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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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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, 2001
</Table>
COMMISSION FILE NUMBER 0-20766
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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 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. [ ]
The aggregate market value on March 15, 2002, 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 15, 2002 was 62.0 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.
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TABLE OF CONTENTS
HCC INSURANCE HOLDINGS, INC.
<Table>
<Caption>
PAGE
----
PART I.
Item 1. Business.................................................... 2
Item 2. Properties.................................................. 32
Item 3. Legal Proceedings........................................... 32
Item 4. Submission of Matters to a Vote of Security Holders......... 33
PART II.
Item 5. Market for the Registrant's Common Equity and Related
Stockholder Matters......................................... 33
Item 6. Selected Financial Data..................................... 33
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 35
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...................................... 52
Item 12. Security Ownership of Certain Beneficial Owners and
Management.................................................. 52
Item 13. Certain Relationships and Related Transactions.............. 52
PART IV.
Item 14. Exhibits, Financial Statement Schedules and Reports on Form
8-K......................................................... 52
Signatures............................................................ 53
</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
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 at this time what the present and
longer term effects of the September 11, 2001 attacks or other future possible
terrorist attacks which result in 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. 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 liability to our policyholders.
Accordingly, we bear credit risk with 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.
It is presently unclear what effect the attacks of September 11, 2001 will
ultimately have on the financial position of our reinsurers. At present, we can
neither determine the extent to which we will be liable, as a result of the
terrorist attacks of September 11, for risks we have ceded to reinsurers, nor
can we determine the extent to which our credit risk with respect to our
reinsurers may have increased because the reinsurers are in a weakened financial
position as a result of the September 11 attacks. If we become liable for risks
we have ceded with respect to the September 11 attacks or if our reinsurers
cease to meet their obligations to us, whether because they are in a weakened
position as a result of the September 11 attacks or otherwise, our results of
operations and financial position could be materially adversely affected.
2
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 medical stop-loss
line of business; and Underwriters at Lloyd's, ACE Limited and XL Capital Ltd.
in our accident and health 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 attacks 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 attacks, 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 2002, we expect 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 between the major European currencies
(particularly the British pound sterling) and the U.S. dollar. Consequently, a
change in the exchange rate between the U.S. dollar and the British pound
sterling 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 currency at a known rate in an amount that
approximates average monthly expenses. Thus, the effect of these transactions is
to limit the foreign
3
currency exchange risk of the recurring monthly expenses. We use these foreign
currency forward contracts strictly as a 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 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.
4
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 have recorded a pre-tax gross loss related to the terrorist attacks of
September 11, 2001 of $141.0 million and a pre-tax net loss of $35.0 million. We
believe our estimates of gross and net losses to be reasonable, but they may be
subject to adjustment as we receive additional information from our clients and
producers. It is difficult to fully estimate our losses from the September 11,
2001 attacks given the uncertain nature of the damage theories related to
insurance claims made in connection with the attacks.
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, 2001, $525.4 million of our $888.5 million investment
portfolio was invested in fixed income securities. The fair market value of
these fixed income securities and the investment income from these fixed income
securities 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. Historically, the impact of market fluctuations has affected our
financial statements. Because all of our fixed income securities
5
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 generally accepted accounting principles, or GAAP,
shareholders' equity, total comprehensive income and/or our cash flows.
Historically, the impact of market fluctuations has affected our financial
statements. Unrealized pre-tax net investment gains (losses) on investments in
fixed-income securities were $0.7 million, $11.9 million and ($19.0) million for
the years ended 2001, 2000 and 1999, 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. 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 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
and the United Kingdom, 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.
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 a World Wide Web-site at
www.hcch.com. The reference to our World Wide Web address does not constitute
the incorporation by reference of the information contained at this site in this
report.
Since our founding, we have been consistently profitable, generally
reporting annual increases in gross written premium and total revenue. During
the period 1997 through 2001, we had an average statutory combined ratio of
98.3% versus the less favorable 106.3% (1997-2000) recorded by the U.S. property
and casualty insurance industry overall. During the same period, our gross
written premium increased from $346.4 million to $1.0 billion, an increase of
192% while net written premium increased 161% from $142.9 million to $373.0
million. During this period, our revenue increased from $281.5 million to $505.5
million, an increase of 80%.
During the period December 31, 1997 through December 31, 2001, our
shareholders' equity increased from $365.8 million to $763.5 million, a 109%
increase. During the same period, our assets increased from $1.2 billion to $3.2
billion, a 169% 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:
- life, accident and health
- aviation
- marine, energy and property
- 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 operates 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.
Our operating property and casualty 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. Our life insurance company is rated "A
(Excellent)" (3rd of 16 ratings) by A.M. Best Company, Inc. 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 insurance
and other specialty lines of business. Our principal underwriting agencies, ASU
International, LLC, HCC Benefits Corporation and Professional Indemnity Agency,
Inc.
In 2001 and 2002 we consolidated the operations of several of our agencies
with certain of our insurance companies to improve operational efficiencies.
Our combined gross written premium in 2001 was over $1.3 billion, after
intercompany eliminations. Our insurance companies wrote $1.0 billion of gross
premium and our underwriting agencies wrote $808.1 million of premium, before
intercompany eliminations.
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 on risks by providing information to clients about insurance
coverage;
- marketing risks by providing information and assistance on pricing a
particular insurance risk;
- placing risks by negotiating with insurers and reinsurers to accept an
insurance risk; and
- servicing risks by facilitating the collection of premiums and resolution
of claims on behalf of their clients.
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 Intermediaries, Inc., HCC Employee Benefits, 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
focus on lines of business that have relatively short lead times between the
occurrence of an insured event and the reporting of
7
claims. 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, and the
premiums tend to go down, and other times where insurance companies decide to
limit their writings in certain lines of business or suffer from excessive
losses, which tends to increase the 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 among 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 from both individual and catastrophic risks to
our insurance companies. 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 2001, due to a continuing hardening of the respective markets, premium
rates in the life, accident and health, aviation and marine, energy and property
lines of business increased. We anticipate continued improvements in these
markets and in all of our lines of business during 2002. 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 seek to acquire complementary businesses with established management
and established reputations in the insurance industry. 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.
8
MAJOR ACQUISITIONS
We have made a series of strategic acquisitions that have furthered our
overall business strategy. Our recent larger transactions are described below:
On January 31, 1999, we acquired PEPYS Holdings Limited. PEPYS is a holding
company for Rattner Mackenzie Limited. The initial consideration was $54.8
million in cash and deferred payments of $8.3 million in cash and 414,207 shares
of our common stock. As of December 31, 2001, we have accrued $0.7 million and
may pay additional amounts in the future based upon the attainment of certain
earnings benchmarks through December 31, 2003. Rattner Mackenzie Limited
provides intermediary services for reinsurance business placed by our insurance
companies as well as other insurance and reinsurance companies and underwriting
agencies, primarily in the accident and health area.
On December 20, 1999, we acquired all of the outstanding shares of the
publicly traded The Centris Group, Inc. following a tender offer at a price of
$12.50 per share in cash. We paid $149.5 million for The Centris Group, Inc.'s
acquisition. The Centris Group, Inc. was the parent corporation of a group of
insurance companies and underwriting agencies principally operating in the
medical stop-loss line of business. The Centris Group, Inc.'s primary insurance
company subsidiary was the entity now known as HCC Life Insurance Company. HCC
Life Insurance Company's operations were relocated to Houston, and it has become
a subsidiary of Houston Casualty Company. The medical stop-loss underwriting
agency operations of The Centris Group, Inc. have been combined with HCC
Benefits' Corporation operations.
On January 19, 2001, we issued 996,805 shares of our common stock to
acquire the Schanen Consulting Corporation and its operating subsidiary, The
Schanen Consulting Group, LLC. The Schanen Consulting Group, LLC provides
employee benefit consulting and retail insurance intermediary services and has
been consolidated with HCC Employee Benefits, Inc.'s operations.
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.
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.
We continue to evaluate possible acquisition candidates and we may complete
additional acquisitions during 2002. 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.
DISPOSITIONS
In March, 2000, we sold Trafalgar Insurance Company, an Oklahoma domiciled
insurance company subsidiary, for a price which approximated its shareholder's
equity determined in accordance with generally accepted accounting principles in
the United States, or GAAP.
In September, 2000, we sold a substantial portion of the assets of The
Wheatley Group, Ltd., a subsidiary of Avemco Corporation.
In September, 2001, we sold substantially all of the assets of Universal
Loss Management, Inc., our aviation claims administration services company for
$5.6 million plus an additional amount based on future revenue of the operation.
9
In September, 2001, we sold USF Insurance Company, a Pennsylvania domiciled
insurance company and former subsidiary of The Centris Group, Inc. for
approximately $2.0 million in excess of its shareholder's equity in accordance
with generally accepted accounting principles.
None of these operations were material to our financial condition, results
of operations or cash flows.
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>
2001 2000 1999
---------------- -------------- --------------
Life, accident and health............ $ 629,228 62% $546,702 56% $217,659 38%
Aviation............................. 198,015 20 191,089 20 210,029 37
Marine, energy and property.......... 83,068 8 64,352 7 82,003 15
Other specialty lines................ 15,602 2 29,281 3 17,962 3
---------- --- -------- --- -------- ---
925,913 92 831,424 86 527,653 93
Exited and discontinued lines of
business........................... 84,162 8 136,033 14 40,678 7
---------- --- -------- --- -------- ---
Total gross written
premium.................. $1,010,075 100% $967,457 100% $568,331 100%
========== === ======== === ======== ===
</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>
2001 2000 1999
-------------- -------------- --------------
Life, accident and health.......... $188,580 51% $148,100 52% $ 48,899 35%
Aviation........................... 98,249 26 79,794 28 68,513 49
Marine, energy and property........ 34,750 9 16,256 6 9,561 7
Other specialty lines.............. 14,390 4 14,552 5 8,730 6
-------- --- -------- --- -------- ---
335,969 90 258,702 91 135,703 97
Exited and discontinued lines of
business......................... 36,989 10 25,086 9 4,221 3
-------- --- -------- --- -------- ---
Total net written
premium................ $372,958 100% $283,788 100% $139,924 100%
======== === ======== === ======== ===
</Table>
UNDERWRITING
Direct
We underwrite direct business produced through independent agents and
brokers, affiliated intermediaries, and by direct marketing efforts. Our direct
underwriting includes general aviation, medical stop-loss and professional
liability business.
Reinsurance
In 2001 and prior years, our insurance companies participated in certain
insurance and reinsurance underwriting pools managed by our underwriting
agencies, in the life, accident and health line of business. Our insurance
companies also write facultative, or individual account, reinsurance,
particularly in the aviation and marine, energy and property lines of business.
Our facultative underwriting is typically on international business in order to
comply with local licensing requirements or as reinsurance of captive insurance
companies controlled by others, and can be considered direct business for most
purposes, since we maintain underwriting
10
and claims control. However, we record all of this business under the caption of
"Reinsurance Assumed" in our financial statements.
Life, Accident and Health
We began writing accident and health reinsurance risks through Houston
Casualty Company in 1996 through its participation in reinsurance facilities
managed by LDG Reinsurance Corporation. Our gross written premium increased from
$114.8 million in 1998 to $128.2 million in 2001. Net written premium in this
area increased because Houston Casualty Company retained a larger percentage of
the increased gross premium. During 2001, we began to produce and underwrite
this business directly through Houston Casualty Company and at the beginning of
2002, we completed the consolidation of LDG Reinsurance Corporation's new
business operations into Houston Casualty Company. We maintain reinsurance on an
excess of loss basis, where we transfer liability, premium and loss on a
non-proportional basis above our net retention of risk to reinsurers, to protect
us against severe losses on individual risks and catastrophe exposures.
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. When measured on a gross written premium
basis, medical stop-loss was our largest single line of business in 2001. We
also underwrite a limited program of group life insurance offered to our
insureds as complement to our medical stop-loss products. Group life gross
premium in 2001 amounted to $0.7 million. 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. HCC Benefits Corporation's
business has grown both internally and through acquisitions, most notably of The
Centris Group, Inc. HCC Benefits Corporation began underwriting this business in
1980. The 2001 gross written premium in our medical stop-loss line of business
underwritten in our insurance companies was $426.6 million and net written
premium was $140.9 million. We maintain reinsurance on a proportional basis,
where we share a 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 to independent truckers in 1996. This business is currently
written through U.S. Specialty Insurance Company. We maintain reinsurance on an
excess of loss basis. We believe there is a relatively low level of catastrophe
exposure in our alternative workers' compensation line of business.
Aviation
We have grown into 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. Avemco Insurance Company has been insuring aviation risks since
1959. Our gross written premium has remained
11
relatively flat during the period 1998 to 2001. During this period we have
successfully re-underwritten our book of business, removing under-performing
classes of business where premium rates were insufficient and focusing on areas
where increasing rates were able to generate profitable business. Our aviation
net written premium increased during the period because we increased our
retentions, i.e., the portion of risk that we retain for our own account.
We maintain reinsurance on both a proportional and excess of loss basis. We
believe that the aviation risks we underwrite carry a relatively low level of
catastrophe exposures.
Marine, Energy and Property
We underwrite marine risks for oceangoing vessels as well as inland,
coastal trading and fishing vessels. The marine risks we write include:
- hull and machinery
- liabilities, including protection and
indemnity
- marine cargo
- various ancillary coverages
We have underwritten marine risks since 1984, primarily in Houston Casualty
Company. Competition has created downward pressure on premium rates since 1996,
causing a reduction in our gross written premium since 1997 and a corresponding
decrease in net written premium. During 2001 we have seen rate increases that
are encouraging and we expect this trend to continue in 2002.
We maintain marine reinsurance on both a facultative and an excess of loss
basis. We believe that the marine risks we underwrite carry a relatively low
level of catastrophe exposure.
We have been underwriting energy risks since 1988, primarily in Houston
Casualty Company. The energy risks we write include:
- drilling rigs
- natural gas facilities
- petrochemical plants
- pipelines
- production and gathering platforms
- refineries
We underwrite physical damage, liabilities, business interruption and
various ancillary coverages.
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 we have seen rate increases that are
encouraging and we expect this trend to continue in 2002.
We maintain energy reinsurance on both a facultative basis and an excess of
loss basis to protect us against severe losses on individual risks and the
catastrophe exposure that exists, for example, from a hurricane or a major
platform explosion.
In the property area, we specialize in writing 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, primarily through Houston
Casualty Company. Gross written premium declined from $106.5 million in 1998 to
$45.0 million in 2001 as premium rates were soft due in a large part to excess
capacity and the absence of significant catastrophe losses. Net written premium
12
increased slightly from $8.4 million to $9.5 million in the same period. Our
property gross written premium exceeds our net written premium by a substantial
amount due to the amount of facultative reinsurance, which is the separately
negotiated reinsurance of all or part of the coverage provided by a single
policy, and other reinsurance purchased in order to protect us from catastrophe
losses. During 2001 we have seen rate increases that are encouraging and we
expect this trend to continue in 2002.
We maintain reinsurance on both a proportional basis and an excess of loss
basis in an effort to ensure adequate reinsurance protection, particularly
against catastrophe exposures. We estimate our aggregate probable maximum loss
in any individual catastrophe zone and maintain catastrophe reinsurance in an
amount we believe will cover such exposure to any one occurrence.
Other Specialty Lines
In addition to the above, we underwrite insurance in a variety of other
specialty lines of business, but the specific lines of business included in this
caption are too small at this time to break out separately.
Exited and Discontinued Lines of Business
Our exited and discontinued lines of business include provider excess,
lender's single interest, program property and casualty and primary statutory
workers' compensation business.
PRINCIPAL INSURANCE COMPANIES
Houston Casualty Company
Houston Casualty Company is our principal insurance company subsidiary. It
is rated "A+ (Superior), IX (policyholders' surplus between $250.0 million and
$500.0 million)" by A.M. Best Company, Inc. and "AA (Very Strong)" by Standard &
Poor's Corporation. Houston Casualty Company operates worldwide and is domiciled
and licensed in Texas and operates on a surplus lines basis in 47 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 has a highly experienced staff
of underwriters trained to deal with the high value, complicated exposures
prevailing in many of the lines of business in which we specialize. It is our
intention to utilize Houston Casualty Company as an issuing carrier for certain
business underwritten by ASU International, LLC and Professional Indemnity
Agency, Inc. and in 2002 Houston Casualty Company began writing directors and
officers liability and professional liability. As of December 31, 2001, Houston
Casualty Company's policyholders' surplus was $285.4 million, which is its total
admitted assets less total liabilities determined in accordance with statutory
accounting principles. Houston Casualty Company's shareholder's equity in
accordance with generally accepted accounting principles was $379.3 million as
of December 31, 2001.
In 2001 and 2002, we consolidated the new business operations of our
accident and health reinsurance underwriting agency, LDG Reinsurance
Corporation, with those of Houston Casualty Company.
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 accident and health
reinsurance, marine, energy and property business.
HCC Life Insurance Company
HCC Life Insurance Company is an Indiana-domiciled life insurance company
which became a direct subsidiary of Houston Casualty Company in December, 1999
following The Centris Group, Inc. acquisition. HCC Life Insurance Company is
rated "A (Excellent), VII (policyholders' surplus between $50.0 million and
$100.0 million)" by A.M. Best Company, Inc. and operates as a life, accident and
health insurer on an
13
admitted basis in 41 states and the District of Columbia. HCC Life Insurance
Company is an issuing carrier for medical stop-loss products produced and
underwritten by HCC Benefits Corporation. As of December 31, 2001, HCC Life
Insurance Company had statutory policyholders' surplus of $77.1 million and
shareholder's equity in accordance with generally accepted accounting principles
of $88.4 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 is rated "A+ (Superior), VIII (policyholders'
surplus between $100.0 million and $250.0 million)" by A.M. Best Company, Inc.
and "AA (Very Strong)" by Standard & Poor's Corporation. U.S. Specialty
Insurance Company operates on an admitted basis throughout the United States,
primarily writing general aviation, occupational accident and alternative
workers' compensation insurance. In September, 2001, we decided that U.S.
Specialty Insurance Company would exit the statutory workers' compensation
market. It is our intention to utilize U.S. Specialty Insurance Company as an
issuing carrier for certain business underwritten by ASU International, LLC and
Professional Indemnity Agency, Inc., and in 2002 U.S. Specialty Insurance
Company began writing directors and officers liability and professional
liability business produced by Professional Indemnity Agency, Inc. As of
December 31, 2001, U.S. Specialty Insurance Company had statutory policyholders'
surplus of $105.9 million and shareholder's equity in accordance with generally
accepted accounting principles of $116.3 million.
Avemco Insurance Company
Avemco Insurance Company is a Maryland-domiciled property and casualty
insurer, is rated "A+ (Superior), VIII (policyholders' surplus between $100.0
million and $250.0 million)" by A.M. Best Company, Inc. and "AA (Very Strong)"
by Standard & Poor's Corporation, and is operating as a direct market
underwriter of general aviation business on an admitted basis throughout the
United States and Canada (except Quebec). In addition, Avemco Insurance Company
is an issuing carrier for medical stop-loss products produced and underwritten
by HCC Benefits Corporation and for indemnity accident and health business
produced by an unaffiliated agency. The latter business is fully reinsured. As
of December 31, 2001, Avemco Insurance Company had statutory policyholders'
surplus of $107.1 million and shareholder's equity in accordance with generally
accepted accounting principles of $117.2 million.
UNDERWRITING AGENCY OPERATIONS
Our underwriting agencies act on behalf of our insurance companies and
those of other firms, 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. Our insurance companies may retain a portion of the risk
and reinsure the remainder with unaffiliated insurance companies or reinsure all
of the risk. 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 2001 amounted to $61.8 million.
LINES OF BUSINESS
This table shows our underwriting agencies' revenue by line of business for
the years indicated (dollars in thousands):
<Table>
<Caption>
2001 2000 1999
------------- ------------- -------------
Life, accident and health............. $47,857 77% $70,536 73% $66,127 73%
Property and casualty................. 13,938 23 25,522 27 24,586 27
------- --- ------- --- ------- ---
Total management fees....... $61,795 100% $96,058 100% $90,713 100%
======= === ======= === ======= ===
</Table>
14
HCC BENEFITS CORPORATION
HCC Benefits Corporation, with its home office in Atlanta, Georgia and
regional offices in Costa Mesa, California; Wakefield, Massachusetts;
Minneapolis, Minnesota; and Dallas, Texas, acts as an underwriting manager
writing medical stop-loss products for employer sponsored self-insured health
plans. In 2001, HCC Benefits Corporation generated approximately $51.4 million
in management fees. Substantially all of the business was underwritten on behalf
of HCC Life Insurance Company and Avemco Insurance Company.
