Edgar Filing: HCC INSURANCE HOLDINGS INC/DE/

Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

þ	Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

for the Quarterly Period Ended September 30, 2012.

¨	Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

from to

Commission file number 001-13790

HCC Insurance Holdings, Inc.

(Exact name of registrant as specified in its charter)


Delaware		76-0336636
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)

13403 Northwest Freeway, Houston, Texas		77040-6094
(Address of principal executive offices)		(Zip Code)

(713) 690-7300

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.

Yes þ No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes þ No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):


Large accelerated filer þ	Accelerated filer ¨	Non-accelerated filer ¨	Smaller reporting company ¨
		(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ¨ No þ

Indicate the number of shares outstanding of each of the registrant’s classes of common stock as of the latest practicable date.

On October 26, 2012, there were approximately 101.3 million shares of common stock outstanding.

HCC Insurance Holdings, Inc. and Subsidiaries

Table of Contents


	Page

Part I. FINANCIAL INFORMATION

Item 1. Financial Statements

Consolidated Balance Sheets — September 30, 2012 and December 31, 2011		5

Consolidated Statements of Earnings — Nine and three months ended September 30, 2012 and 2011		6

Consolidated Statements of Comprehensive Income — Nine and three months ended September 30, 2012 and 2011		7

Consolidated Statement of Changes in Shareholders’ Equity — Nine months ended September 30, 2012		8

Consolidated Statements of Cash Flows — Nine months ended September 30, 2012 and 2011		9

Notes to Consolidated Financial Statements		10

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		24

Item 3. Quantitative and Qualitative Disclosures About Market Risk		43

Item 4. Controls and Procedures		43

Part II. OTHER INFORMATION

Item 1. Legal Proceedings		44

Item 1A. Risk Factors		44

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		44

Item 3. Defaults Upon Senior Securities		44

Item 4. Mine Safety Disclosures		44

Item 5. Other Information		44

Item 6. Exhibits		45

Signatures		46

FORWARD-LOOKING STATEMENTS

This Report on Form 10-Q 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. These forward-looking statements reflect our current expectations and projections about future events and 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 growth of our business and operations, business strategy, competitive strengths, goals, plans, future capital expenditures and references to future successes may be considered forward-looking statements. Generally, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “plan,” “probably” or similar expressions indicate forward-looking statements.

Many risks and uncertainties may have an impact on the matters addressed in these forward-looking statements, which could affect our future financial results and performance, including, among other things:

•

the effects of catastrophe losses,

•

the cyclical nature of the insurance business,

•

inherent uncertainties in the loss estimation process, which can adversely impact the adequacy of loss reserves,

•

the impact of past and future potential credit market downturns, including any potential additional ratings downgrade and/or impairment or perceived impairment of the debt securities of sovereign issuers, including the United States of America,

•

the effects of emerging claim and coverage issues,

•

the effects of extensive governmental regulation of the insurance industry,

•

changes to the country’s health care delivery system,

•

the effects, if any, of climate change, on the risks we insure,

•

potential credit risk with brokers,

•

the effects of industry consolidations,

•

our assessment of underwriting risk,

•

our retention of risk, which could expose us to potential losses,

•

the adequacy of reinsurance protection,

•

the ability and willingness of reinsurers to pay balances due us,

•

the occurrence of terrorist activities,

•

our ability to maintain our competitive position,

•

fluctuations in securities markets, including defaults, which may reduce the value of our investment assets, reduce investment income or generate realized investment losses,

•

changes in our assigned financial strength ratings,

•

our ability to raise capital and funds for liquidity in the future,

•

attraction and retention of qualified employees,

•

our ability to successfully expand our business through the acquisition of insurance-related companies,

•

impairment of goodwill,

•

the ability of our insurance company subsidiaries to pay dividends in needed amounts,

•

fluctuations in foreign exchange rates,

•

failure of, or loss of security related to, our information technology systems,

•

difficulties with outsourcing relationships, and

•

change of control.

We describe these risks and uncertainties in greater detail in Item 1A, Risk Factors of our Annual Report on Form 10-K for the year ended December 31, 2011.

