- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
---------------------
FORM 10-K
<Table>
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934.
[ ] TRANSACTION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934.
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002
</Table>
COMMISSION FILE NUMBER 0-20766
---------------------
HCC INSURANCE HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
<Table>
DELAWARE 76-0336636
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
13403 NORTHWEST FREEWAY, 77040-6094
HOUSTON, TEXAS (Zip Code)
(Address of principal executive offices)
</Table>
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
(713) 690-7300
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
<Table>
<Caption>
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED:
------------------- ------------------------------------------
Common Stock, $1.00 Par Value New York Stock Exchange
</Table>
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: NONE
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 (the "Act") 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 if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K (sec.229.405 of this chapter) is not contained herein, and
will not be contained, to the best of Registrant's knowledge, in definitive
proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K. [ ]
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [ ]
The aggregate market value on June 28, 2002 (the last business day of the
Registrant's most recently completed second fiscal quarter), of the voting stock
held by non-affiliates of the Registrant was approximately $1.6 billion. For
purposes of the determination of the above stated amount, only directors and
executive officers are presumed to be affiliates, but neither the Registrant nor
any such person concede that they are affiliates of the Registrant.
The number of shares outstanding of the Registrant's Common Stock, $1.00
par value, as of March 14, 2003 was 62.7 million.
Documents incorporated by reference: Information called for in Part III of
this Form 10-K is incorporated by reference to the Registrant's definitive Proxy
Statement to be filed within 120 days of the close of the Registrant's fiscal
year in connection with the Registrant's annual meeting of shareholders.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
TABLE OF CONTENTS
HCC INSURANCE HOLDINGS, INC.
<Table>
<Caption>
PAGE
----
PART I.
Item 1. Business.................................................... 2
Item 2. Properties.................................................. 30
Item 3. Legal Proceedings........................................... 30
Item 4. Submission of Matters to a Vote of Security Holders......... 30
PART II.
Item 5. Market for the Registrant's Common Equity and Related
Stockholder Matters......................................... 31
Item 6. Selected Financial Data..................................... 31
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 33
Item 7A. Quantitative and Qualitative Disclosure About Market Risk... 50
Item 8. Financial Statements and Supplementary Data................. 51
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosures................................... 51
PART III.
Item 10. Directors and Executive Officers of the Registrant.......... 51
Item 11. Executive Compensation...................................... 51
Item 12. Security Ownership of Certain Beneficial Owners and
Management.................................................. 52
Item 13. Certain Relationships and Related Transactions.............. 52
Item 14. Controls and Procedures..................................... 52
PART IV.
Item 15. Exhibits, Financial Statement Schedules and Reports on Form
8-K......................................................... 53
Signatures ............................................................ 54
</Table>
This report on Form 10-K contains certain "forward-looking statements"
within the meaning of Section 27A of the Securities Act of 1933, and Section 21E
of the Securities Exchange Act of 1934, which are intended to be covered by the
safe harbors created by those laws. We have based these forward-looking
statements on our current expectations and projections about future events.
These forward-looking statements include information about possible or assumed
future results of our operations. All statements, other than statements of
historical facts, included or incorporated by reference in this report that
address activities, events or developments that we expect or anticipate may
occur in the future, including such things as future capital expenditures,
business strategy, competitive strengths, goals, growth of our business and
operations, plans and references to future successes may be considered
forward-looking statements. Also, when we use words such as "anticipate,"
"believe," "estimate," "expect," "intend," "plan," "probably" or similar
expressions, we are making forward-looking statements. Many risks and
uncertainties may impact the matters addressed in these forward-looking
statements.
Many possible events or factors could affect our future financial results
and performance. These could cause our results or performance to differ
materially from those we express in our forward-looking statements. Although we
believe that the assumptions underlying our forward-looking statements are
reasonable, any of these assumptions, and therefore also the forward-looking
statements based on these assumptions, could themselves prove to be inaccurate.
In light of the significant uncertainties inherent in the forward-looking
statements which are included in this report, our inclusion of this information
is not a representation by us or any other person that our objectives and plans
will be achieved.
Our forward-looking statements speak only as of the date made and we will
not update these forward-looking statements unless the securities laws require
us to do so. In light of these risks, uncertainties and assumptions, any
forward-looking events discussed in this report may not occur.
1
PART I
ITEM 1. BUSINESS
TERMINOLOGY
HCC Insurance Holdings, Inc. is a Delaware corporation, which was formed in
1991. Its predecessor corporation was formed in 1974. Our principal executive
offices are located at 13403 Northwest Freeway, Houston, Texas 77040 and our
telephone number is (713) 690-7300. We maintain an Internet web-site at
www.hcch.com. The reference to our Internet web-site address does not constitute
the incorporation by reference of the information contained at this site in this
report. We will make available, free of charge through publication on our
Internet web-site, a copy of our Annual Report on Form 10-K and quarterly
reports on Form 10-Q and any current reports on Form 8-K or amendments to those
reports, filed or furnished to the Securities and Exchange Commission as soon as
reasonably practicable after we have filed or furnished such materials with the
Securities and Exchange Commission.
As used in this report, unless otherwise required by the context, the terms
"we," "us" and "our" refer to HCC Insurance Holdings, Inc. and its consolidated
subsidiaries, and the term "HCC" refers only to HCC Insurance Holdings, Inc. All
trade names or trademarks appearing in this report are the property of their
respective holders.
RISK FACTORS
The following factors as well as other information contained in this report
should be considered.
IF WE CANNOT OBTAIN ADEQUATE REINSURANCE PROTECTION FOR THE RISKS WE HAVE
UNDERWRITTEN, WE WILL EITHER BE EXPOSED TO GREATER LOSSES FROM THESE RISKS OR WE
WILL REDUCE THE LEVEL OF BUSINESS WE UNDERWRITE, WHICH WILL REDUCE OUR REVENUES.
We purchase reinsurance for significant amounts of risk underwritten by our
insurance companies, especially catastrophe risks. We also purchase reinsurance
on risks underwritten by others which we reinsure through a retrocession
agreement. Market conditions beyond our control determine the availability and
cost of the reinsurance protection we purchase, which may affect the level of
our business and profitability. For instance, the natural attrition of
reinsurers who exit lines of business, or who curtail their writings, for
economic or other reasons, reduces the capacity of the reinsurance market,
causing rates to rise. In addition, the historical results of reinsurance
programs and the availability of capital also affect the availability of
reinsurance. Our reinsurance facilities are generally subject to annual renewal.
We cannot assure you that we can maintain our current reinsurance facilities or
that we can obtain other reinsurance facilities in adequate amounts and at
favorable rates. Further, we cannot determine what the effect of catastrophic
losses will have on the reinsurance market in general and on our ability to
obtain reinsurance in adequate amounts and at favorable rates in particular. If
we are unable to renew our expiring facilities or to obtain new reinsurance
facilities, either our net exposures would increase or, if we are unwilling to
bear an increase in net exposures, we would have to reduce the level of our
underwriting commitments, especially catastrophe exposed risks. Either of these
potential developments could have a material adverse effect on our business. The
lack of available reinsurance may also adversely affect our ability to generate
fee and commission income in our underwriting agency and reinsurance
intermediary operations. A reinsurance intermediary structures and arranges
reinsurance between insurers seeking to cede insurance risks and reinsurers
willing to assume such risks.
IF THE COMPANIES THAT PROVIDE OUR REINSURANCE DO NOT PAY ALL OF OUR CLAIMS, WE
COULD INCUR SEVERE LOSSES.
We purchase reinsurance by transferring, or ceding, part of the risk we
have assumed to a reinsurance company in exchange for part of the premium we
receive in connection with the risk. The part of the risk we retain for our own
account is known as the retention. Although reinsurance makes the reinsurer
liable to us to the extent the risk is transferred or ceded to the reinsurer, it
does not relieve us, the reinsured, of our full liability to our policyholders,
never the amount above our retention. Accordingly, we bear credit risk with
2
respect to our reinsurers. We cannot assure you that our reinsurers will pay all
of our reinsurance claims, or that they will pay our claims on a timely basis.
If we become liable for risks we have ceded to reinsurers or if our
reinsurers cease to meet their obligations to us, whether because they are in a
weakened position as a result of the incurred losses or otherwise, our financial
position, results of operations and cash flows could be materially adversely
affected.
IF WE ARE UNSUCCESSFUL IN COMPETING AGAINST LARGER OR MORE WELL-ESTABLISHED
BUSINESS RIVALS, OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION WILL BE
ADVERSELY AFFECTED.
In our specialty insurance operations, we compete in narrowly-defined niche
classes of business such as the insurance of private aircraft (aviation), and
employer sponsored, self-insured medical plans (medical stop-loss), as
distinguished from such general lines of business as automobile or homeowners
insurance. We compete with a large number of other companies in our selected
lines of business, including: American International Group and U.S. Aviation
Insurance Group (a subsidiary of Berkshire Hathaway, Inc.) in our aviation line
of business; SAFECO Corporation and Hartford Life, Inc. in our group life,
accident and health line of business; Underwriters at Lloyd's and ACE Limited in
our London market account line of business and The Chubb Corporation and
Travelers Property Casualty Corp. in our global financial products line of
business. We face competition both from specialty insurance companies,
underwriting agencies and intermediaries as well as from diversified financial
services companies that are significantly larger than we are and that have
significantly greater financial, marketing and other resources than we do. Some
of these competitors also have longer experience and more market recognition
than we do. In addition to competition in the operation of our business, we face
competition from a variety of sources in attracting and retaining qualified
employees.
We cannot assure you that we will maintain our current competitive position
in the markets in which we operate, or that we will be able to expand our
operations into new markets. If we fail to do so, our business could be
materially adversely affected.
BECAUSE WE ARE A PROPERTY AND CASUALTY INSURER, UNFORESEEN CATASTROPHIC LOSSES
MAY ADVERSELY AFFECT OUR RESULTS OF OPERATIONS, LIQUIDITY AND FINANCIAL
CONDITION.
Property and casualty insurers are subject to claims arising out of
catastrophes that may have a significant effect on their results of operations,
liquidity and financial condition. Catastrophic losses have had a significant
impact on our results. Catastrophes can be caused by various events, including
hurricanes, windstorms, earthquakes, hailstorms, explosions, severe winter
weather and fires and may include man-made events, such as the September 11,
2001 terrorist attack on the World Trade Center. The incidence, frequency and
severity of catastrophes are inherently unpredictable. The extent of losses from
a catastrophe is a function of both the total amount of insured exposure in the
area affected by the event and the severity of the event. Most catastrophes are
restricted to small geographic areas; however, hurricanes, earthquakes and
terrorist attacks may produce significant damage in large, heavily populated
areas. Catastrophes can cause losses in a variety of our property and casualty
lines, and most of our past catastrophe-related claims have resulted from
hurricanes and earthquakes; however, as a result of the September 11, 2001
terrorist attack, we experienced the largest single loss to our insurance
company operations in our history. Insurance companies are not permitted to
reserve for a catastrophe until it has occurred. In 2003, we estimate that
approximately 10% of our current business may be affected by catastrophes. It is
therefore possible that a catastrophic event or multiple catastrophic events
could have material adverse effect upon our results of operations, liquidity and
financial condition.
BECAUSE WE OPERATE INTERNATIONALLY, FLUCTUATIONS IN CURRENCY EXCHANGE RATES MAY
AFFECT OUR RECEIVABLE AND PAYABLE BALANCES AND OUR RESERVES, WHICH MAY ADVERSELY
AFFECT OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION.
We underwrite insurance coverages which are denominated in a number of
foreign currencies, and we establish and maintain our loss reserves with respect
to these policies in their respective currencies. Our net earnings could be
adversely affected by exchange rate fluctuations, which would adversely affect
receivable and payable balances and reserves. Our principal area of exposure
relates to fluctuations in exchange rates
3
between the major European currencies (particularly the British pound sterling
and the Euro) and the U.S. dollar. Consequently, a change in the exchange rate
between the U.S. dollar and the British pound sterling or the Euro could have an
adverse effect on our net earnings.
On a limited basis, we enter into foreign currency forward contracts as a
hedge against foreign currency fluctuations. The foreign currency forward
contracts are used to convert U.S. dollars at a known rate in an amount that
approximates or is less than monthly British pound sterling expenses of certain
of our London operations. Thus, the effect of these transactions is to limit the
foreign currency exchange risk of the recurring monthly expenses. We use these
foreign currency forward contracts strictly as a cash flow hedge against
existing exposure to foreign currency fluctuations rather than as a form of
speculative or trading investment.
IF WE FAIL TO COMPLY WITH EXTENSIVE STATE, FEDERAL AND FOREIGN REGULATIONS, WE
WILL BE SUBJECT TO PENALTIES, WHICH MAY INCLUDE FINES AND SUSPENSION AND WHICH
MAY ADVERSELY AFFECT OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION.
We are subject to extensive governmental regulation and supervision. Most
insurance regulations are designed to protect the interests of policyholders
rather than shareholders and other investors. This regulation, generally
administered by a department of insurance in each state in which we do business,
relates to, among other things:
- approval of policy forms and premium rates;
- standards of solvency, including risk-based capital measurements (which
are a measure developed by the National Association of Insurance
Commissioners and used by state insurance regulators to identify
insurance companies that potentially are inadequately capitalized);
- licensing of insurers and their agents;
- restrictions on the nature, quality and concentration of investments;
- restrictions on the ability of our insurance companies to pay dividends
to us;
- restrictions on transactions between insurance companies and their
affiliates;
- restrictions on the size of risks insurable under a single policy;
- requiring deposits for the benefit of policyholders;
- requiring certain methods of accounting;
- periodic examinations of our operations and finances;
- prescribing the form and content of records of financial condition
required to be filed; and
- requiring reserves for unearned premium, losses and other purposes.
State insurance departments also conduct periodic examinations of the
affairs of insurance companies and require the filing of annual and other
reports relating to the financial condition of insurance companies, holding
company issues and other matters.
Recently adopted federal financial services modernization legislation is
expected to lead to additional federal regulation of the insurance industry in
the coming years. Also, foreign governments regulate our international
operations. Our business depends on compliance with applicable laws and
regulations and our ability to maintain valid licenses and approvals for our
operations.
Some regulatory authorities have relatively broad discretion to grant,
renew, or revoke licenses and approvals. Regulatory authorities may deny or
revoke licenses for various reasons, including the violation of regulations. In
some instances, we follow practices based on our interpretations of regulations,
or those that we believe to be generally followed by the industry, which may be
different from the requirements or interpretations of regulatory authorities. If
we do not have the requisite licenses and approvals and do not comply with
applicable regulatory requirements, the insurance regulatory authorities could
preclude or temporarily suspend us from carrying on some or all of our
activities or otherwise penalize us. That type of
4
action could have a material adverse effect on our business. Also, changes in
the level of regulation of the insurance industry (whether federal, state or
foreign), or changes in laws or regulations themselves or interpretations by
regulatory authorities, could have a material adverse effect on our business.
IF THE RATING AGENCIES DOWNGRADE OUR COMPANY OR OUR INSURANCE COMPANIES, OUR
RESULTS OF OPERATIONS AND COMPETITIVE POSITION IN THE INDUSTRY MAY SUFFER.
Ratings have become an increasingly important factor in establishing the
competitive position of insurance companies. Our insurance companies are rated
by A.M. Best Company, Inc. and Standard & Poor's Corporation. A.M. Best Company,
Inc. and Standard & Poor's Corporation ratings reflect their opinions of an
insurance company's and insurance holding company's financial strength,
operating performance, strategic position, and ability to meet its obligations
to policyholders, and are not evaluations directed to investors. Our ratings are
subject to periodic review by A.M. Best Company, Inc. and Standard & Poor's
Corporation and the continued retention of those ratings cannot be assured. If
our ratings are reduced from their current levels by A.M. Best Company, Inc.
and/or Standard & Poor's Corporation, our results of operations could be
adversely affected.
OUR LOSS RESERVES ARE BASED ON AN ESTIMATE OF OUR FUTURE LIABILITY. IF ACTUAL
CLAIMS PROVE TO BE GREATER THAN OUR RESERVES, OUR RESULTS OF OPERATIONS AND
FINANCIAL CONDITION MAY BE ADVERSELY AFFECTED.
We maintain loss reserves to cover our estimated liability for unpaid
losses and loss adjustment expenses, including legal and other fees as well as a
portion of our general expenses, for reported and unreported claims incurred as
of the end of each accounting period. Reserves do not represent an exact
calculation of liability. Rather, reserves represent an estimate of what we
expect the ultimate settlement and administration of claims will cost. These
estimates, which generally involve actuarial projections, are based on our
assessment of facts and circumstances then known, as well as estimates of future
trends in claims severity, frequency, judicial theories of liability and other
factors. These variables are affected by both internal and external events, such
as changes in claims handling procedures, inflation, judicial trends and
legislative changes. Many of these items are not directly quantifiable in
advance. Additionally, there may be a significant reporting lag between the
occurrence of the insured event and the time it is reported to us. The inherent
uncertainties of estimating reserves are greater for certain types of
liabilities, particularly those in which the various considerations affecting
the type of claim are subject to change and in which long periods of time may
elapse before a definitive determination of liability is made. Reserve estimates
are continually refined in a regular and ongoing process as experience develops
and further claims are reported and settled. Adjustments to reserves are
reflected in the results of the periods in which such estimates are changed.
Because setting reserves is inherently uncertain, there can be no assurance that
current reserves will prove adequate in light of subsequent events.
WE INVEST A SIGNIFICANT AMOUNT OF OUR ASSETS IN FIXED INCOME SECURITIES THAT
HAVE EXPERIENCED MARKET FLUCTUATIONS. FLUCTUATIONS IN THE FAIR MARKET VALUE OF
FIXED INCOME SECURITIES MAY GREATLY REDUCE THE VALUE OF OUR INVESTMENT
PORTFOLIO, AND AS A RESULT, OUR FINANCIAL CONDITION MAY SUFFER.
As of December 31, 2002, $841.5 million of our $1.2 billion investment
portfolio was invested in fixed income securities. The fair market value of
these fixed income securities and the related investment income fluctuate
depending on general economic and market conditions. With respect to our
investments in fixed income securities, the fair market value of these
investments generally increases or decreases in an inverse relationship with
fluctuations in interest rates, while net investment income realized by us from
future investments in fixed income securities will generally increase or
decrease with interest rates. In addition, actual net investment income and/or
cash flows from investments that carry prepayment risk (such as mortgage-backed
and other asset-backed securities) may differ from those anticipated at the time
of investment as a result of interest rate fluctuations. An investment has
prepayment risk when there is a risk that the timing of cash flows that result
from the repayment of principal might occur earlier than anticipated because of
declining interest rates or later than anticipated because of rising interest
rates. Although we maintain an investment grade portfolio (96% are rated "A" or
better), our fixed income securities are also subject to credit risk. If any of
the issuers of our fixed income securities suffer financial set backs, the
ratings on the fixed income securities could fall (with a concurrent fall in
market value) and, in a worst case scenario, the issuer
5
could default on its financial obligations. Historically, the impact of market
fluctuations has affected our financial statements. Because all of our fixed
income securities are classified as available for sale, changes in the fair
market value of our securities are reflected in our other comprehensive income.
Similar treatment is not available for liabilities. Therefore, interest rate
fluctuations could adversely affect our shareholders' equity, total
comprehensive income and/or our cash flows. Unrealized pre-tax net investment
gains on investments in fixed-income securities were $22.0 million, $0.7 million
and $11.9 million for the years ended December 31, 2002, 2001 and 2000,
respectively.
IF STATES DRASTICALLY INCREASE THE ASSESSMENT OUR INSURANCE COMPANIES ARE
REQUIRED TO PAY, OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION WILL SUFFER.
Our insurance companies are subject to assessments in most states where we
are licensed for the provision of funds necessary for the settlement of covered
claims under certain policies provided by impaired, insolvent or failed
insurance companies or for the issuance of insurance policies to "high risk" or
otherwise uninsured individuals. Maximum contributions required by law in any
one year vary by state and have historically been between 1% and 2% of annual
premiums written. We cannot predict with certainty the amount of future
assessments. Significant assessments could have a material adverse effect on our
financial condition or results of operations.
IF WE ARE UNABLE TO OBTAIN DIVIDENDS IN NEEDED AMOUNTS FROM OUR INSURANCE
COMPANIES AS A RESULT OF REGULATORY RESTRICTIONS, WE MAY NOT BE ABLE TO MEET OUR
DEBT, DIVIDEND, AND EXPENSE OBLIGATIONS.
Our principal assets are the shares of capital stock of our insurance
companies. We may rely on dividends from our insurance companies to meet our
obligations for paying principal and interest on outstanding debt obligations,
dividends to shareholders and corporate expenses. The payment of dividends by
our insurance companies is subject to regulatory restrictions and will depend on
the surplus and future earnings of these subsidiaries, as well as the regulatory
restrictions. As a result, should our other sources of funds prove to be
inadequate, we may not be able to receive dividends from our insurance companies
at times and in amounts necessary to meet our obligations.
BUSINESS OVERVIEW
We provide group life, accident and health and property and casualty
insurance coverages, underwriting agency and intermediary services both to
commercial customers and individuals. We concentrate our activities in selected
narrowly defined specialty lines of business. We operate primarily in the United
States, the United Kingdom and Spain, although some of our operations have a
broader international scope. We underwrite insurance both on a direct basis,
where we insure a risk in exchange for a premium, and on a reinsurance basis,
where we insure all or a portion of another insurance company's risk in exchange
for all or a portion of the premium. We market our insurance products both
directly to customers and through a network of independent or affiliated agents
and brokers.
Since our founding, we have been consistently profitable, generally
reporting annual increases in gross written premium and total revenue. During
the period 1998 through 2001, we had an average statutory combined ratio of
103.2% versus the less favorable 109.8% (source: A.M. Best Company, Inc.)
recorded by the U.S. property and casualty insurance industry overall. During
the period 1998 through 2002, our gross written premium increased from $498.3
million to $1.2 billion, an increase of 133% while net written premium increased
348% from $121.9 million to $545.9 million. During this period, our revenue
increased from $310.4 million to $669.4 million, an increase of 116%.
During the period December 31, 1998 through December 31, 2002, our
shareholders' equity increased from $440.4 million to $882.9 million, a 100%
increase. During the same period, our assets increased from $1.7 billion to $3.7
billion, a 117% increase.
6
Our insurance companies are risk-bearing and focus their underwriting
activities on providing insurance and/or reinsurance in the following lines of
business:
- group life, accident and health
- aviation
- London market account
- global financial products
- other specialty lines
In the United States, Avemco Insurance Company, U.S. Specialty Insurance
Company and HCC Life Insurance Company operate on an admitted, or licensed,
basis. Houston Casualty Company and HCC Specialty Insurance Company operate on a
surplus lines basis as a non-admitted, or unlicensed, insurer offering insurance
coverage not otherwise available from an admitted insurer in the relevant state.
Houston Casualty Company operates a registered branch office in London and
offers insurance in the United Kingdom and selected other countries. Houston
Casualty Company Europe Seguros y Reaseguros S.A., which does business as HCC
Europe, operates from its Madrid, Spain offices and offers insurance throughout
the European Union and in selected other countries.
Our operating insurance companies are rated "A+ (Superior)" (2nd of 16
ratings) by A.M. Best Company , Inc. and "AA (Very Strong)" (3rd of 22 ratings)
by Standard and Poor's Corporation, two nationally recognized independent rating
agencies. These ratings are intended to provide an independent opinion of an
insurer's ability to meet its obligations to policyholders and are not
evaluations directed at investors.
Our underwriting agencies underwrite on behalf of our insurance companies
and other insurance companies. They receive fees for these services and do not
bear any of the insurance risk of the companies for which they underwrite. Our
underwriting agencies generate revenues based entirely on management fees and
profit commissions and specialize in life, accident and health, contingency
(including contest indemnification, event cancellation, and weather coverages),
directors and officers liability, individual disability (for athletes and other
high profile individuals), kidnap and ransom, professional liability and other
specialty lines of business. Our principal underwriting agencies are ASU
International, LLC, Dickson Manchester & Company Limited, HCC Benefits
Corporation, HCC Global Financial Products and Professional Indemnity Agency,
Inc.
Our intermediaries provide insurance and reinsurance brokerage services for
our insurance companies and our clients, and receive fees for their services.
Our intermediaries do not bear any of the insurance risks of their client
companies. They earn commission income and to a lesser extent fees for certain
services, generally paid by the insurance and reinsurance companies with whom
the business is placed. These operations consist of consulting with clients by
providing information about insurance coverage and marketing, placing and
negotiating particular insurance risks.
Our intermediaries specialize in developing and marketing employee benefit
plans on a retail basis and in placing reinsurance for life, accident and
health, and property and casualty lines of business. Our principal
intermediaries are HCC Employee Benefits, Inc., HCC Risk Management, Inc. and
Rattner Mackenzie Limited.
OUR STRATEGY
Our business philosophy as an insurer is to maximize underwriting profits
while limiting risk in order to preserve shareholders' equity and maximize
earnings. We concentrate our insurance writings in selected, narrowly defined
lines of business where we believe we can achieve an underwriting profit. We
market our insurance products both directly to customers and through independent
or affiliated agents and brokers.
The property and casualty insurance industry and individual lines of
business within the industry are cyclical in that there are times when a large
number of companies offer insurance on certain lines of business,
7
causing premiums to trend downward, and other times where insurance companies
decide to limit their writings in certain lines of business or suffer from
excessive losses, which results in an increase in premiums for those companies
that continue to write insurance in those lines of business. In our insurance
company operations, we believe our operational flexibility, which permits us to
shift the focus of our insurance underwriting activity amongst our various lines
of business and also to shift the emphasis from our insurance risk-bearing
business to our non-insurance fee-based business, as well as our experienced
underwriting personnel and access to, and expertise in, the reinsurance
marketplace allow us to implement a strategy of emphasizing more profitable
lines of business during periods of increased premium rates and de-emphasizing
less profitable lines of business during periods of severe competition. In
addition, we believe that our underwriting agencies and intermediaries
complement our insurance underwriting activities. Our ability to utilize
affiliated insurers, underwriting agencies and intermediaries permits us to
retain a greater portion of the gross revenue derived from written premium.
Reinsurance enables us to transfer part of the risk we have underwritten
through the process of ceding this risk to a reinsurance company in exchange for
part of the premium we receive in connection with the risk. We purchase
reinsurance to limit the net loss to our insurance companies from both
individual and catastrophic risks. The amount of reinsurance we purchase varies
by, among other things, the particular risks inherent in the policies
underwritten, the pricing of reinsurance and the competitive conditions within
the relevant line of business.
In 2002, due to a continuing hardening of the insurance market, premium
rates increased in varying amounts across all of our lines of business,
substantially improving our underwriting profitability. We anticipate continued
underwriting profitability during 2003. In response to these changing market
conditions, we plan to continue to expand the underwriting activities in our
insurance company operations.
We also acquire or make strategic investments in companies that present an
opportunity for future profits or for enhancement of our business. We expect to
continue to acquire complementary businesses. We believe that we can enhance
acquired businesses through the synergies created by our underwriting
capabilities and our other operations. However, our business plan is shaped by
our underlying business philosophy, which is to maximize underwriting profit,
while preserving shareholders' equity. As a result, our primary objective is to
increase net earnings rather than market share or gross written premium.
In our ongoing operations, we will continue to:
- emphasize the underwriting of lines of business in which premium rates,
the availability and cost of reinsurance, and market conditions warrant;
- limit our net loss exposure to our insurance companies from a catastrophe
loss through the use of reinsurance; and
- review the potential acquisition of specialty insurance operations and
other strategic investments.
INDUSTRY SEGMENT INFORMATION
Financial information concerning our operations by industry segment is set
forth in the Consolidated Financial Statements and the Notes thereto.
RECENT ACQUISITIONS
We have made a series of strategic acquisitions that have furthered our
overall business strategy. Our recent transactions are described below:
On October 22, 2001, we acquired all of the outstanding shares of Marshall
Rattner, Inc. Marshall Rattner, Inc. is a holding company for Professional
Indemnity Agency, Inc. and its related companies. We paid $63.0 million in cash
and 300,000 shares of our common stock for the Marshall Rattner, Inc./
Professional Indemnity Agency, Inc. acquisition. Professional Indemnity Agency,
Inc. is an underwriting agency specializing in the errors and omissions, kidnap
and ransom and professional liability areas.
8
On October 30, 2001, we acquired all of the outstanding shares of ASU
International, Inc. and the membership interests in its affiliate, ASU
International, LLC. We paid $29.2 million for the ASU International, LLC
acquisition. ASU International, LLC is an underwriting agency specializing in
contingency and disability insurance. We may pay additional amounts in the
future based upon the attainment of certain earnings benchmarks through December
31, 2004.
On October 1, 2002, we acquired all of the outstanding member interests of
MAG Global Financial Products, LLC. We paid $6.9 million for the MAG Global
Financial Products, LLC acquisition. MAG Global Financial Products, LLC is an
underwriting agency specializing in directors and officers liability,
professional liability and errors and omissions insurance. MAG Global Financial
Products, LLC has been renamed HCC Global Financial Products, LLC. We may pay
additional amounts in the future based upon the attainment of certain earnings
benchmarks through September, 2007.
On December 24, 2002, we acquired all of the outstanding shares of
Manchester Dickson Holdings Limited, the parent Company of Dickson Manchester &
Company Limited. We paid $17.0 million for the Dickson Manchester & Company
Limited acquisition. Dickson Manchester & Company Limited is an underwriting
agency and Lloyd's broker specializing in U.K. professional liability products.
We may pay additional amounts in the future based upon the attainment of certain
earnings benchmarks through December 31, 2005.
On December 31, 2002, we acquired all of the outstanding shares of St. Paul
Holdings Limited. St. Paul Holdings Limited is a holding company for St. Paul
Espana Compania de Seguros y Reaseguros S.A., a Spanish insurer. We paid $18.9
million for the St. Paul acquisition, subject to adjustment based upon the
finalization of the closing date balance sheet. St. Paul Espana writes foreign
surety, directors and officers liability and professional liability insurance in
Spain and other countries in the European Union. St. Paul Espana now operates as
HCC Europe.
We continue to evaluate possible acquisition candidates and we may complete
additional acquisitions during 2003. Any future acquisitions will be designed to
expand and strengthen our existing lines of business and perhaps provide access
to additional specialty sectors, which we expect to contribute to our overall
growth.
9
INSURANCE COMPANY OPERATIONS
LINES OF BUSINESS
This table shows our insurance companies' total premium written, otherwise
known as gross written premium, by line of business and the percentage of each
line to total gross written premium for the years indicated (dollars in
thousands):
<Table>
<Caption>
2002 2001 2000
---------------- ---------------- --------------
Group life, accident and
health........................ $ 503,263 44% $ 502,086 49% $422,384 43%
Aviation........................ 212,518 18 198,015 20 191,089 20
London market account........... 199,816 17 133,579 13 83,521 9
Global financial products....... 178,653 15 46 -- -- --
Other specialty lines........... 32,563 3 15,556 2 15,906 2
---------- --- ---------- --- -------- ---
1,126,813 97 849,282 84 712,900 74
Discontinued lines of
business...................... 32,436 3 160,793 16 254,557 26
---------- --- ---------- --- -------- ---
Total gross written
premium.................. $1,159,249 100% $1,010,075 100% $967,457 100%
========== === ========== === ======== ===
</Table>
This table shows our insurance companies' actual premium retained,
otherwise known as net written premium, by line of business and the percentage
of each line to total net written premium for the years indicated (dollars in
thousands):
<Table>
<Caption>
2002 2001 2000
-------------- -------------- --------------
Group life, accident and health.... $244,554 45% $146,220 39% $109,005 38%
Aviation........................... 99,826 18 98,249 26 79,794 28
London market account.............. 113,925 21 54,056 15 22,292 8
Global financial products.......... 43,731 8 44 -- -- --
Other specialty lines.............. 25,621 5 14,346 4 14,552 5
-------- --- -------- --- -------- ---
527,657 97 312,915 84 225,643 79
Discontinued lines of business..... 18,254 3 60,043 16 58,145 21
-------- --- -------- --- -------- ---
Total net written premium..... $545,911 100% $372,958 100% $283,788 100%
======== === ======== === ======== ===
</Table>
UNDERWRITING
We underwrite direct business produced through independent agents and
brokers, affiliated intermediaries, and by direct marketing efforts. Our
insurance companies write facultative, or individual account, reinsurance, as
well as a treaty reinsurance business.
GROUP LIFE, ACCIDENT AND HEALTH
We write medical stop-loss business for employer-sponsored, self-insured
health plans. Our medical stop-loss insurance provides coverages to companies,
associations and public entities that elect to self-insure their employee's
medical coverage for losses within specified levels, allowing them to manage the
risk of excessive health insurance exposure by limiting aggregate and specific
losses to a predetermined amount. We also underwrite a small program of group
life insurance offered to our insureds as complement to our medical stop-loss
products. Our underwriting agency, HCC Benefits Corporation, produces and
underwrites this business on behalf of our insurance companies. We first began
writing this business in our insurance companies in 1997 and gross written
premium and net written premium have increased as a result of greater
participation by our insurance companies, primarily HCC Life Insurance Company
and Avemco Insurance Company. In 1999, we acquired The Centris Group, Inc.,
doubling our gross written premium to approximately $400.0 million. HCC Benefits
Corporation began underwriting this business in 1980 and has grown both
internally and through acquisitions during the past five years. We maintain
reinsurance on a proportional basis, where we share a
10
proportional part of the original premium and losses with reinsurers, and
believe that these risks carry a relatively low level of catastrophe exposure.
We began writing alternative workers' compensation and occupational
accident insurance in 1996. We transfer liability, premium and loss with respect
to this business on a non-proportional basis above our net retention to
reinsurers. The business is currently written through U.S. Specialty Insurance
Company. We maintain specific reinsurance on an excess of loss basis and we
believe there is a relatively low level of catastrophe exposure in this
business.
AVIATION
We are a market leader in the aviation insurance industry. We insure
general aviation risks, both domestically and internationally, including:
- antique and vintage military aircraft
- cargo operations
- commuter airlines
- corporate aircraft
- fixed base operations
- military and law enforcement aircraft
- private aircraft owners and pilots
- rotor wing aircraft
We offer coverages that include hulls, engines, avionics and other systems,
liabilities, war, cargo and other ancillary coverages. At this time, we do not
generally insure major airlines, major manufacturers or satellites. Insurance
claims related to general aviation business tend to be seasonal, with the
majority of the claims being incurred during the spring and summer months.
We have been underwriting aviation risks through Houston Casualty Company
since 1981 and in 1997 purchased Avemco Insurance Company, one of the largest
writers of personal aircraft insurance in the United States. Avemco Insurance
Company has been insuring aviation risks since 1959. Our aviation premium has
remained relatively stable since 1998, during which time it returned to
underwriting profitability. Our aviation gross written premium for 2002 was
$212.5 million.
We maintain reinsurance on both a proportional and excess of loss basis and
believe that the aviation risks we underwrite carry a relatively low level of
catastrophe exposures.
LONDON MARKET ACCOUNT
Our London market account business consists of marine, energy, property and
accident and health business and is underwritten by Houston Casualty Company's
London branch office.
We underwrite marine risks for oceangoing vessels as well as inland,
coastal trading and fishing vessels. The marine risks we write include hull,
liabilities and marine cargo.
We have underwritten marine risks on both a direct and reinsurance basis
since 1984, and currently write a relatively small book of business due to the
competitive state of the market. In 2002, our gross written premium was $8.8
million.
We have been underwriting energy risks since 1988, which include:
- drilling rigs
- natural gas facilities
- petrochemical plants
- pipelines
- gas production and gathering platforms
- refineries
We underwrite physical damage, liabilities and business interruption.
Rates have been relatively low during the past few years at levels where
underwriting profitability has been difficult to obtain. As a result, we have
underwritten offshore energy risks on a very selective basis, striving for
quality rather than quantity. During 2001 and 2002 we have seen rate increases
that are encouraging and we expect this trend to continue in 2003. In 2002,
gross written premium was $68.3 million.
11
We underwrite property business specializing in risks of large, often
multinational, corporations, covering a variety of commercial risks including:
- factories
- hotels
- industrial plants
- office buildings
- retail locations
- utilities
The insurance we offer includes business interruption, physical damage and
catastrophe risks including flood and earthquake.
