps purchased as short-term investments   (732   656     (30   626     520  
Credit swaps purchased to offset credit risk on certain swaps sold   (46           63     17  
Total $ 23,599   $ 1,245   $ (3,049 $ (33,572 $ (11,777

Net credit swap revenues/ (losses) for the three months ended June 30, 2004


  Premium
income/
(expense)
Realized
gains
Realized
(losses)
Change in
unrealized
gains/(losses)
Total
Credit swaps sold – single name $ 10,398   $ 936   $ (1 $ (5,288 $ 6,045  
Credit swaps sold – tranche   (126   304     (32   (313   (167
Credit swaps purchased to offset credit risk on certain swaps sold   (23           10     (13
Total $ 10,249   $ 1,240   $ (33 $ (5,591 $ 5,865  

11




Primus Guaranty, Ltd.
Notes to Consolidated Financial Statements
June 30, 2005

Net credit swap revenues/ (losses) for the six months ended June 30, 2004


  Premium
income/
(expense)
Realized
gains
Realized
(losses)
Change in
unrealized
gains/(losses)
Total
Credit swaps sold – single name $ 20,408   $ 2,109   $ (13 $ (20,255 $ 2,249  
Credit swaps sold – tranche   (248   740     (47   137     582  
Credit swaps purchased to offset credit risk on certain swaps sold   (46           50     4  
Total $ 20,114   $ 2,849   $ (60 $ (20,068 $ 2,835  

For the six months ended June 30, 2005, two counterparties each generated greater than ten percent of the Company's total premium revenue, and for the six months ended June 30, 2004, three counterparties each generated greater than ten percent of the Company's total premium revenue.

In accordance with accounting principles generally accepted in the United States, the Company carries its credit swaps on its balance sheet at their fair value. Changes in the fair value of the Company's credit swap portfolio are recorded as unrealized gains or losses in the Company's consolidated income statement. If a credit swap has an increase in fair value during a period, the increase will add to the Company's net credit swap revenues for that period. Conversely, if a credit swap has a decline in fair value during the period, the decline will subtract from the Company's net credit swap revenues for that period. Changes in the fair value of the Company's credit swap portfolio are a function of the notional amount and composition of the portfolio and prevailing market credit swap premiums for comparable credit swaps. The Company generally holds the credit swaps it sells to maturity, at which point, assuming no credit event has occurred, the cumulative unrealized gains and losses on each credit swap would equal zero. In general, the Company aggregates fair values of individual credit swaps by counterparty for presentation on the Company's statement of condition. If the aggregate total of fair values for a counterparty is a net gain, the total is recorded as a component of unrealized gains on credit swaps, at fair value in the statement of financial condition. If the aggregate total of fair values for a counterparty is a net loss, the total is recorded as a component of unrealized losses on credit swaps, at fair value in the statement of financial condition. Aggregation by counterparty is applied where a valid ISDA master agreement is in place with the counterparty. In instances where the Company does not yet have a valid ISDA master agreement with the counterparty, the fair values of individual swap transactions are recorded as components of unrealized gains or losses on credit swaps, at fair value, dependent upon whether the individual contract was at a gain or a loss.

12




Primus Guaranty, Ltd.
Notes to Consolidated Financial Statements
June 30, 2005

The notional amount, fair value and average fair value of open credit swap transactions entered into with third parties at June 30, 2005 and December 31, 2004 are as follows (in thousands):


  June 30,
2005
December 31,
2004
Gross Notional Amounts:
Credit swaps sold – single name $ 12,227,060   $ 10,544,728  
Credit swaps sold – tranche   50,000      
Credit swaps purchased   389,512     468,175  
Fair value:            
Asset   17,511     46,517  
Liability   4,843     259  
Average fair value:            
Asset   28,866     33,778  
Liability   4,471     392  

"Asset" in the above table represents unrealized gains on credit swaps while "Liability" represents unrealized losses on credit swaps. All credit swaps that have been contractually established with each counterparty under an ISDA master agreement are subject to netting arrangements. The notional amounts of the credit swap contracts in the preceding table are presented on a gross basis and the fair values of such contracts are presented net by counterparty, where a master agreement is in place. "Average fair value" in the table above represents the averages over the six months ended June 30, 2005 and the year ended December 31, 2004.

The tables below summarize the notional amounts and net fair value by Reference Entities and Counterparties of credit swap transactions as of June 30, 2005 and December 31, 2004.

Risk off-set transactions are included in the table above and tables below as part of Credit Swaps Purchased. The total notional amounts of risk off-set transactions were $5.0 million at June 30, 2005 and December 31, 2004. Fair value of the risk offset transactions equaled $(142) thousand and $(206) thousand at June 30, 2005 and December 31, 2004, respectively.

13




Primus Guaranty, Ltd.
Notes to Consolidated Financial Statements
June 30, 2005

(in thousands and U.S. dollar equivalent)