These events or factors 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, 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 that are included in this Report, our inclusion of this information is not a representation by us or any other person that our objectives or plans will be achieved.

Our forward-looking statements speak only at 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.

HCC Insurance Holdings, Inc. and Subsidiaries

Consolidated Balance Sheets

(unaudited, in thousands except per share data)


	September 30, 2012			December 31, 2011
				(as adjusted)

ASSETS

Investments
Fixed maturity securities – available for sale, at fair value (amortized cost: 2012 – $5,847,178 and 2011 – $5,385,432)	$	6,315,365		$	5,718,834
Fixed maturity securities – held to maturity, at amortized cost (fair value: $163,136)		-			161,102
Equity securities – available for sale, at fair value (cost: $197,469)		202,864			-
Short-term investments, at cost (approximates fair value)		160,138			133,917
Other investments, at fair value (amortized cost: 2012 – $31,550 and 2011 – $38,230)		34,044			35,897

Total investments		6,712,411			6,049,750

Cash		64,293			104,550
Restricted cash		125,974			229,821
Premium, claims and other receivables		604,881			688,732
Reinsurance recoverables		1,013,957			1,056,068
Ceded unearned premium		262,168			222,300
Ceded life and annuity benefits		58,771			61,061
Deferred policy acquisition costs		199,401			189,633
Goodwill		885,860			872,814
Other assets		152,668			122,549


Total assets	$	10,080,384		$	9,597,278


LIABILITIES

Loss and loss adjustment expense payable	$	3,692,250		$	3,658,317
Life and annuity policy benefits		58,771			61,061
Reinsurance, premium and claims payable		321,064			366,499
Unearned premium		1,118,094			1,031,034
Deferred ceding commissions		74,441			62,364
Notes payable		548,906			478,790
Accounts payable and accrued liabilities		762,038			665,231


Total liabilities		6,575,564			6,323,296


SHAREHOLDERS’ EQUITY

Common stock, $1.00 par value; 250,000 shares authorized (shares issued: 2012 – 124,459 and 2011 – 122,720; outstanding: 2012 – 101,297 and 2011 – 104,101)		124,459			122,720
Additional paid-in capital		1,046,435			1,001,308
Retained earnings		2,664,745			2,429,818
Accumulated other comprehensive income		318,239			227,659
Treasury stock, at cost (shares: 2012 – 23,162 and 2011 – 18,619)		(649,058	)		(507,523	)


Total shareholders’ equity		3,504,820			3,273,982


Total liabilities and shareholders’ equity	$	10,080,384		$	9,597,278

See Notes to Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Consolidated Statements of Earnings

(unaudited, in thousands except per share data)


	Nine months ended September 30,						Three months ended September 30,
	2012			2011			2012			2011
REVENUE

Net earned premium	$	1,676,122		$	1,576,987		$	563,650		$	544,256
Net investment income		166,642			158,782			56,342			54,765
Other operating income		23,229			23,625			10,840			8,829
Net realized investment gain		8,519			3,169			1,472			2,674
Other-than-temporary impairment credit losses		(1,028	)		(3,479	)		(631	)		-


Total revenue		1,873,484			1,759,084			631,673			610,524


EXPENSE

Loss and loss adjustment expense, net		969,767			1,062,240			304,014			380,372
Policy acquisition costs, net		211,554			193,180			67,620			57,496
Other operating expense		268,164			244,491			100,458			84,254
Interest expense		19,101			16,597			5,962			5,610


Total expense		1,468,586			1,516,508			478,054			527,732


Earnings before income tax expense		404,898			242,576			153,619			82,792
Income tax expense		121,759			65,671			46,557			22,355


Net earnings	$	283,139		$	176,905		$	107,062		$	60,437


Earnings per common share

Basic	$	2.77		$	1.58		$	1.06		$	0.56


Diluted	$	2.76		$	1.57		$	1.05		$	0.56

See Notes to Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income

(unaudited, in thousands)


	Nine months ended September 30,						Three months ended September 30,
	2012			2011			2012			2011