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 branch offices in San Francisco, California and Palm Beach Gardens,
Florida, acts as an underwriting manager writing directors and officers
liability, kidnap and ransom and professional liability insurance coverages. For
the full year 2001, Professional Indemnity Agency, Inc. generated $20.4 million
in management fees on premium written on behalf of unaffiliated insurers.
Professional Indemnity Agency, Inc. will underwrite some of the above lines of
business on behalf of our insurance companies in 2002.
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 of specialty insurance for the
sports, entertainment and promotion marketing industries. ASU International, LLC
offers contingency insurance (including contest indemnity, event cancellation
and weather coverages) and individual disability insurance for athletes and
other high profile individuals. For the full year 2001, ASU International, LLC
generated $13.8 million in management fees on premium written on behalf of
unaffiliated insurers. ASU International, LLC will underwrite selected risks in
some of the above lines of business on behalf of our insurance companies in
2002.
OTHER AGENCY OPERATIONS
We have consolidated certain of our other underwriting agencies with
certain of our insurance companies for the purpose of improving the operational
efficiencies of our business. We have consolidated the operations of our
domestic general aviation underwriting agency, HCC Aviation Insurance Group,
Inc., and our occupational accident and alternative workers' compensation
underwriting agency, HCC Employer Services, Inc. into U.S. Specialty Insurance
Company. We have also consolidated both offices of our accident and health
reinsurance underwriting agency, LDG Reinsurance Corporation, into Houston
Casualty Company.
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, 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 2001 amounted to $43.4 million.
This table shows our intermediaries' revenue by line of business for the
years indicated (dollars in thousands):
<Table>
<Caption>
2001 2000 1999
------------- ------------- -------------
Life, accident and health............. $33,739 78% $36,795 74% $39,354 68%
Property and casualty................. 9,673 22 13,091 26 18,879 32
------- --- ------- --- ------- ---
Total commission income..... $43,412 100% $49,886 100% $58,233 100%
======= === ======= === ======= ===
</Table>
15
RATTNER MACKENZIE LIMITED
Rattner Mackenzie Limited is an intermediary based in London, England.
Rattner Mackenzie Limited is a Lloyd's broker specializing in 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 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 INTERMEDIARIES, INC.
HCC Intermediaries, 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 Intermediaries, Inc. acts as a
reinsurance intermediary on behalf of affiliated and non-affiliated 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.
The primary operating entities in this segment provided insurance claims
adjusting services. During 2001, we sold the last of our service operations,
which will result in a decrease in other operating income in future years.
Additionally, other operating income may be in the form of equity in the
earnings of a company in which we invest, or dividends or gains or losses from
the disposition of these investments. Other operating income was $17.4 million
in 2001. Revenue and earnings can vary considerably from period to period
depending on investment or disposition activity.
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. We believe that we reinsure our risks
to a greater extent than most of our competitors and most other insurance
companies. We use this strategy to protect our shareholders' equity.
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 2001 some of those renewed contained price increases which
are not material to our underwriting results. Additionally, we retained higher
percentages of our business in connection with certain lines of business which
are reinsured on a proportional basis. We plan to continue to increase our
retentions as underwriting conditions improve in many of our lines of business.
We consider the maintenance of reinsurance protection to be an important
part of our business plan, protecting shareholders' equity from catastrophe
losses and fluctuations in the insurance market cycles of the insurance
industry. We have built important relationships over the years with many core
reinsurers. We intend to continue to share our business with these partners as
underwriting profitability returns in an improving market in order to build even
stronger relationships for the future. We believe that increased retentions
during
16
profitable periods are made possible not at the sacrifice of core reinsurers but
through reduction of facultative reinsurance and the natural attrition of
certain reinsurers who exit lines of business or curtail their writings for
other reasons. This reduction in reinsurance market capacity causes rates to
rise but the increased rates historically have been passed on to the original
insureds.
We structure a specific reinsurance program for each line of business we
underwrite. We place this reinsurance in order to protect our insurance
companies from exposure to foreseeable events. We place reinsurance
proportionally to cover loss frequency and catastrophe exposure. We obtain
additional reinsurance on an excess of loss basis to cover individual risk
severity of loss and on a catastrophe basis to cover exposure from occurrences
involving multiple risks, such as those resulting from a hurricane, an
earthquake or a man-made event, such as a terrorist attack. Additionally, we may
also obtain facultative reinsurance protection on an excess of loss or
proportionate basis on any single risk. We do not intend to expose our assets to
any net loss in excess of our reinsurance protection.
Certain of our lines of business are exposed to catastrophe losses in a
greater degree than others. We have exposures to this type of loss primarily in
our accident and health reinsurance, energy and property lines of business. We
carefully assess our overall exposure 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.
Subsequent to the terrorist attacks 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 lines of business. All new and
renewal policies are written with an appropriate terrorist exclusion except for
lines of business, such as aviation, where reinsurance for acts of terrorism is
available at an economic cost or where we feel comfortable with the net
exposure.
At January 1, 2002, and February 1, 2002, respectively, our onshore energy
and property reinsurance protections were renewed without coverage for acts of
terrorism. Therefore, to the extent that certain existing, in-force policies
contain such coverage, then we would have a net exposure to any applicable
losses. The actual amount of this exposure is not determinable but could
represent a catastrophic loss, a risk for which we would usually purchase
reinsurance protection. We do not believe that any loss would severely impact
our capital. As each month goes by, existing in-force policies will expire and
the overall exposure continues to reduce substantially.
In general, we 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 Intermediaries, 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.
17
The table below shows property and casualty reinsurance balances relating
to our reinsurers with net recoverable balances greater than $15.0 million as of
December 31, 2001. The total recoverables column includes paid loss recoverable,
outstanding loss recoverable, incurred but not reported recoverables and ceded
unearned premium (in thousands).
<Table>
<Caption>
LETTERS OF CREDIT,
CASH DEPOSITS
CURRENT TOTAL AND OTHER
REINSURER RATING LOCATION RECOVERABLES PAYABLES NET
- --------- ------- -------------- ------------ ------------------ -------
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 had 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 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 $83.0 million as of
December 31, 2001.
We have a reserve of $5.2 million as of December 31, 2001 for potential
collectibility issues related to reinsurance recoverables and associated
expenses. The adverse economic environment in the worldwide insurance industry
and the terrorist attacks on September 11 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, such as the
marketplace has experienced for the last several years. While we believe that
the reserve is adequate based on currently available information, conditions may
change or additional information might be obtained that would affect our
estimate of the adequacy of the level of the reserve and which may result in a
future change in the reserve. We continually review our financial exposure to
the reinsurance market and continue to take actions to mitigate our position.
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 to 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
18
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, 2001, our insurance companies had
initiated litigation or arbitration proceedings against five reinsurers and were
involved in one arbitration proceeding initiated by a reinsurer. These
proceedings primarily concern the collection of amounts owing under reinsurance
agreements. As of such date, our insurance companies had an aggregate amount of
$15.3 million which had not been paid to us under the disputed agreements and we
estimate that there could be an additional $31.2 million of incurred losses and
loss expenses under the subject agreements. In addition, because our insurance
companies, principally Houston Casualty Company, participated in facilities
which were managed by one of our underwriting agencies, they are indirectly
involved in any reinsurance disputes which affect the applicable facilities. As
of December 31, 2001, Houston Casualty Company's allocated portion of aggregate
amounts which had not been reimbursed to the applicable facilities under the
disputed agreements was $4.8 million and we estimate that there could be an
additional $4.0 million of incurred losses and loss expenses under the subject
agreements allocated to Houston Casualty Company. Houston Casualty Company has
no net exposure on disputed amounts due to the non-affiliated companies who also
participated in the applicable facilities.
During 1999, we recorded a provision for reinsurance totaling $29.5 million
in connection with the insolvency of a reinsurer. We continue to expect this
provision to be sufficient. We also recorded a $14.0 million provision following
a commutation (the contractual settlement of outstanding and future liabilities)
with another reinsurer, the majority of which represents the present value
discount of ceded losses.
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>
2001 2000 1999 1998 1997
---------- -------- -------- -------- --------
Gross written premium.......... $1,014,833 $972,154 $576,184 $500,962 $346,094
Net written premium............ 371,409 283,947 150,261 123,315 143,068
Policyholders' surplus......... 401,393 326,249 315,474 369,401 331,922
Gross written premium ratio.... 252.8% 298.0% 182.6% 135.6% 104.3%
Gross written premium industry
average(1)................... * 174.1% 154.1% 147.9% 154.7%
Net written premium ratio...... 92.5% 87.0% 47.6% 33.4% 43.1%
Net written premium industry
average(1)................... * 94.4% 85.5% 84.3% 89.7%
</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. In the past, our property and casualty insurance companies have
maintained premium to surplus ratios generally lower than such guidelines and
below industry norms. The gross written premium ratio increased during 2000 with
the acquisition of The Centris Group, Inc.'s book of medical stop-loss business
in December, 1999 and the increasing use of our insurance companies as the
issuing company for business written by our underwriting agencies. This ratio is
expected to slowly decrease
19
from its current level as statutory policyholders' surplus increases due to the
retention of earnings and other increases in policyholders' surplus.
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>
2001 2000 1999 1998 1997
----- ---- ----- ---- ----
Loss ratio........................................ 78.0% 74.2% 77.6% 63.8% 59.4%
Expense ratio..................................... 25.7 21.0 51.7 21.5 22.0
----- ---- ----- ---- ----
Combined ratio.................................... 103.7% 95.2% 129.3% 85.3% 81.4%
===== ==== ===== ==== ====
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 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>
2001 2000 1999 1998 1997
----- ----- ----- ----- -----
Loss ratio..................................... 78.0% 71.1% 107.1% 67.2% 61.6%
Expense ratio.................................. 23.8 27.0 22.8 15.7 17.2
----- ----- ----- ----- -----
Combined ratio................................. 101.8% 98.1% 129.9% 82.9% 78.8%
===== ===== ===== ===== =====
Combined ratio excluding the effects of the
provision for reinsurance in 1999............ 104.1%
=====
Industry average(1)............................ * 110.1% 107.8% 105.6% 101.6%
</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 (15) 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.
20
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 an immaterial amount of reserves acquired in a transaction recorded using
the purchase method of accounting. The net 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 independent actuaries.
PricewaterhouseCoopers LLP certified the reserves of our insurance companies in
accordance with statutory accounting principles as of December 31, 2001.
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 majority of the risks
currently underwritten by our insurance companies tend to have shorter lead
times.
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.
21
The loss development triangles below show changes in our GAAP 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.
This loss development triangle shows development in loss reserves on a
gross basis (in thousands):
<Table>
<Caption>
2001 2000 1999 1998 1997 1996 1995 1994 1993
---------- -------- -------- -------- -------- -------- -------- -------- --------
Balance sheet reserves:...... $1,130,748 $944,117 $871,104 $460,511 $275,008 $229,049 $200,756 $170,957 $144,178
Reserve adjustments from
acquisition and disposition
of subsidiaries............ -- (66,571) (32,437) (136) -- -- -- -- --
---------- -------- -------- -------- -------- -------- -------- -------- --------
Adjusted reserves........ 1,130,748 877,546 838,667 460,375 275,008 229,049 200,756 170,957 144,178
Cumulative paid as of:
One year later............. 400,279 424,379 229,746 160,324 119,453 118,656 97,580 82,538
Two years later............ 561,246 367,512 209,724 179,117 167,459 143,114 126,290
Three years later.......... 419,209 241,523 193,872 207,191 166,541 157,509
Four years later........... 259,067 212,097 214,046 192,540 176,472
Five years later........... 223,701 226,762 195,930 195,269
Six years later............ 233,831 202,844 197,147
Seven years later.......... 208,112 203,075
Eight years later.......... 207,474
Nine years later...........
Re-estimated liability as of:
End of year................ 1,130,748 877,546 838,667 460,375 275,008 229,049 200,756 170,957 144,178
One year later............. 922,080 836,775 550,409 308,501 252,236 243,259 186,898 163,967
Two years later............ 868,438 545,955 316,250 249,013 248,372 207,511 183,015
Three years later.......... 547,179 304,281 250,817 247,053 214,738 203,137
Four years later........... 305,022 247,245 248,687 220,695 211,546
Five years later........... 249,853 248,559 217,892 218,182
Six years later............ 250,176 219,196 214,498
Seven years later.......... 219,002 216,820
Eight years later.......... 216,627
Nine years later...........
Cumulative redundancy
(deficiency)............... $(44,534) $(29,771) $(86,804) $(30,014) $(20,804) $(49,420) $(48,045) $(72,449)
<Caption>
1992
---------
Balance sheet reserves:...... $ 129,503
Reserve adjustments from
acquisition and disposition
of subsidiaries............ --
---------
Adjusted reserves........ 129,503
Cumulative paid as of:
One year later............. 83,574
Two years later............ 130,379
Three years later.......... 158,973
Four years later........... 182,193
Five years later........... 192,512
Six years later............ 213,052
Seven years later.......... 215,280
Eight years later.......... 221,403
Nine years later........... 225,706
Re-estimated liability as of:
End of year................ 129,503
One year later............. 162,827
Two years later............ 176,817
Three years later.......... 194,419
Four years later........... 215,531
Five years later........... 222,746
Six years later............ 234,115
Seven years later.......... 231,269
Eight years later.......... 233,995
Nine years later........... 233,865
Cumulative redundancy
(deficiency)............... $(104,362)
</Table>
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.
22
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.
- 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.
23
This loss development triangle shows development in loss reserves on a net
basis (in thousands):
<Table>
<Caption>
2001 2000 1999 1998 1997 1996 1995 1994 1993
---------- -------- -------- -------- -------- -------- -------- -------- --------
Gross reserves................. $1,130,748 $944,117 $871,104 $460,511 $275,008 $229,049 $200,756 $170,957 $144,178
Less reinsurance
recoverables................. 817,651 694,245 597,498 341,599 155,374 111,766 101,497 95,279 82,289
---------- -------- -------- -------- -------- -------- -------- -------- --------
Reserves, net of
reinsurance.............. 313,097 249,872 273,606 118,912 119,634 117,283 99,259 75,678 61,889
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.............. 313,097 243,824 270,263 182,353 134,642 119,919 100,701 75,729 61,889
Cumulative paid, net of
reinsurance, as of:
One year later............... 102,244 145,993 56,052 48,775 47,874 41,947 36,500 29,258
Two years later.............. 174,534 103,580 64,213 66,030 56,803 49,283 41,207
Three years later............ 113,762 80,227 72,863 64,798 56,919 46,576
Four years later............. 81,845 81,620 67,355 60,441 51,536
Five years later............. 81,968 72,627 61,781 53,110
Six years later.............. 73,501 66,591 53,879
Seven years later............ 64,410 58,353
Eight years later............ 58,713
Nine years later.............
Ten years later..............
Re-estimated liability, net of
reinsurance, as of:
End of year.................. 313,097 243,824 270,263 182,353 134,642 119,919 100,701 75,729 61,889
One year later............... 233,111 260,678 186,967 120,049 116,145 95,764 72,963 59,659
Two years later.............. 254,373 175,339 116,745 101,595 94,992 74,887 60,079
Three years later............ 171,165 110,673 97,353 85,484 76,474 62,224
Four years later............. 107,138 95,118 80,890 73,660 64,377
Five years later............. 93,528 79,626 69,528 64,103
Six years later.............. 79,968 70,642 59,408
Seven years later............ 70,278 60,960
Eight years later............ 60,729
Nine years later.............
Ten years later..............
Cumulative redundancy
(deficiency)................. $ 10,713 $ 15,890 $ 11,188 $ 27,504 $ 26,391 $ 20,733 $ 5,451 $ 1,160
<Caption>
1992 1991
-------- --------
Gross reserves................. $129,503 $123,248
Less reinsurance
recoverables................. 81,075 83,727
-------- --------
Reserves, net of
reinsurance.............. 48,428 39,521
Reserve adjustments from
acquisition and disposition
of subsidiaries.............. -- --
Effect on loss reserves of 1999
write off of reinsurance
recoverables................. -- --
-------- --------
Adjusted reserves, net of
reinsurance.............. 48,428 39,521
Cumulative paid, net of
reinsurance, as of:
One year later............... 18,978 18,416
Two years later.............. 32,733 23,057
Three years later............ 36,536 31,903
Four years later............. 38,480 33,875
Five years later............. 40,327 34,970
Six years later.............. 40,550 36,203
Seven years later............ 41,133 35,413
Eight years later............ 45,552 35,960
Nine years later............. 45,837 39,770
Ten years later.............. 39,976
Re-estimated liability, net of
reinsurance, as of:
End of year.................. 48,428 39,521
One year later............... 45,812 38,575
Two years later.............. 44,964 38,656
Three years later............ 46,129 39,176
Four years later............. 48,993 40,407
Five years later............. 50,785 43,418
Six years later.............. 50,585 45,142
Seven years later............ 46,071 43,924
Eight years later............ 47,629 39,858
Nine years later............. 47,407 41,513
Ten years later.............. 41,368
Cumulative redundancy
(deficiency)................. $ 1,021 $ (1,847)
</Table>
We believe that our loss reserves are adequate to provide for all material
net incurred losses.
24
The following table provides a reconciliation of the gross liability of
loss and loss adjustment expenses on the basis of generally accepted accounting
principles for the three years ended December 31, 2001 (in thousands):
<Table>
<Caption>
2001 2000 1999
---------- -------- --------
Reserves for loss and loss adjustment expense at beginning
of year................................................. $ 944,117 $871,104 $460,511
Reserve adjustments from acquisition and disposition of
subsidiaries............................................ (69,725) 1,709 146,233
Provision for loss and loss adjustment expense for claims
occurring In the current year........................... 1,019,311 775,538 595,425
Increase (decrease) in estimated loss and loss adjustment
expense for claims occurring in prior years (1)......... 44,534 (1,892) 90,034
---------- -------- --------
Incurred loss and loss adjustment expense................. 1,063,845 773,646 685,459
---------- -------- --------
Loss and loss adjustment expense payments for claims
occurring during:
Current year............................................ 407,210 277,963 191,353
Prior years............................................. 400,279 424,379 229,746
---------- -------- --------
Loss and loss adjustment expense payments................. 807,489 702,342 421,099
---------- -------- --------
Reserves for loss and loss adjustment expense at end of
the year................................................ $1,130,748 $944,117 $871,104
========== ======== ========
</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 for the three years ended December 31, 2001 (in
thousands):
<Table>
<Caption>
2001 2000 1999
-------- -------- --------
Reserves for loss and loss adjustment expense at beginning
of year.................................................. $249,872 $273,606 $118,912
Reserve adjustments from acquisition and disposition of
subsidiaries............................................. 285 514 55,523
Effect on loss reserves of write off of ceded outstanding
and incurred but not reported reinsurance recoverables... -- -- 82,343
Provision for loss and loss adjustment expense for claims
occurring in the current year............................ 278,103 208,055 105,036
Increase (decrease) in estimated loss and loss adjustment
expense for claims occurring in prior years (2).......... (10,713) (9,585) 4,614
-------- -------- --------
Incurred loss and loss adjustment expense.................. 267,390 198,470 109,650
-------- -------- --------
Loss and loss adjustment expense payments for claims
occurring during:
Current year............................................. 102,206 76,725 36,770
Prior years.............................................. 102,244 145,993 56,052
-------- -------- --------
Loss and loss adjustment expense payments.................. 204,450 222,718 92,822
-------- -------- --------
Reserves for loss and loss adjustment expense at end of the
year..................................................... $313,097 $249,872 $273,606
======== ======== ========
</Table>
- ---------------
(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 gross loss deficiencies during 2001 and 1999, the
business was substantially reinsured and, therefore, there was no material
effect to our insurance companies on a net loss basis.
25
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 a deficiency of $4.6 million in 1999. The deficiencies and
redundancies in the net reserves result from our continued review with our
actuaries of our loss reserves and the increase or reduction of reserves 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.