  June 30,
2005
December 31,
2004
Moody's Rating Category Notional
Amount
Fair
Value
Notional
Amount
Fair
Value
Reference Entity
Credit Swaps Sold – Single Name:
    Aaa $ 625,540   $ 544   $ 651,270   $ 866  
    Aa   2,284,290     3,197     1,917,131     5,609  
    A   4,920,193     13,204     4,310,452     22,511  
    Baa   4,329,983     (57   3,642,330     19,295  
    Ba   61,000     (2,186   23,545     179  
    Caa   6,054     (905        
Total $ 12,227,060   $ 13,797   $ 10,544,728   $ 48,460  
Credit Swaps Sold – Tranche:
    Aa $ 50,000   $ 467   $   $  
Total $ 50,000   $ 467   $   $  
Credit Swaps Purchased:
Aaa $ 44,216   $ (185 $ 47,090   $ (158
Aa   12,108     (15   13,545     (44
A   200,810     (585   209,815     (803
Baa   96,054     (510   160,635     (969
NR   36,324     (281   37,090     (228
Total $ 389,512   $ (1,576 $ 468,175   $ (2,202
Counterparty Buyer      
Credit Swaps Sold – Single Name:
Aaa $ 5,000   $ 21   $ 5,000   $ 49  
Aa   10,163,957     8,321     8,304,867     35,922  
A   2,058,103     5,455     2,234,861     12,489  
Total $ 12,227,060   $ 13,797   $ 10,544,728   $ 48,460  
Credit Swaps Sold – Tranche:
Aa $ 50,000   $ 467   $   $  
Total $ 50,000   $ 467   $   $  
Counterparty Seller
Credit Swaps Purchased:
Aa $ 301,350   $ (1,213 $ 387,858   $ (1,699
A   88,162     (363   80,317     (503
Total $ 389,512   $ (1,576 $ 468,175   $ (2,202

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Primus Guaranty, Ltd.
Notes to Consolidated Financial Statements
June 30, 2005


  June 30,
2005
December 31,
2004
S&P Rating Category Notional
Amount
Fair
Value
Notional
Amount
Fair
Value
Reference Entity
Credit Swaps Sold − Single Name:
    AAA $ 640,540   $ 448   $ 627,725   $ 822  
    AA   1,962,182     2,388     1,826,628     4,462  
    A   5,651,273     15,532     4,863,204     25,569  
    BBB   3,844,011     2,889     3,217,171     17,536  
    BB   123,000     (6,555   10,000     71  
    B   6,054     (905        
Total $ 12,227,060   $ 13,797   $ 10,544,728   $ 48,460  
Credit Swaps Sold − Tranche:
    AA $ 50,000   $ 467   $   $  
Total $ 50,000   $ 467   $   $  
Credit Swaps Purchased:
    AAA $ 44,216   $ (185 $ 57,090   $ (198
    AA   24,216     (61   27,090     (109
    A   213,702     (759   216,270     (940
    BBB   95,270     (446   167,725     (955
    N/R   12,108     (125        
Total $ 389,512   $ (1,576 $ 468,175   $ (2,202
Counterparty Buyer
Credit Swaps Sold − Single Name:
    AAA $ 29,216   $ (303 $ 5,000   $ 49  
    AA   8,224,179     6,123     6,643,559     27,941  
    A   3,973,665     7,977     3,896,169     20,470  
Total $ 12,227,060   $ 13,797   $ 10,544,728   $ 48,460  
Credit Swaps Sold − Tranche:
    AA $ 50,000   $ 467   $   $  
Total $ 50,000   $ 467   $   $  
Counterparty Seller
Credit Swaps Purchased:
    AA $ 247,134   $ (1,219 $ 290,768   $ (1,433
    A   142,378     (357   177,407     (769
Total $ 389,512   $ (1,576 $ 468,175   $ (2,202

Primus Financial's operating guidelines impose various limits on the geographical concentration of its business based on the country of domicile of each Reference Entity. Additionally, Primus Financial's counterparties are global financial institutions, and nearly all have entered into Master Agreements with Primus Financial that consolidate the counterparty risk to one office of that counterparty.

15




Primus Guaranty, Ltd.
Notes to Consolidated Financial Statements
June 30, 2005

The table below shows the geographical distribution of Primus Guaranty's credit swap portfolio by domicile of the Reference Entity and domicile of the counterparty (in thousands and U.S. dollar equivalent):


  June 30,
2005
December 31,
2004
Country of Domicile Notional
Amount
Fair
Value
Notional
Amount
Fair
Value
Credit Swaps Sold – Single Name
By Reference Entity:
    North America $ 7,259,770   $ 2,652   $ 5,798,363   $ 28,926  
    Europe   4,478,290     10,445     4,367,365     17,733  
    Pacific   365,000     708     305,000     1,421  
    Others   124,000     (8   74,000     380  
Total $ 12,227,060   $ 13,797   $ 10,544,728   $ 48,460  
By Counterparty:
    North America $ 6,687,777   $ 4,899   $ 5,596,849   $ 23,146  
    Europe   5,482,283     8,808     4,885,879     25,110  
    Others   57,000     90     62,000     204  
Total $ 12,227,060   $ 13,797   $ 10,544,728   $ 48,460  
Credit Swaps Sold – Tranche      
By Counterparty:
    U.S. $ 50,000   $ 467   $   $  
Total $ 50,000   $ 467   $   $  
Credit Swaps Purchased
By Reference Entity:
    North America $ 220,000   $ (844 $ 265,000   $ (1,282
    Europe   169,512     (732   203,175     (920
Total $ 389,512   $ (1,576 $ 468,175   $ (2,202
By Counterparty:
    North America $ 171,324   $ (572 $ 215,635   $ (935
    Europe   198,188     (915   232,540     (1,110
    Others   20,000     (89   20,000     (157
Total $ 389,512   $ (1,576 $ 468,175   $ (2,202

Notional amount and fair value is not broken out by country for the tranche sold, as it is not applicable.