Net earnings	$	283,139		$	176,905		$	107,062		$	60,437

Other comprehensive income:

Investment gains:
Investment gains during the period		152,498			155,933			91,185			100,555
Income tax charge		54,078			51,356			32,274			36,059


Investment gains, net of tax		98,420			104,577			58,911			64,496


Less reclassification adjustments for:
Gains (losses) included in net earnings		7,491			(306	)		832			2,672
Income tax charge (benefit)		2,622			(107	)		291			935


Gains (losses) included in net earnings, net of tax		4,869			(199	)		541			1,737


Net unrealized investment gains		93,551			104,776			58,370			62,759


Foreign currency translation adjustment		(3,454	)		1,865			(141	)		(6,297	)
Income tax charge (benefit)		(483	)		1,809			(234	)		331


Foreign currency translation adjustment, net of tax		(2,971	)		56			93			(6,628	)


Other comprehensive income		90,580			104,832			58,463			56,131


Comprehensive income	$	373,719		$	281,737		$	165,525		$	116,568

See Notes to Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Consolidated Statement of Changes in Shareholders’ Equity

Nine months ended September 30, 2012

(unaudited, in thousands except per share data)


	Common stock		Additional paid-in capital		Retained earnings			Accumulated other comprehensive income		Treasury stock			Total shareholders’ equity
Balance at December 31, 2011 (as previously reported)	$	122,720	$	1,001,308	$	2,447,850		$	227,659	$	(507,523	)	$	3,292,014

Cumulative effect of accounting change (deferred policy acquisition costs)		-		-		(18,032	)		-		-			(18,032	)


Balance at December 31, 2011 (as adjusted)		122,720		1,001,308		2,429,818			227,659		(507,523	)		3,273,982

Net earnings		-		-		283,139			-		-			283,139

Other comprehensive income		-		-		-			90,580		-			90,580

Issuance of 1,437 shares for exercise of options, including tax effect		1,437		38,668		-			-		-			40,105

Purchase of 4,543 common shares		-		-		-			-		(141,535	)		(141,535	)

Stock-based compensation		302		6,459		-			-		-			6,761

Cash dividends declared, $0.475 per share		-		-		(48,212	)		-		-			(48,212	)


Balance at September 30, 2012	$	124,459	$	1,046,435	$	2,664,745		$	318,239	$	(649,058	)	$	3,504,820

See Notes to Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(unaudited, in thousands)


	Nine months ended September 30,
	2012		2011
Operating activities
Net earnings	$	283,139	$	176,905
Adjustments to reconcile net earnings to net cash provided by operating activities:
Change in premium, claims and other receivables		6,623		(76,927)
Change in reinsurance recoverables		47,149		(56,510)
Change in ceded unearned premium		(39,918)		47,477
Change in loss and loss adjustment expense payable		16,052		196,046
Change in unearned premium		87,177		24,655
Change in reinsurance, premium and claims payable, excluding restricted cash		(32,743)		(34,052)
Change in accounts payable and accrued liabilities		79,500		5,082
Stock-based compensation expense		10,361		10,017
Depreciation and amortization expense		13,919		13,214
Other, net		24,776		(17,948)


Cash provided by operating activities		496,035		287,959


Investing activities
Sales of available for sale fixed maturity securities		293,969		494,532
Sales of equity securities		7,145		-
Maturity or call of available for sale fixed maturity securities		504,583		318,558
Maturity or call of held to maturity fixed maturity securities		28,511		24,950
Cost of available for sale fixed maturity securities acquired		(1,056,909)		(1,243,124)
Cost of equity securities acquired		(205,092)		-
Change in short-term investments		(5,401)		288,909
Cost of other investments acquired		-		(33,060)
Payments for purchase of businesses, net of cash received		(32,590)		(1,892)
Other, net		(2,911)		(14,184)


Cash used by investing activities		(468,695)		(165,311)