We have written property business since 1986, and due to severe
competition, our gross written premium declined to $45.0 million in 2001 and
$40.8 million in 2002.
We began writing London market accident and health risks in 1996 including:
trip accident, medical and disability and have steadily increased premiums. Our
gross written premium was $81.9 million in 2002.
Our London market account business is reinsured both proportionally and on
an excess of loss basis where we transfer liability, premium and loss on a
non-proportional basis, for individual and catastrophe risks, above our net
retention of risk to reinsurers. Catastrophe exposure is more concentrated in
our energy and property lines of business.
GLOBAL FINANCIAL PRODUCTS
We underwrite a variety of financial insurance risks in our global
financial products line of business. These risks include:
- directors and officers liability
- employment practices liability
- errors and omissions
- surety
We began to underwrite this line of business with our acquisition of
Professional Indemnity Agency, Inc. in October, 2001 and have substantially
increased our level of business in this area through our October, 2002
acquisition of HCC Global Financial Products, LLC and December, 2002
acquisitions of Dickson Manchester & Company Limited and HCC Europe. Each of the
acquired entities has substantial experience in their respective specialty
within this line of business.
In 2002, we experienced substantial rate increases throughout this line of
business generally caused by high profile corporate governance issues in U.S.
public companies. Gross written premium rose dramatically to $178.6 million
compared to $46 thousand in 2001. We maintain reinsurance on our global
financial products line of business on both a proportional and excess of loss
basis. Although individual losses have potential severity, there is a relatively
low risk of catastrophe exposure.
OTHER SPECIALTY LINES
In addition to the above, we underwrite various other specialty lines of
business, of which individual premiums by line of business are not at this time
significant to our overall results of operations.
PRINCIPAL INSURANCE COMPANIES
Our operating insurance companies are rated "A+ (Superior)" (2nd of 16
ratings) by A.M. Best Company , Inc. and "AA (Very Strong)" (3rd of 22 ratings)
by Standard and Poor's Corporation, two nationally recognized independent rating
agencies. These ratings are intended to provide an independent opinion of an
insurer's ability to meet its obligations to policyholders and are not
evaluations directed at investors.
12
HOUSTON CASUALTY COMPANY
Houston Casualty Company is our principal insurance company subsidiary.
Houston Casualty Company operates worldwide and is domiciled and licensed in
Texas and operates on a surplus lines basis in 49 states. Houston Casualty
Company receives business through independent agents and brokers, our
underwriting agencies and intermediaries, and other insurance and reinsurance
companies. Houston Casualty Company writes aviation, London market account,
global financial products and other specialty lines business. Houston Casualty
Company's 2002 gross written premium was $490.2 million.
HOUSTON CASUALTY COMPANY -- LONDON
Houston Casualty Company operates a full branch office in the United
Kingdom. Houston Casualty Company established its London branch operation in
order to more closely align its underwriting operations with the London market,
a historical focal point for much of the business that Houston Casualty Company
underwrites. Houston Casualty Company-London underwrites global financial
products and London market account business.
HCC LIFE INSURANCE COMPANY
HCC Life Insurance Company is an Indiana-domiciled life insurance company
and a subsidiary of Houston Casualty Company. It operates as a group life,
accident and health insurer on an admitted basis in 41 states and the District
of Columbia. HCC Life Insurance Company is an issuing carrier for HCC Benefits
Corporation. HCC Life Insurance Company's gross written premium in 2002 was
$326.1 million.
U.S. SPECIALTY INSURANCE COMPANY
U.S. Specialty Insurance Company is a Texas-domiciled property and casualty
insurance company. It is a direct subsidiary of Houston Casualty Company. U.S.
Specialty Insurance Company operates on an admitted basis throughout the United
States, primarily writing aviation, group life, accident and health and global
financial products business. U.S. Specialty Insurance Company acts as an issuing
carrier for certain business underwritten by our underwriting agencies. U.S.
Specialty Insurance Company's gross written premium in 2002 was $143.9 million.
AVEMCO INSURANCE COMPANY
Avemco Insurance Company is a Maryland-domiciled property and casualty
insurer, and is operating as a direct market underwriter of aviation business on
an admitted basis throughout the United States. Avemco Insurance Company is also
an issuing carrier for group life, accident and health business underwritten by
our underwriting agencies and an unaffiliated underwriting agency. Avemco
Insurance Company's gross written premium in 2002 was $203.1 million.
HCC SPECIALTY INSURANCE COMPANY
HCC Specialty Insurance Company is an Oklahoma domiciled company. HCC
Specialty Insurance Company operates on a surplus lines basis in Texas and
writes global financial products and other specialty lines business produced by
our underwriting agencies. HCC Specialty Insurance Company's gross written
premium in 2002 was $1.7 million.
HCC EUROPE
HCC Europe was acquired on December 31, 2002. HCC Europe is a Spanish
insurer and underwrites global financial products business throughout the
European Union and in selected other countries. We also intend to utilize HCC
Europe as an issuing carrier for the business produced by our underwriting
agencies.
13
UNDERWRITING AGENCY OPERATIONS
Our underwriting agencies act on behalf of affiliated and non-affiliated
insurance companies and provide insurance underwriting management and claims
administration services. Our underwriting agencies do not assume any insurance
or reinsurance risk themselves and generate revenues based entirely on
management fees and profit commissions. These subsidiaries are in a position to
direct and control business that they produce. Our insurance companies serve as
policy issuing companies for the majority of the business written by our
underwriting agencies. In instances where our insurance companies are not the
policy issuing company, our insurance companies may reinsure the business
written by the underwriting agencies. Management fees generated by our
underwriting agencies in 2002 amounted to $77.1 million.
LINES OF BUSINESS
This table shows our underwriting agencies' revenue by line of business for
the years indicated (dollars in thousands):
<Table>
<Caption>
2002 2001 2000
------------- ------------- -------------
Life, accident and health............. $44,615 58% $47,857 77% $70,536 73%
Property and casualty................. 32,467 42 13,938 23 25,522 27
------- --- ------- --- ------- ---
Total management fees....... $77,082 100% $61,795 100% $96,058 100%
======= === ======= === ======= ===
</Table>
HCC BENEFITS CORPORATION
HCC Benefits Corporation has its home office in Atlanta, Georgia and
regional offices in Costa Mesa, California; Wakefield, Massachusetts;
Minneapolis, Minnesota; and Dallas, Texas. HCC Benefits Corporation underwrites
group life, accident and health business on behalf of affiliated insurance
companies.
PROFESSIONAL INDEMNITY AGENCY, INC.
We acquired Professional Indemnity Agency, Inc. in October, 2001.
Professional Indemnity Agency, Inc., with its home office in Mount Kisco, New
York and a branch office in San Francisco, California, acts as an underwriting
manager for global financial products business on behalf of affiliated and
unaffiliated insurance companies.
ASU INTERNATIONAL, LLC
We acquired ASU International, LLC in October, 2001. ASU International,
LLC, with its home office in Woburn, Massachusetts and a branch office in
London, England acts as an underwriting manager for group life, accident and
health and other specialty lines of business on behalf of affiliated and
unaffiliated insurance companies.
HCC GLOBAL FINANCIAL PRODUCTS, LLC
We acquired HCC Global Financial Products, LLC in October, 2002. HCC Global
Financial Products, LLC was formerly known as MAG Global Financial Products, LLC
and has offices in Farmington, Connecticut, Houston, Texas, Jersey City, New
Jersey, Barcelona, Spain and London, England. HCC Global Financial Products, LLC
acts as an underwriting manager for global financial products business on behalf
of affiliated insurance companies.
DICKSON MANCHESTER & COMPANY LIMITED
We acquired Dickson Manchester & Company Limited in December, 2002. Dickson
Manchester & Company Limited is an underwriting agency and Lloyd's broker based
in London, England and underwrites global financial products business on behalf
of affiliated and unaffiliated insurance companies.
14
INTERMEDIARY OPERATIONS
Our intermediaries provide a variety of services, including marketing,
placing, consulting on and servicing insurance risks for their clients, which
include medium to large corporations, unaffiliated and affiliated insurance and
reinsurance companies and other risk taking entities. The intermediaries earn
commission income and to a lesser extent fees for certain services, generally
paid by the underwriters with whom the business is placed. Some of these risks
may be initially underwritten by our insurance companies, which may retain a
portion of the risk. Commission income generated by our intermediaries in 2002
amounted to $41.6 million.
This table shows our intermediaries' revenue by line of business for the
years indicated (dollars in thousands):
<Table>
<Caption>
2002 2001 2000
------------- ------------- -------------
Life, accident and health............. $32,045 77% $33,739 78% $36,795 74%
Property and casualty................. 9,527 23 9,673 22 13,091 26
------- --- ------- --- ------- ---
Total commission income..... $41,572 100% $43,412 100% $49,886 100%
======= === ======= === ======= ===
</Table>
RATTNER MACKENZIE LIMITED
Rattner Mackenzie Limited is an intermediary based in London, England with
other operations in Bermuda. Rattner Mackenzie Limited is a Lloyd's broker
specializing in group life, accident and health reinsurance and some specialty
property and casualty lines of business. Rattner Mackenzie Limited is considered
a market leader in its core businesses. Rattner Mackenzie Limited serves as an
intermediary for reinsurance business placed by unaffiliated and affiliated
insurance companies and reinsurance companies and underwriting agencies.
HCC EMPLOYEE BENEFITS, INC.
HCC Employee Benefits, Inc., with operations in Houston, Texas and Atlanta,
Georgia, is a retail insurance agency and consulting firm specializing in group
life, accident and health insurance for employee benefit plans of medium and
large commercial customers throughout the United States. We acquired Schanen
Consulting Corporation of Atlanta, Georgia in January, 2001 and consolidated its
operations with those of HCC Employee Benefits, Inc.
HCC RISK MANAGEMENT, INC.
HCC Risk Management, Inc., based in Houston, Texas, is an intermediary
specializing in marketing and servicing large, complicated insurance and
reinsurance programs placed on behalf of multinational clients operating in our
lines of business. This business is placed with domestic and international
insurance companies, including our insurance companies, on a direct basis and
through other intermediaries. In addition, HCC Risk Management, Inc. acts as a
reinsurance intermediary on behalf of affiliated and unaffiliated insurance
companies.
OTHER OPERATIONS
Our other operations historically consisted of insurance related services
offered to our subsidiaries, our reinsurers and unaffiliated entities. The
revenue earned from these services primarily consisted of fees or commissions.
Additionally, other operating income may be in the form of equity in the
earnings of insurance related companies in which we invest, or dividends or
gains or losses from the disposition of these investments. Other operating
revenue was $7.0 million in 2002, but can vary considerably from period to
period depending on investment or disposition activity.
15
REINSURANCE CEDED
We purchase reinsurance to reduce our net liability on individual risks, to
protect against catastrophe losses and to achieve a desired ratio of net written
premium to policyholders' surplus. We purchase reinsurance on both a
proportional and an excess of loss basis. The type, cost and limits of
reinsurance we purchase can vary from year to year based upon our desired
retention levels and the availability of quality reinsurance at an acceptable
price. Our reinsurance programs renew throughout the year and during 2002 some
of those renewed contained price increases which are not material to our
underwriting results.
We structure a specific reinsurance program for each line of business we
underwrite. We place reinsurance proportionally to cover loss frequency and
catastrophe exposure. We obtain reinsurance on an excess of loss basis to cover
individual risk severity of loss and catastrophe exposure. Additionally, we may
also obtain facultative reinsurance protection on a single risk. Our reinsurance
generally does not cover war or terrorism risks, which are excluded from many of
our policies.
Subsequent to the terrorist attack on September 11, 2001, where possible,
we canceled all terrorist coverage under the terms of existing in-force
policies, primarily in the property and energy book of the London market account
line of business. Our reinsurance protections in these books have been renewed
without coverage for acts of terrorism. We thus only have exposure on policies
that contained such coverage and are still in force. This exposure is
diminishing as these policies expire and with respect to some risks, would be
covered by the provisions of the Federal Terrorism Risk Insurance Act of 2002.
In our proportional reinsurance programs, we generally receive an
overriding (ceding) commission on the premium ceded to reinsurers. This
compensates our insurance companies for the direct costs associated with the
production of the business, the servicing of the business during the term of the
policies ceded and the costs associated with the placement of the related
reinsurance. In addition, certain of our reinsurance treaties allow us to share
with the reinsurers in any net profits generated under such treaties. Various
intermediaries, including HCC Risk Management, Inc. and Rattner Mackenzie
Limited, arrange for the placement of this reinsurance coverage on our behalf
and are compensated, directly or indirectly, by the reinsurers.
We have a reserve of $7.1 million as of December 31, 2002 for potential
collectibility issues and associated expenses related to reinsurance
recoverables. The adverse economic environment in the worldwide insurance
industry, the decline in the market value of investments in equity securities
and the terrorist attack on September 11, 2001 have placed great pressure on
reinsurers and the results of their operations. Ultimately, these conditions
could affect reinsurers' solvency. Historically, there have been insolvencies
following a period of competitive pricing in the industry. While we believe that
the reserve is adequate based on currently available information, conditions may
change or additional information might be obtained which may result in a future
change in the reserve. We periodically review our financial exposure to the
reinsurance market and the level of our reserve and continue to take actions in
an attempt to mitigate our exposure to possible loss.
A number of reinsurers have delayed or suspended the payment of amounts
recoverable under certain reinsurance contracts to which we are a party. Such
delays have affected, although not materially to date, the investment income of
our insurance companies, but not to any extent their liquidity. We limit our
liquidity exposure by holding funds, letters of credit or other security such
that net balances due are significantly less than the gross balances shown in
our consolidated balance sheets. In some instances, the reinsurers have withheld
payment without reference to a substantive basis for the delay or suspension. In
other cases, the reinsurers have claimed they are not liable for payment to us
of all or part of the amounts due under the applicable reinsurance agreement. We
believe these claims are without merit and expect to collect the full amounts
recoverable. We are currently in negotiations with most of these parties, but if
such negotiations do not result in a satisfactory resolution of the matters in
question, we may seek or be involved in a judicial or arbitral determination of
these matters. In some cases, the final resolution of such disputes through
arbitration or litigation may extend over several years. In this regard, as of
December 31, 2002, our insurance companies had initiated two litigation
proceedings against reinsurers. As of such date, our insurance companies had an
aggregate amount of $5.8 million which had not been paid to us under the
agreements and we estimate that there could be up to an additional $10.7 million
of incurred losses and loss expenses and other balances due under the subject
agreements.
16
OPERATING RATIOS
PREMIUM TO SURPLUS RATIO
This table shows, for the years indicated, the ratio of statutory gross
written premium and net written premium to statutory policyholders' surplus for
our property and casualty insurance companies (dollars in thousands):
<Table>
<Caption>
2002 2001 2000 1999 1998
---------- ---------- -------- -------- --------
Gross written premium........ $1,163,397 $1,014,833 $972,154 $576,184 $500,962
Net written premium.......... 545,475 371,409 283,947 150,261 123,315
Policyholders' surplus....... 523,807 401,393 326,249 315,474 369,401
Gross written premium
ratio...................... 222.1% 252.8% 298.0% 182.6% 135.6%
Gross written premium
industry average(1)........ * 210.8% 174.1% 154.1% 147.9%
Net written premium ratio.... 104.1% 92.5% 87.0% 47.6% 33.4%
Net written premium industry
average(1)................. * 112.0% 94.4% 85.5% 84.3%
</Table>
- ---------------
(1) Source: A.M. Best Company, Inc.
* Not available
While there is no statutory requirement regarding a permissible premium to
policyholders' surplus ratio, guidelines established by the National Association
of Insurance Commissioners provide that a property and casualty insurer's annual
statutory gross written premium should not exceed 900% and net written premium
should not exceed 300% of its policyholders' surplus. However, industry
standards and rating agency criteria place these ratios at 300% and 200%,
respectively. Our property and casualty insurance companies have maintained
premium to surplus ratios generally lower than such guidelines.
COMBINED RATIO IN ACCORDANCE WITH GENERALLY ACCEPTED ACCOUNTING PRINCIPLES
The underwriting experience of a property and casualty insurance company is
indicated by its combined ratio. Under generally accepted accounting principles,
the combined ratio is a combination of the loss ratio in accordance with
generally accepted accounting principles, or the ratio of incurred losses and
loss adjustment expenses to net earned premium, and the expense ratio in
accordance with generally accepted accounting principles, which is the ratio of
policy acquisition costs and other underwriting expenses, net of ceding
commissions, to net earned premium. Our insurance companies' loss ratios,
expense ratios and combined ratios in accordance with generally accepted
accounting principles are shown in the following table for the years indicated:
<Table>
<Caption>
2002 2001 2000 1999 1998
---- ----- ---- ----- ----
Loss ratio........................................ 60.6% 78.0% 74.2% 77.6% 63.8%
Expense ratio..................................... 25.4 25.7 21.0 51.7 21.5
---- ----- ---- ----- ----
Combined ratio.................................... 86.0% 103.7% 95.2% 129.3% 85.3%
==== ===== ==== ===== ====
Combined ratio excluding the effects of the
provision for reinsurance in 1999............... 98.6%
=====
</Table>
COMBINED RATIO IN ACCORDANCE WITH STATUTORY ACCOUNTING PRINCIPLES
The combined ratio in accordance with statutory accounting principles is a
combination of the loss ratio in accordance with statutory accounting
principles, or the ratio of incurred losses and loss adjustment expenses to net
earned premium, and the expense ratio in accordance with statutory accounting
principles, which is the ratio of policy acquisition costs and other
underwriting expenses, net of ceding commissions, to net written
17
premium. Our insurance companies' loss ratios, expense ratios and combined
ratios in accordance with statutory accounting principles are shown in the
following table for the years indicated:
<Table>
<Caption>
2002 2001 2000 1999 1998
---- ----- ----- ----- -----
Loss ratio...................................... 62.0% 78.0% 71.1% 107.1% 67.2%
Expense ratio................................... 23.9 23.8 27.0 22.8 15.7
---- ----- ----- ----- -----
Combined ratio.................................. 85.9% 101.8% 98.1% 129.9% 82.9%
==== ===== ===== ===== =====
Combined ratio excluding the effects of the
provision for reinsurance in 1999............. 104.1%
=====
Industry average................................ * 115.9% 110.1% 107.8% 105.6%
</Table>
- ---------------
* Not available
The ratio data in accordance with statutory accounting principles is not
intended to be a substitute for results of operations in accordance with
generally accepted accounting principles. The differences between statutory
accounting principles and generally accepted accounting principles are described
in Note (14) of our consolidated financial statements included in this report.
Including this information on the basis of statutory accounting principles is
meaningful and useful to allow a comparison of our operating results with those
of other companies in the insurance industry. The source of the industry average
is A.M. Best Company, Inc. A.M. Best Company, Inc. reports on insurer
performance on the basis of statutory accounting principles to provide for more
standardized comparisons among individual companies, as well as overall industry
performance.
RESERVES
Applicable insurance laws require us to maintain reserves to cover our
estimated ultimate liability for reported and incurred but not reported losses
under insurance and reinsurance policies that we wrote and for loss adjustment
expenses relating to the investigation and settlement of policy claims. In most
cases, we estimate such losses and claims costs through an evaluation of
individual claims. However, for some types of claims, we use an average
reserving method until more information becomes available to permit an
evaluation of individual claims.
We establish loss reserves for individual claims by evaluating reported
claims on the basis of:
- jurisdiction of the occurrence;
- our experience with the insured and the line of business and policy
provisions relating to the particular type of claim;
- our knowledge of the circumstances surrounding the claim;
- the information and reports received from ceding insurance companies
where applicable;
- the potential for ultimate exposure;
- the severity of injury or damage; and
- the type of loss.
We establish loss reserves for incurred but not reported losses based in
part on statistical information and in part on industry experience with respect
to the probable number and nature of claims arising from occurrences that have
not been reported. We also establish our reserves based on predictions of future
events, our estimates of future trends in claims severity, and other subjective
factors. Insurance companies are not permitted to reserve for a catastrophe
until it has occurred. Reserves are recorded on an undiscounted basis, except
for reserves acquired in transactions recorded using the purchase method of
accounting. The reserves of each of our insurance companies are established in
conjunction with and reviewed by our in-house actuarial staff and our reserves
in accordance with statutory accounting principles are certified annually by our
18
independent actuaries. PricewaterhouseCoopers LLP certified the reserves of our
insurance companies in accordance with statutory accounting principles as of
December 31, 2002.
With respect to some classes of risks, the period of time between the
occurrence of an insured event and the final settlement of a claim may be many
years, and during this period it often becomes necessary to adjust the claim
estimates either upward or downward. Certain classes of marine and offshore
energy and workers' compensation insurance which are or were underwritten by our
insurance companies have historically had longer lead times between the
occurrence of an insured event, reporting of the claim, and final settlement. In
such cases, we are forced to estimate reserves over long periods of time with
the possibility of several adjustments to reserves. Other classes of insurance
that we underwrite, such as most aviation, property and medical stop-loss,
historically have shorter lead times between the occurrence of an insured event,
reporting of the claim and final settlement. Reserves with respect to these
classes are, therefore, less likely to be adjusted.
The reserving process is intended to reflect the impact of inflation and
other factors affecting loss payments by taking into account changes in
historical payment patterns and perceived trends. However, there is no precise
method for the subsequent evaluation of the adequacy of the consideration given
to inflation, or to any other specific factor, or to the way one factor may
impact another.
We underwrite, directly and through reinsurance, risks which are
denominated in a number of foreign currencies, and therefore maintain loss
reserves with respect to these policies in the respective currencies. These
reserves are subject to exchange rate fluctuations, which may have an effect on
our earnings. We may attempt to limit our exposure to future currency
fluctuations through the use of foreign currency forward contracts.
The loss development triangles below show changes in our reserves in
subsequent years from the prior loss estimates based on experience as of the end
of each succeeding year on the basis of generally accepted accounting
principles. The estimate is increased or decreased as more information becomes
known about the frequency and severity of losses for individual years. A
redundancy means the original estimate was higher than the current estimate; a
deficiency means that the current estimate is higher than the original estimate.
The first line of each loss development triangle presents, for the years
indicated, our gross or net reserve liability including the reserve for incurred
but not reported losses. The first section of each table shows, by year, the
cumulative amounts of loss and loss adjustment expense paid as of the end of
each succeeding year. The second section sets forth the re-estimates in later
years of incurred losses, including payments, for the years indicated. The
"cumulative redundancy (deficiency)" represents, as of the date indicated, the
difference between the latest re-estimated liability and the reserves as
originally estimated.
19
This loss development triangle shows development in loss reserves on a
gross basis (in thousands):
<Table>
<Caption>
2002 2001 2000 1999 1998 1997 1996 1995 1994
---------- ---------- -------- -------- -------- -------- -------- -------- --------
Balance sheet reserves:.... $1,155,290 $1,130,748 $944,117 $871,104 $460,511 $275,008 $229,049 $200,756 $170,957
Reserve adjustments from
acquisition and
disposition of
subsidiaries.............. -- (66,571) (32,437) (136) -- -- -- --
---------- ---------- -------- -------- -------- -------- -------- -------- --------
Adjusted reserves....... 1,155,290 1,130,748 877,546 838,667 460,375 275,008 229,049 200,756 170,957
Cumulative paid as of:
One year later............ 388,722 400,279 424,379 229,746 160,324 119,453 118,656 97,580
Two years later........... 537,354 561,246 367,512 209,724 179,117 167,459 143,114
Three years later......... 611,239 419,209 241,523 193,872 207,191 166,541
Four years later.......... 435,625 259,067 212,097 214,046 192,540
Five years later.......... 262,838 223,701 226,762 195,930
Six years later........... 225,595 233,831 202,844
Seven years later......... 235,236 208,112
Eight years later......... 209,056
Nine years later..........
Ten years later...........
Re-estimated liability as
of:
End of year............... 1,155,290 1,130,748 877,546 838,667 460,375 275,008 229,049 200,756 170,957
One year later............ 1,107,588 922,080 836,775 550,409 308,501 252,236 243,259 186,898
Two years later........... 925,922 868,438 545,955 316,250 249,013 248,372 207,511
Three years later......... 854,987 547,179 304,281 250,817 247,053 214,738
Four years later.......... 537,968 305,022 247,245 248,687 220,695
Five years later.......... 295,975 249,853 248,559 217,892
Six years later........... 243,015 250,176 219,196
Seven years later......... 246,661 219,002
Eight years later......... 219,478
Nine years later..........
Ten years later...........
Cumulative redundancy
(deficiency).............. $ 23,160 $(48,376) $(16,320) $(77,593) $(20,967) $(13,966) $(45,905) $(48,521)
<Caption>
1993 1992
-------- ---------
Balance sheet reserves:.... $144,178 $ 129,503
Reserve adjustments from
acquisition and
disposition of
subsidiaries.............. -- --
-------- ---------
Adjusted reserves....... 144,178 129,503
Cumulative paid as of:
One year later............ 82,538 83,574
Two years later........... 126,290 130,379
Three years later......... 157,509 158,973
Four years later.......... 176,472 182,193
Five years later.......... 195,269 192,512
Six years later........... 197,147 213,052
Seven years later......... 203,075 215,280
Eight years later......... 207,474 221,403
Nine years later.......... 208,049 225,706
Ten years later........... 226,143
Re-estimated liability as
of:
End of year............... 144,178 129,503
One year later............ 163,967 162,827
Two years later........... 183,015 176,817
Three years later......... 203,137 194,419
Four years later.......... 211,546 215,531
Five years later.......... 218,182 222,746
Six years later........... 214,498 234,115
Seven years later......... 216,820 231,269
Eight years later......... 216,627 233,995
Nine years later.......... 216,542 233,865
Ten years later........... 233,921
Cumulative redundancy
(deficiency).............. $(72,364) $(104,418)
</Table>
The gross redundancy for 2001 resulted from the following items:
- A $21.5 million reduction in gross losses from the September 11 terrorist
attack and a $14.0 million reduction in gross losses from the Total Oil
Company loss. Both of these losses were substantially reinsured and thus
they had no material net effect.
- $36.2 million in negative development due to late reporting of an
aggregate program that we no longer write. As this program is
substantially reinsured, there was no material net effect.
- A $7.7 million charge related to certain business included in
discontinued lines.
- $31.5 million in other positive development spread across the group life,
accident and health, aviation and London market account lines of
business. On average these losses were 55% ceded, which created net
positive development of approximately $14.5 million.
The gross deficiencies reflected in the table for 2000 and 1999 result from
late reported loss information received during 2001. These losses primarily came
from assumed reinsurance business written by one of our insurance companies.
However, as these policies were substantially reinsured, there was no material
effect to our net earnings.
The gross deficiencies reflected in the table for the years prior to 1999
result from three principal conditions:
- The development of large claims on individual policies which were either
reported late or for which reserves were increased as subsequent
information became available. However, as these policies were
substantially reinsured, there was no material effect to our net
earnings.
20
- During 1999, in connection with the insolvency of one of our reinsurers
and the commutation of all liabilities with another, we re-evaluated all
loss reserves and incurred but not reported loss reserves related to
business placed with these reinsurers to determine the ultimate losses we
might conservatively expect. These reserves were then used as the basis
for the determination of the provision for reinsurance recorded in 1999.
- For the years prior to 1997, the runoff of the retrocessional excess of
loss business, which we underwrote between 1988 and 1991, experienced
gross development. This development was due primarily to the delay in
reporting of losses by the London insurance market, coupled with the
unprecedented number of catastrophe losses during that period. This
business was substantially reinsured and there was no material effect to
our net earnings.
This loss development triangle shows development in loss reserves on a net
basis (in thousands):
<Table>
<Caption>
2002 2001 2000 1999 1998 1997 1996 1995 1994
---------- ---------- ---------- -------- -------- -------- -------- -------- --------
Gross reserves............. $1,155,290 $1,130,748 $ 944,117 $871,104 $460,511 $275,008 $229,049 $200,756 $170,957
Less reinsurance
recoverables.............. 697,972 817,651 694,245 597,498 341,599 155,374 111,766 101,497 95,279
---------- ---------- ---------- -------- -------- -------- -------- -------- --------
Reserves, net of
reinsurance............... 457,318 313,097 249,872 273,606 118,912 119,634 117,283 99,259 75,678
Reserve adjustments from
acquisition and
disposition of
subsidiaries.............. -- -- (6,048) (3,343) (410) -- -- -- --
Effect on loss reserves of
1999 write off of
reinsurance
recoverables.............. -- -- -- -- 63,851 15,008 2,636 1,442 51
---------- ---------- ---------- -------- -------- -------- -------- -------- --------
Adjusted reserves, net of
reinsurance............... 457,318 313,097 243,824 270,263 182,353 134,642 119,919 100,701 75,729
Cumulative paid, net of
reinsurance, as of:
One year later............ 126,019 102,244 145,993 56,052 48,775 47,874 41,947 36,500
Two years later........... 139,659 174,534 103,580 64,213 66,030 56,803 49,283
Three years later......... 185,744 113,762 80,227 72,863 64,798 56,919
Four years later.......... 121,293 81,845 81,620 67,355 60,441
Five years later.......... 84,986 81,968 72,627 61,781
Six years later........... 82,681 73,501 66,591
Seven years later......... 73,792 66,410
Eight years later......... 66,749
Nine years later..........
Ten years later...........
Re-estimated liability, net
of reinsurance, as of:
End of year............... 457,318 313,097 243,824 270,263 182,353 134,642 119,919 100,701 75,729
One year later............ 306,318 233,111 260,678 186,967 120,049 116,145 95,764 72,963
Two years later........... 222,330 254,373 175,339 116,745 101,595 94,992 74,887
Three years later......... 244,650 171,165 110,673 97,353 85,484 76,474
Four years later.......... 163,349 107,138 95,118 80,890 73,660
Five years later.......... 103,243 93,528 79,626 69,528
Six years later........... 91,413 79,968 70,642
Seven years later......... 78,614 70,278
Eight years later......... 70,060
Nine years later..........
Ten years later...........
Cumulative redundancy
(deficiency).............. $ 6,779 $ 21,494 $ 25,613 $ 19,004 $ 31,399 $ 28,506 $ 22,087 $ 5,669
<Caption>
1993 1992
-------- --------
Gross reserves............. $144,178 $129,503
Less reinsurance
recoverables.............. 82,289 81,075
-------- --------
Reserves, net of
reinsurance............... 61,889 48,428
Reserve adjustments from
acquisition and
disposition of
subsidiaries.............. -- --
Effect on loss reserves of
1999 write off of
reinsurance
recoverables.............. -- --
-------- --------
Adjusted reserves, net of
reinsurance............... 61,889 48,428
Cumulative paid, net of
reinsurance, as of:
One year later............ 29,258 18,978
Two years later........... 41,207 32,733
Three years later......... 46,576 36,536
Four years later.......... 51,536 38,480
Five years later.......... 53,110 40,327
Six years later........... 53,879 40,550
Seven years later......... 58,353 41,133
Eight years later......... 58,713 45,552
Nine years later.......... 60,658 45,837
Ten years later........... 47,693
Re-estimated liability, net
of reinsurance, as of:
End of year............... 61,889 48,428
One year later............ 59,659 45,812
Two years later........... 60,079 44,964
Three years later......... 62,224 46,129
Four years later.......... 64,377 48,993
Five years later.......... 64,103 50,785
Six years later........... 59,408 50,585
Seven years later......... 60,960 46,071
Eight years later......... 60,729 47,629
Nine years later.......... 62,874 47,407
Ten years later........... 49,460
Cumulative redundancy
(deficiency).............. $ (985) $ (1,032)
</Table>
We believe that our loss reserves are adequate to provide for all material
net incurred losses.
21
The following table provides a reconciliation of the gross liability of
loss and loss adjustment expenses on the basis of generally accepted accounting
principles in the United States for the three years ended December 31, 2002 (in
thousands):
<Table>
<Caption>
2002 2001 2000
---------- ---------- --------
Reserves for loss and loss adjustment expense at
beginning of year............................... $1,130,748 $ 944,117 $871,104
Reserve adjustments from acquisition and
disposition of subsidiaries..................... 82,289 (69,725) 1,709
Incurred loss and loss adjustment expense:
Provision for loss and loss adjustment expense
for claims occurring in the current year..... 627,412 1,019,311 775,538
Increase (decrease) in estimated loss and loss
adjustment expense for claims occurring in
prior years(1)............................... (23,160) 44,534 (1,892)
---------- ---------- --------
Incurred loss and loss adjustment expense......... 604,252 1,063,845 773,646
---------- ---------- --------
Loss and loss adjustment expense payments for
claims occurring during:
Current year.................................... 273,277 407,210 277,963
Prior years..................................... 388,722 400,279 424,379
---------- ---------- --------
Loss and loss adjustment expense payments......... 661,999 807,489 702,342
---------- ---------- --------
Reserves for loss and loss adjustment expense at
end of the year................................. $1,155,290 $1,130,748 $944,117
========== ========== ========
</Table>
- ---------------
(1) Changes in loss and loss adjustment expense reserves (on the basis of
generally accepted accounting principles) for losses occurring in prior
years reflect the gross effect of the resolution of losses for other than
the reserve value and the subsequent adjustments of loss reserves.
This table provides a reconciliation of the liability for loss and loss
adjustment expense, net of reinsurance ceded, on the basis of generally accepted
accounting principles in the United States for the three years ended December
31, 2002 (in thousands):
<Table>
<Caption>
2002 2001 2000
-------- -------- --------
Reserves for loss and loss adjustment expense at
beginning of year.................................. $313,097 $249,872 $273,606
Reserve adjustments from acquisition and disposition
of subsidiaries.................................... 79,558 285 514
Incurred loss and loss adjustment expense:
Provision for loss and loss adjustment expense for
claims occurring in the current year............ 313,270 278,103 208,055
Increase (decrease) in estimated loss and loss
adjustment expense for claims occurring in prior
years(2)........................................ (6,779) (10,713) (9,585)
-------- -------- --------
Incurred loss and loss adjustment expense............ 306,491 267,390 198,470
-------- -------- --------
Loss and loss adjustment expense payments for claims
occurring during:
Current year....................................... 115,809 102,206 76,725
Prior years........................................ 126,019 102,244 145,993
-------- -------- --------
Loss and loss adjustment expense payments............ 241,828 204,450 222,718
-------- -------- --------
Reserves for loss and loss adjustment expense at end
of the year........................................ $457,318 $313,097 $249,872
======== ======== ========
</Table>
22
- ---------------
(2) Changes in loss and loss adjustment expense reserves (on the basis of
generally accepted accounting principles) for losses occurring in prior
years reflect the net effect of the resolution of losses for other than the
reserve value and the subsequent adjustments of loss reserves.
Although we experienced a gross loss deficiency during 2001, the business
was substantially reinsured and, therefore, there was no material effect to our
insurance companies on a net loss basis.
During 2002, we had net loss and loss adjustment expense redundancy of $6.8
million relating to prior year losses compared to redundancies of $10.7 million
in 2001 and $9.6 million in 2000. The 2002 redundancy resulted from a deficiency
of $7.7 million due to a third quarter charge related to certain business
included in discontinued lines, offset by a net redundancy of $14.5 million from
all other sources. Deficiencies and redundancies in the reserves occur as we
continually review our loss reserves with our actuaries, increasing or reducing
loss reserves as a result of such reviews and as losses are finally settled and
claims exposures are reduced. We believe we have provided for all material net
incurred losses.
We have no material exposure to environmental pollution losses, because
Houston Casualty Company only began writing business in 1981 and its policies
normally contain pollution exclusion clauses which limit pollution coverage to
"sudden and accidental" losses only, thus excluding intentional (dumping) and
seepage claims. Policies issued by HCC Life Insurance Company, Avemco Insurance
Company and U.S. Specialty Insurance Company, because of the types of risks
covered, are not considered to have significant environmental exposures. We do
not expect to experience any material development in reserves for environmental
pollution claims. Likewise, we have no material exposure to asbestos claims.
INVESTMENTS
Insurance company investments must comply with applicable regulations which
prescribe the type, quality and concentration of investments. These regulations
permit investments, within specified limits and subject to certain
qualifications, in federal, state and municipal obligations, corporate bonds,
and preferred and common equity securities. As of December 31, 2002, we had $1.2
billion of investment assets. The majority of our investment assets are held by
our insurance companies. All of our securities are classified as available for
sale and are recorded at market value.