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, 2001, we had
$888.5 million 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, 2001, our fixed income securities have a weighted average maturity of five
years and a weighted average duration of four years. Our financial statements
reflect an unrealized gain on fixed income securities available for sale as of
December 31, 2001, of $11.8 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, 2001, we had cash and short-term investments of approximately
$355.8 million, of which $220.6 million were in our agencies and intermediaries.
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>
2001 2000 1999
-------- -------- --------
Average investments, at cost......................... $789,860 $643,721 $545,876
Net investment income(1)............................. 39,638 39,836 30,946
Average short-term yield(1).......................... 4.3% 6.6% 5.6%
Average long-term yield(1)........................... 5.6% 6.1% 5.6%
Average long-term tax equivalent yield(1)............ 6.4% 7.4% 7.5%
Weighted average combined tax equivalent yield(1).... 5.6% 7.1% 7.1%
</Table>
- ---------------
(1) Excluding realized and unrealized capital gains and losses.
26
This table summarizes, by type, the estimated market value of our
investments as of December 31, 2001 (dollars in thousands):
<Table>
<Caption>
AMOUNT PERCENT OF TOTAL
-------- ----------------
Short-term investments...................................... $338,904 38%
U.S. Treasury securities.................................... 71,368 8
Obligations of states, municipalities and political
subdivisions.............................................. 53,918 6
Special revenue fixed income securities..................... 151,740 17
Corporate fixed income securities........................... 145,285 16
Structured securities....................................... 98,628 11
Foreign government securities............................... 4,489 1
Marketable equity securities................................ 16,569 2
Other investments........................................... 7,565 1
-------- ---
TOTAL INVESTMENTS................................. $888,466 100%
======== ===
</Table>
This table summarizes, by rating, the market value of our investments in
fixed income securities as of December 31, 2001 (dollars in thousands):
<Table>
<Caption>
AMOUNT PERCENT OF TOTAL
-------- ----------------
AAA......................................................... $258,724 49%
AA.......................................................... 93,773 17
A........................................................... 162,241 31
BBB......................................................... 10,500 2
C........................................................... 190 1
-------- ---
TOTAL FIXED INCOME SECURITIES..................... $525,428 100%
======== ===
</Table>
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>
AMOUNT PERCENT OF TOTAL
-------- ----------------
One year or less............................................ $ 18,416 3%
One year to five years...................................... 194,022 37
Five years to ten years..................................... 94,184 18
Ten years to fifteen years.................................. 76,721 15
More than fifteen years..................................... 43,457 8
-------- ---
Securities with fixed maturities.......................... 426,800 81
Asset-backed and mortgage-backed securities................. 98,628 19
-------- ---
TOTAL FIXED INCOME SECURITIES..................... $525,428 100%
======== ===
</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. The total amount of securities held by us as of
December 31, 2001 that would be subject to these tests and potential write downs
is immaterial.
27
2% CONVERTIBLE NOTES AND BANK LOAN
On August 23, 2001, we issued an aggregate $172.5 million principal amount
of 2% Convertible Notes due 2021 in a public offering. Each $1,000 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%
(currently $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, 2002, 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. We used the
proceeds from this offering to repay our remaining indebtedness under the bank
facility described below, assist in financing the recent acquisitions, make a
$60.0 million capital contribution to our principal insurance company subsidiary
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. Outstanding advances under the facility bear interest at
agreed upon rates, which ranged between 2.6% and 3.1% at December 31, 2001. The
facility is collateralized in part by the pledge of the stock of two of our
principal insurance companies, Houston Casualty Company and Avemco Insurance
Company, and by the stock of and guarantees entered into by our principal
underwriting agencies and intermediaries. The facility agreement contains
certain restrictive covenants, including minimum net worth requirements for us
and certain of our subsidiaries, restrictions on certain extraordinary corporate
actions, notice requirements for certain material occurrences and required
maintenance of specified financial ratios. We believe that the restrictive
covenants and our obligations that are contained in the facility agreement are
typical for financing arrangements comparable to our facility. As of December
31, 2001, there was no outstanding balance on this facility.
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
28
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 accredited reinsurer in
35 states and an approved surplus lines insurer or is otherwise permitted to
write surplus lines insurance in 47 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, the District of Columbia, and all Canadian provinces except Quebec.
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.
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.
29
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;
- 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 adoption
of these principles by the states is referred to as codification. 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 $3.2
million reduction in our insurance companies' aggregate statutory policyholders'
surplus compared to amounts that would have been recorded under the National
Association of Insurance Commissioners
30
codification rules. 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, 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, 2001, each of our domestic insurance companies' total adjusted
capital is significantly in excess of the National Association of Insurance
Commissioners 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.
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
31
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, 2001, we had 997 employees. The employees include seven
executive officers, 18 senior management, 95 management and 877 other personnel.
Of this number, 366 are employed by our insurance companies, 389 are employed by
our underwriting agencies, 127 are employed by our intermediaries, and 115 are
employed at the corporate headquarters and elsewhere. We are not a party to any
collective 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 an
approximately 51,000 square foot building owned by Houston Casualty Company.
Houston Casualty Company also owns a 77,000 square foot building adjacent to its
home office building. We also maintain offices in over 20 locations elsewhere in
the United States and England. The majority of these additional locations are in
leased facilities.
Besides our home office, our principal office facilities are as follows:
<Table>
<Caption>
SUBSIDIARY LOCATION SQ. FT. LEASE TERMINATION DATE
- ---------- -------- ------- ----------------------
Avemco Insurance Company Frederick, Maryland 40,000 Owned
U.S. Specialty Insurance Company Aviation
Division Dallas, Texas 40,000 March 31, 2004
Professional Indemnity Agency, Inc. Mount Kisco, New York 38,000 Owned
Houston Casualty Company Accident and
Health Division Wakefield, Massachusetts 28,000 October 31, 2006
HCC Benefits Corporation Costa Mesa, California 22,000 March 31, 2007
Kennesaw, Georgia 21,000 January 31, 2006
HCC Employee Benefits, Inc. Houston, Texas 20,000 August 31, 2006
Rattner Mackenzie Limited London, England 15,000 September 29, 2003
ASU International, LLC Woburn, Massachusetts 12,000 January 31, 2005
</Table>
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. 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.
32
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 2001.
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, 2000 through December 31, 2001, as reported by the New York
Stock Exchange were as follows:
<Table>
<Caption>
2001 2000
--------------- ---------------
HIGH LOW HIGH LOW
------ ------ ------ ------
First quarter...................................... $26.88 $20.50 $15.00 $11.50
Second quarter..................................... 29.65 23.26 19.69 10.94
Third quarter...................................... 26.67 21.21 22.94 18.69
Fourth quarter..................................... 29.20 25.15 27.19 17.63
</Table>
On March 15 2002, the last reported sales price of our common stock as
reported by the New York Stock Exchange was $28.13 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 15, 2002, there were 62.0
million shares of issued and outstanding common stock held by 954 shareholders
of record; however, we believe there are in excess of 15,000 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, 2001, our quarterly dividend was $0.0625 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.
33
<Table>
<Caption>
FOR THE YEARS ENDED DECEMBER 31,
(IN THOUSANDS, EXCEPT PER SHARE DATA)(1)
----------------------------------------------------
2001 2000 1999 1998 1997
-------- -------- -------- -------- --------
STATEMENT OF EARNINGS DATA
Revenue
Net earned premium.................................. $342,787 $267,647 $141,362 $143,100 $162,571
Management fees..................................... 61,795 96,058 90,713 74,045 51,039
Commission income................................... 43,412 49,886 58,233 40,804 25,375
Net investment income............................... 39,638 39,836 30,946 29,342 27,588
Net realized investment gain (loss)................. 393 (5,321) (4,164) 845 (328)
Other operating income.............................. 17,436 25,497 28,475 22,268 15,239
-------- -------- -------- -------- --------
Total revenue................................ 505,461 473,603 345,565 310,404 281,484
Expense
Loss and loss adjustment expense, net............... 267,390 198,470 109,650 91,302 96,514
Operating expense
Policy acquisition costs, net................... 27,923 23,743 8,177 10,978 13,580
Compensation expense............................ 69,762 83,086 79,196 57,227 51,994
Provision for reinsurance....................... -- -- 43,462 -- --
Other operating expense......................... 71,119 53,274 53,273 36,451 31,935
Merger expense.................................. -- -- -- 107 8,069
-------- -------- -------- -------- --------
Total operating expense...................... 168,804 160,103 184,108 104,763 105,578
Interest expense.................................... 8,884 20,347 12,964 6,021 6,004
-------- -------- -------- -------- --------
Total expense................................ 445,078 378,920 306,722 202,086 208,096
-------- -------- -------- -------- --------
Earnings before income tax provision......... 60,383 94,683 38,843 108,318 73,388
Income tax provision................................ 30,186 37,202 12,271 35,208 23,305
-------- -------- -------- -------- --------
Net earnings before accounting change........ 30,197 57,481 26,572 73,110 50,083
Cumulative effect of accounting change(2)............. -- (2,013) -- -- --
-------- -------- -------- -------- --------
Net earnings................................. $ 30,197 $ 55,468 $ 26,572 $ 73,110 $ 50,083
======== ======== ======== ======== ========
BASIC EARNINGS PER SHARE DATA:
Earnings before accounting change................. $ 0.52 $ 1.13 $ 0.53 $ 1.49 $ 1.04
Cumulative effect of accounting change (2)........ -- (0.04) -- -- --
-------- -------- -------- -------- --------
Net earnings...................................... $ 0.52 $ 1.09 $ 0.53 $ 1.49 $ 1.04
======== ======== ======== ======== ========
Weighted average shares outstanding............... 58,321 50,742 50,058 48,917 47,992
======== ======== ======== ======== ========
DILUTED EARNINGS PER SHARE DATA:
Earnings before accounting change................. $ 0.51 $ 1.11 $ 0.52 $ 1.46 $ 1.02
Cumulative effect of accounting change (2)........ -- (0.04) -- -- --
-------- -------- -------- -------- --------
Net earnings...................................... $ 0.51 $ 1.07 $ 0.52 $ 1.46 $ 1.02
======== ======== ======== ======== ========
Weighted average shares outstanding............... 59,619 51,619 50,646 49,933 49,206
======== ======== ======== ======== ========
Cash dividends declared, per share.................... $ 0.245 $ 0.22 $ 0.20 $ 0.16 $ 0.12
======== ======== ======== ======== ========
</Table>
34
<Table>
<Caption>
DECEMBER 31,
(IN THOUSANDS, EXCEPT PER SHARE DATA)
--------------------------------------------------------------
2001 2000 1999 1998 1997
---------- ---------- ---------- ---------- ----------
BALANCE SHEET DATA:
Total investments.......................... $ 888,466 $ 711,113 $ 581,322 $ 525,646 $ 518,772
Premium, claims and other receivables...... 665,965 609,716 636,671 382,885 252,759
Reinsurance recoverables................... 899,128 789,412 736,485 372,672 176,965
Ceded unearned premium..................... 71,140 114,469 133,657 149,568 84,610
Goodwill and intangible assets............. 328,815 266,015 263,687 88,043 34,758
Total assets............................... 3,219,120 2,790,755 2,679,737 1,709,643 1,198,353
Loss and loss adjustment expense payable... 1,130,748 944,117 871,104 460,511 275,008
Unearned premium........................... 179,530 190,550 188,524 201,050 152,094
Notes payable.............................. 181,928 212,133 242,546 121,600 80,750
Shareholders' equity....................... 763,453 530,930 458,439 440,430 365,779
Book value per share(3).................... 12.40 10.29 9.12 8.94 7.50
</Table>
- ---------------
(1) Certain amounts in the 2000, 1999, 1998 and 1997 selected consolidated
financial data have been reclassified to conform to the 2001 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
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) Book value per share is calculated by dividing the sum of shares outstanding
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 capital and other operating
income. Our core underwriting activities involve providing life, accident and
health; aviation; marine, energy and property; and other specialty lines of
insurance and reinsurance, 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 the issuance of equity securities and through our
retaining of 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 core 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.
Currently, our underwriting agencies underwrite 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 and professional
liability insurance and other specialty lines of business on behalf of our
insurance companies and unaffiliated insurance companies. Our underwriting
agency activities are fee based and non-risk bearing.
In conjunction with the expansion of underwriting activities by our
insurance companies and in an effort to increase the efficiency of certain of
our operations, we consolidated the operations of certain of our agency
operations with those of certain of our insurance companies in 2001 and 2002.
These consolidations will result
35
in a reduction in management fee income and the net earnings from our
underwriting agency segment, but such reduction should be more than offset over
time by increases in net earnings of our insurance company segment.
Our intermediaries are fee based, non-risk bearing and place reinsurance
for our insurance companies and underwriting agencies and for other
non-affiliated insurance companies and risk taking entities, as well as
insurance on behalf of medium and large corporate clients.
Other operating income has been generated through our insurance services
operations, which supported our own operations as well as provided services for
other clients. Additionally, other operating income may include the equity in
the earnings of a company in which we invest, dividends or gains or losses from
the disposition of these investments. In 2001, we sold the last of our service
operations, which will result in a decrease in other operating income in future
years.
From 1999 through 2001, in response to adverse market conditions, we
focused our acquisition activities on expanding our underwriting agency and
intermediary operations for three principal reasons:
- to provide a future source of premium revenue to our insurance companies
in existing and new specialty lines of business and greater control of
premium distribution channels;
- to insulate us from a decline in our revenue growth rate as insurance
premium rates became more competitive in our specialty lines of business
and we became more selective in our underwriting, resulting in reduced
earned premium;
- to increase the management fees and commission income components of our
total revenue, which we believed were a more predictable and stable
source of revenue than the potential underwriting gain from insurance
company operations during periods of overly competitive pricing.
Late in 1999, primarily due to a reduction in reinsurance capacity, rates
began to increase, particularly in our life, accident and health, and aviation
lines of business. These market conditions continued to improve during 2000 and
2001 and also in our marine, energy and property line of business. This
improvement accelerated after the September 11 terrorist attacks and we expect
this to continue in 2002. In response to these changing market conditions, we
plan to continue to expand our underwriting activities.
During December, 1999, we acquired all of the outstanding shares of The
Centris Group, Inc. in a transaction recorded using the purchase method of
accounting. During October, 2001, we acquired all of the outstanding shares of
ASU International, LLC and Marshall Rattner, Inc. and its operating subsidiary,
Professional Indemnity Agency, Inc., which were also transactions recorded for
using the purchase method of accounting. The results of operations and cash
flows of these three companies are included in our consolidated results
beginning on the effective date of each transaction.
During January, 2001, we acquired all of the outstanding shares of The
Schanen Consulting Group, LLC. This business combination has been recorded using
the pooling-of-interests method of accounting. Our consolidated financial
statements have been restated to include the accounts and operations of The
Schanen Consulting Group, LLC for all periods presented.
36
RESULTS OF OPERATIONS
The following table sets forth certain premium revenue information for the
three years ended December 31, 2001 (in thousands):
<Table>
<Caption>
2001 2000 1999
---------- --------- ---------
Direct............................................ $ 783,124 $ 676,730 $ 291,513
Reinsurance assumed............................... 226,951 290,727 276,818
---------- --------- ---------
Gross written premium........................... 1,010,075 967,457 568,331
Reinsurance ceded................................. (637,117) (683,669) (428,407)
---------- --------- ---------
Net written premium............................. 372,958 283,788 139,924
Change in unearned premium........................ (30,171) (16,141) 1,438
---------- --------- ---------
Net earned premium.............................. $ 342,787 $ 267,647 $ 141,362
========== ========= =========
</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, 2001:
<Table>
<Caption>
2001 2000 1999
----- ----- -----
Net earned premium.......................................... 67.8% 56.5% 40.9%
Management fees............................................. 12.2 20.3 26.2
Commission income........................................... 8.6 10.5 16.9
Net investment income....................................... 7.8 8.4 9.0
Net realized investment gain (loss)......................... 0.1 (1.1) (1.2)
Other operating income...................................... 3.5 5.4 8.2
----- ----- -----
Total revenue..................................... 100.0 100.0 100.0
Loss and loss adjustment expense, net....................... 52.9 41.9 31.7
Net operating expense....................................... 33.4 33.8 53.3
Interest expense............................................ 1.7 4.3 3.8
----- ----- -----
Earnings before income tax provision.............. 12.0 20.0 11.2
Income tax provision........................................ 6.0 7.9 3.5
Net earnings before accounting change............. 6.0% 12.1% 7.7%
===== ===== =====
</Table>
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. We anticipate that
total revenue will continue to increase in 2002 as earned premium continues to
grow and revenue from recent acquisitions is included in our consolidated
financial statements.
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.
We expect positive operating cash flow to continue in 2002, thereby increasing
invested assets and investment income, but the increase could again be
substantially offset by the effect of continued low interest rates. 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.
37
During 2001, we experienced three significant gross losses. The largest
loss was as a result of the terrorist attacks 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 attacks were
considered multiple events rather than a single event, and communications from
our clients and producers. We also have 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 have
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. We continue to monitor the reserve
and believe our estimates to be reasonable, but they may be subject to
adjustment as we receive additional information, which could take several years
to finalize. In addition, we have reviewed the estimated reinsurance
recoverables related to this loss and believe that they are collectible in the
normal course of business. Over 95% of the total amount of reinsurance
recoverables from this loss are due from 38 companies and Lloyds' syndicates,
each of which is rated "A-" or better by either A.M. Best Company, Inc. or
Moody's Investors Services, Inc. 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. The
Petrobras loss was paid during the third quarter of 2001 and all reinsurance
recoverables related to it have been collected. We expect the reinsurance
recoverables related to the Total loss to be collected in due course once the
original claim is settled.
During 2001, we recorded a charge totaling $37.3 million related to lines
of business that we are exiting, 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 the 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 being exited. 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 $789,000 reflecting the reversal of some restructuring charges
recorded during the previous year, whereas during 2001 we recorded $176,000 in
merger expense resulting from an acquisition. Currency conversion gains amounted
to $324,000 in 2001, compared to losses of $330,000 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
related to our exit from the primary workers' compensation line of business.
That charge was not deductible for income tax purposes.
38
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. This decrease primarily results from the after tax loss from the
September 11 terrorist attacks of $22.8 million, or $0.38 per diluted share, and
the after tax charge for lines of business being exited 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
Gross written premium increased to $1.0 billion for 2001 from $967.5
million in 2000 with strong growth in the life, accident and health line of
business and, to a lesser extent, in the marine, energy and property line of
business, as rates continue to rise, offset by a planned decrease from exited
lines. Gross written premium growth is not our focus in 2002, as we are able to
grow our revenue simply by retaining more of the business we currently write.
Net written premium for 2001 increased 31% to $373.0 million compared to the
previous year, as our insurance companies have increased retentions on many of
their lines of business as underwriting profitability improves. Net earned
premium increased 28% to $342.8 million for the same reason. The increase in net
written premium and net earned premium is expected to continue in 2002.
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
being exited. The net loss ratio in accordance with generally accepted
accounting principles was 78.0% (62.3% excluding the September 11 loss and the
charge related to lines of business being exited) for 2001 compared to 74.2% in
2000. The medical stop-loss line of business continues to have significantly
improved underwriting results. The gross loss ratio in accordance with generally
accepted accounting principles was 105.5% (77.6% excluding the September 11,
Petrobras and Total losses and the charge related to lines of business being
exited) 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 in accordance with generally accepted
accounting principles was 103.7% (87.1% excluding the September 11 loss and the
charge related to lines of business being exited) in 2001 compared to 95.2% for
2000.
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 rate 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 with our actuaries of loss reserves and the increase
or reduction of such reserves as losses are finally settled and claims exposures
are reduced. We continue to believe we have provided for all material net
incurred losses.
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 being exited.
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 September 11 of $22.8 million and expenses of $29.4 million.
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
39
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. We expect management fees (before eliminations) and net earnings of our
underwriting agency segment to grow in 2002 due to organic growth and recent
acquisitions.
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 who
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, somewhat offset by a lower effective tax
rate.
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. As of December 31, 2001, all operating entities included in
this segment had been sold or closed so revenue is expected to decrease
substantially in 2002.
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.
YEAR ENDED DECEMBER 31, 2000 VERSUS YEAR ENDED DECEMBER 31, 1999
Our total revenue increased 37% to $473.6 million in 2000 compared to 1999.