Financing activities
Advances on line of credit		140,000		210,000
Payments on line of credit		(70,000)		(15,000)
Sale of common stock		40,105		36,245
Purchase of common stock		(135,151)		(303,311)
Dividends paid		(47,617)		(49,301)
Other, net		5,066		(6,001)


Cash used by financing activities		(67,597)		(127,368)


Net decrease in cash		(40,257)		(4,720)
Cash at beginning of year		104,550		97,857


Cash at end of period	$	64,293	$	93,137

See Notes to Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

(1) General Information

HCC Insurance Holdings, Inc. (HCC) and its subsidiaries (collectively we, us or our) include domestic and foreign property and casualty and life insurance companies and underwriting agencies with offices in the United States, the United Kingdom, Spain and Ireland. We underwrite a variety of relatively non-correlated specialty insurance products, including property and casualty, accident and health, surety, credit and aviation product lines, in approximately 180 countries. We market our products through a network of independent agents and brokers, producers, managing general agents and directly to customers.

Basis of Presentation

Our unaudited consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (GAAP) and include the accounts of HCC and its subsidiaries. We have made all adjustments that, in our opinion, are necessary for a fair statement of results of the interim periods, and all such adjustments are of a normal recurring nature. All significant intercompany balances and transactions have been eliminated in consolidation. The consolidated financial statements should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2011. The consolidated balance sheet at December 31, 2011 was derived from the audited financial statements but does not include all disclosures required by GAAP.

Management must make estimates and assumptions that affect amounts reported in our consolidated financial statements and in disclosures of contingent assets and liabilities. Ultimate results could differ from those estimates. We have reclassified certain amounts in our 2011 consolidated financial statements to conform to the 2012 presentation. None of our reclassifications had an effect on our consolidated net earnings, shareholders’ equity or cash flows.

Accounting Guidance Adopted in 2012

Deferred Policy Acquisition Costs

A new accounting standard clarifies the definition of acquisition costs incurred by an insurance company and limits capitalization to such costs directly related to renewing or acquiring new insurance contracts. Under the new standard, we expense all costs incurred for unsuccessful marketing or underwriting efforts, along with indirect costs, as incurred. We adopted this guidance on January 1, 2012 through retrospective adjustment of the capitalized deferred policy acquisition costs, deferred income taxes and consolidated shareholders’ equity in our prior years’ consolidated financial statements. We also reclassified expenses in our prior years’ consolidated income statements to reflect the new definition of policy acquisition costs. Application of the new guidance did not impact our reported consolidated net earnings or cash flows in prior years. The following line items in our consolidated financial statements were affected by this change in accounting guidance:


	December 31, 2011
	As originally reported		Change		As adjusted
Deferred policy acquisition costs	$	217,608	$	(27,975)	$	189,633
Accounts payable and accrued liabilities (deferred income taxes)		675,174		(9,943)		665,231
Retained earnings		2,447,850		(18,032)		2,429,818


	Nine months ended September 30, 2011							Three months ended September 30, 2011
	As originally							As originally
	reported		Change			As adjusted		reported		Change			As adjusted
Policy acquisition costs, net	$	239,160	$	(45,980	)	$	193,180	$	71,299	$	(13,803	)	$	57,496
Other operating expense		198,511		45,980			244,491		70,451		13,803			84,254

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

(2) Investments

On March 31, 2012, we reclassified our entire portfolio of fixed maturity securities classified as held to maturity, which consisted of corporate, U.S. government and foreign government securities, to fixed maturity securities classified as available for sale. The European debt crisis and the August 2011 downgrade of U.S. government debt by Standard & Poor’s Corporation had recently disrupted the financial markets. Due to these market disruptions and our desire to maintain greater flexibility in managing our entire investment portfolio in an uncertain economy, we changed our prior intent to hold these securities to maturity. On the date of transfer, these securities had a fair value of $139.1 million and an amortized cost of $136.0 million. The securities’ net unrealized appreciation, net of tax, increased our accumulated other comprehensive income and shareholders’ equity by $2.0 million as of March 31, 2012.