Our investment policy is determined by our Board of Directors and our
Investment and Finance Committee and is reviewed on a regular basis. We continue
to engage a nationally prominent investment advisor, New England Asset
Management, a subsidiary of Berkshire Hathaway, Inc., to oversee our investments
and to make recommendations to our Board's Investment and Finance Committee.
Although we generally intend to hold fixed income securities to maturity, we
regularly re-evaluate our position based upon market conditions. As of December
31, 2002, our fixed income securities had a weighted average maturity of 4.2
years and a weighted average duration of 3.5 years. Our financial statements
reflect an unrealized gain on fixed income securities available for sale as of
December 31, 2002, of $33.8 million.
We have maintained a substantial level of cash and liquid short-term
instruments in our insurance companies in order to maintain the ability to fund
losses of our insureds. Our underwriting agencies and intermediaries typically
have short-term investments, which are fiduciary funds held on behalf of others.
As of December 31, 2002, we had cash and short-term investments of approximately
$347.5 million, of which $239.6 million were in our underwriting agencies and
intermediaries.
23
This table shows a profile of our investments. The table shows the average
amount of investments, income earned, and the yield thereon for the periods
indicated (dollars in thousands):
<Table>
<Caption>
2002 2001 2000
---------- -------- --------
Average investments, at cost........................ $1,005,541 $789,860 $643,721
Net investment income(1)............................ 37,769 39,638 39,836
Average short-term yield(1)......................... 2.2% 4.3% 6.6%
Average long-term yield(1).......................... 4.8% 5.6% 6.1%
Average long-term tax equivalent yield(1)........... 5.4% 6.4% 7.4%
Weighted average combined tax equivalent yield(1)... 4.6% 5.6% 7.1%
</Table>
- ---------------
(1) Excluding realized and unrealized capital gains and losses.
This table summarizes, by type, the estimated market value of our
investments as of December 31, 2002 (dollars in thousands):
<Table>
<Caption>
PERCENT OF
AMOUNT TOTAL
---------- ----------
Short-term investments...................................... $ 307,215 26%
U.S. Treasury securities.................................... 96,546 8
Obligations of states, municipalities and political
subdivisions.............................................. 49,230 4
Special revenue fixed income securities..................... 210,238 18
Corporate fixed income securities........................... 244,276 21
Asset-backed and mortgage-backed securities................. 149,873 13
Foreign government securities............................... 91,385 8
Marketable equity securities................................ 15,609 2
Other investments........................................... 3,264 --
---------- ---
TOTAL INVESTMENTS................................. $1,167,636 100%
========== ===
</Table>
This table summarizes, by rating, the market value of our investments in
fixed income securities as of December 31, 2002 (dollars in thousands):
<Table>
<Caption>
PERCENT OF
AMOUNT TOTAL
-------- ----------
AAA......................................................... $469,841 56%
AA.......................................................... 159,447 19
A........................................................... 179,726 21
BBB......................................................... 32,534 4
-------- ---
TOTAL FIXED INCOME SECURITIES..................... $841,548 100%
======== ===
</Table>
24
The table set forth below indicates the expected maturity distribution of
the estimated market value of our fixed income securities as of December 31,
2001 (dollars in thousands):
<Table>
<Caption>
PERCENT OF
AMOUNT TOTAL
-------- ----------
One year or less............................................ $ 66,673 8%
One year to five years...................................... 326,561 39
Five years to ten years..................................... 135,984 16
Ten years to fifteen years.................................. 82,488 10
More than fifteen years..................................... 79,969 9
-------- ---
Securities with fixed maturities.......................... 691,675 82
Asset-backed and mortgage-backed securities................. 149,873 18
-------- ---
TOTAL FIXED INCOME SECURITIES..................... $841,548 100%
======== ===
</Table>
The weighted average life of our structured securities is five years. The
value of our portfolio of fixed income securities is inversely correlated to
changes in market interest rates. In addition, some of our fixed income
securities have call or prepayment options. This could subject us to a
reinvestment risk should interest rates fall or issuers call their securities
and we are forced to invest the proceeds at lower interest rates. We mitigate
this risk by investing in securities with varied maturity dates, so that only a
portion of the portfolio will mature at any point in time. Some of our
asset-backed securities are subject to re-evaluation and additional specialized
impairment tests. Under this guidance, these securities have to be written down
in value if certain tests are met. Any write down is recouped prospectively
through net investment income, if contractual cash flows are ultimately
received. The total amount of securities held by us as of December 31, 2002 that
would be subject to these tests and potential write downs is $9.4 million.
2% CONVERTIBLE NOTES AND BANK LOAN
In a public offering on August 23, 2001, we issued an aggregate $172.5
million principal amount of 2% Convertible Notes due in 2021. Our debt
securities are rated A by Standard & Poor's (3rd of 10 ratings). Each $1
thousand principal amount of notes is convertible into 31.25 shares of our
common stock, which represents an initial conversion price of $32.00 per share.
The initial conversion price is subject to change under certain conditions.
Interest is to be paid by us on March 1 and September 1 each year. Holders may
surrender notes for conversion into shares of our common stock in any calendar
quarter if, as of the last day of the preceding calendar quarter, the closing
sale price of our common stock for at least 20 trading days in the period of 30
consecutive trading days ending on the last trading day of the quarter is more
than 120% ($38.40 per share) of the conversion price per share of our common
stock on the last trading day of the quarter. We can redeem the notes for cash
at any time on or after September 1, 2006. Holders of the notes may require us
to repurchase the notes on September 1, 2004, 2006, 2008, 2011 and 2016. If the
holders exercise this option, we may choose to pay the purchase price in cash,
in shares of our common stock, or a combination thereof. On September 1, 2002,
the first repurchase date of the notes, $49 thousand of the notes were tendered
to us and we repurchased them with cash. We used the proceeds from this offering
to repay our remaining indebtedness under our bank facility, assist in financing
the recent acquisitions, make a $60.0 million capital contribution to our
insurance companies and for general corporate purposes.
On December 17, 1999, we entered into a $300.0 million Revolving Loan
Facility with a group of banks. At our request, the amount available under the
facility was reduced to $200.0 million by an amendment on June 6, 2001. We can
borrow up to the maximum allowed by the facility on a revolving basis until the
facility expires on December 17, 2004. The facility is collateralized in part by
the pledge of our insurance companies stock and guarantees entered into by our
underwriting agencies and intermediaries. The facility agreement contains
certain restrictive covenants, which we believe are typical for similar
financing arrangements. As of December 31, 2002, there was an outstanding
balance of $53.0 million on this facility bearing interest at an average
interest rate of 3.2%.
25
REGULATION
The business of insurance is extensively regulated by the government. At
this time, the insurance business in the United States is regulated primarily by
the individual states. However, a form of federal financial services
modernization legislation enacted in 1999 is expected to result in additional
federal regulation of the insurance industry. In addition, some insurance
industry trade groups are actively lobbying for legislation that would allow an
option for a separate federal charter for insurance companies. The full extent
to which the federal government will determine to directly regulate the business
of insurance has not been determined by lawmakers. Also, various foreign
governments regulate our international operations.
Our business depends on our compliance with applicable laws and regulations
and our ability to maintain valid licenses and approvals for our operations. We
devote a significant effort toward obtaining and maintaining our licenses and
compliance with a diverse and complex regulatory structure. In all
jurisdictions, the applicable laws and regulations are subject to amendment or
interpretation by regulatory authorities. Generally, regulatory authorities are
vested with broad discretion to grant, renew and revoke licenses and approvals
and to implement regulations governing the business and operations of insurers
and insurance agents.
INSURANCE COMPANIES
Our insurance companies, in common with other insurers, are subject to
regulation and supervision by the states and by other jurisdictions in which
they do business. Regulation by the states varies, but generally involves
regulatory and supervisory powers of a state insurance official. The regulation
and supervision of our insurance operations relates primarily to:
- approval of policy forms and premium rates;
- licensing of insurers and their agents;
- periodic examinations of our operations and finances;
- prescribing the form and content of records of financial condition
required to be filed;
- requiring deposits for the benefit of policyholders;
- requiring certain methods of accounting;
- requiring reserves for unearned premium, losses and other purposes;
- restrictions on the ability of our insurance companies to pay dividends
to us;
- restrictions on the nature, quality and concentration of investments;
- restrictions on transactions between insurance companies and their
affiliates;
- restrictions on the size of risks insurable under a single policy; and
- standards of solvency, including risk-based capital measurements (which
is a measure developed by the National Association of Insurance
Commissioners and used by state insurance regulators to identify
insurance companies that potentially are inadequately capitalized.)
In general, state insurance regulations are intended primarily for the
protection of policyholders rather than shareholders. The state insurance
departments monitor compliance with regulations through periodic reporting
procedures and examinations. The quarterly and annual financial reports to the
state insurance regulators utilize accounting principles which are different
from the generally accepted accounting principles we use in our reports to
shareholders. Statutory accounting principles, in keeping with the intent to
assure the protection of policyholders, are generally based on a liquidation
concept while generally accepted accounting principles are based on a
going-concern concept.
Houston Casualty Company is domiciled in Texas. It operates on an admitted
basis in Texas and may write reinsurance on all lines of business that it may
write on a direct basis. Houston Casualty Company is an
26
accredited reinsurer in 39 states and an approved surplus lines insurer or is
otherwise permitted to write surplus lines insurance in 49 states, three United
States territories and the District of Columbia. When a reinsurer obtains
accreditation from a particular state, insurers within that state are permitted
to obtain statutory credit for risks ceded to the reinsurer. Surplus lines
insurance is offered by non-admitted companies on risks which are not insured by
admitted companies. All surplus lines insurance is required to be written
through licensed surplus lines insurance brokers, who are required to be
knowledgeable of and follow specific state laws prior to placing a risk with a
surplus lines insurer.
Houston Casualty Company's branch office in London, England is subject to
regulation by regulatory authorities in the United Kingdom. Avemco Insurance
Company is domiciled in Maryland and operates as a licensed admitted insurer in
all states and the District of Columbia. U.S. Specialty Insurance Company is
domiciled in Texas and operates as a licensed admitted insurer in all states and
the District of Columbia. HCC Life Insurance Company is domiciled in Indiana,
and operates as a licensed admitted insurer in 41 states and the District of
Columbia. HCC Specialty Insurance Company is domiciled in Oklahoma and operates
on a surplus lines basis in Texas. HCC Europe is domiciled in Spain and operates
on the equivalent of an "admitted" basis throughout the European Union and
operates in selected other countries as permitted under local regulations.
State insurance regulations also affect the payment of dividends and other
distributions by insurance companies to their shareholders. Generally, insurance
companies are limited by these regulations to the payment of dividends above a
specified level. Dividends in excess of those thresholds are "extraordinary
dividends" and subject to prior regulatory approval.
UNDERWRITING AGENCIES AND INTERMEDIARIES
In addition to the regulation of insurance companies, the states impose
licensing and other requirements on the insurance agency and service operations
of our other subsidiaries. These regulations relate primarily to:
- advertising and business practice rules;
- contractual requirements;
- financial security;
- licensing as agents, brokers, intermediaries, managing general agents or
third party administrators;
- limitations on authority; and
- recordkeeping requirements.
The manner of operating our underwriting agency and intermediary activities
in particular states may vary according to the licensing requirements of the
particular state, which may require, among other things, that we operate in the
state through a local corporation. In a few states, licenses are issued only to
individual residents or locally-owned business entities. In such cases, we may
have arrangements with residents or business entities licensed to act in the
state. The majority of states, however, have recently enacted legislation in
response to the Federal Gramm-Leach-Bliley Act that streamlines and makes more
uniform the licensing requirements.
STATUTORY ACCOUNTING PRINCIPLES
The principal differences between statutory accounting principles and
generally accepted accounting principles, the method by which we report our
financial results to our shareholders are:
- a liability is recorded for certain reinsurance recoverables under
statutory accounting principles, whereas under generally accepted
accounting principles there is no such provision unless the recoverables
are deemed to be doubtful of collectibility;
- under statutory accounting principles, life insurance companies record
investment related liabilities, the asset valuation reserve and interest
maintenance reserve, whereas there is not such liability under generally
accepted accounting principles;
27
- certain assets which are considered "non-admitted assets" are eliminated
from a balance sheet prepared in accordance with statutory accounting
principles but are included in a balance sheet prepared in accordance
with generally accepted accounting principles;
- only some of the deferred tax assets are recognized under statutory
accounting principles;
- fixed-income investments classified as available for sale are recorded at
market value for generally accepted accounting principles and at
amortized cost under statutory accounting principles;
- outstanding losses and unearned premium are recorded on a gross basis
under generally accepted accounting principles and on a net basis under
statutory accounting principles; and
- under statutory accounting principles, policy acquisition costs are
expensed as incurred and under generally accepted accounting principles
such costs are deferred and amortized to expense as the related premium
is earned.
The National Association of Insurance Commissioners adopted Statements of
Statutory Accounting Principles in March, 1998, which became effective on
January 1, 2001, through their adoption by the individual states. The cumulative
effect of codification increased the statutory policyholders' surplus of our
insurance companies by approximately $8.9 million. Our use of statutory
accounting practices prescribed by state regulatory authorities caused a $1.5
million increase in our insurance companies' aggregate statutory policyholders'
surplus as of December 31, 2002 compared to amounts that would have been
recorded under the codification rules of the National Association of Insurance
Commissioners. The statutory policyholders' surplus of each of our insurance
companies is significantly in excess of regulatory risk-based capital
requirements.
INSURANCE HOLDING COMPANY ACTS
Because we are an insurance holding company, we are subject to the
insurance holding company system regulatory requirements of the states of
Arkansas, Indiana, Maryland, Oklahoma and Texas. Under these regulations, we are
required to report information regarding our capital structure, financial
condition and management. We are also required to provide prior notice to, or
seek the prior approval of insurance regulatory authorities of certain
agreements and transactions between our affiliated companies. These agreements
and transactions must satisfy certain regulatory requirements.
RISK-BASED CAPITAL
The National Association of Insurance Commissioners has developed a formula
for analyzing insurance companies called risk-based capital. The risk-based
capital formula is intended to establish minimum capital thresholds that vary
with the size and mix of a company's business and assets. It is designed to
identify companies with capital levels that may require regulatory attention. As
of December 31, 2002, each of our domestic insurance companies' total adjusted
capital is significantly in excess of the authorized control level risk-based
capital.
INSURANCE REGULATORY INFORMATION SYSTEM
The National Association of Insurance Commissioners has also developed a
rating system, the Insurance Regulatory Information System, primarily intended
to assist state insurance departments in overseeing the financial condition of
all insurance companies operating within their respective states. The Insurance
Regulatory Information System consists of eleven key financial ratios that
address various aspects of each insurer's financial condition and stability. Our
insurance companies' Insurance Regulatory Information System ratios generally
fall within the usual prescribed ranges except in satisfactorily explainable
circumstances such as when there is a large reinsurance transaction, capital
change, merger or planned growth.
28
TERRORISM RISK INSURANCE ACT
In 2002, the Federal Terrorism Risk Insurance Act was enacted for the
purpose of ensuring the availability of insurance coverage for terrorist acts in
the United States. The law establishes a financial "backstop" program through
the end of 2005 to assist the commercial property and casualty insurance
industry in providing coverage related to future acts of terrorism within the
United States.
Under the Terrorism Risk Insurance Act of 2002, we are required to offer
terrorism coverage to our commercial policyholders in certain lines of business
written in the United States, for which we may, when warranted, charge an
additional premium. The policyholders may or may not accept such coverage. This
law also established a deductible that each insurer would have to meet before
U.S. Federal reimbursement would occur. For 2003, our deductible is
approximately $11.2 million based on 7% of 2002 subject premium as defined under
the applicable regulations. Thereafter, the Federal government would provide
reimbursement for 90% of our insured, covered insured losses up to the maximum
amount set out in the Act.
PENDING OR PROPOSED LEGISLATION
In recent years, state legislatures have considered or enacted laws that
modify and, in many cases, increase state authority to regulate insurance
companies and insurance holding company systems. State insurance regulators are
members of the National Association of Insurance Commissioners, which seeks to
promote uniformity of, and to enhance the state regulation of, insurance. In
addition, the National Association of Insurance Commissioners and state
insurance regulators, as part of the National Association of Insurance
Commissioners' state insurance department accreditation program and in response
to new federal laws, have re-examined existing state laws and regulations,
specifically focusing on insurance company investments, issues relating to the
solvency of insurance companies, licensing and market conduct issues,
streamlining agent licensing and policy form approvals, adoption of privacy
rules for handling policyholder information, interpretations of existing laws,
the development of new laws, and the definition of extraordinary dividends.
In recent years, a variety of measures have been proposed at the federal
level to reform the current process of federal and state regulation of the
financial services industries in the United States, which include the banking,
insurance and securities industries. These measures, which are often referred to
as financial services modernization, have as a principal objective the
elimination or modification of current regulatory barriers to cross-industry
combinations involving banks, securities firms and insurance companies. A form
of financial services modernization legislation was enacted at the federal level
in 1999 through the Gramm-Leach-Bliley Act. That federal legislation was
expected to have significant implications on the banking, insurance and
securities industries and to result in more cross-industry consolidations among
banks, insurance companies and securities firms and increased competition in
many of the areas of our operations. Such wide-spread cross-industry
consolidation has not occurred to date. It also mandated the adoption of laws
allowing reciprocity among the states in the licensing of agents and, along with
other federal laws, mandated the adoption of laws and regulations dealing with
the protection of the privacy of policyholder information. Also, the federal
government has conducted investigations of the current condition of the
insurance industry in the United States to determine whether to impose overall
federal regulation of insurers. In the past several years there have been a
number of recommendations that the industry's anti-trust exemption be removed
and the industry placed under federal regulation. If so, we believe state
regulation of the insurance business would likely continue. This could result in
an additional layer of federal regulation.
We do not know at this time the full extent to which these federal or state
legislative or regulatory initiatives will or may affect our operations, and no
assurance can be given that they would not, if adopted, have a material adverse
effect on our business or its results of operations.
EMPLOYEES
As of December 31, 2002 we had 1,096 employees. The employees include six
executive officers, 24 senior management, 94 management and 972 other personnel.
Of this number, 353 are employed by our insurance companies, 501 are employed by
our underwriting agencies, 128 are employed by our intermediaries, and 114 are
employed at the corporate headquarters and elsewhere. We are not a party to any
collective
29
bargaining agreement and have not experienced work stoppages or strikes as a
result of labor disputes. We consider our employee relations to be good.
ITEM 2. PROPERTIES
Our principal and executive offices are located in Houston, Texas, in a
building owned by Houston Casualty Company. We also maintain offices in over 25
locations elsewhere in the United States, England and Spain. The majority of
these additional locations are in leased facilities.
Our principal office facilities are as follows:
<Table>
<Caption>
SUBSIDIARY LOCATION SQ. FT. LEASE TERMINATION DATE
- ---------- -------- ------- ----------------------
HCC Insurance Holdings, Inc. and Houston
Casualty Company Houston, Texas 51,000 Owned
Houston Casualty Company Houston, Texas 77,000 Owned
Avemco Insurance Company Frederick, Maryland 40,000 Owned
U.S. Specialty Insurance Company Aviation
Division Dallas, Texas 40,000 Leased*
Professional Indemnity Agency, Inc. Mount Kisco, New York 38,000 Owned
</Table>
- ---------------
* Lease termination date is March 31, 2004
ITEM 3. LEGAL PROCEEDINGS
In addition to the matters discussed in the Reinsurance Ceded section
contained in Item 1, Business, we are party to numerous lawsuits and other
proceedings that arise in the normal course of our business. Many of such
lawsuits and other proceedings involve claims under policies that we underwrite
as an insurer or reinsurer, the liabilities for which, we believe have been
adequately included in our loss reserves. Also, from time to time, we are a
party to lawsuits and other proceedings which relate to disputes over
contractual relationships with third parties, or which involve alleged errors
and omissions on the part of our subsidiaries. In addition, we are presently
engaged in litigation initiated by the appointed liquidator of a former
reinsurer concerning payments made to us prior to the date of the appointment of
the liquidator. The disputed payments were made by the now insolvent reinsurer
in connection with a commutation agreement. Our understanding is that such
litigation is one of a number of similar actions brought by the liquidator. We
intend to vigorously contest the action. We believe the resolution of any such
lawsuits will not have a material adverse effect on our financial condition,
results of operations or cash flows.
We have received substantial assessments from a state health insurance
association, which was established by the state to provide health insurance to
"high-risk" or otherwise uninsured individuals within that state. The expenses
of the association are currently funded principally through assessments on
insurers. With the current assessment, the association changed the calculation
method for the amount of the assessment, which resulted in a significant
increase in the amount of our assessment ($5.2 million). We and other insurers
are presently contesting the change in the assessment methodology. We believe we
will receive relief from the current assessment and that any amount we may
ultimately have to pay will not be material to our financial position and
results of operations, after taking into consideration credits we would receive
against other taxes in the state.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the
fourth quarter of 2002.
30
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
PRICE RANGE OF COMMON STOCK
Our common stock trades on the New York Stock Exchange under the ticker
symbol "HCC".
The intra-day high and low sales prices for quarterly periods during the
period January 1, 2001 through December 31, 2002, as reported by the New York
Stock Exchange were as follows:
<Table>
<Caption>
2002 2001
--------------- ---------------
HIGH LOW HIGH LOW
------ ------ ------ ------
First quarter...................................... $28.95 $24.90 $26.88 $20.50
Second quarter..................................... 28.50 24.70 29.65 23.26
Third quarter...................................... 26.60 19.11 26.67 21.21
Fourth quarter..................................... 25.70 22.37 29.20 25.15
</Table>
On March 14, 2003, the last reported sales price of our common stock as
reported by the New York Stock Exchange was $25.25 per share.
SHAREHOLDERS
We have one class of authorized capital stock: 250.0 million shares of
common stock, par value $1.00 per share. As of March 14, 2003, there were 62.7
million shares of issued and outstanding common stock held by 924 shareholders
of record; however, we believe there are in excess of 12,000 beneficial owners.
DIVIDEND POLICY
Beginning in June, 1996, we announced a planned quarterly program of paying
cash dividends to shareholders. We paid a cash dividend of $0.02 per share in
July, 1996 and in each succeeding quarter through the first quarter of 1997. We
have increased the quarterly cash dividend in each year and beginning in
September, 2002, our quarterly dividend was $0.065 per share. Our Board of
Directors may review our dividend policy from time to time, and any
determination with respect to future dividends will be made in light of
regulatory and other conditions at that time, including our earnings, financial
condition, capital requirements, loan covenants, and other related factors.
Under the terms of our bank loan, we are prohibited from paying dividends in
excess of an agreed upon maximum amount in any fiscal year. That limitation
should not affect our ability to pay dividends in a manner consistent with our
past practice and current expectations.
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial data set forth below has been derived
from the Consolidated Financial Statements. All information contained herein
should be read in conjunction with the Consolidated Financial Statements, the
related notes thereto and Management's Discussion and Analysis of Financial
Condition and Results of Operations included elsewhere in this Report.
31
<Table>
<Caption>
FOR THE YEARS ENDED DECEMBER 31,
(IN THOUSANDS, EXCEPT PER SHARE DATA)(1)
----------------------------------------------------
2002 2001 2000 1999 1998
-------- -------- -------- -------- --------
STATEMENT OF EARNINGS DATA:
Revenue
Net earned premium........................ $505,521 $342,787 $267,647 $141,362 $143,100
Management fees........................... 77,082 61,795 96,058 90,713 74,045
Commission income......................... 41,572 43,412 49,886 58,233 40,804
Net investment income..................... 37,769 39,638 39,836 30,946 29,342
Net realized investment gain (loss)....... 453 393 (5,321) (4,164) 845
Other operating income.................... 6,985 17,436 25,497 28,475 22,268
-------- -------- -------- -------- --------
Total revenue..................... 669,382 505,461 473,603 345,565 310,404
Expense
Loss and loss adjustment expense, net..... 306,491 267,390 198,470 109,650 91,302
Operating expense:
Policy acquisition costs, net........ 63,274 27,923 23,743 8,177 10,978
Compensation expense................. 80,495 69,762 83,086 79,196 57,227
Provision for reinsurance............ -- -- -- 43,462 --
Other operating expense.............. 47,642 71,119 53,274 53,273 36,558
-------- -------- -------- -------- --------
Total operating expense........... 191,411 168,804 160,103 184,108 104,763
Interest expense.......................... 8,301 8,884 20,347 12,964 6,021
-------- -------- -------- -------- --------
Total expense..................... 506,203 445,078 378,920 306,722 202,086
-------- -------- -------- -------- --------
Earnings before income tax
provision....................... 163,179 60,383 94,683 38,843 108,318
Income tax provision...................... 57,351 30,186 37,202 12,271 35,208
-------- -------- -------- -------- --------
Net earnings before accounting
change.......................... 105,828 30,197 57,481 26,572 73,110
Cumulative effect of accounting change(2)... -- -- (2,013) -- --
-------- -------- -------- -------- --------
Net earnings...................... $105,828 $ 30,197 $ 55,468 $ 26,572 $ 73,110
======== ======== ======== ======== ========
BASIC EARNINGS PER SHARE DATA:
Earnings before accounting change...... $ 1.70 $ 0.52 $ 1.13 $ 0.53 $ 1.49
Cumulative effect of accounting
change(2)............................ -- -- (0.04) -- --
-------- -------- -------- -------- --------
Net earnings........................... $ 1.70 $ 0.52 $ 1.09 $ 0.53 $ 1.49
======== ======== ======== ======== ========
Weighted average shares outstanding.... 62,225 58,321 50,742 50,058 48,917
======== ======== ======== ======== ========
DILUTED EARNINGS PER SHARE DATA:
Earnings before accounting change...... $ 1.68 $ 0.51 $ 1.11 $ 0.52 $ 1.46
Cumulative effect of accounting
change(2)............................ -- -- (0.04) -- --
-------- -------- -------- -------- --------
Net earnings........................... $ 1.68 $ 0.51 $ 1.07 $ 0.52 $ 1.46
======== ======== ======== ======== ========
Weighted average shares outstanding.... 62,936 59,619 51,619 50,646 49,933
======== ======== ======== ======== ========
Cash dividends declared, per share.......... $ 0.255 $ 0.245 $ 0.22 $ 0.20 $ 0.16
======== ======== ======== ======== ========
Amounts adjusted for the non-amortization of
goodwill(3):
Adjusted net earnings.................. $105,828 $ 41,584 $ 67,302 $ 31,980 $ 74,856
======== ======== ======== ======== ========
Adjusted basic earnings per share...... $ 1.70 $ 0.71 $ 1.33 $ 0.64 $ 1.53
======== ======== ======== ======== ========
Adjusted diluted earnings per share.... $ 1.68 $ 0.70 $ 1.30 $ 0.63 $ 1.50
======== ======== ======== ======== ========
</Table>
32
<Table>
<Caption>
DECEMBER 31,
(IN THOUSANDS, EXCEPT PER SHARE DATA)
--------------------------------------------------------------
2002 2001 2000 1999 1998
---------- ---------- ---------- ---------- ----------
BALANCE SHEET DATA:
Total investments................ $1,167,636 $ 885,659 $ 711,113 $ 581,322 $ 525,646
Premium, claims and other
receivables.................... 753,527 665,965 609,716 636,671 382,885
Reinsurance recoverables......... 798,934 899,128 789,412 736,485 372,672
Ceded unearned premium........... 164,224 71,140 114,469 133,657 149,568
Goodwill and intangible assets... 350,086 328,815 266,015 263,687 88,043
Total assets..................... 3,704,151 3,219,120 2,790,755 2,679,737 1,709,643
Loss and loss adjustment expense
payable........................ 1,155,290 1,130,748 944,117 871,104 460,511
Unearned premium................. 331,050 179,530 190,550 188,524 201,050
Notes payable.................... 230,027 181,928 212,133 242,546 121,600
Shareholders' equity............. 882,907 763,453 530,930 458,439 440,430
Book value per share(4).......... 14.15 12.40 10.29 9.12 8.94
</Table>
- ---------------
(1) Certain amounts in the 2001, 2000, 1999, and 1998 selected consolidated
financial data have been reclassified to conform to the 2002 presentation.
Such reclassifications had no effect on our net earnings, shareholders'
equity, or cash flows.
(2) During 2000, we changed certain of our revenue recognition methods for our
underwriting agencies and intermediaries to agree to guidance contained in
Securities and Exchange Commission's Staff Accounting Bulletin Number 101
entitled "Revenue Recognition in Financial Statements". See Note (1) in the
Notes to Consolidated Financial Statements.
(3) During 2002, we adopted Statement of Financial Accounting Standards ("SFAS")
No. 142 entitled "Goodwill and Other Intangible Assets", which required that
goodwill and indefinite-lived intangible assets no longer be amortized. The
adjusted amounts presented are amounts that we would have reported had we
adopted SFAS No. 142 on January 1, 1998.
(4) Book value per share is calculated by dividing the sum of outstanding shares
plus contractually issuable shares into total shareholders' equity.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
We primarily receive our revenue from earned premium derived from our
insurance company operations, management fees generated by our underwriting
agency operations, commission income produced by our intermediary operations,
investment income from all of our operations and other operating income. Our
core underwriting activities involve providing group life, accident and health,
aviation, London market account, global financial products and other specialty
lines of business, each of which is marketed by our insurance companies and our
underwriting agencies either directly to customers or through a network of
independent or affiliated agents and brokers.
During the past several years, we have substantially increased our
shareholders' equity through issuing equity securities and through retaining our
earnings, thereby enabling us to increase the underwriting capacity of our
insurance companies. With this additional equity, we increased underwriting
activity across many of our lines of business, emphasizing lines of business and
individual opportunities with the most favorable underwriting characteristics at
a particular point in the insurance cycle. As an insurer, we also purchase
reinsurance for each of our lines of business. We purchase different types of
reinsurance in amounts we consider appropriate for each of our lines of business
based upon market conditions and the level of risk we wish to retain.
33
Market conditions improved during 2000, 2001 and 2002 across all of our
lines of business. This improvement accelerated after the September 11, 2001
terrorist attack and highly publicized corporate governance failures and
continued throughout 2002 with significant rate increases particularly evident
in our global financial products line of business. We plan to continue to expand
our underwriting activities, in response to these hardening market conditions.
During 2001 and 2002 we acquired the following companies in transactions
that were recorded using the purchase method of accounting. Accordingly, the
results of operations and cash flows of these companies are included in our
underwriting results beginning on the effective date of each transaction.
<Table>
<Caption>
COMPANY SEGMENT EFFECTIVE DATE ACQUIRED
- ------- ------------------- -----------------------
Professional Indemnity Agency, Inc. Underwriting Agency October 22, 2001
ASU International, LLC Underwriting Agency October 30, 2001
HCC Global Financial Products LLC
(formerly MAG Global Financial Products) Underwriting Agency October 1, 2002
Dickson Manchester & Company Limited Underwriting Agency December 24, 2002
HCC Europe, (formerly St. Paul Espana) Insurance Company December 31, 2002
</Table>
RESULTS OF OPERATIONS
The following table sets forth certain premium revenue information for the
three years ended December 31, 2002 (in thousands):
<Table>
<Caption>
2002 2001 2000
---------- ---------- ---------
Direct........................................... $ 904,737 $ 783,124 $ 676,730
Reinsurance assumed.............................. 254,512 226,951 290,727
---------- ---------- ---------
Gross written premium.......................... 1,159,249 1,010,075 967,457
Reinsurance ceded................................ (613,338) (637,117) (683,669)
---------- ---------- ---------
Net written premium............................ 545,911 372,958 283,788
Change in unearned premium....................... (40,390) (30,171) (16,141)
---------- ---------- ---------
Net earned premium............................. $ 505,521 $ 342,787 $ 267,647
========== ========== =========
</Table>
The following table sets forth the relationships of certain income
statement items as a percent of total revenue for the three years ended December
31, 2002:
<Table>
<Caption>
2002 2001 2000
----- ----- -----
Net earned premium.......................................... 75.5% 67.8% 56.5%
Management fees............................................. 11.5 12.2 20.3
Commission income........................................... 6.2 8.6 10.5
Net investment income....................................... 5.7 7.8 8.4
Net realized investment gain (loss)......................... 0.1 0.1 (1.1)
Other operating income...................................... 1.0 3.5 5.4
----- ----- -----
Total revenue............................................. 100.0 100.0 100.0
Loss and loss adjustment expense, net....................... 45.8 52.9 41.9
Net operating expense....................................... 28.6 33.4 33.8
Interest expense............................................ 1.2 1.7 4.3
----- ----- -----
Earnings before income tax provision...................... 24.4 12.0 20.0
Income tax provision........................................ 8.6 6.0 7.9
----- ----- -----
Net earnings before accounting change..................... 15.8% 6.0% 12.1%
===== ===== =====
</Table>
34
Year Ended December 31, 2002 Versus Year Ended December 31, 2001
Total revenue increased 32% to $669.4 million for 2002 from $505.5 million
in 2001. The revenue increase in the insurance company segment resulted from
organic growth in our existing lines of business, the addition of our new global
financial products line of business, and increased premium retention. The
revenue in the underwriting agency segment increased due to organic growth and
acquisitions made in 2002 and late 2001, but the increase was partially offset
by reduced revenue in the intermediary and other operations segments as a result
of market conditions and the sale or other disposition of various operations in
2001.
Net investment income decreased to $37.8 million for 2002 from $39.6
million in 2001. This decrease was due to the reduction in interest rates,
substantially offset by the higher level of invested assets which resulted from
cash flow provided by operating activities and capital contributions made to our
insurance company subsidiaries. We expect investment assets to continue to
increase which, even without an increase in market interest rates, should
produce a growth in investment income in 2003.
The year 2001 was adversely affected as we experienced the largest loss to
our insurance company operations in our history due to the terrorist attack on
September 11, with incurred net losses of $35.0 million. In 2001, we also
recorded a charge totaling $37.3 million related to our primary workers'
compensation line of business and other lines of business that we decided to
cease writing. Included in this charge was $15.0 million related to the
impairment of goodwill associated with our primary workers' compensation line of
business.
Compensation expense increased to $80.5 million during 2002 from $69.8
million in 2001. Much of this increase was due to the underwriting agency
subsidiaries acquired in 2002 and late 2001, somewhat offset by a decrease from
operations sold or otherwise disposed of during late 2001 and efficiencies
gained from the consolidation of certain of our underwriting agencies into our
insurance company operations.
Other operating expense decreased to $47.6 million during 2002 compared to
$71.1 million in 2001, primarily as a result of the reduction in the
amortization of goodwill, operations sold or disposed of, somewhat offset by the
effect of acquisitions in 2002 and late 2001, and the goodwill impairment charge
in 2001. Currency conversion gains amount to $1.2 million in 2002 compared to
$0.3 million in 2001.
Interest expense was $8.3 million for 2002 compared to $8.9 million in
2001. Included in 2002 is $2.9 million representing the amortization of
underwriting discounts and other costs of our August 2001 issuance of 2%
convertible notes, compared to $1.5 million of similar amortization in 2001.
These costs were fully amortized at the end of August 2002.
Income tax expense was $57.4 million for 2002 compared to $30.2 million in
2001. Our effective tax rate was 35.1% in 2002. The unusually high tax rate for
2001 results from the write off related to the impairment of goodwill, which was
not deductible for income tax purposes.
Net earnings increased to $105.8 million, or $1.68 per diluted share, for
2002 from $30.2 million, or $0.51 per diluted share, in 2001. The increase in
net earnings resulted from increased revenue and an improved underwriting
performance by the insurance company segment, net of a charge in 2002 related to
a discontinued line of business ($5.0 million or $0.08 per share). Other events
affecting the comparison include losses from the September 11 terrorist attack
recorded during 2001 ($22.8 million or $0.38 per share), the charge for lines of
business we decided to cease writing during 2001 ($29.6 million or $0.50 per
share) and the amortization of goodwill in 2001, ($11.4 million or $0.19 per
share) prior to our adoption of SFAS No. 142.