This revenue increase resulted from the higher retention of premium underwritten
by our insurance companies, particularly in the medical stop-loss line of
business, and increased investment income.
Our net investment income increased 29% to $39.8 million in 2000 compared
to 1999. This increase was primarily due to a higher level of invested assets
which resulted from the greater retentions of premium underwritten by our
insurance companies, the investment of cash received during the first quarter of
2000 from our commutation with a reinsurer and cash flow from operations.
In 2000, we engaged General Re New England Asset Management, a subsidiary
of Berkshire Hathaway, Inc. and a nationally prominent investment advisor,
particularly to insurance companies, and undertook an in-depth review and
restructuring of our investment portfolio. As a part of this restructuring, we
shortened our investment portfolio's duration but did not significantly change
the average credit rating. Our net realized investment losses from sales or
write downs of equity securities was $5.6 million in 2000, compared to losses of
$3.9 million in 1999. In 2000, we recognized a $5.1 million realized loss from
the write down of an equity investment to its estimated fair market value based
upon market quotations compared to a similar write down
40
of $4.3 million in 1999. Our net realized investment gains from the disposition
of fixed income securities were $203,000 in 2000, compared to losses of $164,000
in 1999.
Our compensation expense increased to $83.1 million during 2000 from $79.2
million in 1999. This increase reflects a normal progressional increase due to
business growth plus the increase due to The Centris Group, Inc. acquisition,
offset by the savings resulting from the 1999 fourth quarter restructuring and
the sale of non-core subsidiaries. Other than the restructuring expenses
discussed below, other operating expenses increased to $52.5 million from $47.7
million for similar reasons. Included in other operating expense are
restructuring expenses of $761,000 in 2000 and $5.5 million in 1999. Currency
conversion losses amounted to $330,000 in 2000, compared to gains of $442,000 in
1999.
Our interest expense was $20.3 million in 2000 compared to $13.0 million in
1999. This increase is a result of higher interest rates and increased debt
outstanding, principally as a result of funding The Centris Group, Inc.
acquisition.
Our income tax expense was $35.9 million in 2000 compared to $12.3 million
in 1999. Our effective tax rate was 39% in the 2000 period compared to 32% in
1999. Most of the increase in the effective tax rate was due to non-deductible
goodwill amortization relating to The Centris Group, Inc. acquisition, a shift
of fixed income investments to taxable instruments from tax exempt instruments
and increased underwriting agency income which is subject to state income taxes.
Our net earnings in 2000 increased 109% to $55.5 million or $1.07 per
diluted share from $26.6 million or $0.52 per diluted share in 1999. These
increases result principally from improved underwriting results, an increase in
investment income and the effects of the provision for reinsurance and a larger
restructuring expense recorded during 1999. In 2000, we incurred a $2.0 million
after-tax charge for a change in accounting principles to conform our agency and
intermediary revenue recognition principles to those required by the guidance in
Securities and Exchange Commission's Staff Accounting Bulletin Number 101
entitled "Revenue Recognition in Financial Statements". The change was not
material to earnings before cumulative effect of accounting change for 2000.
Our book value per share was $10.29 as of December 31, 2000, up from $9.12
as of December 31, 1999.
SEGMENTS
INSURANCE COMPANIES
Gross written premium generated by our insurance companies increased 70% to
$967.5 million in 2000 compared to 1999 due to new business, rate increases,
increased participation by our insurance companies in the business underwritten
by our underwriting agencies and the acquisition of The Centris Group, Inc. Net
written premium generated by our insurance companies in 2000 increased 103% to
$283.8 million compared to 1999, as our insurance companies have increased
retentions in many of their lines of business as underwriting results showed
improvement. Net earned premium increased 89% to $267.6 million during 2000 for
the same reasons.
Loss and loss adjustment expense incurred by our insurance companies
increased to $198.5 million in 2000 from $109.7 million in 1999. The increase in
net loss and loss adjustment expense is due to the higher level of net retained
premium, net of the effect of improved underwriting results. The net loss ratio
in accordance with generally accepted accounting principles decreased to 74.2%
in 2000 from 77.6% in 1999. In 2000, we also recorded a $4.4 million increase in
reserves for exited lines of business acquired with our 1999 acquisition of The
Centris Group, Inc. This increase represents 1.6% of the 2000 net loss ratio.
The gross loss ratio in accordance with generally accepted accounting principles
decreased to 79.4% in 2000 from 116.5% in 1999. The general improvement in our
loss ratios results from the effects of increased premium rates in certain lines
of business, reduced writings in other unprofitable lines of business and a
general improvement in market conditions, particularly in the domestic aviation
and medical stop-loss lines of business. The combined ratio in accordance with
generally accepted accounting principles of our insurance companies was 95.2%
for 2000 compared to 129.3% (98.6% excluding effects of the provision for
reinsurance) in 1999.
41
During 2000, we had net loss and loss adjustment expense redundancy of $9.6
million relating to prior year losses compared to a deficiency of $4.6 million
in 1999 and we had gross loss and loss adjustment expense redundancy of $1.9
million compared to a deficiency of $90.0 million in 1999. The 1999 gross
deficiency results from two principal conditions. The first is 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. Secondly, during 1999 in connection with the
insolvency of one of the our reinsurers and with the commutation, finalized
subsequent to year end, 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. The other
deficiencies and redundancies in the reserves result from our continued review
with our actuaries of loss reserves and the increase or reduction of such
reserves as losses are finally settled and claims exposures are reduced. We
continue to believe we have provided for all material net incurred losses.
Policy acquisition costs, which are net of commissions on ceded
reinsurance, increased to $23.7 million during 2000 from $8.2 million for 1999.
This increase in costs results from higher retained premium and the resulting
reduced ceding commissions.
Net earnings of our insurance companies increased to $24.2 million in 2000
from a loss of $10.7 million in 1999, primarily as a result of improved
underwriting results, the effect of the provision for reinsurance recorded in
1999 and the increase in investment income.
UNDERWRITING AGENCIES
Management fees generated by our underwriting agencies increased 6% to
$96.1 million in 2000 compared to 1999. This increase resulted primarily from
the increased premium volume in the medical stop-loss line of business, which
was due to rate increases and The Centris Group, Inc. acquisition. The increase
in management fees was disproportionate to the increase in premium as a result
of higher policy issuance fees and increased retentions by our insurance
companies which reduced management fees earned by our underwriting agencies.
These reductions are offset by an equal reduction in net policy acquisition
costs of our insurance companies. Net earnings of our underwriting agencies
increased 25% to $21.4 million in 2000 from $17.2 million in 1999 due to
increased revenue, a smaller restructuring charge in 2000 than in 1999 and
higher pretax margins primarily as a result of the successful integration of The
Centris Group, Inc. acquisition.
INTERMEDIARIES
Commission income decreased to $49.9 million in 2000 from $58.2 million in
1999. Net earnings of our intermediaries decreased to $11.2 million in 2000 from
$15.1 million in 1999. These decreases were due to a significant reduction in
the amount of ceded reinsurance placed on behalf of our insurance companies as a
result of their planned increase in retentions.
OTHER OPERATIONS
Other operating revenue decreased to $25.5 million during 2000 from $28.5
million for the same period in 1999. Net earnings of our other operations
decreased to $6.0 million in 2000 from $7.6 million in 1999. Revenue and
earnings can vary considerably from period to period depending on investment or
disposition activity.
CORPORATE
The net loss of the corporate segment was $4.7 million in 2000 compared to
a net loss of $2.3 million in 1999. This resulted from the increase of interest
expense not allocated to the operating segments during 2000 as well as costs of
the closing of some operations of a company acquired in late 1999.
42
RESTRUCTURING
As of December 31, 1999, we accrued a restructuring liability of $4.0
million related to our ongoing operations. As of December 31, 2000, all
restructuring costs had been paid or adjusted with the exception of a remaining
liability of $105,000. During 2000, we determined that one of the leased offices
scheduled to be closed would be retained. Therefore, we reversed $789,000
(included as a credit in other operating expenses in the consolidated financial
statements) of the restructuring expense recorded during the fourth quarter of
1999, of which $514,000 was the reversal of the accrual for future lease
payments and $275,000 was the reversal of the write-off of certain assets.
As of December 31, 1999, we had also accrued a restructuring liability
related to our acquisition of The Centris Group, Inc. Changes in the accrual
between December 31, 1999 and December 31, 2000 are shown in the table below (in
thousands):
<Table>
<Caption>
ACCRUED AT PAID IN 2000 ACCRUED AT
12/31/99 2000 ADJUSTMENTS 12/31/00
----------- ------- ----------- -----------
Contractual executive severance
accruals................................ $5,866 $6,027 $ 166 $ 5
Other severance accruals.................. 397 541 258 114
Lease obligation accruals................. 848 1,004 1,196 1,040
------ ------ ------ ------
TOTAL........................... $7,111 $7,572 $1,620 $1,159
====== ====== ====== ======
</Table>
The adjustments in 2000 were recorded as management decided to take
additional steps to integrate parts of The Centris Group, Inc. operations. As of
December 31, 2001, all amounts have been paid except for a $0.3 million lease
obligation.
During the fourth quarter of 2000, we also recorded a restructuring charge
and associated expenses of $1.5 million. A total of 26 employees were terminated
as a result of our restructuring of certain underwriting agency operations and
their integration into our insurance company operations. The charges affected
both segments and consisted of $557,000 accrued severance pay to be paid at
various times throughout 2001 and $992,000 for the write down or write off of
various impaired assets, primarily redundant computer software.
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 $180.3 million, or 25% during 2001, and
totaled $905.4 million as of December 31, 2001, of which $355.8 million was cash
and short-term investments. The increase in investments resulted primarily from
operating cash flows and the $60.0 million in capital contributions we made to
our insurance companies in 2002. Total assets increased to $3.2 billion as of
December 31, 2001.
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 5.6% in
2001, compared to 7.1% in 2000. The weighted average duration of the portfolio
was four years as of December 31, 2001. Over 98% 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
43
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.
On August 23, 2001, we issued an aggregate $172.5 million principal amount
of 2% Convertible Notes due 2021 in a public offering. Each $1,000 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%
(currently $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, 2002, 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. We paid $4.4
million in underwriting discounts and expenses in connection with the offering,
which are being amortized from the issue date until September 1, 2002. We used
the proceeds from this offering to repay our remaining indebtedness under the
bank facility, assist in financing the recent acquisitions, make a $60.0 million
capital contribution to our principal 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. Outstanding advances under the
facility bear interest at agreed upon rates, which ranged between 2.6% and 3.1%
as of December 31, 2001. The facility is collateralized in part by the pledge of
the stock of two of our principal insurance companies, Houston Casualty Company
and Avemco Insurance Company, and by the stock of and guarantees entered into by
our principal underwriting agencies and intermediaries. The facility agreement
contains certain restrictive covenants, including minimum net worth requirements
for us and certain of our subsidiaries, restrictions on certain extraordinary
corporate actions, notice requirements for certain material occurrences and
required maintenance of specified financial ratios. We believe that the
restrictive covenants and our obligations that are contained in the facility
agreement are typical for financing arrangements comparable to our facility. As
of December 31, 2001, there was no outstanding balance on this facility.
As of December 31, 2001, certain of our subsidiaries maintained revolving
lines of credit with a bank in the combined maximum amount of $20.0 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 $25.0 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 (4.75% at December 31, 2001) for draws on
the letters of credit and prime less 1% on short-term cash advances. As of
December 31, 2001, letters of credit totaling $7.1 million had been issued to
insurance companies by the bank on behalf of our subsidiaries, with total
securities of $8.9 million collateralizing the lines.
44
The following is a summary of our contractual cash payment obligations as
of December 31, 2001 (in thousands):
<Table>
<Caption>
PAYMENTS BY DUE DATE
--------------------------------------------
TOTAL 2002 2003-2004 2005-2006 THEREAFTER
-------- ------- --------- --------- ----------
Convertible notes................. $172,500 $ -- $ -- $ -- $172,500
Bank facility..................... -- -- -- -- --
Other notes payable............... 9,428 5,193 2,516 404 1,315
Operating leases.................. 26,639 6,663 11,741 7,350 885
-------- ------- ------- ------ --------
$208,567 $11,856 $14,257 $7,754 $174,700
======== ======= ======= ====== ========
</Table>
See preceding paragraphs and Notes (5) and (9) in Notes to the Consolidated
Financial Statements for additional information of these obligations. The
convertible notes have various put dates beginning September 1, 2002.
The following is a summary of our various commitments and their expirations
as of December 31, 2001 (in thousands):
<Table>
<Caption>
COMMITMENT EXPIRATION BY PERIOD
---------------------------------
TOTAL 2002 2003-2004 2005-2006
------- ------- ---------- ----------
Outgoing letters of credit..................... $ 7,137 $ -- $7,137 $ --
Mortgage guarantee............................. 11,356 -- -- 11,356
Investment commitments......................... 5,600 5,600 -- --
------- ------ ------ -------
Total commitments.................... $24,093 $5,600 $7,137 $11,356
======= ====== ====== =======
</Table>
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 its statutory policyholders' surplus as of the prior year end. Dividends
may only be paid out of statutory unassigned surplus funds. During 2002, Houston
Casualty Company's ordinary dividend capacity will be approximately $28.5
million and U.S. Specialty Insurance Company's ordinary dividend capacity will
be zero.
Under the laws of the State of Maryland, Avemco Insurance Company may only
pay dividends out of statutory earned surplus. The maximum amount of dividends
that Avemco Insurance Company may pay without prior regulatory approval in any
twelve-month period is 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 2002, Avemco
Insurance Company will have an ordinary dividend capacity of approximately $7.2
million.
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. During 2002, HCC Life Insurance Company's ordinary dividend capacity
will be approximately $15.1 million.
As of December 31, 2001, we had a net deferred tax asset of $16.5 million
compared to $6.7 million as of December 31, 2000. Due to our history of
consistent earnings, expectations for future earnings and taxable income in
carry back years, we expect to be able to fully realize the benefit of our net
deferred tax asset.
45
We have a reserve of $5.2 million as of December 31, 2001 for potential
collectibility issues related to reinsurance recoverables and associated
expenses. The adverse economic environment in the worldwide insurance industry
and the terrorist attacks on September 11 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, such as the
marketplace has experienced for the last several years. While we believe that
the reserve is adequate based on currently available information, conditions may
change or additional information might be obtained that would affect our
estimate of the adequacy of the level of the reserve and which may result in a
future change in the reserve. We continually review our financial exposure to
the reinsurance market and continue to take actions to mitigate our position.
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 to 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, 2001, our insurance companies had
initiated litigation or arbitration proceedings against five reinsurers and were
involved in one arbitration proceeding initiated by a reinsurer. These
proceedings primarily concern the collection of amounts owing under reinsurance
agreements. As of such date, our insurance companies had an aggregate amount of
$15.3 million which had not been paid to us under the disputed agreements and we
estimate that there could be an additional $31.2 million of incurred losses and
loss expenses under the subject agreements. In addition, because our insurance
companies, principally Houston Casualty Company, participated in facilities
which were managed by one of our underwriting agencies, they are indirectly
involved in any reinsurance disputes which affect the applicable facilities. As
of December 31, 2001, Houston Casualty Company's allocated portion of aggregate
amounts which had not been reimbursed to the applicable facilities under the
disputed agreements was $4.8 million and we estimate that there could be an
additional $4.0 million of incurred losses and loss expenses under the subject
agreements allocated to Houston Casualty Company. Houston Casualty Company has
no net exposure on disputed amounts due to the non-affiliated companies who also
participated in the applicable facilities.
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. In the past, our
property and casualty insurance companies have maintained premium to surplus
ratios generally lower than such guidelines and below industry norms. For the
year ended December 31, 2001, our statutory gross written premium to
policyholders' surplus was 252.8% compared to 298.0% for the year ended December
31, 2000. For the year ended December 31, 2001, our statutory net written
premium to policyholders' surplus was 92.5% compared to 87.0% for the year ended
December 31, 2000. The gross written premium ratio increased during 2000 with
the acquisition of The Centris Group, Inc.'s book of medical stop-loss business
and the increasing use of our insurance companies as the issuing company for
business written by our underwriting agencies. This ratio is expected to
decrease slowly from its current level as statutory policyholders' surplus
increases due to the retention of earnings, capital contributions and other
increases in policyholders' surplus. As of December 31, 2001, 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.
46
Subsequent to the terrorist attacks on September 11, 2001, where possible,
we canceled all terrorist coverage, to the extent we could, under the terms of
existing in-force policies, primarily in the property and energy lines of
business. All new and renewal policies are written with an appropriate terrorist
exclusion except for lines of business, such as aviation, where reinsurance for
acts of terrorism is available at an economic cost or where we feel comfortable
with the net exposure.
At January 1, 2002, and February 1, 2002, respectively, our onshore energy
and property reinsurance protections were renewed without coverage for acts of
terrorism. Therefore, to the extent that certain existing, in-force policies
contain such coverage, then we would have a net exposure to any applicable
losses. The actual amount of this exposure is not determinable but could
represent a catastrophic loss, a risk for which we would usually purchase
reinsurance protection. We do not believe that any loss would severely impact
our capital. As each month goes by, existing in-force policies will expire and
the overall exposure continues to reduce substantially.
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 significant 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 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. Also, the market value of our investments vary
depending on economic and market conditions and 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 rate between the major
European currencies 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, 2001, our gain from currency conversion
was $0.3 million compared to a loss of $0.3 million in 2000 and a gain of $0.4
million in 1999.
On a limited basis, we enter into foreign currency forward contracts as a
hedge against foreign currency fluctuations. RML has revenue streams in U.S.
Dollars and Canadian Dollars but incurs expenses in British Pound Sterling
("GBP"). To mitigate the foreign exchange risk, we have entered into foreign
currency forward contracts expiring at staggered times through December, 2002.
As of December 31, 2001, we had forward contracts to sell US $6.0 million for
GBP at an average rate of GBP 1.00 equals US $1.43. The foreign currency forward
contracts are used to convert currency at a known rate in an amount which either
approximates or is less than average monthly expenses. Thus, the effect of these
transactions is to limit the
47
foreign currency exchange risk of the recurring monthly expenses. We utilize
these foreign currency forward contracts strictly as a hedge against existing
exposure to foreign currency fluctuations rather than as a form of speculative
or trading investment. The fair value of foreign currency forward contracts
December 31, 2001 was immaterial.
SIGNIFICANT 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.
Earned Premium and Policy Acquisition Costs
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
Loss and loss adjustment expense payable by our insurance companies is
based on estimates of payments to be made for reported and incurred but not
reported losses and anticipated receipts from salvage and subrogation receipts.
All reserves are recorded on an undiscounted basis, except for an immaterial
amount of reserves acquired in a transaction recorded using the purchase method
of accounting. Estimates for reported losses are based on all available
information, including reports received from ceding companies on 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 change.
Reinsurance Recoverables
We constantly review the collectibility of the reinsurance recoverables of
our insurance companies and 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.
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 Securities and Exchange
Commission Staff Accounting Bulletin Number 101 entitled "Revenue Recognition in
Financial Statements."
48
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. 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.
Valuation of Goodwill and Intangible Assets
We assess the impairment of goodwill and intangible assets whenever events
or changes in circumstances indicate that the carrying value may not be
recoverable. Factors we consider important which could trigger an impairment
review include the following:
- significant underperformance relative to expected historical or projected
future operating results;
- significant changes in the strategy for our overall business; and
- significant negative industry or economic trends.
When we determine that the carrying value of goodwill and other intangible
assets may not be recoverable on an undiscounted cash flow basis, we will reduce
the carrying value of the asset to estimated fair value, which is most often
based on projected discounted cash flows using a discount rate we determine to
be commensurate with the risk. Utilization of different assumptions to project
cash flows and changes in interest rates could yield different estimates of
discounted cash flow and fair value.
EFFECTS OF RECENT ACCOUNTING PRONOUNCEMENTS
We adopted Statement of Financial Accounting Standards ("SFAS") No. 133
entitled "Accounting for Derivative Instruments and Hedging Activities"
effective January 1, 2001. The cumulative effect adjustment due to this change
in accounting is not material to our financial position, results of operations
or cash flows. Since we utilize derivatives or hedging strategies on a limited
basis, we do not expect the adoption of SFAS No. 133 to be material on an
ongoing basis. SFAS No. 141 entitled "Business Combinations" was issued in June,
2001 and became effective July 1, 2001. SFAS No. 141 requires that all business
combinations be accounted for using the purchase method of accounting, which
requires that acquisitions be recorded at fair value as of the date of
acquisition. The pooling-of-interests method of accounting allowed under prior
standards, which reflected business combinations using historical financial
information, is now prohibited.