16




Primus Guaranty, Ltd.
Notes to Consolidated Financial Statements
June 30, 2005

The table below shows the distribution of Primus Guaranty's credit swap portfolio by year of maturity as of June 30, 2005 and December 31, 2004 (in thousands and U.S. dollar equivalent):


  June 30, 2005 December 31, 2004
Country of Domicile Notional
Amount
Fair Value
of
Transaction
Notional
Amount
Fair Value
of
Transaction
Credit Swaps Sold – Single Name
Year of Maturity
    2005 $ 1,745,638   $ 908   $ 2,841,441   $ 3,859  
    2006   998,562     992     1,014,554     1,340  
    2007   2,512,296     14,750     2,583,503     20,442  
    2008   1,123,383     7,673     1,184,157     11,427  
    2009   2,741,492     (1,385   2,901,073     11,423  
    2010   3,105,689     (9,141   20,000     (31
Total $ 12,227,060   $ 13,797   $ 10,544,728   $ 48,460  
Credit Swaps Sold – Tranche
Year of Maturity $ 50,000   $ 467   $   $  
    2010 $ 50,000   $ 467   $   $  
Credit Swaps Purchased
Year of Maturity
    2007 $ 10,000   $ (47 $ 10,000   $ (43
    2008   15,000     74     15,000     (21
    2009   344,512     (1,605   443,175     (2,138
    2010   20,000     2          
Total $ 389,512   $ (1,576 $ 468,175   $ (2,202

6.    Long Term Debt of Subsidiary

Primus Financial issued $75.0 million of subordinated deferrable interest notes on July 23, 2004 that mature in July 2034. The notes are subordinated in right of payment to the prior payment in full of all existing and future senior indebtedness of the company, including counterparty claims. The rate on the notes is set through a monthly auction process, although the Company has the option to fix the rate for longer periods of time. The notes are redeemable at the option of Primus Financial, in whole or in part, on any auction date, at a redemption price equal to 100% of the principal amount of the notes to be redeemed, plus any accrued and unpaid interest thereon to the redemption date. The interest rate on the notes was fixed on the issue date at a rate of 2.57% (LIBOR plus 20 basis points) for a period of one year, expiring in July of 2005, at which point the rate will be set through a monthly auction process. The Company incurred interest expense (excluding amortization of debt issuance costs) of $487 and $969 thousand on these subordinated notes for the three and six months ended June 30, 2005, respectively.

Costs associated with the issuance of this debt were approximately $1.2 million and are shown net of accumulated amortization in the Company's consolidated statement of financial condition as debt issuance costs, and amortized over the life of the debt. Amortization of debt issuance costs is included in interest expense in the Company's consolidated statement of operations.

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Primus Guaranty, Ltd.
Notes to Consolidated Financial Statements
June 30, 2005

7.    Earnings per Share

Basic earnings per share ("EPS") is calculated by dividing earnings available to common stockholders by the weighted average number of common shares outstanding. Diluted EPS is similar to basic EPS, but adjusts for the effect of the potential issuance of common shares. The following table presents the computations of basic and diluted EPS:


  Three months ended
June 30,
Six months ended
June 30,
  2005 2004 2005 2004
Net earnings (loss) available to common stockholders $ (9,180 $ 174   $ (23,034 $ (8,088
Weighted-average basic shares outstanding   43,108     3,527     43,160     3,353  
Effect of dilutive instruments
Series A Preferred Stock       29,953            (a) 
Employee stock options      (a)    91        (a)       (a) 
Restricted share units      (a)    426        (a)       (a) 
Warrants      (a)    771        (a)       (a) 
Dilutive potential shares       31,241          
Diluted shares   43,108     34,768     43,160     3,353  
Basic EPS $ (0.21 $ 0.05   $ (0.53 $ (2.41
Diluted EPS $ (0.21 $ 0.01   $ (0.53 $ (2.41
(a) Securities (including those issuable pursuant to contingent stock agreements) that could potentially dilute basic EPS were not included in the computation of diluted EPS because to do so would have been anti-dilutive for the periods presented. In 2005, employee stock options totaling 157,545 and 195,069 shares, restricted share units equal to 396,883 and 415,601 shares and warrants representing 868,835 and 898,025 shares of common stock were excluded, for the three and six months ended June 30, 2005, respectively. For the six months ended June 30, 2004, Series A Preferred Stock which converted to 29,953 thousand shares, employee stock options totaling 531,875 shares, restricted share units equaling 728,315 shares and warrants representing 2,476 thousand shares of common stock were excluded.

8.    Stock Based Compensation

For the six months ended June 30, 2005, the company retired common shares in an amount equal to approximately $2.4 million, representing the amount withheld to pay employee income taxes due upon the delivery of common shares to its employees. In addition, for the three and six months ended June 30, 2005, approximately 36 thousand and 40 thousand options were exercised, respectively.

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Item 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following is a discussion and analysis of our financial condition and results of operations. This discussion should be read in conjunction with our consolidated financial statements and accompanying notes which appear in the Company's Annual Report on Form 10-K. It contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and in the Company's Annual Report on Form 10-K, particularly under the headings "Risk Factors" and "Cautionary Note Regarding Forward-Looking Statements."

Business Overview

We, through our principal operating subsidiary, Primus Financial, are primarily engaged in selling credit protection against investment grade credit obligations of corporate and sovereign entities. In exchange for a fixed quarterly premium, if a bankruptcy, failure to pay or restructuring occurs with respect to a Reference Entity upon which Primus Financial has sold credit protection, Primus Financial agrees to pay the notional amount of the credit swap contract to its Counterparty in exchange for delivery of a credit obligation of that Reference Entity. We seek to minimize the risk inherent in our credit swap portfolio by maintaining a high quality, highly diversified credit swap portfolio across Reference Entities, industries and countries.

Primus Financial has the highest counterparty credit ratings offered by S&P (AAA) and Moody's (Aaa) and is managed by an experienced team of professionals who have expertise in credit analysis, investing, risk management and market analysis.

Primus Asset Management manages the credit swap portfolios of Primus Financial and third parties. For such services, Primus Asset Management receives a management fee.

Primus Re operates as a financial guarantee insurance company, and generates revenue by charging a higher insurance premium for protection sold than the premium it pays for the offsetting protection it purchases.