Our book value per share was $14.15 as of December 31, 2002, up from $12.40
as of December 31, 2001. Net earnings and the unrealized gain on available for
sale securities contributed to the increase in book value per share.
35
SEGMENTS
INSURANCE COMPANIES
The following tables provide information by line of business (in
thousands):
<Table>
<Caption>
GROSS NET NET NET
WRITTEN WRITTEN EARNED LOSS
PREMIUM PREMIUM PREMIUM RATIO
---------- -------- -------- -----
For the year ended December 31, 2002:
Group life, accident and health............. $ 503,263 $244,554 $240,070 62.2%
Aviation.................................... 212,518 99,826 100,960 46.3
London market account....................... 199,816 113,925 89,260 51.5
Global financial products................... 178,653 43,731 23,102 46.4
Other specialty lines....................... 32,563 25,621 22,337 101.1
---------- -------- -------- -----
1,126,813 527,657 475,729 57.8
Discontinued lines.......................... 32,436 18,254 29,792 105.0
---------- -------- -------- -----
TOTALS...................................... $1,159,249 $545,911 $505,521 60.6%
========== ======== ========
Expense ratio............................... 25.4
-----
Combined ratio.............................. 86.0%
=====
For the year ended December 31, 2001:
Group life, accident and health............. $ 502,086 $146,220 $143,851 67.5%
Aviation.................................... 198,015 98,249 91,377 62.5
London market account....................... 133,579 54,056 43,360 59.4
Global financial products................... 46 44 4 25.0
Other specialty lines....................... 15,556 14,346 15,120 73.5
---------- -------- -------- -----
849,282 312,915 293,712 65.1
Discontinued lines.......................... 160,793 60,043 49,075 155.5
---------- -------- -------- -----
TOTALS...................................... $1,010,075 $372,958 $342,787 78.0%
========== ======== ========
Expense ratio............................... 25.7
-----
Combined ratio.............................. 103.7%
=====
</Table>
Gross written premium increased 15% to $1.2 billion for 2002 from $1.0
billion in 2001. This increase was 33% before the discontinued lines of
business. The increase resulted from organic growth and premium rate increases
in our London market account line of business, plus our global financial
products line of business not previously written, offset by the decrease in
discontinued lines of business. Gross written premium is expected to continue to
increase in 2003.
Net written premium for 2002 increased 46% to $545.9 million from $373.0
million in 2001, as our insurance companies have increased their overall
retentions, in addition to the effect of the changes in gross premium described
above. Net earned premium also increased 47% to $505.5 million for the same
reasons. Increases in net written and net earned premiums were 69% and 62%,
respectively, before the discontinued lines of business. Increases in net
written and net earned premium are expected to continue in 2003.
Net loss and loss adjustment expense was $306.5 million for 2002 compared
to $267.4 million in 2001. The 2001 net loss expense included $35.0 million from
the September 11 terrorist attack and $18.8 million from the charge for lines of
business we decided to cease writing. Because of these items and generally
better underwriting results in 2002 as a result of higher pricing and improved
policy terms and conditions, the net loss ratio was greatly improved at 60.6%
for 2002 compared to 78.0% in 2001, on substantially increased earned premiums.
The loss ratios for the continuing lines, with the exception of the specialty
lines, also improved for
36
these reasons. The loss ratio in the other specialty lines increased as a result
of some adverse development on policies, which were subsequently not renewed.
During the third quarter of 2002, we also recorded a charge in the amount of
$7.7 million related to certain business included in discontinued lines. This
business was acquired as part of our purchase of The Centris Group, Inc. in 1999
and was of a type that we have not historically written. The gross loss ratio
was 58.6% in 2002 compared to 105.5% in 2001. The 2001 gross loss ratio was high
because we recorded gross losses of $55.0 million due to the Petrobras
production platform, $141.0 million due to the September 11 terrorist attack and
$49.0 million due to the Total Oil Company loss. Additionally, in 2002, as a
result of further evaluation, we reduced our gross losses from the September 11
terrorist attack by $21.5 million and reduced the gross losses from the Total
loss by $14.0 million. Offsetting this positive gross development was $36.2
million of negative development due to late reporting of an aggregate program
that we no longer write. As the adjustments related to gross losses that were
substantially reinsured, there was no material net effect.
During 2002, we had net loss and loss adjustment expense redundancy of $6.8
million relating to prior year losses compared to a redundancy of $10.7 million
in 2001 and we had gross loss and loss adjustment expense redundancy of $23.2
million compared to a deficiency of $44.5 million in 2001. The gross deficiency
for 2001 resulted from late reported loss information received during 2001,
primarily from assumed reinsurance business written by one of our insurance
companies. There was no material net effect on our earnings as that business was
substantially reinsured. The deficiencies and redundancies result from our
continued review of our loss reserves with our actuaries and the increase or
reduction of reserves as losses are finally settled and claims exposures are
reduced. We continue to believe we have provided for all material net incurred
losses.
The tables below show the composition of net and gross incurred loss and
loss adjustment expense (amounts in thousands):
<Table>
<Caption>
NET INCURRED LOSS AND LOSS ADJUSTMENT EXPENSE
---------------------------------------------
2002 2001
--------------------- ---------------------
AMOUNT LOSS RATIO AMOUNT LOSS RATIO
-------- ---------- -------- ----------
September 11 terrorist attack.................. $ -- --% $ 35,000 10.2%
2001 charge for lines of business we ceased
writing...................................... -- -- 18,799 5.5
2002 third quarter charge...................... 7,674 1.5 -- --
Other prior year development................... (14,453) (2.9) (11,963) (3.5)
All other incurred loss and loss adjustment
expense...................................... 313,270 62.0 225,554 65.8
-------- ---- -------- ----
Net incurred loss and loss adjustment
expense...................................... $306,491 60.6% $267,390 78.0%
======== ==== ======== ====
</Table>
<Table>
<Caption>
GROSS INCURRED LOSS AND LOSS ADJUSTMENT EXPENSE
-----------------------------------------------
2002 2001
--------------------- -----------------------
AMOUNT LOSS RATIO AMOUNT LOSS RATIO
-------- ---------- ---------- ----------
September 11 terrorist attack................ $(21,500) (2.1)% $ 140,962 14.0%
Petrobras production platform................ -- -- 55,000 5.4
Total Oil Company loss....................... (14,000) (1.4) 49,000 4.9
2001 charge for lines of business we ceased
writing.................................... -- -- 36,784 3.6
2002 third quarter charge.................... 7,674 0.8 -- --
Aggregate program development................ 36,170 3.5 -- --
Other prior year development................. (31,504) (3.1) 40,367 4.0
All other incurred loss and loss adjustment
expense.................................... 627,412 60.9 741,732 73.6%
-------- ---- ---------- -----
Gross incurred loss and loss adjustment
expense.................................... $604,252 58.6% $1,063,845 105.5%
======== ==== ========== =====
</Table>
Policy acquisition costs, which are net of commissions on reinsurance
ceded, increased to $63.3 million during 2002, from $27.9 million in 2001. This
increase is due to the higher earned premium and the reduction
37
in ceding commissions as a result of our retaining more business. Included in
the 2001 amount is $2.2 million from the charge for lines of business we decided
to cease writing. The expense ratio was substantially unchanged at 25.4% for
2002 compared to 2001 which, when added to our greatly improved loss ratio,
produced a substantially lower combined ratio of 86.0% for 2002 compared to
103.7% in 2001.
Net earnings of our insurance companies increased to $68.2 million in 2002
from a net loss of $2.9 million in 2001, due to increased revenue and improved
underwriting results in 2002. The 2001 results include the effects from the
terrorist attack on September 11 and the charge for lines of business we decided
to cease writing. There was $2.1 million (net of income tax) of goodwill
amortization recorded in 2001. Barring future catastrophic events, we expect
this trend to continue into 2003.
UNDERWRITING AGENCIES
Management fees increased 25% to $77.1 million for 2002, compared to $61.8
million in 2001. The underwriting agencies acquired in 2002 and late 2001
accounted for much of the increase together with organic growth, partially
offset by a decrease in management fees from our other underwriting agencies as
we continued the consolidation of certain other underwriting agency operations
into our insurance companies. Net earnings of our underwriting agencies
increased to $25.3 million for 2002 from $17.2 million in 2001 as a result of
increased revenue and the adoption of SFAS No. 142, somewhat offset by the
integration of certain underwriting agencies into our insurance companies. There
was $5.9 million (net of income tax) of goodwill amortization recorded in 2001.
We expect further improvement in 2003 due to our acquisitions in late 2002 and
organic growth.
INTERMEDIARIES
Commission income decreased to $41.6 million for 2002, compared to $43.4
million in 2001 due to general market conditions and less ceded reinsurance
being placed on behalf of our insurance companies as they increased their
retentions. Net earnings of our intermediaries decreased to $7.6 million for
2002 compared to $8.7 million in 2001. There was $3.4 million (net of income
tax) of goodwill amortization recorded in 2001 compared to none in 2002 due to
the adoption of SFAS No. 142. We anticipate returning to growth in commission
income in 2003 as our non-affiliated business grows.
OTHER OPERATIONS
The decrease in other operating income to $7.0 million during 2002 from
$17.4 million in 2001 was principally due to the disposition or closure of
certain operations during 2001 and the resultant gains totaling $8.2 million
from certain of those dispositions. Net earnings of other operations decreased
to $3.1 million in 2002 from $7.1 million in 2001 for the same reasons. Period
to period comparisons may vary substantially depending on other operating
investments or dispositions thereof in any given period. We anticipate new
strategic investments and possibly a service company acquisition in 2003, which
would provide growth in this revenue.
CORPORATE
The net income of the corporate segment was $2.9 million for 2002 compared
to a net loss of $1.0 million in 2001. This improvement resulted from lower
interest expense due primarily to lower interest rates.
Year Ended December 31, 2001 Versus Year Ended December 31, 2000
Total revenue increased 7% to $505.5 million for 2001 compared to 2000. The
increase in the insurance company segment revenue resulting from increased
business, greater retention levels and higher investment income was offset
primarily by a reduction in the underwriting agency segment revenue as we
consolidated the operations of three of our underwriting agencies into the
operations of our insurance companies on January 1, 2001.
38
Net investment income was $39.6 million for 2001 compared to $39.8 million
in 2000. The positive effect on investment income of our higher level of
invested assets was offset by a significant decrease in interest rates in 2001.
During 2001, we recorded a net realized investment gain of $0.4 million,
compared to a loss of $5.3 million in 2000. During 2001 we recognized a $2.4
million realized loss from the write down of five investments to their estimated
fair market value compared to a similar write down of $5.1 million from one
equity investment during 2000. The loss from write downs during 2001 was offset
by other gains recorded on investments sold.
During 2001, we experienced three significant gross losses. The largest
loss was as a result of the terrorist attack on September 11, which produced the
biggest loss to our insurance company operations in our history. Although we had
no involvement in the insurance coverages of the airlines involved, we had
significant exposure in our accident and health reinsurance account. Our
estimates of ultimate exposure were developed through a review of policy
coverages, consideration of the effect on the estimate if the attack was
considered multiple events rather than a single event, and communications from
our clients and producers. We also had participations in property coverage on
the World Trade Center and some of the surrounding buildings. In addition, we
anticipate some claims from other business written in the New York City area. We
also received some reported claims and estimates of losses for others. We
utilized this information together with known coverage and reinstatement premium
information to establish our gross and net losses reserve of $141.0 million and
$35.0 million, respectively. A charge for the net amount has been included in
our 2001 consolidated financial statements. The other two losses were the
Petrobras (Brazilian offshore energy production platform) and Total (chemical
factory near Toulouse, France) incidents, which produced gross losses of $55.0
million and $49.0 million, respectively. Because these policies were
substantially reinsured, the net losses were not material to our results of
operations.
During 2001, we recorded a charge totaling $37.3 million related to lines
of business that we decided to cease writing, mainly our primary workers'
compensation line of business. The composition of this charge is $18.8 million
for loss and loss adjustment expense, $2.2 million for net policy acquisition
costs and $16.3 million for other operating expense. Included in other operating
expense is $15.0 million related to the impairment of goodwill associated with
our primary workers' compensation line of business. The fair value of this line
of business was calculated based upon the present value of future expected cash
flows.
Compensation expense decreased to $69.8 million for 2001 from $83.1 million
in 2000. The decrease is due principally to the disposition of non-core
subsidiaries, the subsequent closing or reduction of some operations of an
acquired company and efficiencies gained from the consolidation of some of our
underwriting agency operations with those of our insurance companies.
Other operating expense for 2001 included $16.3 million from charges
related to lines of business that we decided to cease writing. Excluding these
charges, other operating expense in 2001 was somewhat reduced for the same
reasons as compensation expense, but to a much lesser extent, and the decrease
was offset by a general increase in expenses in our operating subsidiaries as
business grew. In addition, guarantee fund and other assessments increased $3.5
million in 2001 compared to 2000. Other operating expenses for 2000 also
included a credit of $0.8 million reflecting the reversal of some restructuring
charges recorded during the previous year, whereas during 2001 we recorded $0.2
million in merger expense resulting from an acquisition. Currency conversion
gains amounted to $0.3 million in 2001 compared to losses of $0.3 million in
2000.
Interest expense was $8.9 million for 2001 down from $20.3 million in 2000.
This decrease resulted from our use of the proceeds from our March, 2001 public
offering of common stock and part of our August, 2001 offering of 2% convertible
notes to pay off our debt under the bank facility, lower interest rates and the
low interest rate on our newly issued convertible notes.
Income tax expense on earnings before the change in accounting was $30.2
million for 2001 down from $37.2 million for 2000 primarily due to the reduction
in pre-tax income. The unusual effective tax rate for 2001 of 50% , compared to
39% for 2000, primarily results from the charge for the impairment of goodwill,
which was not deductible for income tax purposes.
39
Net earnings before the change in accounting was $30.2 million, or $0.51
per diluted share, for 2001 compared to $57.5 million, or $1.11 per diluted
share, in 2000 before the cumulative effect of an accounting change. This
decrease primarily results from the after tax loss from the September 11
terrorist attack of $22.8 million, or $0.38 per diluted share, and the after tax
charge for lines of business we decided to cease writing of $29.6 million, or
$0.50 per diluted share.
Our book value per share was $12.40 as of December 31, 2001, up
substantially from $10.29 as of December 31, 2000.
SEGMENTS
INSURANCE COMPANIES
The following tables provide information by line of business (in
thousands):
<Table>
<Caption>
GROSS NET NET NET
WRITTEN WRITTEN EARNED LOSS
PREMIUM PREMIUM PREMIUM RATIO
---------- -------- -------- -----
For the year ended December 31, 2001:
Group life, accident and health............. $ 502,086 $146,220 $143,851 67.5%
Aviation.................................... 198,015 98,249 91,377 62.5
London market account....................... 133,579 54,056 43,360 59.4
Global financial products................... 46 44 4 25.0
Other specialty lines....................... 15,556 14,346 15,120 73.5
---------- -------- -------- -----
849,282 312,915 293,712 65.1
Discontinued lines.......................... 160,793 60,043 49,075 155.5
---------- -------- -------- -----
TOTALS.................................... $1,010,075 $372,958 $342,787 78.0%
========== ======== ========
Expense ratio............................... 25.7
-----
Combined ratio.............................. 103.7%
=====
For the year ended December 31, 2000:
Group life, accident and health............. $ 422,384 $109,005 $109,077 74.4%
Aviation.................................... 191,089 79,794 73,695 70.2
London market account....................... 83,521 22,292 16,234 74.1
Global financial products................... -- -- -- --
Other specialty lines....................... 15,906 14,552 14,552 40.9
---------- -------- -------- -----
712,900 225,643 213,558 70.6
Discontinued lines.......................... 254,557 58,145 54,089 88.0
---------- -------- -------- -----
TOTALS.................................... $ 967,457 $283,788 $267,647 74.2%
========== ======== ========
Expense ratio............................... 21.0
-----
Combined ratio.............................. 95.2%
=====
</Table>
Gross written premium increased to $1.0 billion for 2001 from $967.5
million in 2000 with strong growth in the group life, accident and health and
London market account lines of business, as rates continued to rise. Gross
written premium growth was not our focus in 2001, as we were able to grow our
revenue simply by retaining more of the business. Net written premium for 2001
increased 31% to $373.0 million compared to the previous year, as our insurance
companies increased retentions on many of their lines of business as
underwriting profitability improved. Net earned premium increased 28% to $342.8
million for the same reason. Increases in net written premium and net earned
premium were 39% and 38%, respectively, before the discontinued lines of
business.
40
Loss and loss adjustment expense increased to $267.4 million for 2001
compared to $198.5 million in 2000 substantially due to losses and expenses
arising from the September 11 loss and the charge related to lines of business
we decided to cease writing. The net loss ratio was 78.0% for 2001 compared to
74.2% in 2000. The group life, accident and health, aviation and London market
account loss ratios improved, in spite of losses sustained from the September
11, 2001 terrorist attack, due generally to rate increases and better terms and
conditions. The other specialty lines loss ratio increased between years as a
result of adverse development on policies, which were subsequently not renewed.
The discontinued lines loss ratio increased as a result of the charge related to
lines of business we decided to cease writing and the September 11, 2001 loss.
The gross loss ratio was 105.5% in 2001 compared to 79.4% for 2000. The
Petrobras and Total claims were substantially reinsured and did not have a
material effect on our net loss ratio or net earnings. The combined ratio was
103.7% in 2001 compared to 95.2% for 2000. The expense ratio increased in 2001
to 25.7% from 21.0% in 2000 principally as a result of reduced ceding
commissions as we retained more profitable business.
During 2001, we had net loss and loss adjustment expense redundancy of
$10.7 million relating to prior year losses compared to a redundancy of $9.6
million in 2000 and we had gross loss and loss adjustment expense deficiency of
$44.5 million compared to a redundancy of $1.9 million in 2000. The gross
deficiency for 2001 resulted from late reported loss information received during
2001. These losses primarily came from assumed reinsurance business written by
one of our insurance companies. The other deficiencies and redundancies result
from our continued review of our loss reserves with our actuaries and the
increase or reduction of the loss reserves as losses are finally settled and
claims exposures are reduced.
<Table>
<Caption>
NET INCURRED LOSS AND LOSS ADJUSTMENT EXPENSE
---------------------------------------------
2001 2000
--------------------- ---------------------
AMOUNT LOSS RATIO AMOUNT LOSS RATIO
-------- ---------- -------- ----------
September 11 terrorist attack.................. $ 35,000 10.2% $ -- --%
2001 charge for lines of business we ceased
writing...................................... 18,799 5.5 -- --
Other prior year development................... (11,963) (3.5) (9,585) (3.6)
All other incurred loss and loss adjustment
expense...................................... 225,554 65.8 208,055 77.8
-------- ---- -------- ----
Net incurred loss and loss adjustment
expense...................................... $267,390 78.0% $198,470 74.2%
======== ==== ======== ====
</Table>
<Table>
<Caption>
GROSS INCURRED LOSS AND LOSS ADJUSTMENT EXPENSE
-----------------------------------------------
2001 2000
----------------------- ---------------------
AMOUNT LOSS RATIO AMOUNT LOSS RATIO
---------- ---------- -------- ----------
September 11 terrorist attack................ $ 140,962 14.0% $ -- --%
Petrobras production platform................ 55,000 5.4 -- --
Total Oil Company loss....................... 49,000 4.9 -- --
2001 charge for lines of business we ceased
writing.................................... 36,784 3.6 -- --
Other prior year development................. 40,367 4.0 (1,892) (0.2)
All other incurred loss and loss adjustment
expense.................................... 741,732 73.6 775,538 79.6
---------- ----- -------- ----
Gross incurred loss and loss adjustment
expense.................................... $1,063,845 105.5% $773,646 79.4%
========== ===== ======== ====
</Table>
Policy acquisition costs, which are net of ceding commissions on
reinsurance ceded, increased somewhat to $27.9 million during 2001 compared to
2000. During 2001, our insurance companies charged higher policy issuance fees
on certain lines of business which are recorded as a reduction in acquisition
costs. This reduction in costs is offset by the increase in policy acquisition
costs resulting from higher earned premium and part of the charge from lines of
business we decided to cease writing.
The net loss of our insurance companies was $2.9 million in 2001 compared
to net income of $24.2 million for 2000. The 2001 results include after tax
losses from the September 11 terrorist attack of $22.8 million and the charge
for lines of business we decided to cease writing of $29.4 million.
41
UNDERWRITING AGENCIES
Management fees decreased to $61.8 million for 2001 compared to $96.1
million in 2000. Much of the decrease is the result of our consolidation of the
operations of three of our underwriting agencies into the operations of our
insurance companies effective January 1, 2001. Additional decreases are due to
lines of business either sold or exited and increased retentions of our
insurance companies. Net earnings of our underwriting agencies decreased to
$17.2 million for 2001 from $21.4 million in 2000 for the same reasons.
INTERMEDIARIES
Commission income was $43.4 million for 2001 compared to $49.9 million in
2000. Commission income decreased due to general market conditions and less
ceded reinsurance being placed on behalf of our insurance companies as they
increased their retentions. Net earnings of our intermediaries decreased to $8.7
million for 2001 compared to $11.2 million in 2000. The decrease in net earnings
was partly caused by our acquisition of The Schanen Consulting Group, LLC which
was not subject to income taxes during 2000 prior to our ownership, but
reflected in our historical results due to pooling-of-interest accounting, and
less commission income as a result of the mix of business, which had a lower
gross margin during the current year
OTHER OPERATIONS
The decrease in other operating revenue to $17.4 million for 2001 from
$25.5 million in 2000 results principally from the disposition or closure of
certain non-core operations. During 2001, we recorded gains of $8.2 million from
the sale of other operating investments compared to $5.7 million for 2000. The
increase in gains was somewhat offset by loss of revenue included in the 2000
period related to operations that have since been closed or disposed of. Net
earnings of other operations were $7.1 million in 2001 up from $6.0 million in
2000 for the same reasons. Period to period comparisons may vary substantially
depending on other operating investments, or dispositions of such investments,
in any given period.
CORPORATE
The net loss of the corporate segment was $1.0 million for 2001 compared to
a net loss of $4.7 million in 2000. This improvement resulted from the reduction
of interest expense as we paid off our debt under the bank facility by using the
proceeds from the March, 2001 public offering of common stock and the August,
2001 offering of 2% convertible notes, lower bank interest rates and the low
interest rate on our newly issued 2% convertible notes. Also included in the
amounts for 2000 were the costs of the closing of some operations of an acquired
company.
LIQUIDITY AND CAPITAL RESOURCES
We receive substantial cash from premiums, reinsurance recoverables, and
management fee and commission income and, to a lesser extent, investment income,
and proceeds from sales and redemptions of investments and other assets. Our
principal cash outflows are for the payment of claims and loss adjustment
expenses, payment of premiums to reinsurers, purchase of investments, debt
service, and payment of policy acquisition costs, operating expenses, income and
other taxes and dividends. Variations in operating cash flows can occur due to
timing differences in either the payment of claims and the collection of related
recoverables or the collection of receivables and the payment of related payable
amounts. We limit our liquidity exposure by holding funds, letters of credit and
other security such that net balances due to us are less than the gross balances
shown in our condensed consolidated balance sheets.
We maintain a substantial level of cash and liquid short-term investments
which are used to meet anticipated payment obligations. Our consolidated cash
and investment portfolio increased $305.4 million, or 34% during 2002, and
totaled $1.2 billion as of December 31, 2002, of which $347.5 million was cash
and short-term investments. The increase in investments resulted primarily from
operating cash flows and the $50.0 million in capital contributions we made to
our insurance companies in 2002. Total assets increased to $3.7 billion as of
December 31, 2002.
42
Our investment portfolio includes a high percentage of liquid investments
and generates a significant amount of investment income, which serves as a
source of cash flow. The average tax equivalent yield on investments was 4.6% in
2002, compared to 5.6% in 2001. The weighted average maturity of our fixed
income securities is 4.2 years and weighted average duration of the portfolio
was 3.5 years, both as of December 31, 2002. Over 96% of our fixed income
securities were rated A or better by Standard & Poor's Corporation. The value of
our portfolio of fixed income securities is inversely correlated to changes in
market interest rates. In addition, some of our fixed income securities have
call or prepayment options. This could subject us to reinvestment risk should
interest rates fall or issuers call their securities and we reinvest the
proceeds at lower interest rates. We mitigate this risk by investing in
securities with varied maturity dates, so that only a portion of our portfolio
will mature at any point in time.
On March 6, 2001, we sold 6.9 million shares of our common stock in a
public offering at a price of $23.35 per share. Net proceeds from the offering
amounted to $152.4 million after deducting underwriting discounts, commissions
and offering expenses and were used to pay down our bank facility.
In a public offering on August 23, 2001, we issued an aggregate $172.5
million principal amount of 2% Convertible Notes due in 2021. Each $1 thousand
principal amount of notes is convertible into 31.25 shares of our common stock,
which represents an initial conversion price of $32.00 per share. The initial
conversion price is subject to change under certain conditions. Interest is to
be paid by us on March 1 and September 1 each year. Holders may surrender notes
for conversion into shares of our common stock in any calendar quarter if, as of
the last day of the preceding calendar quarter, the closing sale price of our
common stock for at least 20 trading days in the period of 30 consecutive
trading days ending on the last trading day of the quarter is more than 120%
($38.40 per share) of the conversion price per share of our common stock on the
last trading day of the quarter. We can redeem the notes for cash at any time on
or after September 1, 2006. Holders of the notes may require us to repurchase
the notes on September 1, 2004, 2006, 2008, 2011 and 2016. If the holders
exercise this option, we may choose to pay the purchase price in cash, in shares
of our common stock, or a combination thereof. On September 1, 2002, the first
repurchase date of the notes, $49 thousand of the notes were tendered to us and
we repurchased them with cash. We used the proceeds from this offering to repay
our remaining indebtedness under our bank facility, assist in financing recent
acquisitions, make a $60.0 million capital contribution to our insurance
companies and for general corporate purposes.
On December 17, 1999, we entered into a $300.0 million Revolving Loan
Facility with a group of banks. At our request, the amount available under the
facility was reduced to $200.0 million by an amendment on June 6, 2001. We can
borrow up to the maximum amount allowed by the facility on a revolving basis
until the facility expires on December 17, 2004. The facility is collateralized
in part by the pledge of our insurance companies' stock and guarantees entered
into by our underwriting agencies and intermediaries. The facility agreement
contains certain restrictive covenants, which we believe are typical for similar
financing arrangements. As of December 31, 2002, there was an outstanding
balance of $53.0 million on this facility bearing interest at an average rate of
3.2%.
On December 31, 2001 we filed Form S-3 with the United States Securities
and Exchange Commission, which provides a shelf registration for an aggregate of
$750.0 million of our securities available to be issued. These securities may be
debt securities, equity securities or a combination thereof.
On March 25, 2003, we sold an aggregate $125.0 million principal amount of
1.3% Convertible Notes due in 2023 in a public offering. Each $1 thousand
principal amount of notes is convertible into 29.4377 shares of our common
stock, which represents an initial conversion price of $33.97 per share. Holders
may surrender notes for conversion into shares of our common stock if, as of the
last day of the preceding calendar quarter, the closing sale price of our common
stock for at least 20 consecutive trading days during the period of 30
consecutive trading days ending on the last trading day of that quarter is more
than 130% ($44.16 per share) of the conversion price per share of our common
stock. Holders of the notes may require us to repurchase the notes on April 1,
2009, 2014 and 2019. If the holders exercise this option, we may choose to pay
the purchase price in cash, in shares of our common stock, or in a combination
thereof. We plan to use the
43
proceeds from this offering to pay down existing indebtedness under our bank
facility, assist in financing future acquisitions and strategic investments and
for general corporate purposes.
At December 31, 2002, certain of our subsidiaries maintained revolving
lines of credit with a bank in the combined maximum amount of $26.8 million
available through December 17, 2004. Advances under the lines of credit are
limited to amounts required to fund draws, if any, on letters of credit issued
by the bank on behalf of the subsidiaries and short-term direct cash advances.
The lines of credit are collateralized by securities having an aggregate market
value of up to $33.5 million, the actual amount of collateral at any one time
being 125% of the aggregate amount outstanding. Interest on the lines is payable
at the bank's prime rate of interest (4.25% at December 31, 2002) for draws on
the letters of credit and prime less 1% on short-term cash advances. As of
December 31, 2002, letters of credit totaling $12.1 million had been issued to
insurance companies by the bank on behalf of our subsidiaries, with total
securities of $15.2 million collateralizing the lines.
The following is a summary of our contractual cash payment obligations as
of December 31, 2002 (in thousands):
<Table>
<Caption>
PAYMENTS BY DUE DATE
--------------------------------------------
TOTAL 2003 2004-2005 2006-2007 THEREAFTER
-------- ------- --------- --------- ----------
Convertible notes................. $172,451 $ -- $ -- $ -- $172,451
Bank facility..................... 53,000 -- 53,000 -- --
Other notes payable............... 4,576 2,610 404 404 1,158
Operating leases.................. 29,991 8,687 13,150 6,832 1,322
-------- ------- ------- ------ --------
Total obligations............... $260,018 $11,297 $66,554 $7,236 $174,931
======== ======= ======= ====== ========
</Table>
See preceding paragraphs and Notes (6) and (10) in Notes to the
Consolidated Financial Statements for additional information concerning these
obligations. The convertible notes have various put dates as discussed above.
The following is a summary of our various commitments (in thousands) as of
December 31, 2002, all of which expire during 2004 or 2005:
<Table>
Outgoing letters of credit.................................. $12,140
Mortgage guarantee.......................................... 11,140
-------
Total commitments......................................... $23,280
=======
</Table>
We have sold businesses in the past. In connection with these sales, we
have provided indemnifications to the buyers, which we believe are typical for
transactions of this nature, based upon the type of business sold. Certain of
these indemnifications have no limit. It is not possible to estimate the maximum
potential amount under these indemnifications as our performance under the
indemnifications and our ultimate liability are based upon the occurrence of
future events which may or may not occur. We currently have a liability in the
amount of $6.2 million recorded for performance under one such indemnification.
This indemnification was given by a company we acquired, prior to its
acquisition, in connection with a sale of one of its subsidiaries.
The principal assets of HCC Insurance Holdings, Inc. are the shares of
capital stock of our insurance companies. Historically, we have not relied on
dividends from our insurance companies to meet the obligations of the parent
holding company, which are primarily outstanding debt and debt service
obligations, dividends to shareholders and corporate expenses, but, rather, we
have had sufficient cash flow from our underwriting agencies and intermediaries
to meet our cash flow requirements. The payment of dividends by our insurance
companies is subject to regulatory restrictions and will depend on the surplus
and future earnings of these subsidiaries.
Property and casualty insurance companies domiciled in the State of Texas
are limited in the payment of dividends to their shareholders in any
twelve-month period, without the prior written consent of the Commissioner of
Insurance, to the greater of statutory net income for the prior calendar year or
10% of their
44
statutory policyholders' surplus as of the prior year end. During 2003, Houston
Casualty Company's ordinary dividend capacity will be approximately $40.0
million and U.S. Specialty Insurance Company's ordinary dividend capacity will
be approximately $11.0 million.
Avemco Insurance Company is limited by the State of Maryland in the amount
of dividends which it may pay in any twelve-month period, without prior
regulatory approval, to the lesser of its statutory net investment income
excluding realized capital gains for the prior calendar year or 10% of its
statutory policyholders' surplus as of the prior year end. During 2003, Avemco
Insurance Company's ordinary dividend capacity will be zero as a result of a
special approved dividend paid in 2002.
HCC Life Insurance Company is limited by the laws of the State of Indiana
in the amount of dividends it may pay in any twelve-month period, without prior
regulatory approval, to the greater of its statutory net gain from operations
for the prior calendar year or 10% of its policyholders' surplus as of the prior
year end. Dividends may only be paid out of statutory unassigned surplus funds.
During 2003, HCC Life Insurance Company's ordinary dividend capacity will be
approximately $6.0 million.
We have a reserve of $7.1 million as of December 31, 2002 for potential
collectibility issues and associated expenses related to reinsurance
recoverables. The adverse economic environment in the worldwide insurance
industry, the decline in the market value of investments in equity securities
and the terrorist attack on September 11, 2001 have placed great pressure on
reinsurers and the results of their operations. Ultimately, these conditions
could affect reinsurers' solvency. Historically, there have been insolvencies
following a period of competitive pricing in the industry. While we believe that
the reserve is adequate based on currently available information, conditions may
change or additional information might be obtained which may result in a future
change in the reserve. We periodically review our financial exposure to the
reinsurance market and the level of our reserve and continue to take actions in
an attempt to mitigate our exposure to possible loss.
A number of reinsurers have delayed or suspended the payment of amounts
recoverable under certain reinsurance contracts to which we are a party. Such
delays have affected, although not materially to date, the investment income of
our insurance companies, but not to any extent their liquidity. We limit our
liquidity exposure by holding funds, letters of credit or other security such
that net balances due are significantly less than the gross balances shown in
our consolidated balance sheets. In some instances, the reinsurers have withheld
payment without reference to a substantive basis for the delay or suspension. In
other cases, the reinsurers have claimed they are not liable for payment to us
of all or part of the amounts due under the applicable reinsurance agreement. We
believe these claims are without merit and expect to collect the full amounts
recoverable. We are currently in negotiations with most of these parties, but if
such negotiations do not result in a satisfactory resolution of the matters in
question, we may seek or be involved in a judicial or arbitral determination of
these matters. In some cases, the final resolution of such disputes through
arbitration or litigation may extend over several years. In this regard, as of
December 31, 2002, our insurance companies had initiated two litigation
proceedings against reinsurers. As of such date, our insurance companies had an
aggregate amount of $5.8 million which had not been paid to us under the
agreements and we estimate that there could be up to an additional $10.7 million
of incurred losses and loss expenses and other balances due under the subject
agreements.
Regulatory guidelines suggest that a property and casualty insurer's annual
statutory gross written premium should not exceed 900% of its statutory
policyholders' surplus and net written premium should not exceed 300% of its
statutory policyholders' surplus. However, industry standards and rating agency
criteria place these ratios at 300% and 200%, respectively. Our property and
casualty insurance companies have maintained premium to surplus ratios generally
lower than such guidelines. For the year ended December 31, 2002, our statutory
gross written premium to policyholders' surplus was 222.1%. For the year ended
December 31, 2002, our statutory net written premium to policyholders' surplus
was 104.1%. As of December 31, 2002, each of our domestic insurance companies'
total adjusted capital was significantly in excess of the authorized control
level risk-based capital level prescribed by the National Association of
Insurance Commissioners.
45
IMPACT OF INFLATION
Our operations, like those of other property and casualty insurers, are
susceptible to the effects of inflation, as premiums are established before the
ultimate amounts of loss and loss adjustment expense are known. Although we
consider the potential effects of inflation when setting premium rates, for
competitive reasons, such premiums may not fully offset the effects of
inflation. However, because the majority of our business is comprised of lines
which have relatively short lead times between the occurrence of an insured
event, reporting of the claims to us and the final settlement of the claims, the
effects of inflation are minimized.
A portion of our revenue is related to healthcare insurance and reinsurance
products that are subject to the effects of the underlying inflation of
healthcare costs. Such inflation in the costs of healthcare tends to generate
increases in premiums for medical stop-loss coverage, resulting in greater
revenue, but also higher claim payments. Inflation also may have a negative
impact on insurance and reinsurance operations by causing higher claim
settlements than may originally have been estimated without an immediate
increase in premiums to a level necessary to maintain profit margins. We do not
specifically provide for inflation when setting underwriting terms and claim
reserves, although we do consider trends. We continually review claim reserves
to assess their adequacy and make necessary adjustments.
Inflation can also affect interest rates. Any significant increase in
interest rates could have a material adverse effect on the market value of our
investments. In addition, the interest rate payable under our $200.0 million
bank loan fluctuates with that of the market. Any significant increase in
interest rates could have a material adverse effect on our earnings, depending
on the amount borrowed on our bank facility.