SFAS No. 142 entitled "Goodwill and Other Intangible Assets" was also
issued in June, 2001, in concert with SFAS No. 141. SFAS No. 142 becomes
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, which could be either
our reportable segments or one level lower than our reportable segments. SFAS
No. 142 requires us to perform the first goodwill impairment test on all
reporting units within six months of adoption. The first step is to compare the
fair value with the book value of a reporting unit. If the fair value of a
reporting unit is less than its book value, the second step will be to calculate
the impairment loss, if any. We will recognize any impairment loss from the
initial adoption of SFAS No. 142 as a change in accounting principle. 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 is not expected to have a material
effect on our financial position or cash flows, but it will impact our results
of operations. Based upon our preliminary review of the impact of SFAS No. 142
to determine the effect, if any, of the initial goodwill impairment testing, we
do not believe that we will have to record an impairment charge. However, we are
still in the process of completing the valuations, so our tentative conclusion
could change.
49
SFAS No. 142 also requires the discontinuance of the amortization of
goodwill effective January 1, 2002 and that goodwill recognized for acquisition
which were consummated after July 1, 2001 not be amortized. Amortization of
goodwill charged to operations, net of tax effect, in 2001, 2000 and 1999 was
$11.0 million, $11.5 million and $5.5 million, respectively. We did not amortize
the goodwill related to our acquisitions consummated in October, 2001.
SFAS No. 144 entitled "Accounting for the Impairment or Disposal of
Long-Lived Assets" was issued in August, 2001 and will become effective for us
on January 1, 2002. SFAS No. 144 resolves implementation issues being
experienced under previously existing accounting literature but does not change
previous requirements to (a) recognize an impairment loss if the carrying amount
for an asset is not recoverable from its undiscounted cash flows, and (b)
measure the impairment loss as the difference between carrying amount and fair
value of the asset. SFAS No. 144 also retains the basic provisions of
discontinued operations found in previous accounting literature but broadens the
separate income statement presentation of discontinued operations from a
reporting segment to a component of the entity which has clearly distinguishable
operations and cash flows. We do not expect the adoption of SFAS No. 144 to have
a material effect on our financial position, results of operations or cash
flows.
EURO CONVERSION
On January 1, 1999, certain member countries of the European Union
irrevocably fixed the conversion rates between their national currencies and a
common currency, the Euro, which became the common legal currency of those
countries on that date. The participating countries' former national currencies
continued to serve as legal tender and as denominations of the Euro until
January 1, 2002. The conversion to the Euro is scheduled to be completed on July
1, 2002, when the national currencies will cease to exist. The introduction of
the Euro has not had a material effect on our business, financial condition or
results of operations.
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 from 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, 2001 was $525.4 million and was
$433.8 million as of December 31, 2000. If market interest rates were to change
1%, (e.g. from 5% to 6%) the fair value of our fixed income securities
50
would change approximately $21.0 million as of December 31, 2001. This compares
to change in value of $17.9 million as of December 31, 2000 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, 2000, we had $207.5 million in debt outstanding under
the bank loan. At that debt level, the 1% change in market interest rates (e.g.
from 8.0% to 7.0%) would have changed interest expense by $2.1 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
as of December 31, 2001 was $16.6 million, compared to $6.3 million as of
December 31, 2000. The balance at December 31, 2001 includes mutual fund
securities with a value of $12.8 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 equity portfolio
would have changed $1.7 million as of December 31, 2001 and $0.6 million as of
December 31, 2000.
Foreign Exchange Risk
The table below shows the net amounts of significant foreign currency
balances at December 31, 2001 and 2000 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>
2001 2000
--------------------------- ---------------------------
HYPOTHETICAL HYPOTHETICAL
U.S. DOLLAR 10% CHANGE IN U.S. DOLLAR 10% CHANGE IN
EQUIVALENT FAIR VALUE EQUIVALENT FAIR VALUE
----------- ------------- ----------- -------------
British Pound Sterling............... $2,366 $237 $7,486 $749
Canadian Dollar...................... 1,651 165 65 7
Euro and 12 national currencies...... 313 31 1,345 135
Cape Verde Escudo.................... 762 76 1,685 169
</Table>
See Foreign Exchange Rate Fluctuations section contained in Item 7,
Management's Discussion 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, 2001, and which is
incorporated herein by reference.
51
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, 2001, and which is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
For 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, 2001, 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, 2001, and which is incorporated
herein by reference.
PART IV
ITEM 14. 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 are filed as part of this Report.
(c) Reports on Form 8-K
On October 10, 2001, we reported on Form 8-K two items:
- Our announcement as to the status of our two planned acquisitions.
- Our announcement confirming our estimate of our losses from to the
September 11 terrorist attacks and the anticipated impact on our third
quarter results.
On November 9, 2001, we reported on Form 8-K our announcement of financial
results for the third quarter of 2001.
On November 13, 2001, we reported on Form 8-K the text materials used to a
presentation at an investors' conference.
52
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)
By: /s/ STEPHEN L. WAY
------------------------------------
(Stephen L. Way)
Chairman of the Board and
Chief Executive Officer
Dated: March 29, 2002
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 Directors March 29, 2002
------------------------------------------------ and Chief Executive Officer
(Stephen L. Way) (Principal Executive Officer)
/s/ FRANK J. BRAMANTI* Director March 29, 2002
------------------------------------------------
(Frank J. Bramanti)
/s/ MARVIN P. BUSH* Director March 29, 2002
------------------------------------------------
(Marvin P. Bush)
/s/ PATRICK B. COLLINS* Director March 29, 2002
------------------------------------------------
(Patrick B. Collins)
/s/ JAMES R. CRANE* Director March 29, 2002
------------------------------------------------
(James R. Crane)
/s/ J. ROBERT DICKERSON* Director March 29, 2002
------------------------------------------------
(J. Robert Dickerson)
/s/ EDWARD H. ELLIS, JR. Director, Senior Vice President March 29, 2002
------------------------------------------------ and Chief Financial Officer (Chief
(Edward H. Ellis, Jr.) Accounting Officer)
/s/ JAMES C. FLAGG, PH.D.* Director March 29, 2002
------------------------------------------------
(James C. Flagg, Ph.D.)
/s/ EDWIN H. FRANK, III* Director March 29, 2002
------------------------------------------------
(Edwin H. Frank, III)
</Table>
53
<Table>
<Caption>
NAME TITLE DATE
---- ----- ----
/s/ ALLAN W. FULKERSON* Director March 29, 2002
------------------------------------------------
(Allan W. Fulkerson)
/s/ WALTER J. LACK* Director March 29, 2002
------------------------------------------------
(Walter J. Lack)
/s/ STEPHEN J. LOCKWOOD* Director and Vice Chairman March 29, 2002
------------------------------------------------
(Stephen J. Lockwood)
/s/ JOHN N. MOLBECK, JR. Director, President and Chief March 29, 2002
------------------------------------------------ Operating Officer
(John N. Molbeck, Jr.)
*By: /s/ JOHN N. MOLBECK, JR. March 29, 2002
-----------------------------------------
John N. Molbeck, Jr.,
Attorney-in-fact
</Table>
54
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.
55
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.
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.
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.
(G)10.7 -- HCC Insurance Holdings, Inc. 1994 Nonemployee Director Stock
Option Plan.
(I)10.8 -- HCC Insurance Holdings, Inc. 1992 Incentive Stock Option
Plan, as amended and restated.
(I)10.9 -- HCC Insurance Holdings, Inc. 1995 Flexible Incentive Plan,
as amended and restated.
(I)10.10 -- HCC Insurance Holdings, Inc. 1997 Flexible Incentive Plan,
as amended and restated.
(I)10.11 -- HCC Insurance Holdings, Inc. 1996 Nonemployee Director Stock
Option Plan, as amended and restated.
(J)10.12 -- HCC Insurance Holdings, Inc. 2001 Flexible Incentive Plan.
10.13 -- Form of Incentive Stock Option Agreement under the HCC
Insurance Holdings, Inc. 2001 Flexible Incentive Plan.
(C)10.14 -- Employment Agreement effective as of January 1, 1999,
between HCC Insurance Holdings, Inc. and Stephen L. Way.
(H)10.15 -- Employment Agreement effective as of January 5, 2000,
between HCC Insurance Holdings, Inc. and John N. Molbeck,
Jr.
(E)10.16 -- Employment Agreement effective as of January 5, 2000,
between HCC Insurance Holdings, Inc. and Benjamin D. Wilcox.
(E)10.17 -- Employment Agreement effective as of January 5, 2000,
between HCC Insurance Holdings, Inc. and Frank J. Bramanti.
10.18 -- Employment Agreement effective as of January 1, 2002,
between HCC Insurance Holdings, Inc. and Edward H. Ellis,
Jr.
</Table>
56
<Table>
<Caption>
EXHIBIT
NUMBER
- -------
10.19 -- Employment Agreement effective as of October 1, 2000 between
HCC Insurance Holdings, Inc. and Christopher L. Martin as
amended effective as of January 1, 2002.
12 -- Statement Regarding Computation of Ratios
21 -- Subsidiaries of HCC Insurance Holdings, Inc.
23 -- Consent of Independent Accountants -PricewaterhouseCoopers
LLP dated March 29, 2002.
24 -- Powers of Attorney
</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
Registration Statement on Form S-8 (Registration No. 33-94472) filed July
11, 1995.
(H) Incorporated by reference to Exhibits to HCC Insurance Holdings, Inc.'s Form
10-Q for the fiscal quarter ended March 31, 2000.
(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 24, 2001 Annual Meeting of
Shareholders filed April 26, 2001.
57
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, 2001 and 2000, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 2001, 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, 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".
/s/ PricewaterhouseCoopers LLP
Houston, Texas
March 19, 2002
F-1
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<Table>
<Caption>
DECEMBER 31,
-----------------------
2001 2000
---------- ----------
ASSETS
Investments:
Fixed income securities, at market (cost: 2001 $513,674;
2000 $422,821)......................................... $ 525,428 $ 433,844
Marketable equity securities, at market (cost: 2001
$16,431; 2000 $8,896).................................. 16,569 6,282
Short-term investments, at cost, which approximates
market................................................. 338,904 263,805
Other investments, at estimated fair value (cost: 2001
$8,007; 2000 $7,182)................................... 7,565 7,182
---------- ----------
Total investments.................................... 888,466 711,113
Cash........................................................ 16,891 13,991
Restricted cash and cash investments........................ 138,545 101,738
Premium, claims and other receivables....................... 665,965 609,716
Reinsurance recoverables.................................... 899,128 789,412
Ceded unearned premium...................................... 71,140 114,469
Ceded life and annuity benefits............................. 83,013 86,760
Deferred policy acquisition costs........................... 32,071 39,108
Property and equipment, net................................. 52,486 39,438
Goodwill and intangible assets.............................. 328,815 266,015
Other assets................................................ 42,600 18,995
---------- ----------
Total assets......................................... $3,219,120 $2,790,755
========== ==========
LIABILITIES
Loss and loss adjustment expense payable.................... $1,130,748 $ 944,117
Life and annuity policy benefits............................ 83,013 86,760
Reinsurance balances payable................................ 88,637 130,746
Unearned premium............................................ 179,530 190,550
Deferred ceding commissions................................. 16,681 30,013
Premium and claims payable.................................. 717,159 617,847
Notes payable............................................... 181,928 212,133
Accounts payable and accrued liabilities.................... 57,971 47,659
---------- ----------
Total liabilities.................................... 2,455,667 2,259,825
Shareholders' Equity
Common stock, $1.00 par value; 250.0 million shares
authorized; (shares issued and outstanding: 2001
61,438; 2000 51,342)................................... 61,438 51,342
Additional paid-in capital................................ 402,089 196,999
Retained earnings......................................... 293,426 277,876
Accumulated other comprehensive income.................... 6,500 4,713
---------- ----------
Total shareholders' equity........................... 763,453 530,930
---------- ----------
Total liabilities and shareholders' equity........... $3,219,120 $2,790,755
========== ==========
</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,
---------------------------------
2001 2000 1999
--------- --------- ---------
REVENUE
Net earned premium.......................................... $342,787 $267,647 $141,362
Management fees............................................. 61,795 96,058 90,713
Commission income........................................... 43,412 49,886 58,233
Net investment income....................................... 39,638 39,836 30,946
Net realized investment gain (loss)......................... 393 (5,321) (4,164)
Other operating income...................................... 17,436 25,497 28,475
-------- -------- --------
Total revenue.......................................... 505,461 473,603 345,565
EXPENSE
Loss and loss adjustment expense, net....................... 267,390 198,470 109,650
Operating expense:
Policy acquisition costs, net............................. 27,923 23,743 8,177
Compensation expense...................................... 69,762 83,086 79,196
Provision for reinsurance................................. -- -- 43,462
Other operating expense................................... 71,119 53,274 53,273
-------- -------- --------
Total operating expense................................ 168,804 160,103 184,108
Interest expense............................................ 8,884 20,347 12,964
-------- -------- --------
Total expense.......................................... 445,078 378,920 306,722
-------- -------- --------
Earnings before income tax provision................... 60,383 94,683 38,843
Income tax provision........................................ 30,186 37,202 12,271
-------- -------- --------
Earnings before cumulative effect of accounting
change............................................... 30,197 57,481 26,572
Cumulative effect of accounting change, net of deferred tax
effect of $1,335.......................................... -- (2,013) --
-------- -------- --------
NET EARNINGS........................................... $ 30,197 $ 55,468 $ 26,572
======== ======== ========
BASIC EARNINGS PER SHARE DATA:
Earnings before accounting change...................... $ 0.52 $ 1.13 $ 0.53
Cumulative effect of accounting change................. -- (0.04) --
-------- -------- --------
Net earnings........................................... $ 0.52 $ 1.09 $ 0.53
======== ======== ========
Weighted average shares outstanding.................... 58,321 50,742 50,058
======== ======== ========
DILUTED EARNINGS PER SHARE DATA:
Earnings before accounting change...................... $ 0.51 $ 1.11 $ 0.52
Cumulative effect of accounting change................. -- (0.04) --
-------- -------- --------
Net earnings........................................... $ 0.51 $ 1.07 $ 0.52
======== ======== ========
Weighted average shares outstanding.................... 59,619 51,619 50,646
======== ======== ========
</Table>
See notes to consolidated financial statements.
F-3
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(IN THOUSANDS)
<Table>
<Caption>
FOR THE YEARS ENDED DECEMBER 31,
---------------------------------
2001 2000 1999
--------- --------- ---------
Net earnings................................................ $30,197 $55,468 $26,572
Other comprehensive income (loss), net of tax:
Foreign currency translation adjustment................... (279) (172) 167
Gain in fair value of foreign currency forward contracts
recorded as a cash flow hedge, net of income tax charge
of $13................................................. 24 -- --
Investment gains (losses):
Investment gains (losses) during the year, net of
income tax charge (benefit) of $1,137 in 2001, $2,386
in 2000, and $(8,042) in 1999........................ 2,297 4,118 (15,271)
Less reclassification adjustment for (gains) losses
included in net earnings, net of income tax (charge)
benefit of $(138) in 2001, $1,862 in 2000, and $1,457
in 1999.............................................. (255) 3,459 2,707
------- ------- -------
Other comprehensive income (loss)......................... 1,787 7,405 (12,397)
------- ------- -------
COMPREHENSIVE INCOME................................... $31,984 $62,873 $14,175
======= ======= =======
</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, 2001, 2000 AND 1999
(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, 1998.................. $49,249 $161,106 $220,370 $ 9,705 $440,430
Net earnings..................................... -- -- 26,572 -- 26,572
Other comprehensive income (loss)................ -- -- -- (12,397) (12,397)
506 shares of common stock issued for exercise of
options, including tax benefit of $1,156....... 506 4,277 -- -- 4,783
101 shares of common stock issued for purchased
companies...................................... 101 1,899 -- -- 2,000
414 shares of common stock contractually issuable
in the future.................................. -- 8,271 -- -- 8,271
Dividends to shareholders of pooled company prior
to acquisition................................. -- -- (1,005) -- (1,005)
Cash dividends declared, $0.20 per share......... -- -- (9,733) -- (9,733)
Contractual adjustments to previous
acquisitions................................... (20) (190) (272) -- (482)
------- -------- -------- -------- --------
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
======= ======== ======== ======== ========
</Table>
See Notes to Consolidated Financial Statements.
F-5
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<Table>
<Caption>
FOR THE YEARS ENDED DECEMBER 31,
---------------------------------
2001 2000 1999
--------- --------- ---------
Cash flows from operating activities:
Net earnings............................................ $ 30,197 $ 55,468 $ 26,572
Adjustments to reconcile net earnings to net cash
provided by operating activities:
Change in premium, claims and other receivables...... (33,976) 30,501 (92,206)
Change in reinsurance recoverables................... (191,552) (52,007) (284,504)
Change in ceded unearned premium..................... 28,254 19,188 31,408
Change in loss and loss adjustment expense payable... 262,056 72,311 264,360
Change in reinsurance balances payable............... (29,837) 17,052 (15,098)
Change in unearned premium........................... (1,676) 2,689 (31,138)
Change in premium and claims payable, net of
restricted cash.................................... 22,530 (20,727) 102,114
Gains on sales of other operating investments........ (8,171) (5,739) (5,523)
Provision for reinsurance............................ -- -- 43,462
Depreciation, amortization and impairments........... 34,926 19,908 13,420
Other, net........................................... (7,011) (820) (9,693)
--------- --------- ---------
Cash provided by operating activities.............. 105,740 137,824 43,174
Cash flows from investing activities:
Sales of fixed income securities........................ 140,763 137,175 131,485
Maturity or call of fixed income securities............. 45,754 34,341 17,050
Sales of equity securities.............................. 5,408 7,969 2,886
Dispositions of other operating investments............. 19,965 27,803 15,905
Change in short-term investments........................ (43,986) (69,400) (14,935)
Cash paid for companies acquired, net of cash
received............................................. (95,952) (8,909) (186,923)
Cost of investments acquired............................ (292,926) (244,586) (70,736)
Purchase of property and equipment and other............ (12,283) (9,535) (9,114)
--------- --------- ---------
Cash used by investing activities.................. (233,257) (125,142) (114,382)
Cash flows from financing activities:
Proceeds from notes payable, net of costs............... 174,058 26,700 547,000
Sale of common stock, net of costs...................... 192,831 17,235 3,627
Payments on notes payable............................... (222,116) (57,042) (458,600)
Dividends paid.......................................... (14,356) (12,409) (10,226)
--------- --------- ---------
Cash provided (used) by financing activities....... 130,417 (25,516) 81,801
--------- --------- ---------
Net change in cash................................. 2,900 (12,834) 10,593
Cash as of beginning of year....................... 13,991 26,825 16,232
--------- --------- ---------
Cash as of end of year............................. $ 16,891 $ 13,991 $ 26,825
========= ========= =========
</Table>
See Notes to Consolidated Financial Statements.
F-6
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS)
(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 life, accident and health; general aviation; marine,
energy and property; 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; and Avemco Insurance Company in Frederick, Maryland.
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 areas. 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; 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 Intermediaries, Inc. 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. Our consolidated financial statements have been
restated for all periods presented to include the accounts and operations of a
group of companies acquired on January 19, 2001 in a transaction accounted for
using the pooling-of-interests method of accounting. (See Note 2.)
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.
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
F-7
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
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. The total amount
of securities held by us as of December 31, 2001 that would be subject to these
tests and potential write downs is immaterial.
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. 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. 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.
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.
Earned Premium, Deferred 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.
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
F-8
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
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. The effect of the change was not material to
earnings before cumulative effect of accounting change for the years ended
December 31, 2001, 2000 or 1999.
Other Operating Revenue
Historically, we have had two primary sources of other operating revenue,
which are 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 are
recorded when the service is performed. The second source is income from and
gains or losses from the disposition of investments made in this segment. The
income is recognized as earned and the gains or losses from the sale of
investments are recognized upon consummation of a sale transaction.