Critical Accounting Policies

Valuation of Credit Swaps

From the inception of our business, we have applied SFAS, 133, "Accounting for Derivative Instruments and Hedging Activities," which established accounting and reporting standards for derivative instruments. SFAS 133 requires recognition of all credit swaps on the balance sheet at fair value. The market credit swap premium levels used to determine fair value generally take into account the expectation of such events.

The fair value of the credit swaps depends on a number of factors, primarily the market level of credit swap premiums associated with individual Reference Entities and interest rates. Credit swaps are valued using market-standard pricing models which calculate the net present value of differences between future premiums on currently quoted market credit swaps and the contractual future credit swap premiums on contracts we have undertaken. Our pricing model has been internally developed but is benchmarked against a market-standard model. Generally, our model uses quoted market credit swap premium data on individual Reference Entities that we purchase from an independent pricing service. This service takes pricing information from a number of prominent brokers and dealers in the credit swap market across a range of standard maturities and restructuring terms, and creates average market credit swap premium quotes on specific Reference Entities.

We believe there are a variety of factors that may influence market credit swap premium levels. The principal factor is the market's view of the probability that a Reference Entity will default over the multi-year horizon typical for a credit swap contract. Those views in turn are influenced by the state of the economy, the outlook for corporate financial health in general as well as the outlook for

19




particular industries and companies. Additional factors include the magnitude of debt outstanding and debt paying capacity within those same industries and companies. One factor specific to the credit swap market is the capacity of credit swap market participants to sell credit swaps. If, for example, commercial banks are actively buying protection to manage their regulatory capital, this will tend, other factors being equal, to absorb the capacity of protection sellers and cause an increase in market credit swap premiums. Conversely, creation of special purpose vehicles that sell protection create additional protection seller capacity and, absent additional demand, can cause a decrease in market premiums. Absent rapid and steep changes, interest rates have, at most, a limited effect on market credit swap premium levels.

Financial Guarantees

We have undertaken a limited amount of financial guarantee business through our subsidiary, Primus Re. Financial guarantees are insurance contracts that contingently require the guarantor to make payments to the guaranteed party. Primus Re designs its guarantee contracts to qualify as non-derivatives in accordance with the scope exception under paragraph 10d of SFAS 133, as amended by SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities". We account for our financial guarantee contracts in accordance with SFAS No. 60, "Accounting and Reporting by Insurance Enterprises". This requires that premiums are deferred and recognized over the life of the contract and that losses are recorded in the period that they occur based on an estimate of the ultimate cost of losses incurred. Policy acquisition costs include only those expenses that relate primarily to, and vary with, premium production. No policy acquisition costs have been deferred by us as of June 30, 2005, as any such amounts have been immaterial. As of June 30, 2005, only three contracts had been written.

We do not actively offer financial guarantee insurance. Rather, it is an alternative we have available when a counterparty requests an insurance contract instead of a credit swap. Generally, a counterparty's choice of a financial guarantee insurance contract versus a credit swap is determined by economic terms available in the marketplace as well as regulatory and accounting considerations. Also, the purchaser of an insurance contract cannot submit a claim for payment unless it has an insurable loss, whereas the purchaser of a credit swap need not have actual exposure to the underlying risk.

Stock-Based Employee Compensation Plans

Prior to 2003, we followed Accounting Principles Board, or APB, No. 25, "Accounting for Stock Issued to Employees". In 2003, we adopted the fair value approach on a prospective basis for recording stock-based employee compensation in accordance with the fair value method prescribed in SFAS 123, "Accounting for Stock-Based Compensation", as amended by SFAS 148, "Accounting for Stock-Based Compensation—Transition and Disclosure". Under these rules, compensation expense is recognized based on the fair value of stock options, performance shares, restricted shares and restricted share units at the time of an award, adjusted and amortized over the related vesting period. The fair value of the stock options granted is determined through the use of a market-standard option-pricing model, which requires judgment as to appropriate volatility and interest rate factors. Prior to our IPO on September 30, 2004, in the absence of a public market for our common shares, management and the board of directors estimated the market value of our common shares for all options, restricted share units and share issuances based on valuation opinions from independent valuation consultants. After the IPO, the fair value used is the market value of our common shares at the grant date.

In December 2004, the FASB issued SFAS 123R, which replaces SFAS 123 and supersedes APB 25. SFAS 123R eliminates the choice of alternative accounting methods, and requires that all entities follow the fair value based method of SFAS 123. Public entities will be required to apply Statement 123R as of the first annual reporting period that begins after June 15, 2005. The adoption of SFAS 123R is not expected to have a significant impact on the Company's financial statements.

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Results of Operations

Overview

During early 2005, market premium levels on credit swaps were relatively unchanged from levels as of December 31, 2004. However, from March 2005 through the end of the second quarter, we observed significant increases in market premium levels, particularly in certain reference entity industry sectors, such as automobiles and insurance. As a result of the upward movements in market premium levels, the fair value of our credit swaps sold portfolio declined; this decline was partially offset by a slight reduction in unrealized losses on our portfolio of credit swaps purchased. During the second quarter we terminated a number of credit swaps sold in order to mitigate our credit risk, resulting in realized losses of approximately $2.9 million. In addition, we engaged in our first tranche transaction, whereby we sell credit protection referencing portfolios containing obligations of multiple reference entities. We recorded premium income, as well as an unrealized gain on the tranche sold during the second quarter of 2005.

Three months ended June 30, 2005 compared with three months ended June 30, 2004

We had net income (loss) of $(9.2) million and $174 thousand for the three months ended June 30, 2005 and 2004, respectively. The net loss for the quarter ended June 30, 2005 was primarily driven by the increase in unrealized losses caused by the depreciation in the value of the credit swap portfolio during the quarter, coupled with losses realized from the early termination of certain credit swaps and increased expenses as a result of our expanded operations. The results for the quarter ended June 30, 2005 and the quarter ended June 30, 2004, are discussed below.