FOREIGN EXCHANGE RATE FLUCTUATIONS
We underwrite risks which are denominated in a number of foreign
currencies. As a result, we have receivables and payables in foreign currencies
and we establish and maintain loss reserves with respect to our insurance
policies in their respective currencies. Our net earnings could be impacted by
exchange rate fluctuations affecting these balances. Our principal area of
exposure is with respect to fluctuations in the exchange rates between the major
European currencies (particularly the British pound sterling and the Euro) and
the U.S. dollar. We constantly monitor the balance between our receivables and
payables and loss reserves to mitigate the potential exposure should an
imbalance be expected to exist for other than a short period of time. For the
year ended December 31, 2002, our gain from currency conversion was $1.2 million
compared to a gain of $0.3 million in 2001 and a loss of $0.3 million in 2000.
On a limited basis, we enter into foreign currency forward contracts as a
hedge against foreign currency fluctuations. Rattner Mackenzie Limited has
revenue streams in U.S. dollars and Canadian dollars but incurs expenses in
British pound sterling. To mitigate the foreign exchange risk, from time to time
we have entered into foreign currency forward contracts expiring at staggered
times. As of December 31, 2002, we had no foreign currency forward contracts
outstanding. The foreign currency forward contracts are used to convert currency
at a known rate in an amount which either approximates or is less than monthly
expenses. Thus, the effect of these transactions is to limit the foreign
currency exchange risk of the recurring monthly expenses. We utilize these
foreign currency forward contracts strictly as a cash flow hedge against
existing exposure to foreign currency fluctuations rather than as a form of
speculative or trading investment.
CRITICAL ACCOUNTING POLICIES
The preparation of our consolidated financial statements in conformity with
generally accepted accounting principles requires us to make estimates and
assumptions when applying our accounting policies. Those of our accounting
policies that we consider to be most significant and the estimates and
assumptions we make in the application of those accounting policies are
discussed below.
46
EARNED PREMIUM, POLICY ACQUISITION COSTS AND CEDING COMMISSIONS
All of the property and casualty policies written by our insurance
companies qualify as short-duration contracts as defined by current accounting
literature. Written premium, net of reinsurance, is primarily included in
earnings on a pro rata basis over the lives of the related policies. However,
for certain types of business, it is recognized over the period of risk in
proportion to the amount of insurance risk provided. Policy acquisition costs,
including commissions, taxes, fees and other direct costs of underwriting
policies, less ceding commissions allowed by reinsurers, including expense
allowances, are deferred and charged or credited to earnings proportionate to
the premium earned. Historical and current loss and loss adjustment expense
experience and anticipated investment income are considered in determining
premium deficiencies and the recoverability of deferred policy acquisition
costs.
LOSS AND LOSS ADJUSTMENT EXPENSE
Our net loss and loss adjustment expense reserves are composed of reserves
for reported losses and reserves for incurred but not reported losses less a
reduction for reinsurance recoverable related to those reserves. Reserves are
recorded on an undiscounted basis, except for reserves acquired in transactions
recorded using the purchase method of accounting. The reserves for reported
losses related to our direct business and certain reinsurance assumed are
initially set by our claims personnel or independent claims adjusters hired by
us and subject to our review with a goal of setting the reserves at the ultimate
expected loss amount as soon as possible as information becomes available.
Reserves for reported losses with respect to other reinsurance assumed are
recorded based upon information supplied to us by the ceding company. Our claims
personnel monitor these reinsurance assumed reserves on a current basis and
audit ceding companies' claims to ascertain that claims are being recorded
currently and that net reserves are being set at levels that properly reflect
the liability related to the claims. Our actuaries, in conjunction with our
claims personnel, determine the amount of our incurred but not reported reserves
as well as review the reported claim reserves for positive or adverse
development. Reserves are estimates and changed conditions can cause changes in
the estimates. However, we believe that our review process is effective such
that any required changes are recognized in the period of change as soon as the
need for the change is evident. Reinsurance recoverables offset our gross
reserves based upon the contractual terms of our reinsurance agreements.
Losses in our group life and accident and health, aviation, London market
accounts and other specialty lines of business are recorded and paid relatively
quickly. There is not a significant amount of long-tailed liability exposure in
these lines of business. Therefore, reserves can be determined and recorded with
a higher degree of accuracy and significant development should not be expected
with respect to losses in these lines of business. There is some reinsurance
assumed in these lines of business, but, as discussed above, we monitor the
assumed reported losses closely. Losses related to our global financial products
line of business are reported relatively quickly but can develop over time as,
especially with respect to directors and officers liability business where we
write excess of loss risks, reported losses which are adjusted by the primary
underwriter on the risk may not initially appear to be serious but can develop
and affect our excess layer over time. We believe that we have adequately
reserved for this eventuality. Our discontinued line of business contains both
direct business and assumed business. Some of the losses in this line are
administered by others, subject to our review. It is possible that there can be
development in the loss reserves in this line of business as the business is in
run off and some of it is subject to late reporting by those administering the
claims. We monitor these reserves carefully on a current basis and believe that
they are properly set based upon the information we have at this time.
We have insignificant exposure to asbestos and environment policy
liabilities as we did not begin business until 1981 and the type of business we
wrote contained pollution exclusions or was not of the type that subjected us to
those types of risks.
The table below shows our recorded reserves as of December 31, 2002 (in
thousands) by line of business compared to the high and low ends of the reserve
range as determined by our reserving actuaries. Based upon
47
our historical reserving techniques and the fact that our net reserves have
historically shown positive development, we believe that there will not be any
negative development in our consolidated reserves:
<Table>
<Caption>
RECORDED LOW END OF HIGH END OF
RESERVES ACTUARIAL RANGE ACTUARIAL RANGE
-------- --------------- ---------------
LINES OF BUSINESS
Group life, accident and health............... $ 95,130 $ 81,940 $ 98,411
Aviation...................................... 72,345 63,451 76,110
London market accounts........................ 91,824 77,441 95,993
Global financial products..................... 22,035 19,057 24,081
Other specialty lines......................... 15,584 14,031 16,751
-------- -------- --------
296,918 255,920 311,346
Discontinued lines............................ 160,400 152,006 193,135
-------- -------- --------
Total net reserves......................... $457,318 $407,926 $504,481
======== ======== ========
</Table>
REINSURANCE RECOVERABLES
We constantly review the collectibility of the reinsurance recoverables of
our insurance companies and record a reserve for potentially uncollectible
reinsurance. Our estimates utilized to calculate the reserve are evaluated on a
current basis but are subject to change and this could affect the level of the
reserve required. We believe, based upon periodic detail reviews of our disputed
and aged recoverables, that we have sufficiently provided for potential losses
that are currently evident. See also Item 3, Legal Proceedings and the
Reinsurance Ceded section contained in Item 1, Business.
MANAGEMENT FEES AND COMMISSION INCOME
When there is no significant future servicing obligation, management fees
and commission income from our underwriting agencies and intermediaries,
respectively, are recognized on the revenue recognition date, which is the later
of the effective date of policy, the date when the premium can be reasonably
established, or the date when substantially all the services relating to the
insurance placement have been rendered to the client. Profit commissions based
upon the profitability of business written are recorded as revenue at the end of
each accounting period based upon the respective formula calculation. Such
amounts are adjusted should experience change. When additional services are
required, the service revenue is deferred and recognized over the service
period. We also record an allowance for estimated return commissions which may
be required to be paid upon the early termination of policies. These policies
are consistent with policies that have become generally accepted accounting
principles for insurance agents and brokers and with the Securities and Exchange
Commission's Staff Accounting Bulletin Number 101 entitled "Revenue Recognition
in Financial Statements."
DEFERRED TAXES
We recognize deferred tax assets and liabilities based on the differences
between the financial statement carrying amounts and the tax bases of assets and
liabilities. We regularly review our deferred tax assets for recoverability and
establish a valuation allowance based on our history of earnings, expectations
for future earnings, taxable income in carry back years and the expected timing
of the reversals of existing temporary differences. Although realization is not
assured, we believe it is more likely than not that we will be able to realize
the benefit of our deferred tax assets, with the exception of the benefit of
certain pre-acquisition tax loss carryforwards for which valuation allowances
have been provided. If there is a material change in the tax laws such that the
actual effective tax rate changes or the time periods within which the
underlying temporary differences become taxable or deductible change, we will
need to reevaluate our assumptions which could result in a change in the
valuation allowance required.
48
VALUATION OF GOODWILL
We assess the impairment of goodwill annually or sooner if an event occurs
or circumstances change that would more likely than not reduce the fair value of
a reporting unit below its carrying amount. In determining the fair value of a
reporting unit, we utilize the expected cash flow approach as set forth in FASB
Concepts Statement No. 7. This approach utilizes a risk-free rate of interest,
estimates of future cash flows and probabilities as to the occurrence of the
future cash flows. We utilize our budgets and projection of future operations
based upon historical and expected industry trends to estimate our future cash
flows and the probability of their occurring as projected. Based upon our last
impairment test, the fair value of each of our reporting units exceeded its
carrying amount by a substantial margin.
OTHER THAN TEMPORARY IMPAIRMENTS ON INVESTMENTS
Declines in the market value of invested assets below cost are evaluated
for other than temporary impairment losses on a quarterly basis. Impairment
losses for declines in value of fixed maturity investments and equity securities
below cost attributable to issuer-specific events are based upon all relevant
facts and circumstances for each investment and are recognized when appropriate.
For fixed maturity investments with unrealized losses due to market conditions
or industry-related events where we have the positive intent and ability to hold
the investment for a period of time sufficient to allow a market recovery or to
maturity, declines in value below cost are not assumed to be other than
temporary. Our policy for equity securities is to recognize impairment losses on
specific securities that have had continuous material unrealized losses for more
than three consecutive quarters or less, due to market conditions or
industry-related events. As of December 31, 2002, we had gross unrealized losses
on fixed income and marketable equity securities of $1.5 million (.2% of
aggregate market value) compared to $1.7 million (.3% of aggregate market value)
as of December 31, 2001.
EFFECTS OF RECENT ACCOUNTING PRONOUNCEMENTS
Statement of Financial Accounting Standards ("SFAS") No. 146 entitled
"Accounting for Costs Associated with Exit or Disposal Activities" was issued in
July, 2002 and will become effective for us on January 1, 2003. SFAS No. 146
will spread out the reporting of expenses related to restructurings and is a
change to existing guidance. The commitment to a plan to exit an activity or
dispose of long-lived assets will no longer be enough to record a one-time
charge for most anticipated costs. Instead, companies will record exit or
disposal costs when they are incurred and can be measured at fair value and the
liability will be subsequently adjusted for changes in estimated cash flow. We
do not expect the adoption of SFAS No. 146 to have a material effect on our
financial position, results of operations or cash flows.
Financial Accounting Standards Board Interpretation ("FIN") No. 45 entitled
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others . . ." was issued on November 25,
2002. The provision for initial recognition and measurement are effective on a
prospective basis for guarantees that are issued or modified after December 31,
2002 and disclosure requirements were effective for periods ending after
December 15, 2002. We have complied with the disclosure requirements in these
financial statements and do not believe that the recognition and measurement
provisions will have a material effect on our financial position, results of
operations or cash flows.
FIN No. 46 entitled "Consolidation of Variable Interest Entities", which is
an interpretation of Accounting Research Bulletin No. 51 entitled "Consolidated
Financial Statements" addresses consolidation by business enterprises of
variable interest entities which have certain characteristics. FIN No. 46
requires consolidation of a qualifying variable interest entity when a party has
a controlling financial interest regardless of whether or not the party has a
majority voting interest. FIN No. 46 is immediately effective for qualifying
variable interest entities created after January 31, 2003 and applicable to such
entities created prior to February 1, 2003 by the end of our third fiscal
quarter in 2003. We are currently studying FIN No. 46 for applicability to us.
At the present time we believe FIN No. 46 will only be applicable to one entity
in which we have an investment. We invested in a partnership, which owns a
building which is rented to unaffiliated parties, as a long term investment. The
partnership is not material to our financial position, results of
49
operations or cash flows. We have a maximum exposure to loss of $14.1 million
with respect to this entity as a result of our investment and our guarantee of
the partnership's debt.
Emerging Issues Task Force ("EITF") Issue No. 00-21 entitled "Revenue
Arrangements with Multiple Deliverables" is effective for revenue arrangements
entered into in fiscal periods beginning after June 15, 2003 or alternatively
can be applied retroactively. EITF Issue No. 00-21 addressed how to determine
whether an arrangement involving multiple deliverables contains more than one
unit of accounting. EITF Issue No. 00-21 also addresses how arrangement
consideration should be measured and allocated to the separate units of
accounting in the arrangement. We do not believe that this EITF Issue No. 00-21
will have a material effect on our financial position, results of operations or
cash flows as the issues in EITF Issue No. 00-21 have been previously addressed
when we adopted Securities and Exchange Commissions' Staff Accounting Bulletin
101.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Our principal assets and liabilities are financial instruments which are
subject to the market risk of potential losses from adverse changes in market
rates and prices. Our primary market risk exposures are: interest rate risk on
fixed income securities and interest expense on variable rate debt, equity risk
on marketable equity securities, credit risk on reinsurance recoverables and
foreign currency exchange rate risk.
To manage the exposures of our investment risks, we generally invest in
investment grade securities with characteristics of duration and liquidity to
reflect the underlying characteristics of the insurance liabilities of our
insurance companies. We have not historically used derivatives to manage any of
our investment related market risks.
Caution should be used in evaluating overall market risk utilizing the
information below. Actual results could differ materially from estimates below
for a variety of reasons, including, among other things:
- amounts and balances on which the estimates are based are likely to
change over time;
- assumptions used in the models may prove to be inaccurate;
- market changes could be different from market changes assumed below; and
- not all factors and balances are taken into account.
INTEREST RATE RISK
The value of our portfolio of fixed income securities is inversely
correlated to changes in the market interest rates. In addition, some of our
fixed income securities have call or prepayment options. This could subject us
to reinvestment risk should interest rates fall or issuers call their securities
and we reinvest the proceeds at lower interest rates. We attempt to mitigate
this risk by investing in securities with varied maturity dates, so that only a
portion of the portfolio will mature at any point in time. The fair value of our
fixed income securities as of December 31, 2002 was $841.5 million and was
$525.4 million as of December 31, 2001. If market interest rates were to change
1%, (e.g. from 5% to 6%) the fair value of our fixed income securities would
change approximately $29.5 million as of December 31, 2002. This compares to
change in value of $21.0 million as of December 31, 2001 for the same 1% change
in market interest rates. The change in fair value was determined using duration
modeling assuming no prepayments.
Our $200.0 million bank loan is subject to variable interest rates. Thus,
our interest expense on this loan is directly correlated to market interest
rates. As of December 31, 2002, we had $53.0 million in debt outstanding under
the bank loan. At that debt level, the 1% change in market interest rates would
have changed interest expense by $0.5 million. As of December 31, 2001, there
was no balance outstanding under our bank loan and our 2% convertible notes are
not subject to interest rate changes.
EQUITY RISK
Our portfolio of marketable equity securities is subject to equity price
risk due to market changes. The fair value of our marketable equity securities
(including the amounts, if any, of insurance related equity
50
securities designated as trading securities and included in other assets) as of
December 31, 2002 was $25.7 million, compared to $16.6 million as of December
31, 2001. The balance at December 31, 2002 includes mutual fund securities with
a value of $10.5 million. These mutual funds are invested heavily in fixed
income securities but represent marketable equity securities for reporting
purposes. If the market price of all marketable equity securities were to change
by 10% as of these dates, the fair value of our portfolio of marketable equity
securities would have changed $2.6 million as of December 31, 2002 and $1.7
million as of December 31, 2001.
FOREIGN EXCHANGE RISK
The table below shows the net amounts of significant foreign currency
balances at December 31, 2002 and 2001 converted to U.S. dollars. It also shows
the expected dollar change in fair value that would occur if exchange rates
changed 10% from exchange rates in effect at those times (in thousands):
<Table>
<Caption>
2002 2001
--------------------------- ---------------------------
HYPOTHETICAL HYPOTHETICAL
U.S. DOLLAR 10% CHANGE U.S. DOLLAR 10% CHANGE
EQUIVALENT IN FAIR VALUE EQUIVALENT IN FAIR VALUE
----------- ------------- ----------- -------------
British Pound Sterling.................. $7,617 $762 $2,366 $237
Euro.................................... 3,518 352 313 31
Canadian Dollar......................... 1,815 182 1,651 165
</Table>
See Foreign Exchange Rate Fluctuations section contained in Item 7,
Management's Discussion and Analysis, and Notes (1) and (9) in the Notes to
Consolidated Financial Statements for additional information.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and financial statement schedules listed in the
accompanying index are filed as part of this Report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURES
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
For information regarding Directors and Executive Officers of the
Registrant, reference is made to the Registrant's definitive proxy statement for
its Annual Meeting of Shareholders, which will be filed with the Securities and
Exchange Commission within 120 days after December 31, 2002, and which is
incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
For information regarding Executive Compensation, reference is made to the
Registrant's definitive proxy statement for its Annual Meeting of Shareholders,
which will be filed with the Securities and Exchange Commission within 120 days
after December 31, 2002, and which is incorporated herein by reference.
51
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
EQUITY COMPENSATION PLAN INFORMATION
<Table>
<Caption>
NUMBER OF SECURITIES
REMAINING AVAILABLE FOR
NUMBER OF SECURITIES WEIGHTED AVERAGE FUTURE ISSUANCE UNDER
TO BE ISSUED UPON EXERCISE PRICE OF EQUITY COMPENSATION
EXERCISE OF OUTSTANDING PLANS (EXCLUDING
OUTSTANDING OPTIONS, OPTIONS, WARRANTS SECURITIES REFLECTED IN
PLAN CATEGORY WARRANTS AND RIGHTS AND RIGHTS COLUMN (A))
- ------------- -------------------- ------------------- -----------------------
(A) (B) (C)
Equity compensation plans approved by
security holders...................... 6.3 million $21.03 0.9 million
Equity compensation plans not approved
by security holders(1)(2)............. 0.1 million 16.40 --
----------- ------ -----------
TOTAL.............................. 6.4 million $20.99 0.9 million
=========== ====== ===========
</Table>
- ---------------
(1) On December 16, 1999 the Board of Directors of the Company approved the
issuance of an aggregate of 35,000 stock options to the then serving members
of the Board of Directors. Such options were exercisable upon issuance and
were granted on January 5, 2000 at a per share exercise price of $12.0625
(the closing price of HCC's common stock on the NYSE on January 5, 2000) and
expire on January 5, 2005.
(2) On March 27, 2001, the Compensation Committee of the Board of Directors
approved the issuance of 20,000 options to James C. Flagg, a member of the
Board of Directors. Such options vest over a period of three years and have
an exercise price of $24.00 (the closing price of HCC's Common Stock on the
NYSE on March 29, 2001). The options expire March 29, 2007.
For additional information regarding Security Ownership of Certain
Beneficial Owners and Management, reference is made to the Registrant's
definitive proxy statement for its Annual Meeting of Shareholders, which will be
filed with the Securities and Exchange Commission within 120 days after December
31, 2002, and which is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
For information regarding Certain Relationships and Related Transactions,
reference is made to the Registrant's definitive proxy statement for its Annual
Meeting of Shareholders, which will be filed with the Securities and Exchange
Commission within 120 days after December 31, 2002, and which is incorporated
herein by reference.
ITEM 14. CONTROLS AND PROCEDURES
(a) Evaluation of disclosure controls and procedures.
Within the 90 days prior to the date of this report, we carried out an
evaluation, under the supervision and with the participation of our management,
including our Chief Executive Officer and Chief Financial Officer, of the
effectiveness of the design and operation of our disclosure controls and
procedures pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, the
Chief Executive Officer and Chief Financial Officer concluded that our
disclosure controls and procedures are effective in timely alerting them to
material information relating to HCC Insurance Holdings, Inc. and its
subsidiaries required to be included in our periodic SEC filings.
(b) Changes in internal controls.
There have been no significant changes in our internal controls or in other
factors which could significantly affect internal controls subsequent to the
date we carried out our evaluation.
52
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) Exhibits
The exhibits listed on the accompanying Index to Exhibits are filed as part
of this Report.
(b) Financial Statement Schedules
The financial statements and financial statement schedules listed in the
accompanying Index to Consolidated Financial Statements and Schedules are filed
as part of this Report.
(c) Reports on Form 8-K
On November 8, 2002, we reported on Form 8-K our announcement of operating
results for the third quarter of 2002.
On December 13, 2002, we reported on Form 8-K the text material used for an
investors' conference.
53
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
HCC INSURANCE HOLDINGS, INC.
(Registrant)
<Table>
Dated: March 27, 2003 By: /s/ STEPHEN L. WAY
- ------------------------ ----------------------------------------------------
(Stephen L. Way)
Chairman of the Board and
Chief Executive Officer
</Table>
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
<Table>
<Caption>
NAME TITLE DATE
---- ----- ----
/s/ STEPHEN L. WAY Chairman of the Board of March 27, 2003
------------------------------------------------ Directors, Chief Executive Officer --------------
(Stephen L. Way) and President (Principal Executive
Officer)
/s/ FRANK J. BRAMANTI* Director March 27, 2003
------------------------------------------------ --------------
(Frank J. Bramanti)
/s/ PATRICK B. COLLINS* Director March 27, 2003
------------------------------------------------ --------------
(Patrick B. Collins)
/s/ JAMES R. CRANE* Director March 27, 2003
------------------------------------------------ --------------
(James R. Crane)
/s/ J. ROBERT DICKERSON* Director March 27, 2003
------------------------------------------------ --------------
(J. Robert Dickerson)
/s/ EDWARD H. ELLIS, JR. Director, Executive Vice President March 27, 2003
------------------------------------------------ and Chief Financial Officer (Chief --------------
(Edward H. Ellis, Jr.) Accounting Officer)
/s/ JAMES C. FLAGG, PH.D.* Director March 27, 2003
------------------------------------------------ --------------
(James C. Flagg, Ph.D.)
/s/ EDWIN H. FRANK, III* Director March 27, 2003
------------------------------------------------ --------------
(Edwin H. Frank, III)
/s/ ALLAN W. FULKERSON* Director March 27, 2003
------------------------------------------------ --------------
(Allan W. Fulkerson)
/s/ WALTER J. LACK* Director March 27, 2003
------------------------------------------------ --------------
(Walter J. Lack)
</Table>
54
<Table>
<Caption>
NAME TITLE DATE
---- ----- ----
/s/ MICHAEL A. F. ROBERTS* Director March 27, 2003
------------------------------------------------ --------------
(Michael A. F. Roberts)
*By: /s/ STEPHEN L. WAY March 27, 2003
----------------------------------------- --------------
Stephen L. Way
Attorney-in-fact
</Table>
55
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES
<Table>
Report of Independent Accountants........................... F-1
Consolidated Balance Sheets at December 31, 2001 and 2000... F-2
Consolidated Statements of Earnings for the three years
ended December 31, 2001................................... F-3
Consolidated Statements of Comprehensive Income for the
three years ended December 31, 2001....................... F-4
Consolidated Statements of Changes in Shareholders' Equity
for the three years ended December 31, 2001............... F-5
Consolidated Statements of Cash Flows for the three years
ended December 31, 2001................................... F-6
Notes to Consolidated Financial Statements.................. F-7
SCHEDULES:
Report of Independent Accountants on Financial Statement
Schedules................................................. S-1
Schedule 1 Summary of Investments other than Investments in
Related Parties........................................... S-2
Schedule 2 Condensed Financial Information of Registrant... S-3
Schedule 3 Supplementary Insurance Information............. S-8
Schedule 4 Reinsurance..................................... S-9
Schedule 5 Valuation and Qualifying Accounts............... S-10
</Table>
Schedules other than those listed above have been omitted because they are
either not required, not applicable, or the required information is shown in the
Consolidated Financial Statements and related notes thereto or other Schedules.
56
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders
HCC Insurance Holdings, Inc.
In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of earnings, comprehensive income, changes in
shareholders' equity and cash flows present fairly, in all material respects,
the financial position of HCC Insurance Holdings, Inc. and its subsidiaries at
December 31, 2002 and 2001, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 2002, in
conformity with accounting principles generally accepted in the United States of
America. These financial statements are the responsibility of the Company's
management; our responsibility is to express an opinion on these financial
statements based on our audits. We conducted our audits of these statements in
accordance with auditing standards generally accepted in the United States of
America, which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
As discussed in Note 1 to the consolidated financial statements, effective
January 1, 2000 the Company changed its method of revenue recognition for
certain contracts as prescribed by the Securities and Exchange Commission's
Staff Accounting Bulletin No. 101 entitled "Revenue Recognition in Financial
Statements". Additionally, as discussed in Note 2 to the consolidated financial
statements, effective January 1, 2002 the Company changed its method of
accounting for goodwill as prescribed by Statement of Financial Accounting
Standards No. 142 entitled "Goodwill and Other Intangible Assets".
/s/ PricewaterhouseCoopers LLP
Houston, Texas
March 21, 2003
F-1
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<Table>
<Caption>
DECEMBER 31,
-----------------------
2002 2001
---------- ----------
ASSETS
Investments:
Fixed income securities, at market (cost:
2002 -- $807,772; 2001 -- $513,674).................... $ 841,548 $ 525,428
Marketable equity securities, at market (cost:
2002 -- $15,815; 2001 -- $16,431)...................... 15,609 16,569
Short-term investments, at cost, which approximates
market................................................. 307,215 338,904
Other investments, at estimated fair value (cost:
2002 -- $3,264; 2001 -- $4,400)........................ 3,264 4,758
---------- ----------
Total investments.................................... 1,167,636 885,659
Cash........................................................ 40,306 16,891
Restricted cash and cash investments........................ 189,396 138,545
Premium, claims and other receivables....................... 753,527 665,965
Reinsurance recoverables.................................... 798,934 899,128
Ceded unearned premium...................................... 164,224 71,140
Ceded life and annuity benefits............................. 78,951 83,013
Deferred policy acquisition costs........................... 68,846 32,071
Goodwill.................................................... 335,288 315,318
Other assets................................................ 107,043 111,390
---------- ----------
Total assets......................................... $3,704,151 $3,219,120
========== ==========
LIABILITIES
Loss and loss adjustment expense payable.................... $1,155,290 $1,130,748
Life and annuity policy benefits............................ 78,951 83,013
Reinsurance balances payable................................ 166,659 88,637
Unearned premium............................................ 331,050 179,530
Deferred ceding commissions................................. 49,963 16,681
Premium and claims payable.................................. 749,523 717,159
Notes payable............................................... 230,027 181,928
Accounts payable and accrued liabilities.................... 59,781 57,971
---------- ----------
Total liabilities.................................... 2,821,244 2,455,667
Shareholders' Equity
Common stock, $1.00 par value; 250.0 million shares
authorized; (shares issued and outstanding:
2002 -- 62,358; 2001 -- 61,438)........................ 62,358 61,438
Additional paid-in capital................................ 416,406 402,089
Retained earnings......................................... 383,378 293,426
Accumulated other comprehensive income.................... 20,765 6,500
---------- ----------
Total shareholders' equity........................... 882,907 763,453
---------- ----------
Total liabilities and shareholders' equity........... $3,704,151 $3,219,120
========== ==========
</Table>
See Notes to Consolidated Financial Statements.
F-2
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EARNINGS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<Table>
<Caption>
FOR THE YEARS ENDED DECEMBER 31,
---------------------------------
2002 2001 2000
--------- --------- ---------
REVENUE
Net earned premium.......................................... $505,521 $342,787 $267,647
Management fees............................................. 77,082 61,795 96,058
Commission income........................................... 41,572 43,412 49,886
Net investment income....................................... 37,769 39,638 39,836
Net realized investment gain (loss)......................... 453 393 (5,321)
Other operating income...................................... 6,985 17,436 25,497
-------- -------- --------
Total revenue.......................................... 669,382 505,461 473,603
EXPENSE
Loss and loss adjustment expense, net....................... 306,491 267,390 198,470
Operating expense:
Policy acquisition costs, net............................. 63,274 27,923 23,743
Compensation expense...................................... 80,495 69,762 83,086
Other operating expense................................... 47,642 71,119 53,274
-------- -------- --------
Total operating expense................................ 191,411 168,804 160,103
Interest expense............................................ 8,301 8,884 20,347
-------- -------- --------
Total expense.......................................... 506,203 445,078 378,920
-------- -------- --------
Earnings before income tax provision................... 163,179 60,383 94,683
Income tax provision........................................ 57,351 30,186 37,202
-------- -------- --------
Earnings before cumulative effect of accounting
change............................................... 105,828 30,197 57,481
Cumulative effect of accounting change, net of deferred
tax effect of $1,335................................. -- -- (2,013)
-------- -------- --------
NET EARNINGS........................................... $105,828 $ 30,197 $ 55,468
======== ======== ========
BASIC EARNINGS PER SHARE DATA:
Earnings before accounting change...................... $ 1.70 $ 0.52 $ 1.13
Cumulative effect of accounting change................. -- -- (0.04)
-------- -------- --------
Net earnings........................................... $ 1.70 $ 0.52 $ 1.09
======== ======== ========
Weighted average shares outstanding.................... 62,225 58,321 50,742
======== ======== ========
DILUTED EARNINGS PER SHARE DATA:
Earnings before accounting change...................... $ 1.68 $ 0.51 $ 1.11
Cumulative effect of accounting change................. -- -- (0.04)
-------- -------- --------
Net earnings........................................... $ 1.68 $ 0.51 $ 1.07
======== ======== ========
Weighted average shares outstanding.................... 62,936 59,619 51,619
======== ======== ========
</Table>
See Notes to Consolidated Financial Statements.
F-3
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<Table>
<Caption>
FOR THE YEARS ENDED DECEMBER 31,
----------------------------------
2002 2001 2000
---------- --------- ---------
Net earnings................................................ $105,828 $30,197 $55,468
Other comprehensive income, net of tax:
Foreign currency translation adjustment................... 50 (279) (172)
Gains (losses) in fair value of foreign currency forward
contracts recorded as a cash flow hedge, net of income
tax charge (benefit) of $(13) in 2002 and $13 in
2001................................................... (24) 24 --
Investment gains (losses):
Investment gains during the year, net of income tax
charge of $8,040 in 2002, $1,137 in 2001, and $2,386
in 2000.............................................. 14,533 2,297 4,118
Less reclassification adjustment for (gains) losses
included in net earnings, net of income tax (charge)
benefit of $(159) in 2002, $(138) in 2001, and $1,862
in 2000.............................................. (294) (255) 3,459
-------- ------- -------
Other comprehensive income................................ 14,265 1,787 7,405
-------- ------- -------
COMPREHENSIVE INCOME................................... $120,093 $31,984 $62,873
======== ======= =======
</Table>
See Notes to Consolidated Financial Statements.
F-4
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<Table>
<Caption>
ACCUMULATED
ADDITIONAL OTHER TOTAL
COMMON PAID-IN RETAINED COMPREHENSIVE SHAREHOLDERS'
STOCK CAPITAL EARNINGS INCOME (LOSS) EQUITY
------- ---------- -------- ------------- -------------
BALANCE AS OF DECEMBER 31, 1999...... $49,836 $175,363 $235,932 $(2,692) $458,439
Net earnings......................... -- -- 55,468 -- 55,468
Other comprehensive income........... -- -- -- 7,405 7,405
1,267 shares of common stock issued
for exercise of options, including
tax benefit of $3,627.............. 1,266 19,596 -- -- 20,862
Issuance of 145 shares of
contractually issuable common
stock.............................. 145 (145) -- -- --
Issuance of 95 shares of contingently
issuable common stock.............. 95 1,145 -- -- 1,240
Contractual grant of pooled company
common stock by a shareholder prior
to acquisition..................... -- 1,040 -- -- 1,040
Dividends to shareholders of pooled
company prior to acquisition....... -- -- (2,593) -- (2,593)
Cash dividends declared, $0.22 per
share.............................. -- -- (10,931) -- (10,931)
------- -------- -------- ------- --------
BALANCE AS OF DECEMBER 31, 2000...... 51,342 196,999 277,876 4,713 530,930
Net earnings......................... -- -- 30,197 -- 30,197
Other comprehensive income........... -- -- -- 1,787 1,787
6,900 shares of common stock issued
in public offering, net of costs... 6,900 145,505 -- -- 152,405
2,715 shares of common stock issued
upon exercise of options including
income tax benefit of $12,312...... 2,715 50,023 -- -- 52,738
300 shares of common stock issued for
purchased companies................ 300 8,031 -- -- 8,331
Issuance of 114 shares of
contractually issuable common
stock.............................. 114 (114) -- -- --
Issuance of 67 shares of contingently
issuable common stock.............. 67 1,645 -- -- 1,712
Cash dividends declared, $0.245 per
share.............................. -- -- (14,647) -- (14,647)
------- -------- -------- ------- --------
BALANCE AS OF DECEMBER 31, 2001...... 61,438 402,089 293,426 6,500 763,453
Net earnings......................... -- -- 105,828 -- 105,828
Other comprehensive income........... -- -- -- 14,265 14,265
817 shares of common stock issued for
exercise of options, including tax
benefit of $4,030.................. 817 14,420 -- -- 15,237
Issuance of 103 shares of
contractually issuable common
stock.............................. 103 (103) -- -- --
Cash dividends declared, $0.255 per
share.............................. -- -- (15,876) -- (15,876)
------- -------- -------- ------- --------
BALANCE AS OF DECEMBER 31, 2002...... $62,358 $416,406 $383,378 $20,765 $882,907
======= ======== ======== ======= ========
</Table>
See Notes to Consolidated Financial Statements.
F-5
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<Table>
<Caption>
FOR THE YEARS ENDED DECEMBER 31,
---------------------------------
2002 2001 2000
--------- --------- ---------
Cash flows from operating activities:
Net earnings............................................ $ 105,828 $ 30,197 $ 55,468
Adjustments to reconcile net earnings to net cash
provided by operating activities:
Change in premium, claims and other receivables...... (41,330) (33,976) 30,501
Change in reinsurance recoverables................... 103,870 (191,552) (52,007)
Change in ceded unearned premium..................... (88,940) 28,254 19,188
Change in loss and loss adjustment expense payable... (57,747) 262,056 72,311
Change in reinsurance balances payable............... 70,672 (29,837) 17,052
Change in unearned premium........................... 122,811 (1,676) 2,689
Change in premium and claims payable, net of
restricted cash.................................... (57,317) 22,530 (20,727)
Gains on dispositions of other operating
investments........................................ -- (8,171) (5,739)
Depreciation, amortization and impairments........... 10,808 34,926 19,908
Other, net........................................... 6,467 (7,011) (820)
--------- --------- ---------
Cash provided by operating activities.............. 175,122 105,740 137,824
Cash flows from investing activities:
Sales of fixed income securities........................ 217,370 140,763 137,175
Maturity or call of fixed income securities............. 53,918 45,754 34,341
Sales of equity securities.............................. 3,958 5,408 7,969
Dispositions of other operating investments............. -- 19,965 27,803
Change in short-term investments........................ 84,799 (43,986) (69,400)
Cash paid for companies acquired, net of cash
received............................................. (39,227) (95,952) (8,909)
Cost of investments acquired............................ (505,099) (292,926) (244,586)
Purchases of property and equipment and other........... (5,782) (12,283) (9,535)
--------- --------- ---------
Cash used by investing activities.................. (190,063) (233,257) (125,142)
Cash flows from financing activities:
Proceeds from notes payable, net of costs............... 76,000 174,058 26,700
Sale of common stock, net of costs...................... 11,207 192,831 17,235
Payments on notes payable............................... (31,969) (222,116) (57,042)
Dividends paid and other, net........................... (16,882) (14,356) (12,409)
--------- --------- ---------
Cash provided (used) by financing activities....... 38,356 130,417 (25,516)
--------- --------- ---------
Net change in cash................................. 23,415 2,900 (12,834)
Cash as of beginning of year....................... 16,891 13,991 26,825
--------- --------- ---------
Cash as of end of year............................. $ 40,306 $ 16,891 $ 13,991
========= ========= =========
</Table>
See Notes to Consolidated Financial Statements.