The cost or amortized cost, gross unrealized gain or loss, and fair value of our fixed maturity and equity securities were as follows:


	Cost or		Gross		Gross
	amortized		unrealized		unrealized
	cost		gain		loss		Fair value
September 30, 2012

U.S. government and government agency securities	$	224,267	$	7,769	$	-	$	232,036
Fixed maturity securities of states, municipalities and political subdivisions		977,682		101,493		-		1,079,175
Special purpose revenue bonds of states, municipalities and political subdivisions		1,895,991		180,049		(23)		2,076,017
Corporate securities		1,152,593		66,475		(1,761)		1,217,307
Residential mortgage-backed securities		789,172		52,999		(629)		841,542
Commercial mortgage-backed securities		479,517		44,635		(52)		524,100
Asset-backed securities		47,354		370		-		47,724
Foreign government securities		280,602		16,866		(4)		297,464


Total fixed maturity securities – available for sale	$	5,847,178	$	470,656	$	(2,469)	$	6,315,365


Equity securities – available for sale	$	197,469	$	8,741	$	(3,346)	$	202,864


December 31, 2011

U.S. government and government agency securities	$	285,166	$	10,523	$	(10)	$	295,679
Fixed maturity securities of states, municipalities and political subdivisions		999,940		85,528		(127)		1,085,341
Special purpose revenue bonds of states, municipalities and political subdivisions		1,741,297		122,746		(155)		1,863,888
Corporate securities		817,886		35,221		(6,774)		846,333
Residential mortgage-backed securities		1,036,436		65,771		(2,121)		1,100,086
Commercial mortgage-backed securities		244,535		15,162		(3,573)		256,124
Asset-backed securities		34,655		147		(56)		34,746
Foreign government securities		225,517		11,203		(83)		236,637


Total fixed maturity securities – available for sale	$	5,385,432	$	346,301	$	(12,899)	$	5,718,834


U.S. government securities	$	6,998	$	69	$	-	$	7,067
Corporate securities		110,284		1,814		(455)		111,643
Foreign government securities		43,820		746		(140)		44,426


Total fixed maturity securities – held to maturity	$	161,102	$	2,629	$	(595)	$	163,136

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

Substantially all of our fixed maturity securities are investment grade and only one security was non-income producing in 2012. The following table displays the gross unrealized losses and fair value of all available for sale securities that were in a continuous unrealized loss position for the periods indicated.


	Less than 12 months				12 months or more				Total

	Fair value		Unrealized losses		Fair value		Unrealized losses		Fair value		Unrealized losses
September 30, 2012

Fixed maturity securities
Special purpose revenue bonds of states, municipalities and political subdivisions	$	2,813	$	(23)	$	-	$	-	$	2,813	$	(23)
Corporate securities		89,993		(1,727)		2,441		(34)		92,434		(1,761)
Residential mortgage-backed securities		11,540		(97)		6,633		(532)		18,173		(629)
Commercial mortgage-backed securities		7,906		(52)		-		-		7,906		(52)
Foreign government securities		9,259		(4)		-		-		9,259		(4)
Equity securities		74,051		(3,346)		-		-		74,051		(3,346)


Total	$	195,562	$	(5,249)	$	9,074	$	(566)	$	204,636	$	(5,815)


December 31, 2011

Fixed maturity securities
U.S. government and government agency securities	$	13,984	$	(10)	$	-	$	-	$	13,984	$	(10)
Fixed maturity securities of states, municipalities and political subdivisions		10,256		(107)		899		(20)		11,155		(127)
Special purpose revenue bonds of states, municipalities and political subdivisions		21,856		(67)		6,796		(88)		28,652		(155)
Corporate securities		154,856		(6,391)		18,005		(383)		172,861		(6,774)
Residential mortgage-backed securities		32,430		(1,364)		7,582		(757)		40,012		(2,121)
Commercial mortgage-backed securities		39,075		(3,573)		-		-		39,075		(3,573)
Asset-backed securities		19,648		(56)		-		-		19,648		(56)
Foreign government securities		4,198		(83)		-		-		4,198		(83)