Net Credit Swap Revenue (Loss)

Net credit swap revenue (loss) was $(3.6) million and $5.9 million for the three months ended June 30, 2005 and 2004, respectively. Net credit swap revenue (loss) includes:

•  Net premiums earned;
•  Net realized gains (losses) on credit swaps; and
•  Net unrealized gains (losses) on credit swaps.

The table below shows the component parts of net credit swap revenue for the three months ended June 30, 2005 and 2004:


($ in thousands) Three months ended
June 30,
  2005 2004
Net premiums earned $ 12,396   $ 10,249  
Net realized gains (losses) on credit swaps   (1,937   1,207  
Net unrealized losses on credit swaps   (14,038   (5,591
Total Net Credit Swap Revenue (Loss) $ (3,579 $ 5,865  

Net Premiums Earned

Net premiums earned were $12.4 million and $10.2 million for the three months ended June 30, 2005 and 2004, respectively. Net premiums earned include:

•  Premium income on credit swaps sold-single name;
•  Premium income on credit swaps sold-tranche;
•  Premium expense on credit swaps purchased as short-term investments; and
•  Premium expense on credit swaps purchased to offset credit risk on certain credit swaps sold.

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The increase in net premiums earned was primarily driven by the increase in the size of the credit swaps sold portfolio from the 2004 period, slightly offset by an increase in the premiums paid for credit swaps purchased for short-term investment purposes in the second quarter of 2005. The table below shows the component parts of net premiums earned for the three months ended June 30, 2005 and 2004.


($ in thousands) Three months ended
June 30,
  2005 2004
Premium income on credit swaps sold-single name $ 12,653   $ 10,398  
Premium income on credit swaps sold-tranche   96      
Premium expense on credit swaps purchased as short-term investments   (329   (126
Premium expense on credit swaps purchased to offset credit risk on certain swaps sold   (23   (23
Total Net Premiums Earned $ 12,397   $ 10,249  

Premium income on credit swaps sold-single name increased primarily as a result of the expansion in our credit swaps sold portfolio. The notional amounts outstanding of credit swaps sold were $12.2 billion and $8.6 billion at June 30, 2005 and 2004, respectively.

We began to sell protection in tranche format during the second quarter of 2005, whereby we sell credit swaps referencing portfolios containing obligations of multiple reference entities. Premium income from the tranche sold was $96 thousand for the second quarter of 2005, and the total notional amount outstanding was $50 million at June 30, 2005.

The premium expense on credit swaps purchased as short-term investments was $329 thousand and $126 thousand for the three months ended June 30, 2005 and 2004, respectively. The notional amounts outstanding on credit swaps purchased as short-term investments were $389.5 million and $217.1 million at June 30, 2005 and 2004, respectively.

The notional amounts of credit swaps that we had purchased to offset credit risk on certain credit swaps sold were $5.0 million and $5.0 million at June 30, 2005 and 2004.

Net Realized Gains (Losses) on Credit Swaps

Our business strategy is generally to hold swaps we sell until maturity. However, there are circumstances in which we may terminate a credit swap prior to maturity, either as a result of credit considerations or in order to realize gains. We cannot identify at the outset of any credit swap transaction whether the credit swap will be terminated or otherwise disposed of prior to its maturity. If the credit swaps we terminate are at attractive market values, we are able to realize gains. Terminating transactions also allows us to accelerate premium receipts and provides for additional growth capacity within our credit swap portfolio.

In certain circumstances we will terminate a credit swap at a realized loss. In general, we terminate credit swaps at a loss where we perceive that the credit quality of the underlying reference entity risk has deteriorated, and we wish to reduce or eliminate our exposure to the reference entity. We may also terminate a credit swap at a loss in order to create opportunity to rebalance our portfolio. We terminated $245.1 million and $70.0 million notional amount of credit swaps sold for the three months ended June 30, 2005 and 2004, respectively. Net realized gains (losses) from the early termination of credit swaps were $(1.9) million and $1.2 million for the three months ended June 30, 2005 and 2004, respectively. The net realized losses incurred during the second quarter of 2005 was primarily the result of our decision to mitigate our exposure to a limited number of reference entities, which had become the subject of leveraged buy-outs which increased the credit risk of those reference entities.

We realized gains of $470 thousand and $936 thousand for the three months ended June 30, 2005 and 2004, respectively. The decrease in realized gains is due to smaller gains on terminations that took

22




place in the 2005 period. We realized losses of $3.0 million and $1 thousand for the three months ended June 30, 2005, and 2004, respectively, of which $2.9 million was caused by the termination of credit swaps to mitigate our credit exposure.

Where we have purchased credit protection as a short-term investment, early termination of the credit swaps is a fundamental part of the business strategy. We terminated $83 million and $115 million notional amount of credit swaps purchased during the three months ended June 30, 2005 and 2004, respectively, realizing a net gain of $612 thousand and $272 thousand, respectively.