F-6
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(1) GENERAL INFORMATION AND SIGNIFICANT ACCOUNTING AND REPORTING POLICIES
HCC Insurance Holdings, Inc. and its subsidiaries ("we" or "our"), include
domestic and foreign property and casualty and life insurance companies,
underwriting agencies and intermediaries. Through our subsidiaries, we provide
specialized property and casualty and life and health insurance to commercial
customers in the areas of group life, accident and health, aviation, our London
market account (which includes energy, marine, property and some accident and
health), global financial products (which includes directors and officers
liability, errors and omissions, employment practices liability and surety) and
other specialty lines of insurance. Our principal insurance companies are
Houston Casualty Company in Houston, Texas, and London, England; HCC Life
Insurance Company in Houston, Texas; U.S. Specialty Insurance Company in
Houston, Texas; Avemco Insurance Company in Frederick, Maryland; and HCC Europe
in Madrid, Spain. Our underwriting agencies provide underwriting management and
claims servicing for insurance and reinsurance companies, in specialized lines
of business within the life, accident and health and property and casualty
insurance sectors. Our principal agencies are HCC Benefits Corporation in
Atlanta, Georgia, Costa Mesa, California, Wakefield, Massachusetts, Minneapolis,
Minnesota and Dallas, Texas; ASU International, LLC in Woburn, Massachusetts,
and London, England; HCC Global Financial Products, LLC in Farmington,
Connecticut, Barcelona, Spain and London, England; Dickson Manchester & Company
Limited in London, England; and Professional Indemnity Agency, Inc. in Mount
Kisco, New York. Effective January 1, 2001 and 2002, we consolidated the
operations of three and one of our agencies, respectively, with certain of our
insurance companies. Our intermediaries provide brokerage, consulting and other
intermediary services to insurance and reinsurance companies, commercial
customers and individuals in the same lines of business as the insurance
companies and underwriting agencies operate. Our principal intermediaries are
HCC Risk Management Corporation in Houston, Texas; HCC Employee Benefits, Inc.
in Houston, Texas and Atlanta, Georgia; and Rattner Mackenzie Limited in London,
England. During 2001, we sold the last of our service operations. Our service
companies performed various insurance related services for insurance companies.
The preparation of financial statements in conformity with generally
accepted accounting principles in the United States requires us to make
estimates and assumptions. This affects amounts reported in our financial
statements and the disclosure of contingent assets and liabilities. Actual
results could differ from those estimates.
A description of the significant accounting and reporting policies we
utilize in preparing our consolidated financial statements is as follows:
Principles of Consolidation
Our consolidated financial statements include the accounts of all our
subsidiaries. All significant intercompany balances and transactions have been
eliminated in consolidation.
Investments
Fixed income securities and marketable equity securities are classified as
available for sale and are carried at quoted market value, if readily
marketable, or at management's estimated fair value, if not readily marketable.
The change in unrealized gain or loss with respect to these securities is
recorded as a component of other comprehensive income, net of the related
deferred income tax effects, if any. Fixed income securities available for sale
are purchased with the original intent to hold to maturity, but they may be
available for sale if market conditions warrant, or if our investment policies
dictate, in order to maximize our investment yield. Short-term investments and
restricted short-term investments are carried at cost, which approximates market
value.
F-7
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
For the asset-backed and mortgage-backed securities portion of the fixed
income portfolio, we recognize income using a constant effective yield based on
anticipated prepayments and the estimated economic life of the securities. When
actual prepayments differ significantly from anticipated prepayments, the
estimated economic life is recalculated and the remaining unamortized premium or
discount is amortized prospectively over the remaining economic life. Some of
our asset-backed securities are subject to re-evaluation and additional
specialized impairment tests. Under this guidance, these securities have to be
written down in value if certain tests are met. Any write down is recouped
prospectively through net investment income, if contractual cash flows are
ultimately received. The total amount of securities held by us as of December
31, 2002 that would be subject to these tests and potential write down is $9.4
million.
The realized gain or loss on investment transactions is determined on an
average cost basis and included in earnings on the trade date. When impairment
of the value of an investment is considered other than temporary, the decrease
in value is reported in earnings as a realized investment loss and a new cost
basis is established.
Property and Equipment
Property and equipment are carried at cost, net of accumulated depreciation
and included in other assets on our consolidated balance sheets. Depreciation
expense is provided using the straight-line method over the estimated useful
lives of the related assets. Amortization of leasehold improvements is provided
using the straight-line method over the shorter of the estimated useful life or
the term of the respective lease. Costs incurred in developing or purchasing
management information systems are capitalized and included in property and
equipment. These costs are amortized over their estimated useful lives from the
dates the systems are placed in service. Upon disposal of assets, the cost and
related accumulated depreciation are removed from the accounts and the resulting
gain or loss is included in earnings. Estimated useful lines of major classes of
our property and equipment are as follows: buildings and improvements 30-45
years; furniture, fixtures and equipment 3-20 years; management information
systems 3-10 years. Depreciation of property and equipment was approximately
$7.5 million, $7.0 million and $6.9 million for the years ended December 31,
2002, 2001 and 2000, respectively.
We review the carrying value of all long-lived assets, including property
and equipment and intangible assets subject to amortization, if the facts and
circumstances suggest they may be impaired. If this review indicates that the
carrying value will not be recoverable, as determined based on projected
undiscounted future cash flows, the carrying value is reduced to its estimated
fair value, which is then depreciated or amortized over the remaining useful
life, as indicated during the review.
Earned Premium, Policy Acquisition Costs and Ceding Commissions
All of the property and casualty policies written by our insurance
companies qualify as short-duration contracts as defined by current accounting
literature. Written premium, net of reinsurance, is primarily included in
earnings on a pro rata basis over the lives of the related policies. However,
for certain types of business, it is recognized over the period of risk in
proportion to the amount of insurance risk provided. Policy acquisition costs,
including commissions, taxes, fees and other direct costs of underwriting
policies, less ceding commissions allowed by reinsurers, including expense
allowances, are deferred and charged or credited to earnings proportionate to
the premium earned. Historical and current loss and loss adjustment expense
experience and anticipated investment income are considered in determining
premium deficiencies and the recoverability of deferred policy acquisition
costs.
F-8
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Management Fees and Commission Income
When there is no significant future servicing obligation, management fees
and commission income from our underwriting agencies and intermediaries,
respectively, are recognized on the revenue recognition date, which is the later
of the effective date of policy, the date when the premium can be reasonably
established, or the date when substantially all the services relating to the
insurance placement have been rendered to the client. Profit commissions based
upon the profitability of business written are recorded as revenue at the end of
each accounting period based upon the respective formula calculation. Such
amounts are adjusted should experience change. When additional services are
required, the service revenue is deferred and recognized over the service
period. We also record an allowance for estimated return commissions which may
be required to be paid upon the early termination of policies.
Effective January 1, 2000, we changed certain of our revenue recognition
methods for our agencies and intermediaries to agree with guidance contained in
Securities and Exchange Commission's Staff Accounting Bulletin No. 101 entitled
"Revenue Recognition in Financial Statements". Previously, our agencies and
intermediaries recognized revenue in conformity with principles that
historically had been considered generally accepted accounting principles for
insurance agents and brokers. We had recognized return commissions when the
event occurred that caused the return and accrued a liability for future
servicing costs, when significant, instead of deferring revenue. The after-tax
cumulative non-cash charge resulting from the adoption of Staff Accounting
Bulletin No. 101 was $2.0 million.
Other Operating Income
Historically, we have had two primary sources of other operating income,
which is included in our other operations segment. The first source is a variety
of insurance related services, principally claims adjusting services. This
source is not expected to be significant in future years as our last remaining
service subsidiary was sold in September, 2001. These revenues were recorded
when the service was performed. The second source is income from and gains or
losses from the disposition of investments made in this segment. These
investments principally consist of positions in insurance related businesses
which are synergistic to our business. Income from these investments is
recognized as earned or utilizing the equity basis of accounting if the
investment qualifies and the gains or losses from the sale of investments are
recognized upon consummation of a sale transaction. More recently there has also
been a small portfolio of marketable equity securities that have been designated
trading securities and included in other assets on our consolidated balance
sheets. Realized gains and losses, unrealized gains and losses and dividend
income on these trading securities are all included in other operating income.
Premium and Other Receivables
We use the gross method for reporting receivables and payables on brokered
transactions. We review the collectibility of our receivables on a current basis
and provide an allowance for doubtful accounts if we deem that there are
accounts which are doubtful of collection. The amount of the allowance as of
December 31, 2002 and 2001 was $2.3 million and $2.8 million, respectively. Our
estimate of the level of the allowance could change as conditions change in the
future.
Loss and Loss Adjustment Expense Payable
Loss and loss adjustment expense payable by our insurance companies is
based on estimates of payments to be made for reported losses, incurred but not
reported losses and anticipated receipts from salvage and subrogation. Reserves
are recorded on an undiscounted basis, except for reserves acquired in
transactions recorded using the purchase method of accounting. The discount on
those reserves is not material. Estimates for reported losses are based on all
available information, including reports received from ceding companies on
F-9
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
assumed business. Estimates for incurred but not reported losses are based both
on our experience and the industry's experience. While we believe that amounts
included in our financial statements are adequate, such estimates may be more or
less than the amounts ultimately paid when the claims are settled. We
continually review the estimates with our actuaries and any changes are
reflected in the period of the change.
Reinsurance
We record all reinsurance recoverables and ceded unearned premiums as
assets and deferred ceding commissions as a liability. All such amounts are
recorded in a manner consistent with the underlying reinsured contracts. We also
record a reserve for uncollectible reinsurance. Our estimates utilized to
calculate the reserve are subject to change and this could affect the level of
the reserve required.
Goodwill and Intangible Assets
In connection with our acquisition of subsidiaries prior to July 1, 2001,
accounted for as purchases, the excess of cost over fair value of net assets
acquired was being amortized using the straight-line method over periods from
twenty to forty years. This amortization was discontinued effective December 31,
2001 in accordance with Statement of Financial Accounting Standards ("SFAS") No.
142 entitled "Goodwill and Other Intangible Assets." Goodwill resulting from
acquisitions completed on or after July 1, 2001 was also not being amortized in
accordance with SFAS No. 142. See Note (2) for the effects of these changes.
Other identified intangible assets are amortized over their respective useful
lives.
Prior to our adoption of SFAS No. 142, our accounting policy regarding the
assessment of the recoverability of the carrying value of goodwill was to review
the carrying value of the assets if the facts and circumstances suggested that
it might be impaired. If this review indicated that the carrying value would not
be recoverable, as determined based on projected undiscounted future cash flows,
the carrying value was reduced to its estimated fair value.
With our adoption of SFAS No. 142, beginning January 1, 2002, we assess the
impairment of goodwill annually or sooner if an event occurs or circumstances
change that would more likely than not reduce the fair value of a reporting unit
below its carrying amount. In determining the fair value of a reporting unit, we
utilize the expected cash flow approach as set forth in FASB Concepts Statement
No. 7. This approach utilizes a risk-free rate of interest, estimates of future
cash flows and probabilities as to the occurrence of the future cash flows. We
utilize our budgets and projection of future operations based upon historical
and expected industry trends to estimate our future cash flows and the
probability of their occurring as projected. Based upon our last impairment
test, the fair value of each of our reporting units exceeded its carrying amount
by a substantial margin.
Cash and Short-term Investments
Cash consists of cash in banks, generally in operating accounts. We
classify certificates of deposit, corporate demand notes receivable, commercial
paper and money market funds as short-term investments. Short-term investments
are classified as investments in our consolidated balance sheets as they relate
principally to our investment activities.
As of December 31, 2002 and 2001 we included $175.7 million and $189.2
million, respectively, of certain fiduciary funds in short-term investments.
These are funds held by underwriting agencies or intermediaries for the benefit
of insurance or reinsurance clients. We earn the interest on these funds.
We generally maintain our cash deposits in major banks and invest our
short-term investments in institutional money-market funds and in investment
grade commercial paper and repurchase agreements.
F-10
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
These securities typically mature within ninety days and, therefore, bear
minimal risk. We have not experienced any losses on our cash deposits or our
short-term investments.
Restricted Cash and Cash Investments
Our agencies withhold premium funds for the payment of claims. These funds
are shown as restricted cash and cash investments in our consolidated balance
sheets. The corresponding liability is included within premium and claims
payable in our consolidated balance sheets. These amounts are considered
fiduciary funds and interest earned on these funds accrues to the benefit of the
insurance companies for whom the agencies write business. Therefore, we do not
include these amounts as cash in our consolidated statements of cash flows.
Foreign Currency
The functional currency of some of our foreign subsidiaries and branches is
the U.S. dollar. Assets and liabilities recorded in foreign currencies are
translated into U.S. dollars at exchange rates in effect at the balance sheet
date. Transactions in foreign currencies are translated at the rates of exchange
in effect on the date the transaction occurs. Transaction gains and losses are
recorded in earnings and included in other operating expenses. Our foreign
currency transactions are principally denominated in British pound sterling and
the Euro. For the years ended December 31, 2002, 2001 and 2000, the gain (loss)
from currency conversion was $1.2 million, $0.3 million and $(0.3) million,
respectively.
A foreign branch of one subsidiary has a functional currency of Canadian
dollars. Recent acquisitions have added subsidiaries with functional currencies
of the Euro and British pound sterling. The cumulative translation adjustment,
representing the effect of translating these subsidiaries' assets and
liabilities into U.S. dollars, is included in the foreign currency translation
adjustment within accumulated other comprehensive income.
We periodically enter into foreign exchange forward contracts as a hedge
against future cash flows payable in foreign currencies. To the extent the
foreign exchange forward contracts qualify for cash flow hedge accounting
treatment, the gain or loss due to changes in fair value is not recognized in
our statement of earnings until realized, at which time the gain or loss is
recognized along with the offsetting loss or gain on the hedged item. To the
extent the foreign currency forward contracts do not qualify for cash flow hedge
accounting treatment, the gain or loss due to changes in fair value is
recognized in our consolidated statements of earnings, but is generally offset
by changes in value of the underlying exposure.
Income Tax
We file a consolidated Federal income tax return and include the foreign
subsidiaries' income to the extent required by law. Deferred income tax is
accounted for using the liability method, which reflects the tax impact of
temporary differences between the bases of assets and liabilities for financial
reporting purposes and such bases as measured by tax laws and regulations. Due
to our history of earnings, expectations for future earnings, and taxable income
in carry back years, we expect to be able to fully realize the benefit of any
net deferred tax asset.
Earnings Per Share
Basic earnings per share is based on the weighted average number of common
shares outstanding during the year divided into net earnings. Diluted earnings
per share is based on the weighted average number of common shares outstanding
plus the potential common shares outstanding during the year divided into net
earnings. Outstanding common stock options, when dilutive, are considered to be
potential common stock for
F-11
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
the purpose of the diluted calculation. The treasury stock method is used to
calculate potential common stock outstanding due to options. Contingent shares
to be issued are included in the earnings per share computation when the
underlying conditions for issuance have been met.
Stock Options
We account for stock options granted to employees using the intrinsic value
method of APB Opinion No. 25 entitled "Accounting for Stock Issued to
Employees". All options have been granted at fixed exercise prices at the market
price of our common stock at the grant date. Because of that, no stock-based
employee compensation cost is reflected in our reported net income. Options vest
over a period of up to seven years and expire four to ten years after grant
date. The following table illustrates the effects on net income and earnings per
share (and related assumptions) if we had used the fair value method of SFAS No.
123 entitled "Accounting for Stock-Based Compensation" for the three years ended
December 31, 2002:
<Table>
<Caption>
2002 2001 2000
-------- ------- -------
Reported net earnings.................................. $105,828 $30,197 $55,468
Stock-based compensation using the fair value method,
net of income tax.................................... (6,159) (4,426) (4,689)
-------- ------- -------
Pro forma net earnings................................. $ 99,669 $25,771 $50,779
======== ======= =======
Reported basic earnings per share...................... $ 1.70 $ 0.52 $ 1.09
Fair value stock-based compensation.................... (0.10) (0.08) (0.09)
-------- ------- -------
Pro forma basic earnings per share..................... $ 1.60 $ 0.44 $ 1.00
======== ======= =======
Reported diluted earnings per share.................... $ 1.68 $ 0.51 $ 1.07
Fair value stock-based compensation.................... (0.10) (0.08) (0.09)
-------- ------- -------
Pro forma diluted earnings per share................... $ 1.58 $ 0.43 $ 0.98
======== ======= =======
</Table>
For the purposes of the above presentation, we estimate the fair value of
each option grant on the grant date using the Black-Scholes single option
pricing model. The table below average fair value of options granted for the
three years ended December 31, 2002 and the related assumptions used in the
model:
<Table>
<Caption>
2002 2001 2000
-------- -------- --------
Fair value of options granted........................ $ 7.05 $ 7.66 $ 4.51
Risk free interest rate.............................. 3.5% 4.4% 6.4%
Expected volatility factor........................... .3 .3 .3
Dividend yield....................................... 1.14% 0.91% 0.89%
Expected option life................................. 5 years 5 years 4 years
</Table>
Guarantee Fund and Other Assessments
Certain of our insurance companies are subject to guarantee fund and other
assessments in states where we are licensed. In some cases, the states allow for
recoveries of assessments as premium tax offsets, but only over a period of
years. We generally accrue the liability when an insolvency or other event
occurs that indicates a liability exists and the premium on which the assessment
will be based has been written. We recognize an asset for the premium tax offset
based on in-force policies. During the years ended December 31, 2002, 2001 and
2000, we incurred a net expense for guarantee fund and other assessments of $4.7
million, $4.5 million, and $1.0 million, respectively. As of December 31, 2002
and 2001, accrued guarantee fund and
F-12
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
other assessments were $3.3 million and $2.2 million, respectively, and
recognized future premium tax offsets were $0.9 million and $0.8 million,
respectively.
Effects of Recent Accounting Pronouncements
SFAS No. 146 entitled "Accounting for Costs Associated with Exit or
Disposal Activities" was issued in July, 2002 and will become effective for us
on January 1, 2003. SFAS No. 146 will spread out the reporting of expenses
related to restructurings and is a change to existing guidance. The commitment
to a plan to exit an activity or dispose of long-lived assets will no longer be
enough to record a one-time charge for most anticipated costs. Instead,
companies will record exit or disposal costs when they are incurred and can be
measured at fair value and the liability will be subsequently adjusted for
changes in estimated cash flow. We do not expect the adoption of SFAS No. 146 to
have a material effect on our financial position, results of operations or cash
flows.
Financial Accounting Standards Board Interpretation ("FIN") No. 45 entitled
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others . . ." was issued on November 25,
2002. The provision for initial recognition and measurement are effective on a
prospective basis for guarantees that are issued or modified after December 31,
2002 and disclosure requirements were effective for periods ending after
December 15, 2002. We have complied with the disclosure requirements in these
financial statements and do not believe that the recognition and measurement
provisions will have a material effect on our financial position, result of
operations or cash flows.
FIN No. 46 entitled "Consolidation of Variable Interest Entities", which is
an interpretation of Accounting Research Bulletin No. 51 entitled "Consolidated
Financial Statements" addresses consolidation by business enterprises of
variable interest entities which have certain characteristics. FIN No. 46
requires consolidation of a qualifying variable interest entity when a party has
a controlling financial interest regardless of whether or not the party has a
majority voting interest. FIN No. 46 is immediately effective for qualifying
variable interest entities created after January 31, 2003 and applicable to such
entities created prior to February 1, 2003 by the end of our third fiscal
quarter in 2003. We are currently studying FIN No. 46 for applicability to us.
At the present time we believe FIN No. 46 will only be applicable to one entity
in which we have an investment. We invested in a partnership, which owns a
building which is rented to unaffiliated parties, as a long term investment. The
partnership is not material to our financial position, results of operations or
cash flows. We have a maximum exposure to loss of $14.1 million with respect to
this entity as a result of our investment and our guarantee of the partnership's
debt.
Emerging Issues Task Force ("EITF") Issue No. 00-21 entitled "Revenue
Arrangements with Multiple Deliverables" is effective for revenue arrangements
entered into in fiscal periods beginning after June 15, 2003 or alternatively
can be applied retroactively. EITF Issue No. 00-21 addressed how to determine
whether an arrangement involving multiple deliverables contains more than one
unit of accounting. EITF Issue No. 00-21 also addresses how arrangement
consideration should be measured and allocated to the separate units of
accounting in the arrangement. We do not believe that this EITF Issue No. 00-21
will have a material effect on our financial position, results of operations or
cash flows as the issues in EITF Issue No. 00-21 have been previously addressed
when we adopted Securities and Exchange Commissions' Staff Accounting Bulletin
101.
Unusual Loss Events
During 2001, we experienced three significant gross losses. The first loss
was the September 11 terrorist attack which produced the largest loss to our
insurance company operations in our history. We recorded gross and net loss
reserves of $141.0 million and $35.0 million, respectively. The other two losses
were the Petrobras (Brazilian offshore energy production platform) and Total
(chemical factory near Toulouse, France) incidents, which produced gross losses
of $55.0 million and $49.0 million, respectively. Because these two
F-13
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
losses were substantially reinsured, the net losses were not material to our
results of operations. The Petrobras loss was paid during 2001 and the Total
loss was paid during 2002. All reinsurance recoverables related to both losses
have been collected.
Other Information
During 2001, we recorded a charge totaling $37.3 million related to lines
of business that we decided to cease writing, mainly our primary workers'
compensation line of business. The composition of this charge is $18.8 million
for loss and loss adjustment expense, $2.2 million for net policy acquisition
costs and $16.3 million for other operating expense. Included in other operating
expense is $15.0 million related to the impairment of goodwill. The fair value
of this line of business was calculated based upon the present value of future
expected cash flows.
Reclassifications
Certain amounts in the 2001 and 2000 consolidated financial statements have
been reclassified to conform with the 2002 presentation. Such reclassifications
had no effect on our shareholders' equity, net earnings or cash flows.
(2) GOODWILL AND INTANGIBLE ASSETS
SFAS No. 142 entitled "Goodwill and Other Intangible Assets" was issued in
June, 2001, and became effective for us on January 1, 2002. SFAS No. 142
requires goodwill to be tested for impairment at a level referred to as a
reporting unit. After the initial adoption, goodwill of a reporting unit will be
tested for impairment on an annual basis and between annual tests if an event
occurs or circumstances change that would more likely than not reduce the fair
value of a reporting unit below its carrying amount. SFAS No. 142 also requires
the discontinuance of the amortization of goodwill effective January 1, 2002 and
that goodwill recognized for acquisitions which were consummated after July 1,
2001 not be amortized. During 2002 we determined our reporting units and
completed our initial and first annual goodwill impairment testing and
determined we did not have to record an impairment charge.
F-14
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
The tables below reconcile net earnings and earnings per share we reported
for the three years ended December 31, 2002 to adjusted amounts that we would
have reported had we adopted SFAS No. 142 on January 1, 2000 instead of January
1, 2002:
<Table>
<Caption>
2002 2001 2000
-------- ------- -------
Net earnings:
Reported net earnings................................ $105,828 $30,197 $55,468
Add back goodwill amortization....................... -- 11,924 12,606
Add back license amortization........................ -- 555 317
Less tax benefit from goodwill amortization.......... -- (1,092) (1,089)
-------- ------- -------
ADJUSTED NET EARNINGS............................. $105,828 $41,584 $67,302
======== ======= =======
Basic earnings per share:
Reported basic earnings per share.................... $ 1.70 $ 0.52 $ 1.09
Add back amortization, net of tax effect............. -- 0.19 0.24
-------- ------- -------
ADJUSTED BASIC EARNINGS PER SHARE................. $ 1.70 $ 0.71 $ 1.33
======== ======= =======
Diluted earnings per share:
Reported diluted earnings per share.................. $ 1.68 $ 0.51 $ 1.07
Add back amortization, net of tax effect............. -- 0.19 0.23
-------- ------- -------
ADJUSTED BASIC EARNINGS PER SHARE................. $ 1.68 $ 0.70 $ 1.30
======== ======= =======
</Table>
The following tables show the balances of our intangible assets, which are
included in other assets on our consolidated balance sheets:
<Table>
<Caption>
2002 2001
------- -------
Intangible assets not subject to amortization -- insurance
company and other licenses................................ $ 6,792 $ 6,792
======= =======
Intangible assets subject to amortization:
Gross amounts recorded.................................... $12,080 $10,231
Less accumulated amortization............................. (4,074) (722)
------- -------
NET INTANGIBLE ASSETS SUBJECT TO AMORTIZATION.......... $ 8,006 $ 9,509
======= =======
</Table>
Amortization of intangible assets which are subject to amortization under
SFAS No. 142 amounted to $3.4 million, $0.5 million and $0.1 million for the
years ended December 31, 2002, 2001 and 2000 respectively. Substantially all of
our intangible assets subject to amortization were acquired in our acquisitions
in 2001 and 2002. Estimated amortization expense for 2003 and future years is as
follows:
<Table>
2003........................................................ $2,658
2004........................................................ 1,841
2005........................................................ 1,336
2006........................................................ 730
2007........................................................ 638
Thereafter.................................................. 803
------
TOTAL ESTIMATED AMORTIZATION...................... $8,006
======
</Table>
F-15
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(3) ACQUISITIONS
During 2001 and 2002, we completed several acquisitions. The acquired
companies are well known in their respective lines of business, having excellent
reputations and workforces with significant expertise. They were generally
acquired to diversify into new specialty lines of business or grow existing
lines of business. These business combinations have been recorded using the
purchase method of accounting. The results of operations of these businesses
have been included in our consolidated financial statements beginning on the
effective date of each transaction. The following table provides some additional
information on these transactions (our initial cash consideration includes our
out of pocket expenses):
<Table>
<Caption>
GOODWILL
DEDUCTIBLE FOR
INITIAL CASH GOODWILL INCOME TAX
EFFECTIVE DATE CONSIDERATION RECOGNIZED PURPOSES
----------------- ------------- ------------- --------------
Professional Indemnity Agency, Inc. October 22, 2001 $63.0 million $53.6 million No
ASU International, LLC October 30, 2001 29.2 million 23.7 million Yes
HCC Global Financial Products, LLC
(formerly MAG Global Financial
Products) October 1, 2002 6.9 million -- Yes
Dickson Manchester & Company
Limited December 24, 2002 17.0 million 10.8 million No
HCC Europe (formerly St. Paul
Espana) December 31, 2002 18.9 million 10.8 million No
</Table>
The initial consideration given for Professional Indemnity Agency, Inc.
also included 0.3 million shares of our common stock. The value of our common
stock given as consideration was determined based on closing market price on the
day the acquisition was completed. In addition, we will pay up to a maximum of
$20.4 million with respect to one of the acquisitions made during 2001 if
certain earnings targets are reached through December 31, 2004. The purchase
agreements for two of the 2002 acquisitions have clauses requiring additional
consideration based on pre-tax earnings through September 30, 2007 for one and
December 31, 2005 for the other. Any contingent consideration paid will be
recorded as an increase to goodwill. We are still in the process of completing
the purchase price allocations for the 2002 acquisitions, as we are still
gathering some of the information needed to make the required calculations. Any
subsequent net adjustment will result in a change to recorded goodwill and,
additionally, in the case of the acquisition of HCC Europe, we have not yet
completed the final determination of the purchase price, which will be based
upon an agreed-upon final closing date balance sheet as per the stock purchase
agreement.
F-16
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
The following table summarizes the combined estimated fair values of assets
acquired and liabilities assumed at the respective dates of acquisition:
<Table>
<Caption>
2002 2001
-------- --------
Total investments........................................... $131,280 $ 47,650
Premium and other receivables............................... 46,232 30,506
Reinsurance recoverables.................................... 3,676 --
Other policy related assets................................. 5,808 --
Goodwill and intangible assets.............................. 23,816 83,957
All other assets............................................ 6,937 33,710
-------- --------
Total assets acquired............................. 217,749 195,823
Loss and loss adjustment expense payable.................... 82,289 --
Premium and claims payable.................................. 39,816 44,883
Other policy related liabilities............................ 37,419 --
Notes payable............................................... 3,530 12,735
All other liabilities....................................... 11,813 37,724
-------- --------
Total liabilities................................. 174,867 95,342
-------- --------
Net assets acquired............................... $ 42,882 $100,481
======== ========
</Table>
Currently identified intangible assets from the 2002 acquisitions consisted
of employment and non-compete agreements with an assigned value of $1.9 million
with a five year average amortization period. We are still in the process of
completing the purchase price allocations for the 2002 acquisitions, as we are
still gathering some of the information needed to make the required calculation.
It is probable that additional identified intangible assets will be recorded
during completion of this process.
The following unaudited pro forma summary presents information as if the
purchase acquisitions had occurred at the beginning of 2002 and 2001, after
giving effect to certain adjustments, including amortization of goodwill (for
2001 pro forma only) and intangible assets, increased interest expense from debt
issued to fund the acquisitions and income taxes. The pro forma summary is for
information purposes only, does not necessarily reflect the actual results that
would have occurred, nor is it necessarily indicative of future results of the
combined companies. During 2001, Professional Indemnity Agency, Inc. paid
approximately $33.0 million in bonuses to employees and related employment taxes
immediately prior to the completion of the acquisition. During 2002, HCC Europe
reported a net underwriting loss of approximately $16.7 million due to increases
in their loss reserves.
<Table>
<Caption>
UNAUDITED PROFORMA INFORMATION 2002 2001
- ------------------------------ -------- --------
Revenue..................................................... $731,468 $591,908
Net earnings................................................ 102,960 13,318
Basic earnings per share.................................... 1.65 0.23
Diluted earnings per share.................................. 1.64 0.22
</Table>
F-17
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(4) INVESTMENTS
Substantially all of our fixed income securities are investment grade; 96%
are rated "A" or better. The cost or amortized cost, gross unrealized gain or
loss and estimated market value of investments in fixed income and marketable
equity securities, all of which are classified as available for sale, are as
follows:
<Table>
<Caption>
COST OR GROSS GROSS ESTIMATED
AMORTIZED UNREALIZED UNREALIZED MARKET
COST GAIN LOSS VALUE
--------- ---------- ---------- ---------
December 31, 2002:
Marketable equity securities............... $ 15,815 $ 7 $ (213) $ 15,609
US Treasury securities..................... 93,620 2,935 (9) 96,546
Obligations of states, municipalities and
political subdivisions................... 246,364 13,205 (101) 259,468
Corporate fixed income securities.......... 232,216 12,739 (679) 244,276
Asset-backed and mortgage-backed
securities............................... 144,427 5,907 (461) 149,873
Foreign government securities.............. 91,145 240 -- 91,385
-------- ------- ------- --------
TOTAL SECURITIES................. $823,587 $35,033 $(1,463) $857,157
======== ======= ======= ========
December 31, 2001:
Marketable equity securities............... $ 16,431 $ 176 $ (38) $ 16,569
US Treasury securities..................... 70,235 1,242 (109) 71,368
Obligations of states, municipalities and
political subdivisions................... 200,790 5,513 (645) 205,658
Corporate fixed income securities.......... 140,702 4,999 (416) 145,285
Asset-backed and mortgage-backed
securities............................... 97,684 1,504 (560) 98,628
Foreign government securities.............. 4,263 226 -- 4,489
-------- ------- ------- --------
TOTAL SECURITIES................. $530,105 $13,660 $(1,768) $541,997
======== ======= ======= ========
</Table>
The amortized cost and estimated market value of fixed income securities at
December 31, 2002, by contractual maturity, are shown below. Expected maturities
may differ from contractual maturities because borrowers may have the right to
call or prepay obligations with or without call or prepayment penalties. The
weighted average life of our asset-backed and mortgage-backed securities is five
years.
<Table>
<Caption>
ESTIMATED
AMORTIZED MARKET
COST VALUE
--------- ---------
Due in 1 year or less....................................... $ 65,851 $ 66,673
Due after 1 year through 5 years............................ 315,474 326,561
Due after 5 years through 10 years.......................... 128,883 135,984
Due after 10 years through 15 years......................... 76,966 82,488
Due after 15 years.......................................... 76,171 79,969
-------- --------
Securities with fixed maturities.......................... 663,345 691,675
Asset-backed and mortgage-backed securities................. 144,427 149,873
-------- --------
TOTAL FIXED INCOME SECURITIES........................ $807,772 $841,548
======== ========
</Table>
F-18
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
As of December 31, 2002, our insurance companies had deposited fixed income
securities with an amortized cost of approximately $32.0 million (market: $34.0
million) to meet the deposit requirements of various insurance departments.
All investments in fixed income securities and other investments were
income producing for the twelve months preceding December 31, 2002, except for
one fixed income security valued at $0.5 million. The sources of net investment
income for the three years ended December 31, 2002, are detailed below:
<Table>
<Caption>
2002 2001 2000
------- ------- -------
Fixed income securities................................. $31,773 $27,234 $22,074
Short-term investments.................................. 6,801 12,789 18,085
Marketable equity securities............................ 210 294 59
Other investments....................................... 12 4 4
------- ------- -------
Total investment income.......................... 38,796 40,321 40,222
Investment expense...................................... (1,027) (683) (386)
------- ------- -------
NET INVESTMENT INCOME............................ $37,769 $39,638 $39,836
======= ======= =======
</Table>
Realized pre-tax gain (loss) on the sale or write down of investments is as
follows:
<Table>
<Caption>
GAIN LOSS NET
------ ------- -------
For the year ended December 31, 2002:
Fixed income securities.................................. $3,027 $(1,621) $ 1,406
Marketable equity securities............................. 207 (312) (105)
Other investments........................................ 335 (1,183) (848)
------ ------- -------
REALIZED GAIN (LOSS)........................... $3,569 $(3,116) $ 453
====== ======= =======
For the year ended December 31, 2001:
Fixed income securities.................................. $3,099 $(1,452) $ 1,647
Marketable equity securities............................. 1,224 (1,848) (624)
Other investments........................................ 145 (775) (630)
------ ------- -------
REALIZED GAIN (LOSS)........................... $4,468 $(4,075) $ 393
====== ======= =======
For the year ended December 31, 2000:
Fixed income securities.................................. $1,173 $ (970) $ 203
Marketable equity securities............................. 567 (6,195) (5,628)
Other investments........................................ 104 -- 104
------ ------- -------
REALIZED GAIN (LOSS)........................... $1,844 $(7,165) $(5,321)
====== ======= =======
</Table>
F-19
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Unrealized pre-tax net gains (losses) on investments for three years ended
December 31, 2002 are as follows:
<Table>
<Caption>
2002 2001 2000
------- ------ -------
Fixed income securities.................................. $22,022 $ 731 $11,916
Marketable equity securities............................. (344) 2,752 (91)
Other investments........................................ 442 (442) --
------- ------ -------
NET UNREALIZED INVESTMENT GAIN (LOSS).......... $22,120 $3,041 $11,825
======= ====== =======
</Table>
(5) NOTES PAYABLE
Notes payable as of December 31, 2002 and 2001 are shown in the table
below. The estimated fair value of our 2% convertible notes ($185.2 million and
$185.9 million at December 31, 2002 and 2001, respectively) is based on its
trading market value. For the remainder of our notes payable, the estimated fair
value is based on current rates offered to us for debt with similar terms and
conditions and approximates the carrying value at both balance sheet dates.
<Table>
<Caption>
2002 2001
-------- --------
2% Convertible notes........................................ $172,451 $172,500
Revolving loan facility..................................... 53,000 --
Other debt.................................................. 4,576 9,428
-------- --------
TOTAL NOTES PAYABLE............................... $230,027 $181,928
======== ========
</Table>
In a public offering on August 23, 2001, we issued an aggregate $172.5
million principal amount of 2% Convertible Notes due in 2021. Each $1 thousand
principal amount of notes is convertible into 31.25 shares of our common stock,
which represents an initial conversion price of $32.00 per share. The initial
conversion price is subject to change under certain conditions. Interest is to
be paid by us on March 1 and September 1 each year. Holders may surrender notes
for conversion into shares of our common stock in any calendar quarter if, as of
the last day of the preceding calendar quarter, the closing sale price of our
common stock for at least 20 trading days in the period of 30 consecutive
trading days ending on the last trading day of the quarter is more than 120%
($38.40 per share) of the conversion price per share of our common stock on the
last trading day of the quarter. We can redeem the notes for cash at any time on
or after September 1, 2006. Holders of the notes may require us to repurchase
the notes on September 1, 2004, 2006, 2008, 2011 and 2016. If the holders
exercise this option, we may choose to pay the purchase price in cash, in shares
of our common stock, or a combination thereof. On September 1, 2002, the first
repurchase date of the notes, $49 thousand of the notes were tendered to us and
we repurchased them with cash. We paid $4.4 million in underwriting discounts
and expenses in connection with the offering, which were being amortized from
the issue date until September 1, 2002. We used the proceeds from this offering
to repay our remaining indebtedness under our bank facility, assist in financing
the recent acquisitions, make a $60.0 million capital contribution to our
insurance companies and for general corporate purposes.