Total	$	296,303	$	(11,651)	$	33,282	$	(1,248)	$	329,585	$	(12,899)

Our other-than-temporary impairment losses were as follows:


	Nine months ended September 30,				Three months ended September 30,
	2012		2011		2012		2011
Total other-than-temporary impairment loss	$	(2,069)	$	(4,677)	$	(686)	$	-
Portion recognized in other comprehensive income		1,041		1,198		55		-

Net other-than-temporary impairment loss recognized in earnings (credit loss)	$	(1,028)	$	(3,479)	$	(631)	$	-

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

Certain of our securities with an other-than-temporary impairment loss have had both a credit loss and an impairment loss recorded in other comprehensive income. The rollforward of credit losses on these securities was as follows:


	Nine months ended September 30,				Three months ended September 30,
	2012		2011		2012		2011
Balance at beginning of period	$	5,047	$	4,273	$	5,444	$	3,847
Credit losses recognized in earnings
Securities previously impaired		899		1,597		631		-
Securities not previously impaired		129		1,882		-		-
Securities sold		-		(3,905)		-		-


Balance at September 30	$	6,075	$	3,847	$	6,075	$	3,847

We do not consider the $5.8 million of gross unrealized losses on fixed maturity and equity securities in our portfolio at September 30, 2012 to be other-than-temporary impairments because: 1) as of September 30, 2012, we have received substantially all contractual interest and principal payments on the fixed maturity securities, 2) we do not intend to sell these securities, 3) it is more likely than not that we will not be required to sell the securities before recovery of their amortized cost or cost bases and 4) the unrealized loss relates to non-credit factors, such as interest rate changes and market conditions.

The amortized cost and fair value of our fixed maturity securities at September 30, 2012, 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 mortgage-backed and asset-backed securities was 5.2 years at September 30, 2012.


	Cost or amortized cost		Fair value
Due in 1 year or less	$	335,455	$	340,330
Due after 1 year through 5 years		1,063,361		1,121,440
Due after 5 years through 10 years		1,331,492		1,462,880
Due after 10 years through 15 years		869,485		961,876
Due after 15 years		931,342		1,015,473

Securities with contractual maturities		4,531,135		4,901,999
Mortgage-backed and asset-backed securities		1,316,043		1,413,366


Total fixed maturity securities	$	5,847,178	$	6,315,365

The sources of net investment income were as follows:


	Nine months ended September 30,				Three months ended September 30,
	2012		2011		2012		2011
Fixed maturity securities
Taxable	$	86,548	$	84,228	$	28,330	$	30,009
Exempt from U.S. income taxes		80,163		74,713		27,291		24,887

Total fixed maturity securities		166,711		158,941		55,621		54,896
Equity securities		2,339		-		1,346		-
Short-term investments		397		420		295		99
Other investment income		1,699		2,992		831		962

Total investment income		171,146		162,353		58,093		55,957
Investment expense		(4,504)		(3,571)		(1,751)		(1,192)


Net investment income	$	166,642	$	158,782	$	56,342	$	54,765

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

Realized pretax gains (losses) on the sale of investments, which exclude other-than-temporary impairment credit losses, included the following:


	Nine months ended September 30,				Three months ended September 30,
	2012		2011		2012		2011

Gains	$	11,596	$	8,538	$	3,469	$	4,219
Losses		(3,077)		(5,369)		(1,997)		(1,545)


Net realized investment gain (loss)	$	8,519	$	3,169	$	1,472	$	2,674

(3) Derivative Financial Instrument

We utilize the British pound sterling and the Euro as the functional currency in certain of our foreign operations. As a result, we have exposure to fluctuations in exchange rates between these currencies and the U.S. dollar. From time to time, we may use derivative instruments to protect our investment in these foreign operations by limiting our exposure to fluctuations in exchange rates.