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, 2001 and 2000 was $2.8 million and $3.3 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 and incurred but not
reported losses and anticipated receipts from salvage and subrogation receipts.
Reserves are recorded on an undiscounted basis, except for an immaterial amount
of reserves acquired in a transaction recorded using the purchase method of
accounting. Estimates for reported losses are based on all available
information, including reports received from ceding companies on 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 is being amortized using the straight-line method over periods from
twenty to forty years. Goodwill resulting from acquisitions completed on or
after July 1, 2001 is not being amortized in accordance with new accounting
pronouncements. Other identified intangible assets are amortized over their
respective useful lives. Accumulated amortization of goodwill and intangible
assets as of December 31, 2001 and 2000, was $37.9 million and $24.9 million,
respectively.
F-9
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
Our current accounting policy regarding the assessment of the
recoverability of the carrying value of long-lived assets, including goodwill
and other intangibles and property and equipment, is to review the carrying
value of the assets if the facts and circumstances suggest that 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. Amortization of
goodwill and intangible assets charged to income for the years ended December
31, 2001, 2000 and 1999 was $13.0 million, $13.0 million and $6.7 million,
respectively. During 2001, we also recorded a charge of $15.0 million for
impairment of goodwill related to an operation being exited.
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, 2001 and 2000 we included $189.2 million and $158.3
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. 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 most 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
other European currencies. For the years ended December 31, 2001, 2000 and 1999,
the gain (loss) from currency conversion was $0.3 million, $(0.3) million and
$0.4 million, respectively.
A foreign branch of one subsidiary has a functional currency of Canadian
Dollars. The cumulative translation adjustment, representing the effect of
translating this branch's assets and liabilities into U.S. Dollars, is included
in the foreign currency translation adjustment within accumulated other
comprehensive income.
To the extent the foreign exchange forward contracts qualify for hedge
accounting treatment, the gain (immaterial as of December 31, 2001), 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 hedge accounting
F-10
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
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 our
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 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.
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, 2001, 2000 and
1999, we incurred a net expense for guarantee fund and other assessments of $4.5
million, $1.0 million and $0.3 million, respectively. As of December 31, 2001
and 2000, accrued guarantee fund and other assessments were $2.2 million and
$0.2 million, respectively, and recognized future premium tax offsets were $0.8
million and $0.0 million, respectively.
Effects of Recent Accounting Pronouncements
We adopted Statement of Financial Accounting Standards ("SFAS") No. 133
entitled "Accounting for Derivative Instruments and Hedging Activities"
effective January 1, 2001. The cumulative effect adjustment due to this change
in accounting is not material to our financial position, results of operations
or cash flows. Since we utilize HCC Insurance Holdings, Inc. and Subsidiaries
derivatives or hedging strategies on a limited basis, we do not expect the
adoption of SFAS No. 133 to be material on an ongoing basis.
SFAS No. 141 entitled "Business Combinations" was issued in June, 2001 and
became effective July 1, 2001. SFAS No. 141 requires that all business
combinations be accounted for using the purchase method of accounting, which
requires that acquisitions be recorded at fair value as of the date of
acquisition. The pooling-of-interests method of accounting allowed under prior
standards, which reflected business combinations using historical financial
information, is now prohibited.
SFAS No. 142 entitled "Goodwill and Other Intangible Assets" was also
issued in June, 2001, in concert with SFAS No. 141. SFAS No. 142 becomes
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, which could be either
our
F-11
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
reportable segments or one level lower than our reportable segments. SFAS No.
142 requires us to perform the first goodwill impairment test on all reporting
units within six months of adoption. The first step is to compare the fair value
with the book value of a reporting unit. If the fair value of a reporting unit
is less than its book value, the second step will be to calculate the impairment
loss, if any. We will recognize any impairment loss from the initial adoption of
SFAS No. 142 as a change in accounting principle. 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 is not expected to have a material effect on our
financial position or cash flows, but it will impact our results of operations.
Based upon our preliminary review of the impact of SFAS No. 142 to determine the
effect, if any, of the initial goodwill impairment testing, we do not believe
that we will have to record an impairment charge. However, we are still in the
process of completing the valuations, so our tentative conclusion could change.
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. Amortization of
goodwill charged to operations, net of tax effect, in 2001, 2000 and 1999 was
$11.0 million, $11.5 million and $5.5 million, respectively. We did not amortize
the goodwill related to our acquisitions consummated in October 2001.
SFAS No. 144 entitled "Accounting for the Impairment or Disposal of
Long-Lived Assets" was issued in August, 2001 and will become effective for us
on January 1, 2002. SFAS No. 144 resolves implementation issues being
experienced under previously existing accounting literature but does not change
previous requirements to (a) recognize an impairment loss if the carrying amount
for an asset is not recoverable from its undiscounted cash flows, and (b)
measure the impairment loss as the difference between carrying amount and fair
value of the asset. SFAS No. 144 also retains the basic provisions of
discontinued operations found in previous accounting literature but broadens the
separate income statement presentation of discontinued operations from a
reporting segment to a component of the entity which has clearly distinguishable
operations and cash flows. We do not expect the adoption of SFAS No. 144 to have
a material effect on our financial position, results of operations or cash
flows.
Unusual Loss Events
During 2001, we experienced three significant gross losses. The largest
loss was as a result of the terrorist attacks 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 attacks were
considered multiple events rather than a single event and communications from
our clients and producers. We also have 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 have
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. We continue to monitor the reserve
and believe our estimates to be reasonable, but they may be subject to
adjustment as we receive additional information, which could take several years
to finalize. In addition, we have reviewed the estimated reinsurance
recoverables related to this loss and believe that they are collectible in the
normal course of business. Over 95% of the total amount of reinsurance
recoverables from this loss are due from 38 companies and Lloyds' syndicates,
each of which is rated "A-" or better by either A.M. Best Company, Inc. or
Moody's Investors Services, Inc. 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.
F-12
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
Because these policies were substantially reinsured, the net losses were not
material to our results of operations. The Petrobras loss was paid during the
third quarter of 2001 and all reinsurance recoverables related to it have been
collected. We expect the reinsurance recoverables related to the Total loss to
be collected in due course once the original claim is settled.
Other Information
During 2001, we recorded a charge totaling $37.3 million related to lines
of business that we are exiting, 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 the 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.
Reclassifications
Certain amounts in the 2000 and 1999 consolidated financial statements have
been reclassified to conform with the 2001 presentation. Such reclassifications
had no effect on our shareholders' equity, net earnings or cash flows.
(2) ACQUISITIONS
Pooling-of-Interests
On January 19, 2001, we acquired all of the outstanding shares of Schanen
Consulting Corporation and its operating subsidiary, The Schanen Consulting
Group, LLC, which provides employee benefit consulting and retail insurance
intermediary services. Consideration given was approximately 1.0 million shares
of our common stock. This business combination has been recorded using the
pooling-of-interests method of accounting. Our consolidated financial statements
have been restated to include the accounts and operations of The Schanen
Consulting Group, LLC for all periods presented. The table below shows revenue
and net earnings of the entities being combined for the two years ended December
31, 2000:
<Table>
<Caption>
2000 1999
-------- --------
Revenue:
Amounts as previously reported............................ $466,167 $341,871
The Schanen Consulting Group, Inc......................... 7,436 3,694
-------- --------
Restated total revenue............................ $473,603 $345,565
======== ========
Net earnings:
Amounts as previously reported............................ $ 53,431 $ 25,123
The Schanen Consulting Group, Inc......................... 2,037 1,449
-------- --------
Restated net earnings............................. $ 55,468 $ 26,572
======== ========
</Table>
Purchase Acquisitions
During 2001, we completed the acquisition of all of the outstanding shares
of two specialty underwriting agencies: ASU International, LLC. and Marshall
Rattner, Inc., which is the holding company for Professional Indemnity Agency,
Inc. These business combinations have been recorded using the purchase method of
accounting. The agencies, which were established in 1982 and 1977, respectively,
are recognized as leaders in their respective lines of business and were
acquired to expand our agency operations and diversify into new specialty lines.
They both have a long and profitable history, a market leadership position and
workforces with
F-13
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
significant expertise and reputation to justify the goodwill recorded. 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 as
well as the acquisitions during 1999 that were recorded using the purchase
method of accounting:
<Table>
<Caption>
CONSIDERATION
----------------------------- GOODWILL
SHARES OF GOODWILL DEDUCTIBLE FOR
EFFECTIVE OUR GOODWILL AMORTIZATION INCOME TAX
DATE COMMON STOCK CASH RECOGNIZED PERIOD PURPOSES
---------- ------------ -------------- -------------- ------------ --------------
ASU International LLC 10/30/2001 -- $ 29.2 million $ 23.7 million -- Yes
Professional Indemnity
Agency, Inc. 10/22/2001 0.3 million 63.0 million 53.6 million -- No
The Centris Group, Inc. 12/31/1999 -- 149.5 million 101.9 million 20 Years No
Midwest Stop Loss
Underwriting 01/28/1999 0.1 million 3.0 million 4.8 million 20 Years Yes
Rattner Mackenzie
Limited 01/01/1999 0.4 million 64.6 million 70.8 million 30 Years No
</Table>
The value of our common stock given as consideration was determined based
on closing market price on the days the acquisitions were 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 during
2002 through 2004. Any such 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 2001 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.
The following table summarizes the combined estimated fair values of assets
acquired and liabilities assumed at the respective dates of acquisition:
<Table>
<Caption>
2001 1999
-------- --------
Total investments........................................... $ 47,650 $142,794
Premium and other receivables............................... 30,506 134,167
Reinsurance recoverables.................................... -- 122,771
Other policy related assets................................. -- 115,714
Goodwill and intangible assets.............................. 83,957 181,721
All other assets............................................ 33,710 29,813
-------- --------
Total assets acquired............................. 195,823 726,980
Loss and loss adjustment expense payable.................... -- 146,233
Premium and claims payable.................................. 44,883 145,860
Other policy related liabilities............................ -- 156,703
Notes payable............................................... 12,735 25,000
All other liabilities....................................... 37,724 26,029
-------- --------
Total liabilities................................. 95,342 499,825
-------- --------
Net assets acquired............................... $100,481 $227,155
======== ========
</Table>
F-14
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
Identified intangible assets from the two acquisitions of 2001 consisted of
the following:
<Table>
<Caption>
AVERAGE
VALUE ASSIGNED AMORTIZATION PERIOD
-------------- -------------------
Employment and non-compete agreements................. $3,222 3 years
Other contractual items............................... 3,505 5 years
------ -------
Total identified intangible assets.......... $6,727 4 years
====== =======
</Table>
The following unaudited pro forma summary presents information as if the
purchase acquisitions completed during 2001 had occurred at the beginning of
each year presented after giving effect to certain adjustments, including
amortization of goodwill and intangible assets, increased interest expense from
debt issued to fund the acquisitions and Federal 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. 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.
<Table>
<Caption>
FOR THE YEARS ENDED
DECEMBER 31,
-------------------
UNAUDITED PRO FORMA INFORMATION 2001 2000
- ------------------------------- -------- --------
Revenue..................................................... $546,566 $516,162
Earnings before accounting change........................... 12,475 53,324
Net earnings................................................ 12,475 51,311
Basic earnings per share before accounting change........... 0.21 1.04
Basic earnings per share.................................... 0.21 1.01
Diluted earnings per share before accounting change......... 0.21 1.03
Diluted earnings per share.................................. 0.21 0.99
</Table>
F-15
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
(3) INVESTMENTS
Substantially all of our fixed income securities are investment grade; 98%
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, 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
======== ======= ======= ========
December 31, 2000:
Marketable equity securities....................... $ 8,896 $ 264 $(2,878) $ 6,282
US Treasury securities............................. 71,155 1,482 (25) 72,612
Obligations of states, municipalities and political
subdivisions..................................... 203,768 5,961 (414) 209,315
Corporate fixed income securities.................. 100,881 3,008 (189) 103,700
Asset-backed and mortgage-backed securities........ 39,722 1,183 (113) 40,792
Foreign government securities...................... 7,295 132 (2) 7,425
-------- ------- ------- --------
TOTAL SECURITIES......................... $431,717 $12,030 $(3,621) $440,126
======== ======= ======= ========
</Table>
The amortized cost and estimated market value of fixed income securities at
December 31, 2001, 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....................................... $ 18,111 $ 18,416
Due after 1 year through 5 years............................ 188,642 194,022
Due after 5 years through 10 years.......................... 91,828 94,184
Due after 10 years through 15 years......................... 75,233 76,721
Due after 15 years.......................................... 42,176 43,457
-------- --------
Securities with fixed maturities.......................... 415,990 426,800
Asset-backed and mortgage-backed securities................. 97,684 98,628
-------- --------
TOTAL FIXED INCOME SECURITIES..................... $513,674 $525,428
======== ========
</Table>
F-16
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
As of December 31, 2001, our insurance companies had deposited fixed income
securities with an amortized cost of approximately $30.4 million (market: $31.2
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, 2001, except for
one security valued at $0.4 million and included in other investments. The
sources of net investment income for the three years ended December 31, 2001,
are detailed below:
<Table>
<Caption>
2001 2000 1999
------- ------- -------
Fixed income securities................................. $27,234 $22,074 $20,098
Short-term investments.................................. 12,789 18,085 10,928
Marketable equity securities............................ 294 59 36
Other investments....................................... 4 4 --
------- ------- -------
Total investment income....................... 40,321 40,222 31,062
Investment expense...................................... (683) (386) (116)
------- ------- -------
NET INVESTMENT INCOME......................... $39,638 $39,836 $30,946
======= ======= =======
</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, 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)
====== ======= =======
For the year ended December 31, 1999:
Fixed income securities.................................. $1,226 $(1,390) $ (164)
Marketable equity securities............................. 450 (4,391) (3,941)
Other investments........................................ 120 (179) (59)
------ ------- -------
REALIZED GAIN (LOSS)........................... $1,796 $(5,960) $(4,164)
====== ======= =======
</Table>
F-17
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
Unrealized pre-tax net investment gains (losses) on investments for three
years ended December 31, 2001 are as follows:
<Table>
<Caption>
2001 2000 1999
------ ------- --------
Fixed income securities................................. $ 731 $11,916 $(19,024)
Marketable equity securities............................ 2,752 (91) (3,025)
Strategic operational investments....................... -- -- 2,900
Other investments....................................... (442) -- --
------ ------- --------
NET UNREALIZED INVESTMENT GAIN (LOSS)......... $3,041 $11,825 $(19,149)
====== ======= ========
</Table>
(4) PROPERTY AND EQUIPMENT
The following table summarizes property and equipment at December 31, 2001
and 2000:
<Table>
<Caption>
ESTIMATED
2001 2000 USEFUL LIFE
-------- -------- --------------
Buildings and improvements....................... $ 25,773 $ 19,332 30 to 45 years
Furniture, fixtures and equipment................ 22,974 17,516 3 to 20 years
Management information systems................... 40,874 34,078 3 to 10 years
-------- --------
Total property and equipment........... 89,621 70,926
Less accumulated depreciation and amortization... (37,135) (31,488)
-------- --------
PROPERTY AND EQUIPMENT, NET............ $ 52,486 $ 39,438
======== ========
</Table>
Depreciation and amortization expense on property and equipment was
approximately $7.0 million, $6.9 million and $6.7 million for the years ended
December 31, 2001, 2000 and 1999, respectively.
(5) NOTES PAYABLE
Notes payable as of December 31, 2001 and 2000 are shown in the table
below. The estimated fair value of our 2% convertible notes ($185.9 million at
December 31, 2001) 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>
2001 2000
-------- --------
2% Convertible notes........................................ $172,500 $ --
Bank facility............................................... -- 207,500
Mortgage note............................................... 2,325 --
Acquisition notes........................................... 3,365 4,633
Other short-term debt....................................... 3,738 --
-------- --------
TOTAL NOTES PAYABLE............................... $181,928 $212,133
======== ========
</Table>
On August 23, 2001, we issued an aggregate $172.5 million principal amount
of 2% Convertible Notes due 2021 in a public offering. Each $1,000 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
F-18
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
than 120% (currently $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, 2002, 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. We paid
$4.4 million in underwriting discounts and expenses in connection with the
offering, which are being amortized from the issue date until September 1, 2002.
We used the proceeds from this offering to repay our remaining indebtedness
under the bank facility described below, assist in financing the recent
acquisitions, make a $60.0 million capital contribution to our principal
insurance company subsidiary 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. Outstanding advances under the facility bear interest at
agreed upon rates, which ranged between 2.6% and 3.1% at December 31, 2001. The
facility is collateralized in part by the pledge of the stock of Houston
Casualty Company and Avemco Insurance Company, and by the stock of and
guarantees entered into by our principal underwriting agencies and
intermediaries. The facility agreement contains certain restrictive covenants,
including minimum net worth requirements, restrictions on certain extraordinary
corporate actions, notice requirements for certain material occurrences and
required maintenance of specified financial ratios. We believe that the
restrictive covenants and our obligations that are contained in the facility
agreement are typical for financing arrangements comparable to our facility.
The mortgage note is payable in fixed monthly installments though June 1,
2013 and is collateralized by the land and building occupied by Professional
Indemnity Agency, Inc. The stated interest of the mortgage note is 7.4%.
However, the fair value of the note balance was imputed at 4.1% as of the date
we acquired Professional Indemnity Agency, Inc., based on interest rates offered
to us at that time.
The acquisition notes are payable to former owners of Rattner Mackenzie
Limited. Most of the outstanding balance, $2.5 million, is due or callable
during 2002, with the remaining balance, $0.9 million due in 2003. Most of the
acquisition notes carry no stated interest rate, but were discounted for
financial reporting purposes when the acquisition of Rattner Mackenzie Limited
was recorded. The weighted average interest rate of the acquisition notes as of
December 31, 2001 is 6.0%.
The other short-term debt is payable to a former shareholder of
Professional Indemnity Agency, Inc. and was assumed by us upon the completion of
the acquisition. The notes are due in two installments totaling $4.0 million but
were recorded at fair value by imputing a 4.1% interest rate.
At December 31, 2001, certain of our subsidiaries maintained revolving
lines of credit with a bank in the combined maximum amount of $20.0 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 $25.0 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 (4.75% at December 31, 2001) for draws on
the letters of credit and prime less 1% on short-term cash advances. As of
December 31, 2001, letters of credit totaling $7.1 million had been issued to
insurance companies by the bank on behalf of our subsidiaries, with total
securities of $8.9 million collateralizing the lines.
F-19
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
(6) INCOME TAX
As of December 31, 2001 and 2000, we had income taxes receivable of $32.0
million and $13.2 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, 2001 are as follows:
<Table>
<Caption>
2001 2000 1999
------- ------- -------
Current................................................. $35,055 $26,948 $12,963
Deferred................................................ (4,869) 8,919 (692)
------- ------- -------
TOTAL INCOME TAX PROVISION.................... $30,186 $35,867 $12,271
======= ======= =======
</Table>
The net deferred tax asset is included in other assets in our consolidated
balance sheets. The composition of deferred tax assets and liabilities as of
December 31, 2001 and 2000, is as follows:
<Table>
<Caption>
2001 2000
-------- -------
Tax net operating loss carryforwards........................ $ 15,581 $ 9,698
Excess of financial unearned premium over tax............... 6,555 4,919
Effect of loss reserve discounting and salvage and
subrogation accrual for tax............................... 9,897 7,434
Excess of financial accrued expenses over tax............... 4,918 5,520
Allowance for bad debts, not deductible for tax............. 2,788 2,484
Foreign branch net operating loss carryforwards............. 2,568 1,912
Valuation allowance......................................... (10,435) (9,666)
-------- -------
Total assets...................................... 31,872 22,301
Unrealized gain on increase in value of securities available
for sale (shareholders' equity)........................... 3,717 2,400
Deferred policy acquisition costs, net of ceding
commissions, deductible for tax........................... 2,256 5,237
Amortizable goodwill........................................ 5,256 3,816
Property and equipment depreciation and other items......... 4,165 4,183
-------- -------
Total liabilities................................. 15,394 15,636
-------- -------
NET DEFERRED TAX ASSET............................ $ 16,478 $ 6,665
======== =======
</Table>
Changes in the valuation allowance account applicable to the net deferred
tax asset for the three years ended December 31, 2001 are as follows:
<Table>
<Caption>
2001 2000 1999
------- ------- -------
Balance, beginning of year.............................. $ 9,666 $12,091 $ 50
Increase (decrease) charged (credited) to income........ (536) -- 453
Increase (decrease) charged (credited) to capital....... 1,305 -- --
Valuation allowance related to acquired net operating
loss carryforwards.................................... -- 3,262 11,588
Reduction in valuation allowance resulting from waiver
of previously acquired net operating loss
carryforwards......................................... -- (5,687) --
------- ------- -------
BALANCE, END OF YEAR.......................... $10,435 $ 9,666 $12,091
======= ======= =======
</Table>
As of December 31, 2001, we have Federal tax net operating loss
carryforwards of approximately $30.4 million that will expire in varying amounts
through the year 2021. Future use of these carryforwards is
F-20
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
subject to statutory limitations due to prior changes of ownership. There are
valuation allowances in the amount of $9.5 million recorded with respect to
these loss carryforwards that would reduce goodwill if the carryforwards are
realized. In addition, we have approximately $7.3 million of tax loss
carryforwards, principally from a recently established foreign branch of one of
our insurance companies, that can be used only against future taxable income of
the branch. Based upon our history domestically of taxable income in our
insurance and other operations and our projections of future taxable income
domestically and in our foreign branch insurance operations as they mature, 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.