On December 17, 1999, we entered into a $300.0 million Revolving Loan
Facility with a group of banks. At our request, the amount available under the
facility was reduced to $200.0 million by an amendment on June 6, 2001. Interest
expense for 2001 includes a charge of $0.6 million related to the write off of
prepaid loan fees in connection with the amendment. We can borrow up to the
maximum allowed by the facility on a revolving basis until the facility expires
on December 17, 2004. The facility is collateralized in part by the pledge of
our insurance companies' stock and guarantees entered into by our underwriting
agencies and intermediaries. The facility agreement contains certain restrictive
covenants, which we believe are typical for
F-20
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
similar financing arrangements. As of December 31, 2002 the weighted average
interest rate on the outstanding balance was 3.2%.
At December 31, 2002, certain of our subsidiaries maintained revolving
lines of credit with a bank in the combined maximum amount of $26.8 million
available through December 17, 2004. Advances under the lines of credit are
limited to amounts required to fund draws, if any, on letters of credit issued
by the bank on behalf of the subsidiaries and short-term direct cash advances.
The lines of credit are collateralized by securities having an aggregate market
value of up to $33.5 million, the actual amount of collateral at any one time
being 125% of the aggregate amount outstanding. Interest on the lines is payable
at the bank's prime rate of interest (4.25% at December 31, 2002) for draws on
the letters of credit and prime less 1% on short-term cash advances. As of
December 31, 2002, letters of credit totaling $12.1 million had been issued to
insurance companies by the bank on behalf of our subsidiaries, with total
securities of $15.2 million collateralizing the lines.
(6) INCOME TAX
As of December 31, 2002 and 2001, we had current income taxes receivable of
$3.9 million and $15.5 million, respectively, included in other assets in the
consolidated balance sheets. The components of the income tax provision for the
three years ended December 31, 2002 are as follows:
<Table>
<Caption>
2002 2001 2000
------- ------- -------
Current................................................. $48,111 $35,055 $26,948
Deferred................................................ 9,240 (4,869) 8,919
------- ------- -------
TOTAL INCOME TAX PROVISION.................... $57,351 $30,186 $35,867
======= ======= =======
</Table>
F-21
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
The net deferred tax liability and asset are included in accounts payable
and accrued liabilities and other assets, respectively, in our consolidated
balance sheets. The composition of deferred tax assets and liabilities as of
December 31, 2002 and 2001, is as follows:
<Table>
<Caption>
2002 2001
-------- -------
Federal tax net operating loss carryforwards................ $ 5,370 $10,117
State tax net operating loss carryforwards.................. 5,671 5,464
Excess of financial unearned premium over tax............... 9,746 6,555
Effect of loss reserve discounting and salvage and
subrogation accrual for tax............................... 10,544 9,897
Excess of financial accrued expenses over tax............... 1,960 4,918
Allowance for bad debts, not deductible for tax............. 3,346 2,788
Foreign branch net operating loss carryforwards............. 2,169 2,568
Valuation allowance......................................... (11,547) (10,435)
-------- -------
Total assets...................................... 27,259 31,872
Unrealized gain on increase in value of securities available
for sale (shareholders' equity)........................... 12,170 3,717
Deferred policy acquisition costs, net of ceding
commissions, deductible for tax........................... 4,653 2,256
Amortizable goodwill for tax................................ 11,061 5,256
Property and equipment depreciation and other items......... 9,850 4,165
-------- -------
Total liabilities................................. 37,734 15,394
-------- -------
NET DEFERRED TAX ASSET (LIABILITY)................ $(10,475) $16,478
======== =======
</Table>
Changes in the valuation allowance account applicable to deferred tax
assets result primarily from the acquisition and expiration of net operating
losses and other tax attributes related to acquired subsidiaries. The changes
for the three years ended December 31, 2002 are as follows:
<Table>
<Caption>
2002 2001 2000
------- ------- -------
Balance, beginning of year.............................. $10,435 $ 9,666 $12,091
Change during year...................................... 1,112 769 (2,425)
------- ------- -------
BALANCE, END OF YEAR.......................... $11,547 $10,435 $ 9,666
======= ======= =======
</Table>
As of December 31, 2002, we have Federal tax net operating loss
carryforwards of approximately $14.7 million that will expire in varying amounts
through the year 2021. Future use of these carryforwards is subject to statutory
limitations due to prior changes of ownership. There are valuation allowances in
the amount of $4.3 million recorded with respect to these loss carryforwards
that would reduce goodwill if the carryforwards are realized. In addition, we
have approximately $6.8 million of Federal tax loss carryforwards, principally
from our foreign insurance companies that can be used only against future
taxable income of those entities. There are valuation allowances in the amount
of $0.3 million recorded with respect to these loss carryforwards that would be
credited to income if the carryforwards are realized. Based upon our history of
taxable income in our domestic insurance and other operations and our
projections of future taxable income in our domestic and foreign insurance
operations, we believe it is more likely than not that the deferred tax assets
related to our loss carryforwards, for which there are no valuation allowances,
will be realized. We have various state tax net operating loss carryforwards for
which we have established valuation allowances of approximately $5.6 million
covering all of the related tax benefit.
F-22
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
The following table summarizes the differences between our effective tax
rate for financial statement purposes and the Federal statutory rate for the
three years ended December 31, 2002:
<Table>
<Caption>
2002 2001 2000
------- ------- -------
Statutory tax rate...................................... 35.0% 35.0% 35.0%
Federal tax at statutory rate........................... $57,113 $21,134 $31,967
Nontaxable municipal bond interest and dividends
received deduction.................................... (3,391) (3,314) (3,545)
Other non deductible expenses........................... 442 512 620
Non deductible goodwill amortization.................... -- 7,781 2,497
State income taxes...................................... 2,414 3,259 4,202
Foreign income taxes.................................... 2,921 2,915 1,537
Foreign tax credit...................................... (2,597) (2,968) (1,826)
Other, net.............................................. 449 867 415
------- ------- -------
INCOME TAX PROVISION.......................... $57,351 $30,186 $35,867
======= ======= =======
EFFECTIVE TAX RATE............................ 35.1% 50.0% 39.3%
======= ======= =======
</Table>
(7) SEGMENT AND GEOGRAPHIC DATA
We have classified our activities into four operating business segments
based upon services provided: 1) insurance company operations, 2) underwriting
agency operations, 3) intermediary operations, and 4) other operations. See Note
1 for a description of the services provided by and the principal subsidiaries
included in our insurance company, underwriting agency and intermediary
segments. Our other operations segment performed various insurance related
services and contains insurance related investments made from time to time.
During 2001, we sold the last of our service operations, which will result in a
decrease in other operating income in future years until additional investments,
which are contemplated, are made. Corporate includes general corporate
operations, and those minor operations not included in an operating segment.
Inter-segment revenue consists primarily of management fees of our underwriting
agency segment, commission income of our intermediary segment and service
revenue of our other operations charged to our insurance company segment on
business retained by our insurance companies. Inter-segment pricing (either flat
rate fees or as a percentage premium) approximates what is charged to unrelated
parties for similar services.
The performance of each of our segments is evaluated by our management
based upon net earnings. Net earnings is calculated after tax and after all
corporate expense allocations, amortization of goodwill, interest expense on
debt incurred at the purchase date and intercompany eliminations have been
charged or credited to our individual segments. The following tables show
information by business segment and geographic location. Geographic location is
determined by physical location of our offices and does not represent the
location of insureds or reinsureds from whom the business was generated.
Effective January 1, 2001 and 2002, we consolidated the operations of three
and one of our underwriting agencies, respectively, into the operations of our
insurance companies. Policies incepting on or after the effective dates, along
with associated expenses, will be reported in our insurance company segment. The
administration of all policies incepting before the effective dates, which are
now in run off, along with associated expenses, will continue to be reported in
our underwriting agency segment. This consolidation will affect the
comparability of segment information between periods.
SFAS No. 142, which we adopted effective January 1, 2002, required the
discontinuance of the amortization of goodwill and indefinite lived intangible
assets on a prospective basis. This will affect the
F-23
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
comparability of certain segment information between periods. Pro forma segment
information is shown in the tables for the years ended December 31, 2001 and
2000, as if we had adopted SFAS No. 142 as of January 1, 2000.
<Table>
<Caption>
INSURANCE UNDERWRITING OTHER
COMPANY AGENCY INTERMEDIARY OPERATIONS CORPORATE TOTAL
--------- ------------ ------------ ---------- --------- --------
For the year ended December 31,
2002:
Revenue:
Domestic.......................... $449,391 $ 75,653 $24,104 $4,874 $ 616 $554,638
Foreign........................... 91,796 4,487 18,461 -- -- 114,744
Inter-segment..................... -- 31,906 992 -- -- 32,898
-------- -------- ------- ------ ------ --------
Total segment revenue........ $541,187 $112,046 $43,557 $4,874 $ 616 702,280
======== ======== ======= ====== ======
Inter-segment revenue............... (32,898)
--------
CONSOLIDATED TOTAL REVENUE... $669,382
========
Net earnings:
Domestic.......................... $ 62,190 $ 23,180 $ 5,183 $3,052 $2,922 $ 96,527
Foreign........................... 6,040 2,076 2,390 -- -- 10,506
-------- -------- ------- ------ ------ --------
Total segment net earnings... $ 68,230 $ 25,256 $ 7,573 $3,052 $2,922 107,033
======== ======== ======= ====== ======
Inter-segment eliminations.......... (1,205)
--------
CONSOLIDATED NET EARNINGS.... $105,828
========
Other items:
Net investment income............. $ 33,587 $ 2,954 $ 993 $ 41 $ 194 $ 37,769
Depreciation and amortization..... 3,153 6,190 350 82 1,033 10,808
Interest expense (benefit)........ (113) 7,767 2,575 -- (1,928) 8,301
Capital expenditures.............. 2,803 1,208 1,491 -- 280 5,782
Income tax provision.............. 33,074 15,499 6,550 1,566 1,368 58,057
Inter-segment eliminations........ (706)
--------
Consolidated income tax
provision.................... $ 57,351
========
</Table>
For 2002, earnings before income taxes was $144.3 million for our domestic
subsidiaries and $18.8 million for our foreign subsidiaries and branches.
F-24
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<Table>
<Caption>
INSURANCE UNDERWRITING OTHER
COMPANY AGENCY INTERMEDIARY OPERATIONS CORPORATE TOTAL
--------- ------------ ------------ ---------- --------- --------
For the year ended December 31,
2001:
Revenue:
Domestic.......................... $330,724 $64,848 $23,518 $14,885 $1,426 $435,401
Foreign........................... 45,098 2,312 22,650 -- -- 70,060
Inter-segment..................... -- 22,619 491 1,967 -- 25,077
-------- ------- ------- ------- ------ --------
Total segment revenue..... $375,822 $89,779 $46,659 $16,852 $1,426 530,538
======== ======= ======= ======= ======
Inter-segment revenue............... (25,077)
--------
CONSOLIDATED TOTAL
REVENUE................. $505,461
========
Net earnings (loss):
Domestic.......................... $ 1,020 $16,075 $ 4,382 $ 7,149 $ (979) $ 27,647
Foreign........................... (3,923) 1,137 4,280 -- -- 1,494
-------- ------- ------- ------- ------ --------
Total segment net earnings
(loss).................. $ (2,903) $17,212 $ 8,662 $ 7,149 $ (979) 29,141
======== ======= ======= ======= ======
Inter-segment eliminations........ 1,056
--------
CONSOLIDATED NET
EARNINGS................ $ 30,197
========
SFAS No. 142 pro forma adjustments:
Net effect of goodwill and
intangible asset
amortization................... $ 2,142 $ 5,892 $ 3,353 $ -- $ -- $ 11,387
-------- ------- ------- ------- ------ --------
Pro forma segment net earnings
(loss)......................... $ (761) $23,104 $12,015 $ 7,149 $ (979) 40,528
======== ======= ======= ======= ======
Inter-segment eliminations........ 1,056
--------
PRO FORMA CONSOLIDATED NET
EARNINGS................ $ 41,584
========
Other items:
Net investment income............. $ 30,766 $ 5,202 $ 2,771 $ 85 $ 814 $ 39,638
Depreciation, amortization and
impairments.................... 20,685 9,783 3,723 256 479 34,926
Interest expense.................. 37 5,198 3,534 15 100 8,884
Capital expenditures.............. 3,049 1,048 1,627 107 6,452 12,283
Income tax provision.............. 2,432 15,604 3,054 3,692 4,756 29,538
Inter-segment eliminations........ 648
--------
Consolidated income tax
provision.................... $ 30,186
========
</Table>
During 2001, our insurance company segment recorded two large unusual
items: 1) a $22.8 million (net of income tax) loss due to the terrorist attack
on September 11 and 2) a $29.4 million charge (net of income tax) related to
lines of business we decided to cease writing. Included in the latter amount,
was a $15.0 million charge for the impairment of goodwill, which was not
deductible for income tax purposes. Also during 2001, earnings (loss) before
income taxes was $60.4 million for our domestic subsidiaries and $(0.1) million
for our foreign subsidiaries and branches.
F-25
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<Table>
<Caption>
INSURANCE UNDERWRITING OTHER
COMPANY AGENCY INTERMEDIARY OPERATIONS CORPORATE TOTAL
--------- ------------ ------------ ---------- --------- --------
For the year ended December 31,
2000:
Revenue:
Domestic.......................... $276,240 $ 99,808 $31,525 $23,826 $ 1,035 $432,434
Foreign........................... 15,054 4,446 21,669 -- -- 41,169
Inter-segment..................... -- 16,404 345 1,468 -- 18,217
-------- -------- ------- ------- ------- --------
Total segment revenue..... $291,294 $120,658 $53,539 $25,294 $ 1,035 491,820
======== ======== ======= ======= =======
Inter-segment revenue............... (18,217)
--------
CONSOLIDATED TOTAL
REVENUE................. $473,603
========
Net earnings (loss):
Domestic.......................... $ 27,289 $ 20,771 $ 9,846 $ 5,960 $(4,710) $ 59,156
Foreign........................... (3,094) 672 1,366 -- -- (1,056)
-------- -------- ------- ------- ------- --------
Total segment net earnings
(loss).................. $ 24,195 $ 21,443 $11,212 $ 5,960 $(4,710) 58,100
======== ======== ======= ======= =======
Inter-segment eliminations........ (619)
Cumulative effect of accounting
change......................... (2,013)
--------
CONSOLIDATED NET
EARNINGS................ $ 55,468
========
SFAS No. 142 pro forma adjustments:
Net effect of goodwill and
intangible asset
amortization................... $ 597 $ 7,687 $ 3,522 $ 28 $ -- $ 11,834
-------- -------- ------- ------- ------- --------
Pro forma segment net earnings
(loss)......................... $ 24,792 $ 29,130 $14,734 $ 5,988 $(4,710) 69,934
======== ======== ======= ======= =======
Inter-segment eliminations........ (619)
Cumulative effect of accounting
change......................... (2,013)
--------
PRO FORMA CONSOLIDATED NET
EARNINGS................ $ 67,302
========
Other items:
Net investment income............. $ 27,948 $ 7,547 $ 3,335 $ 476 $ 530 $ 39,836
Depreciation and amortization..... 3,662 11,926 3,567 385 368 19,908
Interest expense.................. 103 9,222 4,846 2 6,174 20,347
Capital expenditures.............. 3,124 4,651 1,082 219 1,074 10,150
Income tax provision (benefit).... 8,308 20,900 6,402 3,578 (1,604) 37,584
Inter-segment eliminations........ (382)
Cumulative effect of accounting
change......................... (1,335)
--------
Consolidated income tax
provision.................... $ 35,867
========
</Table>
For 2000, earnings (loss) before income taxes was $92.7 million for our
domestic subsidiaries and $(1.4) million for our foreign subsidiaries and
branches.
F-26
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
The following tables present revenue by line of business within each of our
operating segments for the three years ended December 31, 2002:
<Table>
<Caption>
2002 2001 2000
-------- -------- --------
Insurance company:
Group life, accident and health.................... $240,070 $143,851 $109,077
Aviation........................................... 100,960 91,377 73,695
London market account.............................. 89,260 43,360 16,234
Global financial products.......................... 23,102 4 --
Other specialty lines.............................. 22,337 15,120 14,552
-------- -------- --------
475,729 293,712 213,558
Discontinued lines................................. 29,792 49,075 54,089
-------- -------- --------
TOTAL NET EARNED PREMIUM........................ $505,521 $342,787 $267,647
======== ======== ========
Underwriting agency:
Life, accident and health.......................... $ 44,615 $ 47,857 $ 70,536
Property and casualty.............................. 32,467 13,938 25,522
-------- -------- --------
TOTAL MANAGEMENT FEES........................... $ 77,082 $ 61,795 $ 96,058
======== ======== ========
Intermediary:
Life, accident and health.......................... $ 32,045 $ 33,739 $ 36,795
Property and casualty.............................. 9,527 9,673 13,091
-------- -------- --------
TOTAL COMMISSION INCOME......................... $ 41,572 $ 43,412 $ 49,886
======== ======== ========
</Table>
Assets by business segment and geographic location are shown in the
following tables:
<Table>
<Caption>
INSURANCE UNDERWRITING OTHER
COMPANY AGENCY INTERMEDIARY OPERATIONS CORPORATE TOTAL
---------- ------------ ------------ ---------- --------- ----------
December 31, 2002:
Domestic...................... $2,068,095 $651,786 $ 47,946 $5,925 $46,477 $2,820,229
Foreign....................... 445,692 61,078 377,152 -- -- 883,922
---------- -------- -------- ------ ------- ----------
Total assets................ $2,513,787 $712,864 $425,098 $5,925 $46,477 $3,704,151
========== ======== ======== ====== ======= ==========
December 31, 2001:
Domestic...................... $1,696,823 $742,739 $ 75,162 $5,790 $32,875 $2,553,389
Foreign....................... 290,597 36,936 338,198 -- -- 665,731
---------- -------- -------- ------ ------- ----------
Total assets................ $1,987,420 $779,675 $413,360 $5,790 $32,875 $3,219,120
========== ======== ======== ====== ======= ==========
</Table>
The changes in the carrying amount of goodwill for the year end December
31, 2002 are as follows:
<Table>
<Caption>
INSURANCE UNDERWRITING
COMPANY AGENCY INTERMEDIARY TOTAL
--------- ------------ ------------ --------
Goodwill as of December 31, 2001........ $130,504 $107,598 $77,216 $315,318
Additions and other adjustments......... 13,700 5,985 285 19,970
-------- -------- ------- --------
Goodwill as of December 31, 2002........ $144,204 $113,583 $77,501 $335,288
======== ======== ======= ========
</Table>
F-27
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
We are still in the process of completing the purchase price allocations
for the 2002 acquisitions (see Note 2). Any subsequent net adjustment will
result in a change to recorded goodwill.
(8) REINSURANCE
In the normal course of business, our insurance companies cede a portion of
their premium to non-affiliated domestic and foreign reinsurers through treaty
and facultative reinsurance agreements. Although the ceding of reinsurance does
not discharge the primary insurer from liability to its policyholder, our
insurance companies participate in such agreements for the purpose of limiting
their loss exposure, protecting them against catastrophic loss and diversifying
their business. The following table represents the effect of such reinsurance
transactions on net premium and loss and loss adjustment expense:
<Table>
<Caption>
LOSS AND LOSS
WRITTEN EARNED ADJUSTMENT
PREMIUM PREMIUM EXPENSE
--------- --------- -------------
For the year ended December 31, 2002:
Direct business.......................................... $ 904,737 $ 801,851 $ 504,815
Reinsurance assumed...................................... 254,512 229,287 99,437
Reinsurance ceded........................................ (613,338) (525,617) (297,761)
--------- --------- ---------
NET AMOUNTS....................................... $ 545,911 $ 505,521 $ 306,491
========= ========= =========
For the year ended December 31, 2001:
Direct business.......................................... $ 783,124 $ 789,893 $ 612,455
Reinsurance assumed...................................... 226,951 218,234 451,390
Reinsurance ceded........................................ (637,117) (665,340) (796,455)
--------- --------- ---------
NET AMOUNTS....................................... $ 372,958 $ 342,787 $ 267,390
========= ========= =========
For the year ended December 31, 2000:
Direct business.......................................... $ 676,730 $ 663,458 $ 493,647
Reinsurance assumed...................................... 290,727 311,137 279,999
Reinsurance ceded........................................ (683,669) (706,948) (575,176)
--------- --------- ---------
NET AMOUNTS....................................... $ 283,788 $ 267,647 $ 198,470
========= ========= =========
</Table>
Ceding commissions netted with policy acquisition costs in the consolidated
statements of earnings are $142.0 million, $185.2 million, and $214.7 million
for the years ended December 31, 2002, 2001, and 2000, respectively.
The table below represents the composition of reinsurance recoverables in
our consolidated balance sheets:
<Table>
<Caption>
2002 2001
-------- --------
Reinsurance recoverable on paid losses...................... $108,104 $ 86,653
Reinsurance recoverable on outstanding losses............... 304,220 414,428
Reinsurance recoverable on incurred but not reported
losses.................................................... 393,752 403,223
Reserve for uncollectible reinsurance....................... (7,142) (5,176)
-------- --------
TOTAL REINSURANCE RECOVERABLES....................... $798,934 $899,128
======== ========
</Table>
F-28
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Our insurance companies require reinsurers not authorized by their
respective states of domicile to collateralize their reinsurance obligations to
us. The table below shows amounts held by us as collateral plus other credits
available for potential offset as of December 31, 2002 and 2001:
<Table>
<Caption>
2002 2001
-------- --------
Payables to reinsurers...................................... $235,727 $199,581
Letters of credit........................................... 141,490 145,796
Cash deposits............................................... 9,384 14,851
-------- --------
TOTAL CREDITS........................................ $386,601 $360,228
======== ========
</Table>
The tables below present the calculation of net reserves, net unearned
premium and net deferred policy acquisition costs as of December 31, 2002 and
2001:
<Table>
<Caption>
2002 2001
---------- ----------
Loss and loss adjustment expense payable.................... $1,155,290 $1,130,748
Reinsurance recoverable on outstanding losses............... (304,220) (414,428)
Reinsurance recoverable on incurred but not reported
losses.................................................... (393,752) (403,223)
---------- ----------
NET RESERVES......................................... $ 457,318 $ 313,097
========== ==========
Unearned premium............................................ $ 331,050 $ 179,530
Ceded unearned premium...................................... (164,224) (71,140)
---------- ----------
NET UNEARNED PREMIUM................................. $ 166,826 $ 108,390
========== ==========
Deferred policy acquisition costs........................... $ 68,846 $ 32,071
Deferred ceding commissions................................. (49,963) (16,681)
---------- ----------
NET DEFERRED POLICY ACQUISITION COSTS................ $ 18,883 $ 15,390
========== ==========
</Table>
In order to reduce our exposure to reinsurance credit risk, we evaluate the
financial condition of our reinsurers and place our reinsurance with a diverse
group of companies and syndicates, which we believe to be financially sound. The
following table shows reinsurance balances relating to our reinsurers with a net
recoverable balance greater than $15.0 million as of December 31, 2002 and 2001.
The total recoverables
F-29
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
column includes paid loss recoverable, outstanding loss recoverable, incurred
but not reported loss recoverable and ceded unearned premium.
<Table>
<Caption>
LETTERS OF CREDIT,
TOTAL CASH DEPOSITS AND
REINSURER RATING LOCATION RECOVERABLES OTHER PAYABLES NET
- --------- ------ -------------- ------------ ------------------ -------
December 31, 2002:
Lloyd's Syndicate Number 1101......... NR United Kingdom $40,450 $ 258 $40,192
Lloyd's Syndicate Number 2488......... A- United Kingdom 31,640 1,998 29,642
Lloyd's Syndicate Number 1206......... C+ United Kingdom 29,540 40 29,500
Odyssey American Reinsurance Corp..... A Connecticut 25,087 843 24,244
American Fidelity Assurance Company... A+ Oklahoma 23,305 -- 23,305
American Re-Insurance Company......... A+ Delaware 19,797 229 19,568
Lloyd's Syndicate Number 0957......... NR United Kingdom 19,403 22 19,381
Lloyd's Syndicate Number 0033......... A- United Kingdom 19,277 62 19,215
Lloyd's Syndicate Number 0055......... NR United Kingdom 17,009 65 16,944
Canada Life Assurance Company......... A+ Canada 16,900 96 16,804
Lloyd's Syndicate Number 0510......... A- United Kingdom 16,250 562 15,688
Transatlantic Reinsurance Company..... A++ New York 17,288 1,771 15,517
Lloyd's Syndicate Number 0990......... NR United Kingdom 15,329 58 15,271
December 31, 2001:
Lloyd's Syndicate Number 1101......... NR United Kingdom $40,913 $1,532 $39,381
Canada Life Assurance Company......... A+ Canada 28,956 -- 28,956
Lloyd's Syndicate Number 1206......... C+ United Kingdom 27,251 351 26,900
AXA Corporate Solutions Reinsurance
Co. ................................ A+ Delaware 26,582 680 25,902
Lloyd's Syndicate Number 2488......... A- United Kingdom 25,813 1,187 24,626
American Re-Insurance Company......... A++ Delaware 24,674 1,697 22,977
SCOR Reinsurance Company.............. A New York 21,883 -- 21,883
American Fidelity Assurance Company... A+ Oklahoma 19,881 12 19,869
Transatlantic Reinsurance Company..... A++ New York 20,543 849 19,694
Federal Insurance Company............. A++ Indiana 26,902 8,971 17,931
Lloyd's Syndicate Number 0957......... NR United Kingdom 17,653 -- 17,653
Lloyd's Syndicate Number 0510......... A- United Kingdom 17,647 1,500 16,147
Lloyd's Syndicate Number 0055......... NR United Kingdom 16,168 305 15,863
</Table>
Ratings for companies are published by A.M. Best Company, Inc. Ratings for
individual syndicates are published by Moody's Investors Services, Inc. "NR"
indicates that the indicated Lloyd's syndicate has not been rated. Lloyd's of
London is an insurance and reinsurance marketplace composed of many independent
underwriting syndicates financially supported by a central trust fund.
HCC Life Insurance Company previously sold its entire block of individual
life insurance and annuity business to Life Reassurance Corporation of America
(rated A++ by A.M. Best Company, Inc.) in the form of an indemnity reinsurance
contract. Ceded life and annuity benefits amounted to $79.0 million and $83.0
million as of December 31, 2002 and 2001, respectively.
F-30
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
We have a reserve of $7.1 million as of December 31, 2002 for potential
collectibility issues and associated expenses related to reinsurance
recoverables. The adverse economic environment in the worldwide insurance
industry, the decline in the market value of investments in equity securities
and the terrorist attack on September 11, 2001 have placed great pressure on
reinsurers and the results of their operations. Ultimately, these conditions
could affect reinsurers' solvency. Historically, there have been insolvencies
following a period of competitive pricing in the industry. While we believe that
the reserve is adequate based on currently available information, conditions may
change or additional information might be obtained which may result in a future
change in the reserve. We periodically review our financial exposure to the
reinsurance market and the level of our reserve and continue to take actions in
an attempt to mitigate our exposure to possible loss.
A number of reinsurers have delayed or suspended the payment of amounts
recoverable under certain reinsurance contracts to which we are a party. Such
delays have affected, although not materially to date, the investment income of
our insurance companies, but not to any extent their liquidity. We limit our
liquidity exposure by holding funds, letters of credit or other security such
that net balances due are significantly less than the gross balances shown in
our consolidated balance sheets. In some instances, the reinsurers have withheld
payment without reference to a substantive basis for the delay or suspension. In
other cases, the reinsurers have claimed they are not liable for payment to us
of all or part of the amounts due under the applicable reinsurance agreement. We
believe these claims are without merit and expect to collect the full amounts
recoverable. We are currently in negotiations with most of these parties, but if
such negotiations do not result in a satisfactory resolution of the matters in
question, we may seek or be involved in a judicial or arbitral determination of
these matters. In some cases, the final resolution of such disputes through
arbitration or litigation may extend over several years. In this regard, as of
December 31, 2002, our insurance companies had initiated two litigation
proceedings against reinsurers. As of such date, our insurance companies had an
aggregate amount of $5.8 million which had not been paid to us under the
agreements and we estimate that there could be up to an additional $10.7 million
of incurred losses and loss expenses and other balances due under the subject
agreements.
(9) COMMITMENTS AND CONTINGENCIES
Litigation
In addition to the matters discussed in Note (8), Reinsurance, we are party
to numerous lawsuits and other proceedings that arise in the normal course of
our business. Many of such lawsuits and other proceedings involve claims under
policies that we underwrite as an insurer or reinsurer, the liabilities for
which, we believe have been adequately included in our loss reserves. Also, from
time to time, we are party to lawsuits and other proceedings which relate to
disputes over contractual relationships with third parties, or which involve
alleged errors and omissions on the part of our subsidiaries. In addition, we
are presently engaged in litigation initiated by the appointed liquidator of a
former reinsurer concerning payments made to us prior to the date of the
appointment of the liquidator. The disputed payments were made by the now
insolvent reinsurer in connection with a commutation agreement. Our
understanding is that such litigation is one of a number of similar actions
brought by the liquidator. We intend to vigorously contest the action. We
believe the resolution of any such lawsuits will not have a material adverse
effect on our financial condition, results of operations or cash flows.
We have received substantial assessments from a state health insurance
association, which was established by the state to provide health insurance to
"high-risk" or otherwise uninsured individuals within that state. The expenses
of the association are currently funded principally through assessments on
insurers. With the current assessment, the association changed the calculation
method for the amount of the assessment, which resulted in a significant
increase in the amount of our assessment ($5.2 million). We and other insurers
are presently contesting the change in the assessment methodology. We believe we
will receive relief from the current assessment and that any amount we may
ultimately have to pay will not be material to
F-31
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
our financial position and result of operations, after taking into consideration
credits we would receive against other taxes in the state.
Foreign Currency Forward Contracts
On a limited basis, we enter into foreign currency forward contracts as a
hedge against foreign currency fluctuations. Rattner Mackenzie Limited has
revenue streams in U.S. dollars and Canadian dollars but incurs expenses in
British pound sterling. To mitigate the foreign exchange risk, from time to time
we have entered into foreign currency forward contracts expiring at staggered
times. As of December 31, 2002, we had no foreign currency forward contracts
outstanding. The foreign currency forward contracts are used to convert currency
at a known rate in an amount which either approximates or is less than monthly
expenses. Thus, the effect of these transactions is to limit the foreign
currency exchange risk of the recurring monthly expenses. We utilize these
foreign currency forward contracts strictly as a cash flow hedge against
existing exposure to foreign currency fluctuations rather than as a form of
speculative or trading investment.
Catastrophe Exposure
We write business in areas exposed to catastrophic losses and have
significant exposures to this type of loss in California, the Atlantic Coast of
the United States, certain United States Gulf Coast states, particularly Florida
and Texas, the Caribbean and Mexico. We assess our overall exposures to a single
catastrophic event and apply procedures that we believe are more conservative
than are typically used by the industry to ascertain our probable maximum loss
from any single event. We maintain reinsurance protection which we believe is
sufficient to cover any foreseeable event.
Leases
We lease administrative office facilities under long-term non-cancelable
operating lease agreements expiring at various dates through the year 2010. In
addition to rent, the agreements generally require the payment of utilities,
real estate taxes, insurance and repairs. We recognize rent expense on a
straight-line basis over the terms of these leases. In addition, we lease
computer equipment and automobiles under operating leases expiring at various
dates through the year 2007. Rent expense under operating leases amounted to
$8.4 million, $7.1 million, and $7.3 million, for the years ended December 31,
2002, 2001, and 2000, respectively.
At December 31, 2002, future minimum annual rental payments required under
long-term, non-cancelable operating leases, excluding certain expenses payable
by us, are as follows:
<Table>
<Caption>
FOR THE YEARS ENDED DECEMBER 31, AMOUNT DUE
- -------------------------------- ----------
2003...................................................... $ 8,687
2004...................................................... 6,956
2005...................................................... 6,194
2006...................................................... 4,227
2007...................................................... 2,605
Thereafter................................................ 1,322
-------
TOTAL FUTURE MINIMUM ANNUAL RENTAL PAYMENTS DUE............. $29,991
=======
</Table>
F-32
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Loan Guarantee
We guaranteed the mortgage debt of a partnership in which we are a limited
partner. The total amount of the loan is $11.1 million as of December 31, 2002.
We invested in the partnership, which owns a building which is rented to
unaffiliated parties, as a long-term investment.
Indemnification
We have sold businesses in the past. In connection with these sales, we
have provided indemnifications to the buyers, which we believe are typical for
transactions of this nature, based upon the type of business sold. Certain of
these indemnifications have no limit. It is not possible to estimate the maximum
potential amount under these indemnifications as our performance under the
indemnifications and our ultimate liability are based upon the occurrence of
future events which may or may not occur. We currently have a liability in the
amount of $6.2 million recorded for performance under one such indemnification.
This indemnification was given by a company we acquired, prior to its
acquisition, in connection with a sale of one of its subsidiaries.
Terrorist Exposure
Subsequent to the terrorist attack on September 11, 2001, where possible,
we canceled all terrorist coverage under the terms of existing in-force
policies, primarily in the property and energy book of the London market account
line of business. Our reinsurance protections in these books have been renewed
without coverage for acts of terrorism. We thus only have exposure on policies
that contained such coverage and are still in force. This exposure is
diminishing as these policies expire and with respect to some risks, would be
covered by the provisions of the Federal Terrorism Risk Insurance Act of 2002.
Under the Terrorism Risk Insurance Act of 2002, we are required to offer
terrorism coverage to our commercial policyholders in certain lines of business
written in the United States, for which we may, when warranted, charge an
additional premium. The policyholders may or may not accept such coverage. This
law also established a deductible that each insurer would have to meet before
U.S. Federal reimbursement would occur. For 2003, our deductible is
approximately $11.2 million based on 7% of 2002 subject premium as defined under
the applicable regulations. Thereafter, the Federal government would provide
reimbursement for 90% of our insured, covered insured losses up to the maximum
amount set out in the Act.
(10) RELATED PARTY TRANSACTIONS
Certain of our Directors are officers, directors or owners of business
entities with which we transact business. Balances with these business entities
and other related parties included in our consolidated balance sheets are as
follows:
<Table>
<Caption>
2002 2001
------- ------
Other investments........................................... $ 3,264 $4,317
Premiums, claims and other receivables...................... 1,189 776
Other assets................................................ 18,252 2,807
</Table>
F-33
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Transactions with these business entities and other related parties
included in our consolidated statements of earnings are as follows:
<Table>
<Caption>
2002 2001 2000
----- ----- -------
Management fees............................................ $ 91 $ 58 $ --
Investment income.......................................... -- -- 112
Net realized investment gain (loss)........................ (601) 53 (5,067)
Other operating income (loss).............................. 668 (508) 89
Other operating expense.................................... -- -- 112
Interest expense........................................... 154 217 74
</Table>
Additionally, we had $10.1 million and $15.7 million payable at December
31, 2002 and 2001, respectively, to former owners of businesses we have acquired
who are now officers of certain of our subsidiaries. Such payables represent
payments due under the terms of the acquisition agreements.
We also have entered into an agreement with an entity owned by an officer
and Director, pursuant to which we rent equipment for providing transportation
services to our employees, our Directors and our clients. We provide our own
employees to operate the equipment and pay all expenses related to their
operation. For the years ended December 31, 2002, 2001 and 2000, we paid rentals
of $1.2 million, $1.0 million, and $0.6 million, respectively, to this entity.
(11) SHAREHOLDERS' EQUITY
On March 6, 2001, we sold 6.9 million shares of our common stock in a
public offering at a price of $23.35 per share. Net proceeds from the offering
amounted to $152.4 million after deducting underwriting discounts, commissions
and offering expenses and were used to pay down our bank facility.