During the second quarter of 2012, we entered into a forward contract to sell 45.0 million Euros for U.S. dollars in the third quarter of 2013. This transaction has been designated and qualifies as a hedge of a portion of our net investment in a Euro-functional currency subsidiary. Changes in the fair value of the forward contract, net of the related deferred tax effect, are recognized in our foreign currency translation adjustment, which is a component of accumulated other comprehensive income. This amount will offset changes in the value of the net investment being hedged as the cumulative translation adjustment related to the foreign subsidiary, representing the effect of translating the subsidiary’s assets and liabilities from Euros to U.S. dollars, is also reported in our foreign currency translation adjustment.

The fair value of the forward contract was a $1.7 million liability at September 30, 2012. This amount is reported in accounts payable and accrued liabilities on our consolidated balance sheet. At inception of the hedge and quarterly thereafter, we assess whether the hedge transaction is effective. Any ineffectiveness would be recognized in earnings immediately as other operating expense. There was no ineffectiveness on the forward contract during 2012.

(4) Fair Value Measurements

Our financial instruments include assets and liabilities carried at fair value, as well as assets and liabilities carried at cost or amortized cost but disclosed at fair value in our financial statements. In determining fair value, we generally apply the market approach, which uses prices and other relevant data based on market transactions involving identical or comparable assets and liabilities. We classify our financial instruments into the following three-level hierarchy:

•

Level 1 – Inputs are based on quoted prices in active markets for identical instruments.

•

Level 2 – Inputs are based on observable market data (other than quoted prices), or are derived from or corroborated by observable market data.

•

Level 3 – Inputs are unobservable and not corroborated by market data.

Our Level 1 investments consist of U.S. Treasuries, money market funds, and equity securities traded in an active exchange market. We use unadjusted quoted prices for identical instruments to measure fair value.

Our Level 2 investments include most of our fixed maturity securities, which consist of U.S. government agency securities, municipal bonds, corporate debt securities, bank loans, and mortgage-backed and asset-backed securities. Level 2 also includes certificates of deposit and other interest-bearing deposits at banks, which we report as short-term investments, and a forward contract, which hedges our net investment in a Euro-functional currency foreign subsidiary. We measure fair value for the majority of our Level 2 investments using quoted prices of securities with similar characteristics. The remaining investments are valued using pricing models or matrix pricing. The fair value measurements consider observable assumptions, including benchmark yields, reported trades,

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, default rates, loss severity and other economic measures.

We use independent pricing services to assist us in determining fair value for approximately 99% of our Level 2 investments. The pricing services provide a single price or quote per security. We use data provided by our third party investment managers to value the remaining Level 2 investments. To validate that these quoted and modeled prices are reasonable estimates of fair value, we perform various quantitative and qualitative procedures, including: 1) evaluation of the underlying methodologies, 2) analysis of recent sales activity, 3) analytical review of our fair values against current market prices and 4) comparison of the pricing services’ fair value to other pricing services’ fair value for the same investment. No markets for our investments were judged to be inactive at period end. Based on these procedures, we did not adjust the prices or quotes provided by our independent pricing services or third party investment managers as of September 30, 2012 or December 31, 2011.

Our Level 2 financial instruments also include our notes payable. We determine the fair value of our 6.30% Senior Notes based on quoted prices, but the market is inactive. The fair value of borrowings under our Revolving Loan Facility approximates the carrying amount because interest is based on 30-day LIBOR plus a margin.

Our Level 3 securities include certain fixed maturity securities and an insurance contract that we account for as a derivative and classify in other assets. We determine fair value of our Level 3 securities based on internally developed models that use assumptions or other data that are not readily observable from objective sources.

The following tables present the fair value of our financial instruments that were carried or disclosed at fair value. Unless indicated, these items were carried at fair value on our consolidated balance sheet.