Net realized gains (losses) for the three months ended June 30, 2005 and 2004 are summarized below:


($ in thousands) Three months ended
June 30,
  2005 2004
Realized gains on terminated credit swaps sold – single name $ 470   $ 936  
Realized losses on terminated credit swaps sold – single name   (3,019   (1
Realized gains on terminated credit swaps purchased as short-term investments   635     304  
Realized losses on terminated credit swaps purchased as short-term investments   (23   (32
Total Net Realized Gains (Losses) on terminated credit swaps $ (1,937 $ 1,207  

Net Unrealized Gains (Losses) on Credit Swaps

Net unrealized losses on credit swaps were $14.0 million for the three months ended June 30, 2005 as compared with $5.6 million for the three months ended June 30, 2004. The increase in unrealized losses on credit swaps reflects the change in the fair value of our credit swap portfolio, and is partially due to the increase in market credit swap premium levels experienced during the quarters ended June 30, 2005 and 2004. In 2005, we also recorded unrealized losses on certain reference entities which were downgraded or were the subject of leveraged buy-outs during the period. The unrealized losses on credit swaps sold-single name, credit swaps sold-tranche and credit swaps purchased as short-term investments and for credit risk offset purposes for the three months ended June 30, 2005 and 2004 are summarized below:


($ in thousands) Three months ended
June 30,
  2005 2004
Net unrealized losses on credit swaps sold-single name   (14,765 $ (5,288
Net unrealized gains on credit swaps sold-tranche   467      
Net unrealized gains (losses) on credit swaps purchased as short-term investments   219     (313
Net unrealized gains on credit swaps purchased to offset credit risk on certain credit swaps sold   40     10  
Total Net Unrealized Losses on credit swaps $ (14,039 $ (5,591

Asset Management Fees

We commenced our third party asset management activity during the latter part of 2004. For the three months ended June 30, 2005, we recognized $49 thousand of asset management fees. Our asset management contracts also provide for contingent performance fees, none of which have been earned or accrued at June 30, 2005.

Interest Income on Investment Portfolio

We had interest income of approximately $2.8 million and $716 thousand for the three months ended June 30, 2005 and 2004, respectively. The increased interest income is attributable to higher

23




average invested balances subsequent to the July 2004 issuance of subordinated debt and the raising of additional equity through our IPO, coupled with higher yields in the cash equivalents and investment accounts as compared with the three month period ended June 30, 2004. Interest income for the second quarter has been adjusted to reflect a reduction of interest income attributable to the fourth quarter of 2004 (in the amount of $126,000) and the first quarter of 2005 (in the amount of $466,000), as the amortization of purchased premium on certain investment securities was not charged against interest income for such periods. The unrecorded amortization was not material to net income (loss) in either of the previous periods. Average yields on the cash equivalents and available-for-sale investments were 2.79% for the three month period ended June 30, 2005 (excluding the above adjustment) compared with 1.06% for the three month period ended June 30, 2004. The increase in average yields is primarily due to a general increase in market interest rates, coupled with an extension in the average duration of our investment portfolio in the second quarter of 2005. Our total cash, cash equivalents and available-for-sale securities were approximately $487.5 million and $276.0 million as of June 30, 2005 and 2004, respectively.

Foreign Currency Revaluation

We started selling Euro-denominated credit swaps in February 2003 and at June 30, 2005, Euro-denominated credit swaps comprise 26.9% of the notional amount of our credit swaps sold portfolio. The Euro had depreciated in value against the U.S. dollar by approximately 6.6% and 0.9 % during the second quarter of 2005 and 2004, respectively, and this depreciation resulted in a net loss of $955 thousand and $33 thousand for the three months ended June 30, 2005 and 2004, respectively.

Operating Expenses

Our operating expenses (excluding financing costs) were $5.9 million and $5.8 million for the three months ending June 30, 2005 and 2004, respectively, as summarized below:


($ in thousands) Three months ended
June 30,
  2005 2004
Employee compensation $ 3,406   $ 3,861  
Professional and legal fees   796     363  
Fixed asset depreciation and amortization   525     485  
Technology and data   398     364  
Other   853     761  
Total Operating Expenses $ 5,978   $ 5,834  
Number of full-time employees, at end of period   34     31  

The decrease in employee compensation over these periods was primarily due to the decrease in the accrual for performance bonuses and performance-related stock compensation. This decrease was offset by a slight increase in salaries expense, due to the increase in number of employees as the business expanded its operations. The increase in professional fees is related to the increased insurance expenses, and the increased costs associated with the requirements of being a public company. Other operating expenses include rent, bank fees and investment management fees, rating agency fees, brokerage expense, travel and entertainment, exchange fees and other administrative expenses. The increase in other operating expenses is partially due to an increase in bank fees and asset management fees, as our cash, cash equivalents and investment balances were higher during second quarter 2005 as compared with the 2004 period. This was partially offset by a decrease in brokerage fees, as we restricted our use of brokers during 2005. The remainder of the other operating expenses increased over the prior period primarily due to expanded operations and our status as a public Company.

Interest Expense and Preferred Distributions

For the three months ended June 30, 2005, we incurred $487 thousand of interest expense on the $75.0 million 30-year subordinated debt that was issued by Primus Financial in July 2004. The interest

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rate for the 30-year subordinated debt is fixed at 2.57% for a period of one year from the issuance date. Primus Financial also made net distributions of $1.1 million and $605 thousand during the three months ended June 30, 2005 and 2004, respectively, on the Primus Financial Cumulative Preferred Stock issued in December 2002. The average rates paid on these securities was 3.97% and 1.75% during the three months ended June 30, 2005 and 2004, respectively.

Income Taxes

Provision for income taxes was $9 thousand and $45 thousand for the three months ended June 30, 2005 and 2004, respectively. Primus Guaranty had a net deferred tax asset fully offset by a valuation allowance of $9.3 million and $5.9 million as of June 30, 2005 and 2004, respectively. The change in the deferred tax asset and valuation allowance resulted from Primus Asset Management's estimated net operating loss. As previously discussed, it is expected that only the income of Primus Asset Management and its subsidiary, Primus Re, are likely to be subject to United States federal and local income taxes. However, were Primus Bermuda to be subject to income tax, at a combined United States federal, New York State and New York City income tax rate of 46%, on its United States GAAP income, then its income tax expense (excluding interest and penalties) since inception, would have been approximately $40.6 million through June 30, 2005, and a benefit of approximately $3.6 million for the three months ended June 30, 2005. These figures assume that Primus Financial is not deemed to be making distributions to Primus Bermuda; such distributions would subject Primus Bermuda to an additional United States federal branch profits tax.