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, 2001:
<Table>
<Caption>
2001 2000 1999
------- ------- -------
Statutory tax rate...................................... 35.0% 35.0% 35.0%
Federal tax at statutory rate........................... $21,134 $31,967 $13,595
Nontaxable municipal bond interest and dividends
received deduction.................................... (3,314) (3,545) (5,460)
Other non deductible expenses........................... 512 620 622
Non deductible goodwill amortization.................... 7,781 2,497 475
State income taxes...................................... 3,259 4,202 3,011
Foreign income taxes.................................... 2,915 1,537 4,793
Foreign tax credit...................................... (2,968) (1,826) (4,354)
Other, net.............................................. 867 415 (411)
------- ------- -------
INCOME TAX PROVISION.......................... $30,186 $35,867 $12,271
======= ======= =======
EFFECTIVE TAX RATE............................ 50.0% 39.3% 31.6%
======= ======= =======
</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. 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.
F-21
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
All segment information for 2000 and 1999 has been restated to include the
accounts and operations of The Schanen Consulting Group, Inc. in the
intermediary segment.
Effective January 1, 2001, we consolidated the operations of three of our
underwriting agencies into the operations of our insurance companies. Policies
incepting on or after January 1, 2001, along with associated expenses, will be
reported in our insurance company segment. The administration of all policies
incepting before January 1, 2001, 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.
<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
========
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 attacks
on September 11 and 2) a $29.4 million charge (net of income tax) related to
lines of business being exited. Included in the latter amount, was a $15.0
million charge for the impairment of goodwill, which is not deductible for
income tax purposes. Also during 2001, earnings (loss)
F-22
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
before income taxes was $60.4 million for our domestic subsidiaries and $(0.1)
million for our foreign subsidiaries and branches.
<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
========
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
Restructuring expense........... 749 798 (789) 3 -- 761
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>
Our insurance company segment increased its policy issuance fees on certain
2000 contracts to reflect current market conditions, which had the effect of
reducing our underwriting agencies' management fees $11.4 million for the year
ended December 31, 2000, but, as our insurance company segment reduced its net
policy acquisition costs by a like amount, there was no effect to consolidated
net income. 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-23
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
<Table>
<Caption>
INSURANCE UNDERWRITING OTHER
COMPANY AGENCY INTERMEDIARY OPERATIONS CORPORATE TOTAL
--------- ------------ ------------ ---------- --------- --------
For the year ended December 31,
1999:
Revenue:
Domestic........................ $151,044 $91,385 $35,472 $27,364 $ 681 $305,946
Foreign......................... 10,676 3,699 25,244 -- -- 39,619
Inter-segment................... -- 3,170 594 1,133 -- 4,897
-------- ------- ------- ------- ------- --------
Total segment revenue........ $161,720 $98,254 $61,310 $28,497 $ 681 350,462
======== ======= ======= ======= =======
Inter-segment revenue............. (4,897)
--------
CONSOLIDATED TOTAL REVENUE... $345,565
========
Net earnings (loss):
Domestic........................ $ (8,631) $17,129 $10,491 $ 7,643 $(2,279) $ 24,353
Foreign......................... (2,078) 21 4,575 -- -- 2,518
-------- ------- ------- ------- ------- --------
Total segment net earnings
(loss)..................... $(10,709) $17,150 $15,066 $ 7,643 $(2,279) 26,871
======== ======= ======= ======= =======
Inter-segment eliminations........ (299)
--------
CONSOLIDATED NET EARNINGS.... $ 26,572
========
Other items:
Net investment income........... $ 23,400 $ 4,186 $ 2,504 $ 424 $ 432 $ 30,946
Depreciation and amortization... 2,880 5,898 3,798 264 580 13,420
Interest expense................ 19 3,809 4,640 -- 4,496 12,964
Restructuring expense........... 687 3,278 1,453 -- 71 5,489
Capital expenditures............ 2,405 5,339 148 585 637 9,114
Income tax provision
(benefit).................... (13,324) 13,969 8,608 4,454 (1,242) 12,465
Inter-segment eliminations...... (194)
--------
Consolidated income tax
provision.................. $ 12,271
========
</Table>
The insurance company segment incurred a provision for reinsurance totaling
$28.3 million, net of income tax, during 1999. Also during 1999, earnings before
income taxes was $33.7 million for our domestic subsidiaries and $5.1 million
for our foreign subsidiaries and branches.
F-24
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
The following tables present revenue by line of business within each of our
operating segments for the three years ended December 31, 2001:
<Table>
<Caption>
2001 2000 1999
-------- -------- --------
Insurance company:
Life, accident and health.......................... $186,188 $148,039 $ 50,919
Aviation........................................... 91,377 73,695 62,784
Marine, energy and property........................ 23,748 10,163 12,779
Other specialty lines.............................. 15,124 14,552 9,072
-------- -------- --------
316,437 246,449 135,554
Exited and discontinued lines of business.......... 26,350 21,198 5,808
-------- -------- --------
TOTAL NET EARNED PREMIUM........................ $342,787 $267,647 $141,362
======== ======== ========
Underwriting agency:
Life, accident and health.......................... $ 47,857 $ 70,536 $ 66,127
Property and casualty.............................. 13,938 25,522 24,586
-------- -------- --------
TOTAL MANAGEMENT FEES........................... $ 61,795 $ 96,058 $ 90,713
======== ======== ========
Intermediary:
Life, accident and health.......................... $ 33,739 $ 36,795 $ 39,354
Property and casualty.............................. 9,673 13,091 18,879
-------- -------- --------
TOTAL COMMISSION INCOME......................... $ 43,412 $ 49,886 $ 58,233
======== ======== ========
</Table>
Assets by business segment and geographic location are shown in the
following table:
<Table>
<Caption>
INSURANCE UNDERWRITING OTHER
COMPANY AGENCY INTERMEDIARY OPERATIONS CORPORATE TOTAL
---------- ------------ ------------ ---------- --------- ----------
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
========== ======== ======== ====== ======= ==========
December 31, 2000:
Domestic....................... $1,613,412 $582,644 $ 89,836 $6,908 $34,299 $2,327,099
Foreign........................ 146,825 37,729 279,102 -- -- 463,656
---------- -------- -------- ------ ------- ----------
Total assets.............. $1,760,237 $620,373 $368,938 $6,908 $34,299 $2,790,755
========== ======== ======== ====== ======= ==========
</Table>
(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
F-25
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
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, 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
======== ======== ========
For the year ended December 31, 1999:
Direct business.................................... $291,513 $294,130 $261,696
Reinsurance assumed................................ 276,818 294,103 423,763
Reinsurance ceded.................................. (428,407) (446,871) (575,809)
-------- -------- --------
NET AMOUNTS................................. $139,924 $141,362 $109,650
======== ======== ========
</Table>
Ceding commissions netted with policy acquisition costs in the consolidated
statements of earnings are $185.2 million, $214.7 million, and $117.0 million
for the years ended December 31, 2001, 2000, and 1999, respectively.
The table below represents the composition of reinsurance recoverables in
our consolidated balance sheets:
<Table>
<Caption>
2001 2000
-------- --------
Reinsurance recoverable on paid losses...................... $ 86,653 $ 99,224
Reinsurance recoverable on outstanding losses............... 414,428 376,778
Reinsurance recoverable on incurred but not reported
losses.................................................... 403,223 317,467
Reserve for uncollectible reinsurance....................... (5,176) (4,057)
-------- --------
TOTAL REINSURANCE RECOVERABLES....................... $899,128 $789,412
======== ========
</Table>
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, 2001 and 2000:
<Table>
<Caption>
2001 2000
-------- --------
Payables to reinsurers...................................... $199,581 $200,591
Letters of credit........................................... 145,796 142,494
Cash deposits............................................... 14,851 23,813
-------- --------
TOTAL CREDITS........................................ $360,228 $366,898
======== ========
</Table>
F-26
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
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, 2001 and 2000.
The total recoverables column includes paid loss recoverable, outstanding loss
recoverable, incurred but not reported losses recoverable and ceded unearned
premium.
<Table>
<Caption>
LETTERS OF CREDIT,
CURRENT TOTAL CASH DEPOSITS AND
REINSURER RATING LOCATION RECOVERABLES OTHER PAYABLES NET
- --------- ------- -------------- ------------ ------------------ -------
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
December 31, 2000:
GE Reinsurance Corporation............ A++ Illinois $38,152 $4,881 $33,271
AXA Corporate Solutions Reinsurance
Co. ................................ A+ Delaware 40,886 9,131 31,755
Underwriters Indemnity Company........ A- Texas 33,912 2,416 31,496
SCOR Reinsurance Company.............. A New York 28,419 734 27,685
Lloyd's Syndicate Number 1101......... NR United Kingdom 27,645 1,142 26,503
American Re-Insurance Company......... A++ Delaware 23,487 2,249 21,238
Lloyd's Syndicate Number 1206......... C+ United Kingdom 18,357 147 18,210
Transamerica Occidental Life Insurance
Co. ................................ A+ California 17,056 151 16,905
</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 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 $83.0 million and $86.8
million as of December 31, 2001 and 2000, respectively.
We have a reserve of $5.2 million as of December 31, 2001 for potential
collectibility issues related to reinsurance recoverables and associated
expenses. The adverse economic environment in the worldwide insurance industry
and the terrorist attacks on September 11 have placed great pressure on
reinsurers and the
F-27
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
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, such as the marketplace has
experienced for the last several years. While we believe that the reserve is
adequate based on currently available information, conditions may change or
additional information might be obtained that would affect our estimate of the
adequacy of the level of the reserve and which may result in a future change in
the reserve. We continually review our financial exposure to the reinsurance
market and continue to take actions to mitigate our position.
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, 2001, our insurance companies had
initiated litigation or arbitration proceedings against five reinsurers and were
involved in one arbitration proceeding initiated by a reinsurer. These
proceedings primarily concern the collection of amounts owing under reinsurance
agreements. As of such date, our insurance companies had an aggregate amount of
$15.3 million which had not been paid to us under the disputed agreements and we
estimate that there could be an additional $31.2 million of incurred losses and
loss expenses under the subject agreements. In addition, because our insurance
companies, principally Houston Casualty Company, participated in facilities
which were managed by one of our underwriting agencies, they are indirectly
involved in any reinsurance disputes which affect the applicable facilities. As
of December 31, 2001, Houston Casualty Company's allocated portion of aggregate
amounts which had not been reimbursed to the applicable facilities under the
disputed agreements was $4.8 million and we estimate that there could be an
additional $4.0 million of incurred losses and loss expenses under the subject
agreements allocated to Houston Casualty Company. Houston Casualty Company has
no net exposure on disputed amounts due to the non-affiliated companies who also
participated in the applicable facilities.
During 1999, we recorded a provision for reinsurance totaling $29.5 million
in connection with the insolvency of a reinsurer. We continue to expect this
provision to be sufficient. We also recorded a $14.0 million provision following
a commutation (the contractual settlement of outstanding and future liabilities)
with another reinsurer, the majority of which represents the present value
discount of ceded losses.
(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. 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.
F-28
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
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 ("GBP"). To mitigate the foreign exchange risk, we have
entered into foreign currency forward contracts expiring at staggered times
through December, 2002. As of December 31, 2001, we had forward contracts to
sell US $6.0 million for GBP at an average rate of GBP 1.00 equals US $1.43. The
foreign currency forward contracts are used to convert currency at a known rate
in an amount which either approximates or is less than average 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 hedge against existing exposure to foreign
currency fluctuations rather than as a form of speculative or trading
investment. The fair value of foreign currency forward contracts as of December
31, 2001 was immaterial.
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.
TERRORIST EXPOSURE
Subsequent to the terrorist attacks 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 lines of business. All new and
renewal policies are written with an appropriate terrorist exclusion except for
lines of business, such as aviation, where reinsurance for acts of terrorism is
available at an economic cost or where we feel comfortable with the net
exposure.
At January 1, 2002, and February 1, 2002, respectively, our energy and
property reinsurance protections were renewed without coverage for acts of
terrorism. Therefore, to the extent that certain existing, in-force policies
contain such coverage, then we would have a net exposure to any applicable
losses. The actual amount of this exposure is not determinable but could
represent a catastrophic loss, a risk for which we would usually purchase
reinsurance protection. As each month goes by, existing in-force policies will
expire and the overall exposure continues to reduce substantially.
LEASES
We lease administrative office facilities under long-term non-cancelable
operating lease agreements expiring at various dates through September, 2007. 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 2004. Rent expense under operating leases amounted to
$7.1 million, $7.3 million, and $5.9 million, for the years ended December 31,
2001, 2000, and 1999, respectively.
F-29
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
At December 31, 2001, 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
- -------------------------------- ----------
2002................................................. $ 6,663
2003................................................. 6,383
2004................................................. 5,358
2005................................................. 4,402
2006................................................. 2,948
Thereafter........................................... 885
-------
TOTAL FUTURE MINIMUM ANNUAL RENTAL PAYMENTS DUE............. $26,639
=======
</Table>
LOAN GUARANTEE
We guaranteed the mortgage debt of a partnership in which we are a limited
partner. The total amount of the loan is $11.4 million as of December 31, 2001.
We invested in the partnership, which owns a building which is rented to
unaffiliated parties, as a long-term investment.
(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>
2001 2000
------- ------
Marketable equity securities................................ $ -- $2,725
Other investments........................................... 7,124 7,182
Premiums, claims and other receivables...................... 776 435
</Table>
Transactions with these business entities and other related parties
included in our consolidated statements of earnings are as follows:
<Table>
<Caption>
2001 2000 1999
----- ------- -------
Management fees........................................... $ 58 $ -- $ --
Investment income......................................... -- 112 206
Net realized investment gain (loss)....................... 53 (5,067) (4,521)
Other operating income (loss)............................. (508) 89 5,221
Other operating expense................................... -- 112 28
Interest expense.......................................... 217 74 418
</Table>
Additionally, we had $15.7 million and $4.6 million payable at December 31,
2001 and 2000, respectively, and sold assets in 2000 for proceeds of $0.6
million 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 or liabilities that existed prior to the
acquisitions and the sale of assets was in accordance with the terms of an
acquisition agrement.
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 its
operation. For the
F-30
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
years ended December 31, 2001, 2000 and 1999, we paid rental of $1.0 million,
$0.6 million and $0.9 million, respectively, to this entity.
We have committed to invest $5.0 million in an investment partnership
managed by a company which is partially owned by a Director. As of December 31,
2001, $4.4 million had been invested under this commitment. We also committed to
invest $5.0 million in another business with which this Director is affiliated.
This investment was funded by us in January, 2002.
(11) EMPLOYEE BENEFIT PLANS
We have a defined contribution retirement plan under Section 401(k) of the
Internal Revenue Code which covers substantially all of our employees residing
in the United States who meet specified service requirements. The contributions
are discretionary and are determined by our management as of the beginning of
each calendar year. We currently match each of our employee's contribution to
the 401(k) plan up to 6% of the employee's salary. Employees who reside outside
the United States receive comparable benefits under different plans. We
contributed $2.7 million, $3.2 million, and $3.1 million to the plans for the
years ended December 31, 2001, 2000, and 1999, respectively, which is included
in compensation expense in our consolidated statements of earnings.
(12) 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.
Under the Texas Insurance Code, Houston Casualty Company and U.S. Specialty
Insurance Company must each maintain minimum statutory capital of $1.0 million
and minimum statutory surplus of $1.0 million, and can only pay dividends out of
statutory unassigned surplus funds. In addition, they are limited in the amount
of dividends which they may pay in any twelve-month period, without prior
regulatory approval, to the greater of their statutory net income for the prior
calendar year or ten percent (10%) of their statutory policyholders' surplus as
of the prior calendar year end. During 2002, Houston Casualty Company's ordinary
dividend capacity will be approximately $28.5 million and U.S. Specialty
Insurance Company's ordinary dividend capacity will be zero.
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 ten percent
(10%) of its statutory policyholders' surplus as of the prior year end. During
2002, Avemco Insurance Company's ordinary dividend capacity will be
approximately $7.2 million.
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 net gain from operations for the
prior calendar year or ten percent (10%) of its statutory capital and surplus as
of the prior year end. During 2002, HCC Life Insurance Company's ordinary
dividend capacity will be approximately $15.1 million.
F-31
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
The components of accumulated other comprehensive income (loss) are as
follows:
<Table>
<Caption>
UNREALIZED ACCUMULATED OTHER
FOREIGN CURRENCY UNREALIZED HEDGE INVESTMENT COMPREHENSIVE
TRANSLATION GAIN (LOSS) GAIN (LOSS) INCOME (LOSS)
---------------- ---------------- ----------- -----------------
Balance December 31, 1998.......... $(650) $-- $ 10,355 $ 9,705
Net change for year................ 167 -- (12,564) (12,397)
----- --- -------- --------
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
===== === ======== ========
</Table>
(13) STOCK OPTIONS
During 2001, we replaced all previous option plans with our 2001 Flexible
Incentive Plan, 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, 2001, 5.8 million
shares of our common stock were reserved for the exercise of options, of which
3.3 million shares were reserved for options previously granted and 2.5 million
shares were reserved for future issuances of options.
Options vest over a zero to five year period and expire four to ten years
after grant date. All options have been granted at fixed exercise prices at the
market price of our common stock on the grant date. If the fair value method of
valuing compensation related to options would have been used, pro forma net
earnings and pro forma diluted earnings per share would have been $25.8 million,
or $0.43 per share, for the year ended December 31, 2001; $50.8 million, or
$0.98 per share, for the year ended December 31, 2000; and $22.2 million, or
$0.44 per share, for the year ended December 31, 1999. The fair value of each
option grant was estimated on the grant date using the Black-Scholes single
option pricing model with the following weighted average assumptions: a) risk
free interest rate of 4.4% for 2001, 6.4% for 2000, and 5.7% for 1999, b)
expected volatility factor of .3, c) dividend yield of 0.91% for 2001, 0.89% for
2000, and 1.52% for 1999, and d) expected option life of five years for 2001 and
four years for 2000 and 1999. The average fair value of options granted during
the years ended December 31, 2001, 2000 and 1999 was $7.66, $4.51 and $4.16,
respectively.