Property and casualty insurance companies domiciled in the State of Texas
are limited in the payment of dividends to their shareholders in any
twelve-month period, without the prior written consent of the Commissioner of
Insurance, to the greater of statutory net income for the prior calendar year or
10% of their statutory policyholders' surplus as of the prior year end. During
2003, Houston Casualty Company's ordinary dividend capacity will be
approximately $40.0 million and U.S. Specialty Insurance Company's ordinary
dividend capacity will be approximately $11.0 million.
Avemco Insurance Company is limited by the State of Maryland in the amount
of dividends which it may pay in any twelve-month period, without prior
regulatory approval, to the lesser of its statutory net investment income
excluding realized capital gains for the prior calendar year or 10% of its
statutory policyholders' surplus as of the prior year end. During 2003, Avemco
Insurance Company's ordinary dividend capacity will be zero as a result of a
special approved dividend paid in 2002.
HCC Life Insurance Company is limited by the laws of the State of Indiana
in the amount of dividends it may pay in any twelve-month period, without prior
regulatory approval, to the greater of its statutory net gain from operations
for the prior calendar year or 10% of its statutory capital and surplus as of
the prior year end. Dividends may only be paid out of statutory unassigned
surplus funds. During 2003, HCC Life Insurance Company's ordinary dividend
capacity will be approximately $6.0 million.
F-34
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
The components of accumulated other comprehensive income (loss) are as
follows:
<Table>
<Caption>
ACCUMULATED
UNREALIZED UNREALIZED OTHER
FOREIGN HEDGE INVESTMENT COMPREHENSIVE
CURRENCY GAIN GAIN INCOME
TRANSLATION (LOSS) (LOSS) (LOSS)
----------- ----------- ----------- -------------
Balance December 31, 1999............... $(483) $ -- $(2,209) $ (2,692)
Net change for year..................... (172) -- 7,577 7,405
----- ---- ------- --------
Balance December 31, 2000............... (655) -- 5,368 4,713
Net change for year..................... (279) 24 2,042 1,787
----- ---- ------- --------
Balance December 31, 2001............... (934) 24 7,410 6,500
Net change for year..................... 50 (24) 14,239 14,265
----- ---- ------- --------
Balance December 31, 2002............... $(884) $ -- $21,649 $ 20,765
===== ==== ======= ========
</Table>
(12) STOCK OPTIONS
During 2001, we replaced all previous option plans with our 2001 Flexible
Incentive Plan for purposes of new option grants, which is administered by the
Compensation Committee of the Board of Directors. Each option may be used to
purchase one share of our common stock. Options cannot be repriced under the
plan. As of December 31, 2002, 7.3 million shares of our common stock were
reserved for the exercise of options, of which 6.4 million shares were reserved
for options previously granted and 0.9 million shares were reserved for future
issuances of options.
The following table provides an analysis of stock option activity during
the three years ended December 31, 2002:
<Table>
<Caption>
2002 2001 2000
-------------------- -------------------- --------------------
AVERAGE AVERAGE AVERAGE
NUMBER EXERCISE NUMBER EXERCISE NUMBER EXERCISE
OF SHARES PRICE OF SHARES PRICE OF SHARES PRICE
--------- -------- --------- -------- --------- --------
Outstanding, beginning of
year........................ 3,305 $17.39 5,494 $15.54 5,470 $16.08
Granted at market value....... 4,116 22.45 797 24.54 1,745 13.59
Forfeitures and expirations... (219) 19.84 (251) 17.73 (434) 18.32
Exercised..................... (831) 14.01 (2,735) 15.68 (1,287) 14.34
----- ------ ------ ------ ------ ------
OUTSTANDING, END OF YEAR...... 6,371 $20.99 3,305 $17.39 5,494 $15.54
===== ====== ====== ====== ====== ======
EXERCISABLE, END OF YEAR...... 1,437 $17.81 1,100 $16.70 2,717 $16.59
===== ====== ====== ====== ====== ======
</Table>
Options outstanding and exercisable as of December 31, 2002 are shown on
the following schedule:
<Table>
<Caption>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
--------------------------------------- --------------------
AVERAGE AVERAGE AVERAGE
RANGE OF NUMBER OF REMAINING EXERCISE NUMBER OF EXERCISE
EXERCISE PRICES SHARES CONTRACTUAL LIFE PRICE SHARES PRICE
- --------------- --------- ---------------- -------- --------- --------
Under $20.50.................... 2,793 4.3 years $17.30 1,003 $15.17
$20.50-$22.50................... 1,616 5.8 years 21.96 208 21.26
$22.51-$27.00................... 1,596 6.0 years 24.82 154 25.42
Over $27.00..................... 366 4.8 years 28.19 72 28.19
----- --------- ------ ----- ------
TOTAL OPTIONS................. 6,371 5.2 years $20.99 1,437 $17.81
===== ========= ====== ===== ======
</Table>
F-35
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(13) EARNINGS PER SHARE
The following table provides reconciliation of the denominators used in the
earnings per share calculations for the three years ended December 31, 2002:
<Table>
<Caption>
2002 2001 2000
-------- ------- -------
NET EARNINGS........................................... $105,828 $30,197 $55,468
======== ======= =======
Reconciliation of number of shares outstanding:
Shares of common stock outstanding at year end......... 62,358 61,438 51,342
Changes in common stock due to issuance................ (185) (3,272) (908)
Contingent shares to be issued......................... -- -- 39
Common stock contractually issuable in the future...... 52 155 269
-------- ------- -------
Weighted average common stock outstanding............ 62,225 58,321 50,742
Additional dilutive effect of outstanding options (as
determined by the application of the treasury stock
method).............................................. 711 1,298 877
-------- ------- -------
WEIGHTED AVERAGE COMMON STOCK AND POTENTIAL COMMON
STOCK OUTSTANDING................................. 62,936 59,619 51,619
======== ======= =======
Anti-dilutive shares not included in computation....... 1,105 187 1,500
======== ======= =======
</Table>
(14) STATUTORY INFORMATION
Our insurance companies file financial statements prepared in accordance
with statutory accounting practices prescribed or permitted by domestic or
foreign insurance regulatory authorities. The differences between statutory
financial statements and financial statements prepared in accordance with
generally accepted accounting principles vary between domestic and foreign
jurisdictions. The principal differences are that for statutory financial
statements deferred policy acquisition costs are not recognized, only some of
the deferred income tax assets are recorded, bonds are generally carried at
amortized cost, certain assets are non-admitted and charged directly to surplus,
a liability for a provision for reinsurance is recorded and charged directly to
surplus, and outstanding losses and unearned premium are presented net of
reinsurance. In addition, under statutory accounting rules, life insurance
companies recognize two investment related liabilities, the asset valuation
reserve and interest maintenance reserve. Statutory policyholders' surplus, and
net income for the three years ended December 31, 2002, after intercompany
eliminations, of our insurance companies included in those companies' respective
filings with regulatory authorities are as follows:
<Table>
<Caption>
2002 2001 2000
-------- -------- --------
Statutory policyholders' surplus..................... $523,807 $401,393 $326,249
Statutory net income................................. 68,462 16,555 13,749
</Table>
Our statutory policyholders' surplus has been adversely affected by
statutory adjustments for reinsurance recoverables which, although required
statutorily, have no effect on net earnings or shareholders' equity in
accordance with generally accepted accounting principles. Our statutory net
income for 2001 has been reduced by $22.8 million (net of income tax) from the
September 11 terrorist attack and $8.1 million (net of income tax) from charges
related to lines of business we decided to cease writing.
The National Association of Insurance Commissioners adopted Statements of
Statutory Accounting Principles in March, 1998, which became effective on
January 1, 2001, through their adoption by the individual states. The cumulative
effect of codification was to increase statutory policyholders' surplus of our
insurance companies by approximately $8.9 million. Our use of statutory
accounting practices prescribed by
F-36
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
state regulatory authorities caused a $1.5 million increase in our insurance
companies' aggregate statutory policyholders' surplus as of December 31, 2002
compared to amounts that would have been recorded under the codification rules
of The National Association of Insurance Commissioners. The statutory surplus of
each of our insurance companies is significantly in excess of regulatory
risk-based capital requirements.
(15) LIABILITY FOR UNPAID LOSS AND LOSS ADJUSTMENT EXPENSE
The following table provides a reconciliation of the liability of loss and
loss adjustment expense for the three years ended December 31, 2002:
<Table>
<Caption>
2002 2001 2000
---------- ---------- --------
Reserves for loss and loss adjustment expense at
beginning of the year........................... $1,130,748 $ 944,117 $871,104
Less reinsurance recoverables..................... 817,651 694,245 597,498
---------- ---------- --------
Net reserves at beginning of the year............. 313,097 249,872 273,606
Net reserve adjustments from acquisition and
disposition of subsidiaries..................... 79,558 285 514
Incurred loss and loss adjustment expense:
Provision for loss and loss adjustment expense
for claims occurring in the current year..... 313,270 278,103 208,055
Increase (decrease) in estimated loss and loss
adjustment expense for claims occurring in
prior years.................................. (6,779) (10,713) (9,585)
---------- ---------- --------
Incurred loss and loss adjustment expense, net of
reinsurance..................................... 306,491 267,390 198,470
---------- ---------- --------
Loss and loss adjustment expense payments for
claims occurring during:
Current year.................................... 115,809 102,206 76,725
Prior years..................................... 126,019 102,244 145,993
---------- ---------- --------
Loss and loss adjustment expense payments, net of
reinsurance..................................... 241,828 204,450 222,718
---------- ---------- --------
Net reserves at end of the year................... 457,318 313,097 249,872
Plus reinsurance recoverables..................... 697,972 817,651 694,245
---------- ---------- --------
RESERVES FOR LOSS AND LOSS ADJUSTMENT EXPENSE
AT END OF THE YEAR......................... $1,155,290 $1,130,748 $944,117
========== ========== ========
</Table>
During 2002, we had net loss and loss adjustment expense redundancy of $6.8
million relating to prior year losses compared to redundancies of $10.7 million
in 2001 and $9.6 million in 2000. The 2002 redundancy resulted from a deficiency
of $7.7 million due to a third quarter charge related to certain business
included in discontinued lines, offset by a net redundancy of $14.5 million from
all other sources. Deficiencies and redundancies in the reserves occur as we
continually review our loss reserves with our actuaries, increasing or reducing
loss reserves as a result of such reviews and as losses are finally settled and
claims exposures are reduced. We believe we have provided for all material net
incurred losses.
We have no material exposure to environmental pollution losses, because
Houston Casualty Company only began writing business in 1981 and its policies
normally contain pollution exclusion clauses which limit
F-37
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
pollution coverage to "sudden and accidental" losses only, thus excluding
intentional (dumping) and seepage claims. Policies issued by HCC Life Insurance
Company, Avemco Insurance Company and U.S. Specialty Insurance Company, because
of the types of risks covered, are not considered to have significant
environmental exposures. Therefore, we do not expect to experience any material
loss development for environmental pollution claims. Likewise, we have no
material exposure to asbestos claims.
(16) SUPPLEMENTAL INFORMATION
Supplemental cash flow information for the three years ended December 31,
2002, is summarized below:
<Table>
<Caption>
2002 2001 2000
------- ------- -------
Interest paid........................................... $ 4,900 $ 7,980 $17,418
Income tax paid......................................... 22,642 28,411 11,859
Dividends declared but not paid at year end............. 4,061 3,848 3,557
</Table>
The unrealized gain or loss on securities available for sale, deferred
taxes related thereto, and the issuance of our common stock for the purchase of
subsidiaries are non-cash transactions which have been included as direct
increases or decreases in our shareholders' equity. The cumulative effect of
accounting change due to our adoption of Staff Accounting Bulletin No. 101
during 2000 was a non-cash charge to our earnings.
(17) QUARTERLY FINANCIAL DATA (UNAUDITED)
<Table>
<Caption>
FOURTH QUARTER THIRD QUARTER SECOND QUARTER FIRST QUARTER
------------------- ------------------- ------------------- -------------------
2002 2001 2002 2001 2002 2001 2002 2001
-------- -------- -------- -------- -------- -------- -------- --------
Total revenue......................... $186,089 $132,192 $175,672 $137,621 $155,912 $120,556 $151,709 $115,092
======== ======== ======== ======== ======== ======== ======== ========
Net earnings (loss)................... $ 31,495 $ 23,837 $ 24,269 $(29,076) $ 26,782 $ 20,258 $ 23,282 $ 15,178
======== ======== ======== ======== ======== ======== ======== ========
Basic earnings (loss) per share data:
Earnings (loss) per share............. $ 0.50 $ 0.39 $ 0.39 $ (0.49) $ 0.43 $ 0.34 $ 0.38 $ 0.28
======== ======== ======== ======== ======== ======== ======== ========
Weighted average shares outstanding... 62,387 61,021 62,335 59,399 62,236 58,998 61,936 53,720
======== ======== ======== ======== ======== ======== ======== ========
Diluted earnings (loss) per share
data:
Earnings (loss) per share............. $ 0.50 $ 0.38 $ 0.39 $ (0.49) $ 0.43 $ 0.34 $ 0.37 $ 0.28
======== ======== ======== ======== ======== ======== ======== ========
Weighted average shares outstanding... 63,109 62,051 62,871 59,399 62,889 60,470 62,713 55,070
======== ======== ======== ======== ======== ======== ======== ========
</Table>
During the third quarter of 2001, we recorded two large unusual items: 1) a
$22.8 million (net of income tax) loss due to the terrorist attack on September
11; and 2) a $29.6 million charge (net of income tax) related to lines of
business we decided to cease writing. Included in the latter amount was a $15.0
million charge for the impairment of goodwill, which was not deductible for
income tax purposes. During the third quarter of 2002, we recorded a $5.0
million (net of income tax) charge to strengthen reserves related to certain
business included in discontinued lines. The sum of the quarters earnings (loss)
per share may not equal the annual amounts due to rounding.
(18) SUBSEQUENT EVENTS
On March 25, 2003, we sold an aggregate of $125.0 million principal amount
of 1.3% Convertible Notes due in 2023 in a public offering. Each $1 thousand
principal amount of notes is convertible into 29.4377 shares of our common
stock, which represents an initial conversion price of $33.97 per share. Holders
may surrender notes for conversion into shares of our common stock if, as of the
last day of the preceding calendar quarter, the closing sale price of our common
stock for at least 20 consecutive trading days during the period of
F-38
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
30 consecutive trading days ending on the last trading day of that quarter is
more than 130% ($44.16 per share) of the conversion price per share of our
common stock. Holders of the notes may require us to repurchase the notes on
April 1, 2009, 2014 and 2019. If the holders exercise this option, we may choose
to pay the purchase price in cash, in shares of our common stock, or in a
combination thereof. We plan to use the proceeds from this offering to pay down
existing indebtedness under our bank facility, assist in financing future
acquisitions and strategic investments and for general corporate purposes.
F-39
REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES
To the Board of Directors and Shareholders
HCC Insurance Holdings, Inc.:
Our report on the consolidated financial statements of HCC Insurance
Holdings, Inc., which included an emphasis paragraph related to a change in
method of revenue recognition for certain contracts, effective January 1, 2000,
and a change in method of accounting for goodwill, effective January 1, 2002, is
included on page F-1 of this Form 10-K. In connection with our audits of such
financial statements, we have also audited the financial statement schedules
listed in Item 15 of this Form 10-K. These financial statement schedules are the
responsibility of the Company's management.
In our opinion, these financial statement schedules present fairly, in all
material respects, the information set forth therein when read in conjunction
with the related consolidated financial statements.
/s/ PricewaterhouseCoopers LLP
Houston, Texas
March 21, 2003
S-1
SCHEDULE 1
HCC INSURANCE HOLDINGS, INC.
SUMMARY OF INVESTMENTS
OTHER THAN INVESTMENTS IN RELATED PARTIES
(IN THOUSANDS)
<Table>
<Caption>
DECEMBER 31, 2002
- ------------------------------------------------------------------------------------------------
COLUMN A COLUMN B COLUMN C COLUMN D
- ------------------------------------------------------------------------------------------------
AMOUNT AT WHICH
SHOWN IN THE
TYPE OF INVESTMENT COST VALUE BALANCE SHEET
- ------------------ ---------- -------- ---------------
Fixed maturities:
Bonds -- United States government and government
agencies and authorities.......................... $ 93,620 $ 96,546 $ 96,546
Bonds -- states, municipalities and political
subdivisions...................................... 46,750 49,230 49,230
Bonds -- special revenue............................. 199,614 210,238 210,238
Bonds -- corporate................................... 232,216 244,276 244,276
Asset-backed and mortgage-backed securities.......... 144,427 149,873 149,873
Bonds -- foreign government.......................... 91,145 91,385 91,385
---------- -------- ----------
Total fixed maturities.......................... 807,772 $841,548 $ 841,548
---------- -------- ----------
Equity securities:
Common stocks -- banks, trusts and insurance
companies......................................... 10,475 $ 10,482 $ 10,482
Common stocks -- industrial, miscellaneous and all
other............................................. 212 121 121
Non-redeemable preferred stocks...................... 5,128 5,006 5,006
---------- -------- ----------
Total equity securities......................... 15,815 $ 15,609 $ 15,609
---------- ======== ----------
Short-term investments................................. 307,215 307,215
Other investments...................................... 3,264 3,264
---------- ----------
TOTAL INVESTMENTS............................... $1,134,066 $1,167,636
========== ==========
</Table>
S-2
SCHEDULE 2
HCC INSURANCE HOLDINGS, INC.
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
BALANCE SHEETS
(IN THOUSANDS)
<Table>
<Caption>
DECEMBER 31,
---------------------
2002 2001
---------- --------
ASSETS
Cash........................................................ $ 56 $ 8,719
Short-term investments...................................... 4,837 1,497
Investment in subsidiaries.................................. 915,213 734,067
Receivable from subsidiaries................................ 14,133 12,754
Intercompany loans to subsidiaries for acquisitions......... 190,187 190,167
Other assets................................................ 1,581 5,732
---------- --------
TOTAL ASSETS...................................... $1,126,007 $952,936
========== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Notes payable............................................... $ 225,629 $173,198
Note payable to related party............................... 825 2,667
Deferred Federal income tax................................. 7,129 1,652
Accounts payable and accrued liabilities.................... 9,517 11,966
---------- --------
Total liabilities................................. 243,100 189,483
Total shareholders' equity........................ 882,907 763,453
---------- --------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY........ $1,126,007 $952,936
========== ========
</Table>
See Notes to Condensed Financial Information.
S-3
SCHEDULE 2
HCC INSURANCE HOLDINGS, INC.
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF EARNINGS
(IN THOUSANDS)
<Table>
<Caption>
FOR THE YEARS ENDED DECEMBER 31,
----------------------------------
2002 2001 2000
---------- --------- ---------
Equity in earnings of subsidiaries.......................... $108,833 $37,439 $62,416
Interest income from subsidiaries........................... 7,277 5,019 9,160
Interest income............................................. 171 764 343
Other income................................................ 10 13 146
-------- ------- -------
Total revenue..................................... 116,291 43,235 72,065
Interest expense............................................ 7,880 8,737 20,249
Other operating expense..................................... 2,290 1,600 1,582
-------- ------- -------
Total expense..................................... 10,170 10,337 21,831
-------- ------- -------
Earnings before income tax benefit................ 106,121 32,898 50,234
Income tax expense (benefit)................................ 293 2,701 (5,234)
-------- ------- -------
NET EARNINGS...................................... $105,828 $30,197 $55,468
======== ======= =======
</Table>
See Notes to Condensed Financial Information.
S-4
SCHEDULE 2
HCC INSURANCE HOLDINGS, INC.
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF COMPREHENSIVE INCOME
(IN THOUSANDS)
<Table>
<Caption>
FOR THE YEARS ENDED DECEMBER 31,
----------------------------------
2002 2001 2000
---------- --------- ---------
Net earnings................................................ $105,828 $30,197 $55,468
Other comprehensive income, net of tax:
Foreign currency translation adjustment..................... 50 (279) (172)
Gains (losses) in fair value of subsidiaries' foreign
currency forward contracts recorded as a hedge, net of
income tax charge (benefit) of $(13) in 2002 and $13 in
2001...................................................... (24) 24 --
Investment gains (losses):
Consolidated subsidiaries' investment gains during the
year, net of deferred tax charge of, $8,040 in 2002;
$1,137 in 2001; and $2,386 in 2000..................... 14,533 2,297 4,118
Less consolidated subsidiaries' reclassification
adjustments for (gains) losses included in net
earnings, net of deferred tax (charge) benefit of
$(159) in 2002; $(138) in 2001; and $1,862 in 2000
(294) (255) 3,459
-------- ------- -------
Other comprehensive income.................................. 14,265 1,787 7,405
-------- ------- -------
COMPREHENSIVE INCOME.............................. $120,093 $31,984 $62,873
======== ======= =======
</Table>
See Notes to Condensed Financial Information.
S-5
SCHEDULE 2
HCC INSURANCE HOLDINGS, INC.
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<Table>
<Caption>
FOR THE YEARS ENDED DECEMBER 31,
---------------------------------
2002 2001 2000
--------- ---------- --------
Cash flows from operating activities:
Net earnings.............................................. $105,828 $ 30,197 $55,468
Adjustment to reconcile net earnings to net cash provided
by operating activities:
Undistributed net income of subsidiaries.................. (74,864) (20,184) (40,818)
Amortization and depreciation............................. 3,279 2,586 527
Increase in accrued interest receivable added to
intercompany loan balances............................. (7,277) (835) (5,160)
Change in accounts payable and accrued liabilities........ (2,663) 1,181 (5,286)
Tax benefit from exercise of stock options................ 4,030 12,312 3,627
Other, net................................................ 2,088 2,000 (1,107)
-------- --------- -------
Cash provided by operating activities.................. 30,421 27,257 7,251
Cash flows from investing activities:
Cash contributions to subsidiaries........................ (69,007) (84,151) (1,130)
Purchase of subsidiaries.................................. (24,593) (96,405) (10,345)
Change in short-term investments.......................... (3,340) 1,991 (3,093)
Change in receivable from subsidiaries.................... (1,379) (11,317) 4,710
Intercompany loans to subsidiaries for acquisitions....... (16,806) (1,275) (16,509)
Payments on intercompany loans to subsidiaries............ 31,964 34,674 42,838
-------- --------- -------
Cash provided (used) by investing activities........... (83,161) (156,483) 16,471
Cash flows from financing activities:
Proceeds from note payable, net of costs.................. 76,000 175,401 26,470
Payments on notes payable................................. (27,467) (216,523) (57,042)
Sale of common stock...................................... 11,207 192,831 17,235
Dividends paid............................................ (15,663) (13,822) (10,350)
-------- --------- -------
Cash provided (used) by financing activities........... 44,077 137,887 (23,687)
-------- --------- -------
Net change in cash..................................... (8,663) 8,661 35
Cash as of beginning of year........................... 8,719 58 23
-------- --------- -------
CASH AS OF END OF YEAR................................. $ 56 $ 8,719 $ 58
======== ========= =======
</Table>
See Notes to Condensed Financial Information.
S-6
HCC INSURANCE HOLDINGS, INC.
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
NOTES TO CONDENSED FINANCIAL INFORMATION
(1) The accompanying condensed financial information should be read in
conjunction with the consolidated financial statements and the related
notes thereto of HCC Insurance Holdings, Inc. and Subsidiaries.
Investments in subsidiaries are accounted for using the equity method.
Certain amounts in the 2001 and 2000 condensed financial information
have been reclassified to conform with the 2002 presentation. Such
reclassifications had no effect on our shareholders' equity, net
earnings or cash flows.
(2) Intercompany loans to subsidiaries are demand notes issued primarily to
fund the cash portion of acquisitions. They bear interest at a rate set
by management, which approximates the interest rate charged to us for
similar debt. As of December 31, 2002, the interest rate on
intercompany loans was 5.0%.
S-7
SCHEDULE 3
HCC INSURANCE HOLDINGS, INC.
SUPPLEMENTARY INSURANCE INFORMATION
(IN THOUSANDS)
<Table>
<Caption>
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN F COLUMN G COLUMN H
- ------------------------ ----------------- ----------------- ------------ -------- -------------- -----------------
(1) (1) (2)
DECEMBER 31, FOR THE YEARS ENDED DECEMBER 31,
---------------------------------------------------- ---------------------------------------------
FUTURE POLICY BENEFITS, CLAIMS,
BENEFITS, LOSSES, LOSSES AND
DEFERRED POLICY CLAIMS AND LOSS UNEARNED PREMIUM NET INVESTMENT SETTLEMENT
SEGMENTS ACQUISITION COSTS EXPENSES PREMIUMS REVENUE INCOME EXPENSES
- ------------------------ ----------------- ----------------- ------------ -------- -------------- -----------------
2002
- ------------------------
Insurance Company....... $18,883 $1,234,241 $331,050 $505,521 $33,587 $306,491
Underwriting Agency..... 2,954
Intermediary............ 993
Other Operations........ 41
Corporate............... 194
------- ---------- -------- -------- ------- --------
Total................... $18,883 $1,234,241 $331,050 $505,521 $37,769 $306,491
======= ========== ======== ======== ======= ========
2001
- ------------------------
Insurance Company....... $15,390 $1,213,761 $179,530 $342,787 $30,766 $267,390
Underwriting Agency..... 5,202
Intermediary............ 2,771
Other Operations........ 85
Corporate............... 814
------- ---------- -------- -------- ------- --------
Total................... $15,390 $1,213,761 $179,530 $342,787 $39,638 $267,390
======= ========== ======== ======== ======= ========
2000
- ------------------------
Insurance Company....... $ 9,095 $1,030,877 $190,550 $267,647 $27,948 $198,470
Underwriting Agency..... 7,547
Intermediary............ 3,335
Other Operations........ 476
Corporate............... 530
------- ---------- -------- -------- ------- --------
Total................... $ 9,095 $1,030,877 $190,550 $267,647 $39,836 $198,470
======= ========== ======== ======== ======= ========
<Caption>
COLUMN A COLUMN I COLUMN J COLUMN K
- ------------------------ ----------------- --------- --------
(3)
FOR THE YEARS ENDED DECEMBER 31,
----------------------------------------
AMORTIZATION OF OTHER
DEFERRED POLICY OPERATING PREMIUM
SEGMENTS ACQUISITION COSTS EXPENSES WRITTEN
- ------------------------ ----------------- --------- --------
2002
- ------------------------
Insurance Company....... $63,274 $ 40,008 $545,911
Underwriting Agency..... 63,448
Intermediary............ 26,857
Other Operations........ 256
Corporate............... (2,432)
------- -------- --------
Total................... $63,274 $128,137 $545,911
======= ======== ========
2001
- ------------------------
Insurance Company....... $27,923 $ 53,250 $372,958
Underwriting Agency..... 51,766
Intermediary............ 31,409
Other Operations........ 5,995
Corporate............... (1,539)
------- -------- --------
Total................... $27,923 $140,881 $372,958
======= ======== ========
2000
- ------------------------
Insurance Company....... $23,743 $ 19,849 $283,788
Underwriting Agency..... 69,092
Intermediary............ 31,078
Other Operations........ 15,755
Corporate............... 586
------- -------- --------
Total................... $23,743 $136,360 $283,788
======= ======== ========
</Table>
- ---------------
(1) Columns C and D are shown ignoring the effects of reinsurance.
(2) Net investment income was allocated to the subsidiary, and therefore the
segment, on which the related investment asset was recorded.
(3) Other operating expenses is after all corporate expense allocations and
amortization of goodwill have been charged or credited to the individual
segments.
Note: Column E is omitted because we have no other policy claims and benefits
payable.
S-8
SCHEDULE 4
HCC INSURANCE HOLDINGS, INC.
REINSURANCE
(DOLLARS IN THOUSANDS)
<Table>
<Caption>
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F
- -----------------------------------------------------------------------------------------------------------------
PERCENT OF
DIRECT CEDED TO OTHER ASSUMED FROM AMOUNT
AMOUNT COMPANIES OTHER COMPANIES NET AMOUNT ASSUMED TO NET
---------- -------------- --------------- ---------- --------------
For the year ended December 31,
2002:
Life insurance in force............. $1,021,600 $529,874 $ -- $491,726 --%
========== ======== ======== ======== ===
Earned premium:
Property and liability insurance.... $ 293,614 $222,906 $133,736 $204,444 65%
Accident and health insurance....... 508,237 302,711 95,551 301,077 32%
---------- -------- -------- --------
Total.......................... $ 801,851 $525,617 $229,287 $505,521 45%
========== ======== ======== ======== ===
For the year ended December 31,
2001:
Life insurance in force............. $ 597,886 $597,310 $ -- $ 576 --%
========== ======== ======== ======== ===
Earned premium:
Property and liability insurance.... $ 284,488 $229,791 $ 95,342 $150,039 64%
Accident and health insurance....... 505,405 435,549 122,892 192,748 64%
---------- -------- -------- --------
Total.......................... $ 789,893 $665,340 $218,234 $342,787 64%
========== ======== ======== ======== ===
For the year ended December 31,
2000:
Life insurance in force............. $ 633,988 $633,851 $ -- $ 137 --%
========== ======== ======== ======== ===
Earned premium:
Property and liability insurance.... $ 290,928 $285,020 $ 92,253 $ 98,161 94%
Accident and health insurance....... 372,530 421,928 218,884 169,486 129%
---------- -------- -------- --------
Total.......................... $ 663,458 $706,948 $311,137 $267,647 116%
========== ======== ======== ======== ===
</Table>
S-9
SCHEDULE 5
HCC INSURANCE HOLDINGS, INC.
VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS)
<Table>
<Caption>
2002 2001 2000
------- ------- -------
Reserve for uncollectible reinsurance:
Balance as of beginning of year........................... $ 5,176 $ 4,057 $ 5,541
Total provision charged to expense........................ 5,530 1,119 465
Total amounts written off................................. (3,564) -- (1,949)
------- ------- -------
BALANCE AS OF END OF YEAR.............................. $ 7,142 $ 5,176 $ 4,057
======= ======= =======
Allowance for doubtful accounts:
Balance as of beginning of year........................... $ 2,779 $ 3,325 $ 1,729
Acquisitions of subsidiaries.............................. 455 453 --
Total provision charged to expense........................ 487 2,366 2,815
Total amounts written off................................. (1,442) (3,365) (1,219)
------- ------- -------
BALANCE AS OF END OF YEAR.............................. $ 2,279 $ 2,779 $ 3,325
======= ======= =======
</Table>
S-10
INDEX TO EXHIBITS
(Items denoted by a letter are incorporated by reference to other documents
previously filed with the Securities and Exchange Commission as set forth at the
end of this index. Items not denoted by a letter are being filed herewith.)
<Table>
<Caption>
EXHIBIT
NUMBER
- -------
(A)3.1 -- Bylaws of HCC Insurance Holdings, Inc., as amended.
(B)3.2 -- Restated Certificate of Incorporation and Amendment of
Certificate of Incorporation of HCC Insurance Holdings,
Inc., filed with the Delaware Secretary of State on July 23,
1996 and May 21, 1998, respectively.
(A)4.1 -- Specimen of Common Stock Certificate, $1.00 par value, of
HCC Insurance Holdings, Inc.
(C)10.1 -- Share Purchase Agreement dated January 29, 1999, among HCC
Insurance Holdings, Inc. and Gerald Axel, Barry J. Cook,
Gary J. Lockett, Christopher F.B. Mays, Mark E. Rattner,
Marshall Rattner, Inc., John Smith and Keith W. Steed.
(D)10.2 -- Agreement and Plan of Merger dated as of October 11, 1999
among HCC Insurance Holdings, Inc., Merger Sub of Delaware,
Inc. and The Centris Group, Inc.
(E)10.3 -- Agreement and Plan of Merger dated as of January 19, 2001
among HCC Insurance Holdings, Inc., HCC Employee Benefits,
Inc. and James Scott Schanen, Lisa Rae Schanen, Conor
Schanen qsst, Austin Schanen qsst, Kevin Tolbert and Schanen
Consulting Corporation.
(F)10.4 -- Loan Agreement ($300,000,000 Revolving Loan Facility) dated
as of December 17, 1999 among HCC Insurance Holdings, Inc.;
Wells Fargo Bank (Texas), National Association; Bank of
America, N.A.; Bank of New York; Bank One, N.A.; First Union
National Bank; and Dresdner Bank AG, New York and Grand
Cayman Branches.
(G)10.5 -- Amendment to Loan Agreement dated as of August 11, 2000
among HCC Insurance Holdings, Inc.; Wells Fargo Bank
(Texas), National Association; First Union National Bank;
Bank of America, N.A.; The Bank of New York; Bank One, N.A.;
and Dresdner Bank AG, New York and Grand Cayman Branches.
(G)10.6 -- Second Amendment to Loan Agreement dated as of June 6, 2001
among HCC Insurance Holdings, Inc.; Wells Fargo Bank
(Texas), National Association; First Union National Bank;
Bank of America, N.A.; and The Bank of New York.
10.7 -- Third Amendment to Loan Agreement dated as of March 21, 2003
among HCC Insurance Holdings, Inc.; Wells Fargo Bank
(Texas), National Association; First Union National Bank;
Bank of America, N.A.; and The Bank of New York.
(H)10.8 -- HCC Insurance Holdings, Inc. 1994 Nonemployee Director Stock
Option Plan.
(I)10.9 -- HCC Insurance Holdings, Inc. 1992 Incentive Stock Option
Plan, as amended and restated.
(I)10.10 -- HCC Insurance Holdings, Inc. 1995 Flexible Incentive Plan,
as amended and restated.
(I)10.11 -- HCC Insurance Holdings, Inc. 1997 Flexible Incentive Plan,
as amended and restated.
(I)10.12 -- HCC Insurance Holdings, Inc. 1996 Nonemployee Director Stock
Option Plan, as amended and restated.
(J)10.13 -- HCC Insurance Holdings, Inc. 2001 Flexible Incentive Plan,
as amended and restated.
10.14 -- Form of Incentive Stock Option Agreement under the HCC
Insurance Holdings, Inc. 2001 Flexible Incentive Plan.
10.15 -- Employment Agreement effective as of January 1, 2003,
between HCC Insurance Holdings, Inc. and Stephen L. Way.
10.16 -- Employment Agreement effective as of January 10, 2002,
between HCC Insurance Holdings, Inc. and Craig J. Kelbel.
10.17 -- Employment Agreement effective as of June 3, 2002, between
HCC Insurance Holdings, Inc. and Michael J. Schell.
(G)10.18 -- Employment Agreement effective as of January 1, 2002,
between HCC Insurance Holdings, Inc. and Edward H. Ellis,
Jr.
</Table>
<Table>
<Caption>
EXHIBIT
NUMBER
- -------
10.19 -- Employment Agreement effective as of January 1, 2003 between
HCC Insurance Holdings, Inc. and Christopher L. Martin.
12 -- Statement Regarding Computation of Ratios.
21 -- Subsidiaries of HCC Insurance Holdings, Inc.
23 -- Consent of Independent Accountants -- PricewaterhouseCoopers
LLP dated March 27, 2003.
24 -- Powers of Attorney.
99.1 -- Certification with respect to annual report.
99.2 -- Certification by Chief Executive Officer.
99.3 -- Certification by Chief Financial Officer.
</Table>
- ---------------
(A) Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Registration Statement on Form S-1 (Registration No. 33-48737) filed
October 27, 1992.
(B) Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Registration Statement on Form S-8 (Registration No. 333-61687) filed
August 17, 1998.
(C) Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Form 10-Q for the fiscal quarter ended March 31, 1999.
(D) Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Schedule 14D-1 Tender Offer Statement in respect to shares of The Centris
Group, Inc. filed October 18, 1999.
(E) Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Form 10-K for the fiscal year ended December 31, 2000.
(F) Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Form 8-K filed December 20, 1999.
(G) Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Form 10-K for the fiscal year ended December 31, 2001.
(H) Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Registration Statement on Form S-8 (Registration No. 33-94472) filed July
11, 1995.
(I) Incorporated by reference to Exhibits to HCC Insurance Holdings, Inc.'s
Form 10-K for the fiscal year ended December 31, 1999.
(J) Incorporated by reference to the Exhibits to HCC Insurance Holdings, Inc.'s
Definitive Proxy Statement for the May 22, 2002 Annual Meeting of
Shareholders filed April 26, 2002.