Six months ended June 30, 2005 compared with six months ended June 30, 2004

We had a net loss of $23.0 million and $8.1 million for the six months ended June 30, 2005 and 2004, respectively. The net loss in the 2005 period was primarily driven by the increase in unrealized losses caused by the depreciation in the value of our credit swap portfolio, coupled with losses realized from the early termination of credit swaps, and increased expenses as a result of our expanded operations and costs associated with being a public company.

Net Credit Swap Revenue (Loss)

Net credit swap revenue (loss) was $(11.8) million and $2.8 million for the six months ended June 30, 2005 and 2004, respectively. Net credit swap revenue (loss) includes:

•  Net premiums earned;
•  Net realized gains (losses) on credit swaps; and
•  Net unrealized gains (losses) on credit swaps.

The table below shows the component parts of net credit swap revenue (loss) for the six months ended June 30, 2005 and 2004:


($ in thousands) Six months ended
June 30,
  2005 2004
Net premiums earned $ 23,599   $ 20,114  
Net realized gains (losses) on credit swaps   (1,804   2,789  
Net unrealized losses on credit swaps   (33,572   (20,068
Total Net Credit Swap Revenue (Loss) $ (11,777 $ 2,835  

Net Premiums Earned

Net premiums earned were $23.6 million and $20.1 million for the six months ended June 30, 2005 and 2004, respectively. Net premiums earned include:

•  Premium income on credit swaps sold – single name;

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•  Premium income on credit swaps sold – tranche;
•  Premium expense on credit swaps purchased as short-term investments; and
•  Premium expense on credit swaps purchased to offset credit risk on certain credit swaps sold.

The increase in net premiums earned was primarily driven by the increase in the size of the credit swaps sold portfolio from the 2004 period, slightly offset by an increase in the premiums paid for credit swaps purchased for short-term investment purposes. The table below shows the component parts of net premiums earned for the six months ended June 30, 2005 and 2004.


($ in thousands) Six months ended
June 30,
  2005 2004
Premium income on credit swaps sold-single name $ 24,281   $ 20,408  
Premium income on credit swaps sold-tranche   96      
Premium expense on credit swaps purchased as short-term investments   (732   (248
Premium expense on credit swaps purchased to offset credit risk on certain swaps sold   (46   (46
Total Net Premiums Earned $ 23,599   $ 20,114  

Premium income on credit swaps sold-single name increased primarily as a result of the expansion in our credit swap portfolio. The notional amounts outstanding of credit swaps sold were $12.2 billion and $8.6 billion at June 30, 2005 and 2004, respectively.

We began to sell protection in tranche format during the second quarter of 2005, whereby we sell credit swaps referencing portfolios containing obligations of multiple reference entities. Premium income from the tranche sold was $96 thousand for the six months ended June 30, 2005, and the notional amount outstanding was $50 million at June 30, 2005.

The premium expense on credit swaps purchased as short-term investments was $732 thousand and $248 thousand for the six months ended June 30, 2005 and 2004, respectively. The notional amounts outstanding on credit swaps purchased as short-term investments were $389.5 million and $217.1 million at June 30, 2005 and 2004, respectively.

Net Realized Gains (Losses) on Credit Swaps

Our business strategy is generally to hold swaps we sell until maturity. However, there are circumstances in which we may terminate a credit swap prior to maturity, either as a result of credit considerations or in order to realize gains. We cannot identify at the outset of any credit swap transaction whether the credit swap will be terminated or otherwise disposed of prior to its maturity. If the credit swaps we terminate are at attractive market values, we are able to realize gains. Terminating transactions also allows us to accelerate premium receipts and provides for additional growth capacity within our credit swap portfolio.

In certain circumstances we will terminate a credit swap at a realized loss. In general, we terminate credit swaps at a loss where we perceive that the credit quality of the underlying reference entity risk has deteriorated, and we wish to reduce or eliminate our exposure to the reference entity. We may also terminate a credit swap at a loss in order to create opportunity to rebalance our exposure to a reference entity. We terminated $250.1 million and $224.3 million notional amount of credit swaps sold for the six months ended June 30, 2005 and 2004, respectively. Net realized gains/ (losses) on the early termination of credit swaps were $(1.8) million and $2.8 million for the six months ended June 30, 2005 and 2004, respectively. The net realized losses incurred during 2005 were primarily the result of our decision to mitigate our exposure to a limited number of reference entities, which had become the subject of leveraged buy-outs which increased the credit risk of those reference entities.

We realized gains of $589 thousand and $2.1 million for the six months ended June 30, 2005 and 2004, respectively. The decrease in realized gains is due to the smaller gains on terminations that took

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place in the 2005 period. We realized losses of $3.0 million for the six months ended June 30, 2005, of which $2.9 million was caused by the termination of credit swaps to mitigate our credit exposure, and $13 thousand for the six months ended June 30, 2004.

Where we have purchased credit protection as a short-term investment, early termination of the credit swaps is a fundamental part of the business strategy. We terminated $93.0 million and $189.0 million notional amount of credit swaps purchased during the six months ended June 30, 2005 and 2004, respectively, realizing a net gain of $626 thousand and $693 thousand, respectively.