The following table provides an analysis of stock option activity during
the three years ended December 31, 2001:
<Table>
<Caption>
2001 2000 1999
-------------------- -------------------- --------------------
AVERAGE AVERAGE AVERAGE
NUMBER EXERCISE NUMBER EXERCISE NUMBER EXERCISE
OF SHARES PRICE OF SHARES PRICE OF SHARES PRICE
--------- -------- --------- -------- --------- --------
Outstanding, beginning of year........ 5,494 $15.54 5,470 $16.08 5,460 $16.73
Granted at market value............... 797 24.54 1,745 13.59 1,869 13.48
Forfeitures and expirations........... (251) 17.73 (434) 18.32 (1,327) 18.36
Exercised............................. (2,735) 15.68 (1,287) 14.34 (532) 7.88
------ ------ ------ ------ ------ ------
Outstanding, end of year.............. 3,305 $17.39 5,494 $15.54 5,470 $16.08
====== ====== ====== ====== ====== ======
Exercisable, end of year.............. 1,100 $16.70 2,717 $16.59 2,983 $16.84
====== ====== ====== ====== ====== ======
</Table>
F-32
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
Options outstanding and exercisable as of December 31, 2001 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 $11.00............................ 470 2.8 years $10.52 223 $10.35
$11.00-$12.25........................... 834 4.5 12.02 214 12.00
$12.26-$20.00........................... 788 3.0 16.76 307 16.42
$20.01-$26.00........................... 802 4.5 22.17 306 23.28
Over $26.00............................. 411 5.8 27.99 50 26.56
----- --------- ------ ----- ------
Total options......................... 3,305 4.1 years $17.39 1,100 $16.70
===== ========= ====== ===== ======
</Table>
(14) 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, 2001:
<Table>
<Caption>
2001 2000 1999
------- ------- -------
Net earnings................................................ $30,197 $55,468 $26,572
======= ======= =======
Reconciliation of number of shares outstanding:
Shares of common stock outstanding at year end.............. 61,438 51,342 49,836
Changes in common stock due to issuance..................... (3,272) (908) (241)
Contingent shares to be issued.............................. -- 39 49
Common stock contractually issuable in the future........... 155 269 414
------- ------- -------
Weighted average common stock outstanding................... 58,321 50,742 50,058
Additional dilutive effect of outstanding options (as
determined by the application of the treasury stock
method)................................................... 1,298 877 588
------- ------- -------
Weighted average common stock and potential common stock
outstanding............................................... 59,619 51,619 50,646
======= ======= =======
</Table>
As of December 31, 2001, there were approximately 0.2 million options that
were not included in the computation of diluted earnings per share because to do
so would have been antidilutive.
(15) 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
F-33
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
net income for the three years ended December 31, 2001, after intercompany
eliminations, of our insurance companies included in those companies' respective
filings with regulatory authorities are as follows:
<Table>
<Caption>
2001 2000 1999
-------- -------- --------
Statutory policyholders' surplus............................ $401,393 $326,249 $315,474
Statutory net income (loss)................................. 16,555 13,749 (8,707)
</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 attacks and $8.1 million (net of income tax) from charges
related to lines of business being exited. Our statutory net loss for 1999
includes a $25.5 million loss (net of income tax) from the provision for
reinsurance.
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 state regulatory authorities caused a $3.2
million reduction in statutory surplus as of December 31, 2001 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.
(16) SUPPLEMENTAL INFORMATION
Supplemental cash flow information for the three years ended December 31,
2001, is summarized below:
<Table>
<Caption>
2001 2000 1999
------- ------- -------
Interest paid............................................... $ 7,980 $17,418 $13,694
Income tax paid............................................. 28,411 11,859 23,116
Dividends declared but not paid at year end................. 3,848 3,557 2,442
</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.
F-34
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
(17) 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, 2001:
<Table>
<Caption>
2001 2000 1999
---------- -------- --------
Reserves for loss and loss adjustment expense at beginning
of the year............................................... $ 944,117 $871,104 $460,511
Less reinsurance recoverables............................... 694,245 597,498 341,599
---------- -------- --------
Net reserves at beginning of the year....................... 249,872 273,606 118,912
Net reserve adjustments from acquisition and disposition of
subsidiaries.............................................. 285 514 55,523
Effect on loss reserves of write off of ceded outstanding
and incurred but not reported reinsurance recoverables.... -- -- 82,343
Provision for loss and loss adjustment expense for claims
occurring in the current year............................. 278,103 208,055 105,036
Increase (decrease) in estimated loss and loss adjustment
expense for claims occurring in prior years............... (10,713) (9,585) 4,614
---------- -------- --------
Incurred loss and loss adjustment expense, net of
reinsurance............................................... 267,390 198,470 109,650
---------- -------- --------
Loss and loss adjustment expense payments for claims
occurring during:
Current year................................................ 102,206 76,725 36,770
Prior years................................................. 102,244 145,993 56,052
---------- -------- --------
Loss and loss adjustment expense payments, net of
reinsurance............................................... 204,450 222,718 92,822
---------- -------- --------
Net reserves at end of the year............................. 313,097 249,872 273,606
Plus reinsurance recoverables............................... 817,651 694,245 597,498
---------- -------- --------
Reserves for loss and loss adjustment expense at end of the
year...................................................... $1,130,748 $944,117 $871,104
========== ======== ========
</Table>
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 a deficiency of $4.6 million in 1999. The deficiencies and
redundancies in the reserves result from our continued review with our actuaries
of our loss reserves and the increase or reduction of such reserves 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.
Therefore, we do not expect to experience any material development in reserves
for environmental pollution claims.
F-35
HCC INSURANCE HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED, IN THOUSANDS)
(18) QUARTERLY FINANCIAL DATA (UNAUDITED)
<Table>
<Caption>
FOURTH QUARTER THIRD QUARTER SECOND QUARTER FIRST QUARTER
------------------- ------------------- ------------------- -------------------
2001 2000 2001 2000 2001 2000 2001 2000
-------- -------- -------- -------- -------- -------- -------- --------
Total revenue......................... $132,192 $110,170 $137,621 $120,539 $120,556 $120,947 $115,092 $121,947
======== ======== ======== ======== ======== ======== ======== ========
Earnings (loss) before accounting
change.............................. $ 23,837 $ 13,135 $(29,076) $ 17,762 $ 20,258 $ 13,180 $ 15,178 $ 13,404
Cumulative effect of accounting
change.............................. -- -- -- -- -- -- -- (2,013)
-------- -------- -------- -------- -------- -------- -------- --------
Net earnings (loss)................... $ 23,837 $ 13,135 $(29,076) $ 17,762 $ 20,258 $ 13,180 $ 15,178 $ 11,391
======== ======== ======== ======== ======== ======== ======== ========
Basic earnings (loss) per share data:
Earnings (loss) before accounting
change.............................. $ 0.39 $ 0.26 $ (0.49) $ 0.35 $ 0.34 $ 0.26 $ 0.28 $ 0.27
Cumulative effect of accounting
change.............................. -- -- -- -- -- -- -- (0.04)
-------- -------- -------- -------- -------- -------- -------- --------
Earnings (loss) per share............. $ 0.39 $ 0.26 $ (0.49) $ 0.35 $ 0.34 $ 0.26 $ 0.28 $ 0.23
======== ======== ======== ======== ======== ======== ======== ========
Weighted average shares outstanding... 61,021 51,181 59,399 50,739 58,998 50,525 53,720 50,400
======== ======== ======== ======== ======== ======== ======== ========
Diluted earnings (loss) per share
data:
Earnings (loss) before accounting
change.............................. $ 0.38 $ 0.25 $ (0.49) $ 0.34 $ 0.34 $ 0.26 $ 0.28 $ 0.26
Cumulative effect of accounting
change.............................. -- -- -- -- -- -- -- (0.04)
-------- -------- -------- -------- -------- -------- -------- --------
Earnings (loss) per share............. $ 0.38 $ 0.25 $ (0.49) $ 0.34 $ 0.34 $ 0.26 $ 0.28 $ 0.22
======== ======== ======== ======== ======== ======== ======== ========
Weighted average shares outstanding... 62,051 52,530 59,399 52,037 60,470 51,083 55,070 50,706
======== ======== ======== ======== ======== ======== ======== ========
</Table>
During the fourth quarter of 2000, we recorded a $2.9 million (net of
income tax) increase in reserves of exited lines of business that were part of
the 1999 The Centris Group, Inc. acquisition and a $1.0 million (net of income
tax) restructuring expense. 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 attacks on September 11; and 2) a $29.6 million charge (net of income
tax) related to lines of business being exited. Included in the latter amount
was a $15.0 million charge for the impairment of goodwill, which is not
deductible for income tax purposes. The sum of the quarters earnings (loss) per
share may not equal the annual amounts due to rounding.
F-36
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 the
Company's method of revenue recognition for certain contracts, effective January
1, 2000, 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 14(b) 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 19, 2002
S-1
SCHEDULE 1
HCC INSURANCE HOLDINGS, INC.
SUMMARY OF INVESTMENTS
OTHER THAN INVESTMENTS IN RELATED PARTIES
DECEMBER 31, 2001
<Table>
<Caption>
COLUMN A COLUMN B COLUMN C COLUMN D
- -------- -------- -------- ---------------
AMOUNT AT WHICH
SHOWN IN THE
TYPE OF INVESTMENT COST VALUE BALANCE SHEET
- ------------------ -------- -------- ---------------
(IN THOUSANDS)
Fixed maturities:
Bonds -- United States government and government
agencies and authorities............................ $ 70,235 $ 71,368 $ 71,368
Bonds -- states, municipalities and political
subdivisions........................................ 52,834 53,918 53,918
Bonds -- special revenue............................... 147,956 151,740 151,740
Bonds -- corporate..................................... 140,702 145,285 145,285
Asset-backed and mortgage-backed securities............ 97,684 98,628 98,628
Bonds -- foreign government............................ 4,263 4,489 4,489
-------- -------- --------
Total fixed maturities......................... 513,674 $525,428 525,428
-------- ======== --------
Equity securities:
Common stocks -- banks, trusts and insurance
companies........................................... 738 $ 700 700
Common stocks -- industrial, miscellaneous and all
other............................................... 13,057 13,065 13,065
Non-redeemable preferred stocks........................ 2,636 2,804 2,804
-------- -------- --------
Total equity securities........................ 16,431 $ 16,569 16,569
-------- ======== --------
Short-term investments................................... 338,904 338,904
Other investments........................................ 8,007 7,565
-------- --------
TOTAL INVESTMENTS.............................. $877,016 $888,466
======== ========
</Table>
S-2
SCHEDULE 2
HCC INSURANCE HOLDINGS, INC.
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
BALANCE SHEETS
(IN THOUSANDS)
<Table>
<Caption>
DECEMBER 31,
-------------------
2001 2000
-------- --------
ASSETS
Cash........................................................ $ 8,719 $ 58
Short-term investments...................................... 1,497 3,488
Investment in subsidiaries.................................. 734,067 616,031
Receivable from subsidiaries................................ 12,754 1,437
Intercompany loans to subsidiaries.......................... 190,167 126,325
Deferred Federal income tax................................. -- 1,711
Other assets................................................ 5,732 3,974
-------- --------
TOTAL ASSETS...................................... $952,936 $753,024
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Notes payable............................................... $173,198 $207,500
Note payable to related party............................... 2,667 4,633
Deferred Federal income tax................................. 1,652 --
Accounts payable and accrued liabilities.................... 11,966 9,961
-------- --------
Total liabilities................................. 189,483 222,094
Total shareholders' equity........................ 763,453 530,930
-------- --------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY........ $952,936 $753,024
======== ========
</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,
---------------------------------
2001 2000 1999
--------- --------- ---------
Equity in earnings of subsidiaries.......................... $37,439 $62,416 $32,397
Interest income from subsidiaries........................... 5,019 9,160 4,165
Interest income............................................. 764 343 146
Other income................................................ 13 146 73
------- ------- -------
Total revenue............................................. 43,235 72,065 36,781
Interest expense............................................ 8,737 20,249 12,907
Other operating expense..................................... 1,600 1,582 266
------- ------- -------
Total expense.......................................... 10,337 21,831 13,173
------- ------- -------
Earnings before income tax benefit..................... 32,898 50,234 23,608
Income tax expense (benefit)................................ 2,701 (5,234) (2,964)
------- ------- -------
NET EARNINGS........................................... $30,197 $55,468 $26,572
======= ======= =======
</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,
----------------------------------
2001 2000 1999
--------- --------- ----------
Net earnings................................................ $30,197 $55,468 $ 26,572
Other comprehensive income (loss), net of tax:
Foreign currency translation adjustment..................... (279) (172) 167
Gain in fair value of subsidiaries' foreign currency forward
contracts recorded as a hedge, net of income tax charge of
$13....................................................... 24 -- --
Investment gains (losses):
Consolidated subsidiaries' investment gains (losses)
during the year, net of deferred tax charge (benefit)
of, $1,137 in 2001; $2,386 in 2000; and $(8,042) in
1999................................................... 2,297 4,118 (15,271)
Less consolidated subsidiaries' reclassification
adjustments for (gains) losses included in net
earnings, net of deferred tax (charge) benefit of
$(138) in 2001; $1,862 in 2000; and $1,457 in 1999..... (255) 3,459 2,707
------- ------- --------
Other comprehensive income (loss)........................... 1,787 7,405 (12,397)
------- ------- --------
COMPREHENSIVE INCOME.............................. $31,984 $62,873 $ 14,175
======= ======= ========
</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,
--------------------------------
2001 2000 1999
--------- -------- ---------
Cash flows from operating activities:
Net earnings............................................. $ 30,197 $ 55,468 $ 26,572
Adjustment to reconcile net earnings to net cash provided
(used) by operating activities:
Undistributed net income of subsidiaries................. (37,439) (62,416) (32,397)
Change in deferred Federal income tax, net of tax effect
of unrealized gain or loss............................ 2,636 (885) 687
Changes in other assets and other........................ (636) (222) 1,768
Amortization and depreciation............................ 2,586 526 513
Increase in accrued interest receivable added to
intercompany loan balances............................ (835) (5,160) (4,035)
Change in accounts payable and accrued liabilities....... 1,181 (5,286) (7,819)
Tax benefit from exercise of stock options............... 12,312 3,628 1,156
--------- -------- ---------
Cash provided (used) by operating activities........ 10,002 (14,347) (13,555)
Cash flows from investing activities:
Sales of other operating investments..................... -- 307 --
Cash contributions to subsidiaries....................... (84,151) (1,130) (36,030)
Purchase of subsidiaries................................. (96,405) (10,345) (201,947)
Change in short-term investments......................... 1,991 (3,093) 4,144
Cost of investment acquired.............................. -- -- (2,898)
Change in receivable from subsidiaries................... (11,317) 4,403 10,084
Intercompany loans to subsidiaries....................... (1,275) (16,509) (27,404)
Payments on intercompany loans to subsidiaries........... 34,674 42,838 66,595
Cash dividends from subsidiaries......................... 17,255 21,598 93,228
--------- -------- ---------
Cash provided (used) by investing activities........ (139,228) 38,069 (94,228)
Cash flows from financing activities:
Proceeds from note payable, net of costs................. 175,401 26,470 547,000
Payments on notes payable................................ (216,523) (57,042) (433,600)
Sale of common stock..................................... 192,831 17,235 3,627
Dividends paid........................................... (13,822) (10,350) (9,221)
--------- -------- ---------
Cash provided (used) by financing activities........ 137,887 (23,687) 107,806
--------- -------- ---------
Net change in cash.................................... 8,661 35 23
Cash as of beginning of year.......................... 58 23 --
--------- -------- ---------
CASH AS OF END OF YEAR................................ $ 8,719 $ 58 $ 23
========= ======== =========
</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 2000 and 1999 condensed financial information
have been reclassified to conform with the 2001 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, 2001, 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, NET LOSSES AND
DEFERRED POLICY CLAIMS AND LOSS UNEARNED PREMIUM INVESTMENT SETTLEMENT
SEGMENTS ACQUISITION COSTS EXPENSES PREMIUMS REVENUE INCOME EXPENSES
- ------------------------ ----------------- ----------------- ----------- ----------------------------------------------------
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
======= ========== ======== ======== ======= ========
1999
- ------------------------
Insurance Company....... $ 658 $ 966,864 $188,524 $141,362 $23,400 $109,650
Underwriting Agency..... 4,186
Intermediary............ 2,504
Other Operations........ 424
Corporate............... 432
------- ---------- -------- -------- ------- --------
Total................... $ 658 $ 966,864 $188,524 $141,362 $30,946 $109,650
======= ========== ======== ======== ======= ========
<Caption>
COLUMN I COLUMN J COLUMN K
--------- -------- ----------
(3)
FOR THE YEARS ENDED DECEMBER 31,
-----------------------------------------------------
AMORTIZATION OF
DEFERRED POLICY OTHER
ACQUISITION OPERATING PREMIUM
COSTS EXPENSES WRITTEN
------------- ----------- ----------
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
======= ======== ========
1999
- ------------------------
Insurance Company....... $ 8,177 $ 63,963 $139,924
Underwriting Agency..... 63,325
Intermediary............ 32,661
Other Operations........ 16,399
Corporate............... (417)
------- -------- --------
Total................... $ 8,177 $175,931 $139,924
======= ======== ========
</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, 2001:
Life insurance in force...... $597,886 $597,310 $ 0 $ 576 0%
======== ======== ======== ======== ===
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 $ 0 $137,000 0%
======== ======== ======== ======== ===
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%
======== ======== ======== ======== ===
For the year ended December
31, 1999:
Life insurance in force...... $832,305 $799,573 $ 0 $ 32,732 0%
======== ======== ======== ======== ===
Earned premium:
Property and liability
insurance.................. $230,879 $277,089 $127,495 $ 81,285 157%
Accident and health
insurance.................. 63,251 169,782 166,608 60,077 277%
-------- -------- -------- --------
Total...................... $294,130 $446,871 $294,103 $141,362 208%
======== ======== ======== ======== ===
</Table>
S-9
SCHEDULE 5
HCC INSURANCE HOLDINGS, INC.
VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS)
<Table>
<Caption>
2001 2000 1999
------- ------- --------
Reserve for uncollectible reinsurance:
Balance as of beginning of year........................... $ 4,057 $ 5,541 $ 2,499
Total provision charged to expense........................ 1,119 465 43,650
Total amounts written off................................. -- (1,949) (40,608)
------- ------- --------
BALANCE AS OF END OF YEAR.............................. $ 5,176 $ 4,057 $ 5,541
======= ======= ========
Allowance for doubtful accounts:
Balance as of beginning of year........................... $ 3,325 $ 1,729 $ 284
Acquisitions of subsidiaries.............................. 453 -- 629
Total provision charged to expense........................ 2,366 2,815 1,171
Total amounts written off................................. (3,365) (1,219) (355)
------- ------- --------
BALANCE AS OF END OF YEAR.............................. $ 2,779 $ 3,325 $ 1,729
======= ======= ========
</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.
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.
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.
(G)10.7 -- HCC Insurance Holdings, Inc. 1994 Nonemployee Director Stock
Option Plan.
(I)10.8 -- HCC Insurance Holdings, Inc. 1992 Incentive Stock Option
Plan, as amended and restated.
(I)10.9 -- HCC Insurance Holdings, Inc. 1995 Flexible Incentive Plan,
as amended and restated.
(I)10.10 -- HCC Insurance Holdings, Inc. 1997 Flexible Incentive Plan,
as amended and restated.
(I)10.11 -- HCC Insurance Holdings, Inc. 1996 Nonemployee Director Stock
Option Plan, as amended and restated.
(J)10.12 -- HCC Insurance Holdings, Inc. 2001 Flexible Incentive Plan.
10.13 -- Form of Incentive Stock Option Agreement under the HCC
Insurance Holdings, Inc. 2001 Flexible Incentive Plan.
(C)10.14 -- Employment Agreement effective as of January 1, 1999,
between HCC Insurance Holdings, Inc. and Stephen L. Way.
(H)10.15 -- Employment Agreement effective as of January 5, 2000,
between HCC Insurance Holdings, Inc. and John N. Molbeck,
Jr.
(E)10.16 -- Employment Agreement effective as of January 5, 2000,
between HCC Insurance Holdings, Inc. and Benjamin D. Wilcox.
(E)10.17 -- Employment Agreement effective as of January 5, 2000,
between HCC Insurance Holdings, Inc. and Frank J. Bramanti.
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 October 1, 2000 between
HCC Insurance Holdings, Inc. and Christopher L. Martin as
amended effective as of January 1, 2002.
12 -- Statement Regarding Computation of Ratios
21 -- Subsidiaries of HCC Insurance Holdings, Inc.
23 -- Consent of Independent Accountants -PricewaterhouseCoopers
LLP dated March 29, 2002.
24 -- Powers of Attorney
</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
Registration Statement on Form S-8 (Registration No. 33-94472) filed July
11, 1995.
(H) Incorporated by reference to Exhibits to HCC Insurance Holdings, Inc.'s Form
10-Q for the fiscal quarter ended March 31, 2000.
(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 24, 2001 Annual Meeting of
Shareholders filed April 26, 2001.