Net realized gains (losses) for the six months ended June 30, 2005 and 2004 are summarized below:


($ in thousands) Six months ended
June 30,
  2005 2004
Realized gains on terminated credit swaps sold – single name $ 589   $ 2,109  
Realized losses on terminated credit swaps sold – single name   (3,019   (13
Realized gains on terminated credit swaps purchased as short-term investments   656     740  
Realized losses on terminated credit swaps purchased as short-term investments   (30   (47
Total Net Realized Gains (Losses) on terminated credit swaps $ (1,804 $ 2,789  

Net Unrealized Losses on Credit Swaps

Net unrealized losses on credit swaps were $33.6 million for the six months ended June 30, 2005 as compared with $20.1 million for the six months ended June 30, 2004. The change in unrealized losses on credit swaps reflects the change in the fair value of our credit swap portfolio, and the losses are partially due to the increase in market credit swap premium levels experienced during the six months ended June 30, 2005 and 2004. In 2005, we also recorded unrealized losses on certain reference entities which had become downgraded or were the subject of leveraged buy-outs during the period. The unrealized gains and losses on credit swaps sold-single name, credit swaps sold-tranche and credit swaps purchased as short-term investments and for credit risk offset purposes for the six months ended June 30, 2005 and 2004 are summarized below:


($ in thousands) Six months ended
June 30,
  2005 2004
Net unrealized losses on credit swaps sold – single name $ (34,728 $ (20,255
Net unrealized gains on credit swaps sold-tranche   467      
Net unrealized gains on credit swaps purchased
as short-term investments
  626     137  
Net unrealized gains on credit swaps purchased
to offset credit risk on certain credit swaps sold
  63     50  
Net Unrealized Losses on credit swaps $ (33,572 $ (20,068

Asset Management Fees

We commenced our third party asset management activity during the latter part of 2004. For the six months ended June 30, 2005, we recognized $91 thousand of asset management fees. Our asset management contracts also provide for contingent performance fees, none of which have been earned or accrued at June 30, 2005.

Interest Income on Investment Portfolio

We had interest income of $6.5 million and $1.4 million for the six months ended June 30, 2005 and 2004, respectively. The increased interest income is attributable to higher average invested

27




balances subsequent to the July 2004 issuance of subordinated debt and the raising of additional equity through our IPO, coupled with higher yields in the cash equivalents and investment accounts, as compared with the six month period ended June 30, 2004. Average yields on the cash equivalents and available-for-sale investments were 2.92% in the six months ended June 30, 2005 compared with 1.02 % in the six months ended June 30, 2004. This increase is primarily due to a general increase in market interest rates, coupled with an extension in the average duration of our investment portfolio during the second quarter of 2005. Our total cash, cash equivalents and available-for-sale investments were approximately $487.5 million and $276.0 million as of June 30, 2005 and 2004, respectively.

Foreign Currency Revaluation

We started selling Euro-denominated credit swaps in February 2003 and by June 30, 2004, Euro-denominated credit swaps comprised 26.9% of the notional amount of our credit swaps sold portfolio. The Euro had depreciated in value against the U.S. dollar by approximately 10.6 % and 3.0% during the first half of 2005 and 2004, respectively, and this depreciation resulted in a net loss of $1.5 million and $106 thousand for the six months ended June 30, 2005 and 2004, respectively.

Operating Expenses

Our operating expenses (excluding financing costs) were approximately $13.7 million and $11.2 million for the six months ending June 30, 2005 and 2004, respectively, as summarized below:


($ in thousands) Six months ended
June 30,
  2005 2004
Employee compensation $ 8,602   $ 7,284  
Professional and legal fees   1,750     778  
Fixed asset depreciation and amortization   1,041     959  
Technology and data   715     671  
Other   1,618     1,465  
Total Operating Expenses $ 13,726   $ 11,157  
Number of full-time employees, at end of period   34     31  

The increase in employee compensation over these periods was partially due to the increase in the number of employees as the business expanded its operations. In addition, in the first quarter of 2005 we accrued an additional expense of approximately $800 thousand for the accelerated compensation expenses and accelerated vesting of stock related to the departure of former employees. Professional and legal fees expense includes audit and tax advisor expenses, legal costs and insurance expenses. The increase in professional fees is related to increased costs associated with the requirements of being a public company. Other operating expenses include rent, bank fees and investment management fees, rating agency fees, brokerage expense, travel and entertainment, exchange fees and other administrative expenses. The increase in other operating expenses is partially due to an increase in bank fees and asset management fees, as our cash, cash equivalents and investment balances are higher than the 2004 period. This was partially offset by a decrease in brokerage fees, as we restricted our use of brokers during 2005. The remainder of the other operating expenses increased over the prior period primarily due to expanded operations and our status as a public company.

Interest Expense and Preferred Distributions

For the six months ended June 30, 2005, we incurred $969 thousand of interest expense on the $75.0 million 30-year subordinated debt that was issued by Primus Financial in July 2004. The interest rate for the 30-year subordinated debt is fixed at 2.57% for a period of one year from the issuance date. Primus Financial also made net distributions of $1.8 million and $1.1 million during the six months ended June 30, 2005 and 2004, respectively, on the Primus Financial Cumulative Preferred Stock issued in December 2002. The average rates paid on these securities was 3.46% and 1.75% during the six months ended June 30, 2005 and 2004, respectively.

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Income Taxes

Provision for income taxes was $45 thousand and $117 thousand for the six months ended June 30, 2005 and 2004, respectively. Primus Guaranty had a net deferred tax asset fully offset by a valuation allowance of $9.3 million and $5.9 million as of June 30, 2005 and 2004, respectively. The change in the deferred tax asset and valuation allowance resulted from Primus Asset Management's estimated net operating loss. As previously discussed, it is expected that only the income of Primus Asset Management and its subsidiary, Primus Re, are likely to be subject to United States federal and local income taxes. However, were Primus Bermuda to be subject to income tax, at a combined United States federal, New York State and New York City income tax rate of 46%, on its United States GAAP income, then its income tax expense (excluding interest and penalties) since inception, would have been approximately $40.6 million through June 30, 2005, and