	Level 1		Level 2		Level 3		Total
September 30, 2012

Fixed maturity securities – available for sale
U.S. government and government agency securities	$	193,051	$	38,985	$	-	$	232,036
Fixed maturity securities of states, municipalities and political subdivisions		-		1,079,175		-		1,079,175
Special purpose revenue bonds of states, municipalities and political subdivisions		-		2,076,017		-		2,076,017
Corporate securities		-		1,217,145		162		1,217,307
Residential mortgage-backed securities		-		841,542		-		841,542
Commercial mortgage-backed securities		-		524,100		-		524,100
Asset-backed securities		-		47,724		-		47,724
Foreign government securities		-		297,464		-		297,464

Total fixed maturity securities – available for sale		193,051		6,122,152		162		6,315,365
Equity securities – available for sale		202,864		-		-		202,864
Short-term investments*		81,947		78,191		-		160,138
Other investments		34,044		-		-		34,044
Other assets		-		-		206		206


Total assets measured at fair value	$	511,906	$	6,200,343	$	368	$	6,712,617


Notes payable*	$	-	$	595,804	$	-	$	595,804
Accounts payable and accrued liabilities – forward contract		-		1,705		-		1,705


Total liabilities measured at fair value	$	-	$	597,509	$	-	$	597,509

*Carried at cost or amortized cost on our consolidated balance sheet.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)


	Level 1		Level 2		Level 3		Total
December 31, 2011

Fixed maturity securities – available for sale
U.S. government and government agency securities	$	201,582	$	94,097	$	-	$	295,679
Fixed maturity securities of states, municipalities and political subdivisions		-		1,085,341		-		1,085,341
Special purpose revenue bonds of states, municipalities and political subdivisions		-		1,863,888		-		1,863,888
Corporate securities		-		846,178		155		846,333
Residential mortgage-backed securities		-		1,100,086		-		1,100,086
Commercial mortgage-backed securities		-		256,124		-		256,124
Asset-backed securities		-		33,731		1,015		34,746
Foreign government securities		-		236,637		-		236,637

Total fixed maturity securities – available for sale		201,582		5,516,082		1,170		5,718,834
Fixed maturity securities – held to maturity*		-		163,136		-		163,136
Short-term investments*		67,288		66,629		-		133,917
Other investments		35,720		-		-		35,720
Other assets		-		-		1,516		1,516


Total assets measured at fair value	$	304,590	$	5,745,847	$	2,686	$	6,053,123


Notes payable*	$	-	$	505,671	$	-	$	505,671

*Carried at cost or amortized cost on our consolidated balance sheet.

The following tables present the changes in fair value of our Level 3 financial instruments.


	2012									2011
	Fixed									Fixed
	income			Other						income			Other
	securities			assets			Total			securities			assets		Total
Balance at beginning of year	$	1,170		$	1,516		$	2,686		$	1,438		$	857	$	2,295
Net gains (losses)		2			215			217			(13	)		263		250
Sales		-			-			-			(144	)		-		(144	)
Transfers out of Level 3		(1,015	)		-			(1,015	)		-			-		-


Balance at March 31		157			1,731			1,888			1,281			1,120		2,401
Net gains (losses)		2			116			118			18			122		140
Sales		-			-			-			(55	)		-		(55	)


Balance at June 30		159			1,847			2,006			1,244			1,242		2,486
Settlements		-			(1,863	)		(1,863	)		-			-		-
Net gains (losses)		3			222			225			17			131		148
Sales		-			-			-			(43	)		-		(43	)


Balance at September 30	$	162		$	206		$	368		$	1,218		$	1,373	$	2,591

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

We transferred an investment from Level 3 to Level 2 in the first quarter of 2012 because we were able to determine its fair value using inputs based on observable market data in the period transferred. There were no transfers between Level 1, Level 2 or Level 3 in the second and third quarters of 2012 or the first nine months of 2011.

(5) Goodwill

The goodwill balances by reportable segment and the changes in goodwill are shown in the table below.


	U.S. Property		Professional		Accident &			U.S. Surety
	& Casualty		Liability		Health			& Credit		International		Total
Balance at beginning of year	$	223,000	$	301,547	$	144,132		$	79,700	$	124,435		$	872,814
Earnout and other		-		12,542		(19	)		-		523			13,046


Balance at September 30, 2012	$	223,000	$	314,089	$	144,113		$	79,700	$	124,958		$	885,860

We acquired HCC Global Financial Products (HCC Global), which underwrites our U.S. and International directors’ and officers’ liability business, in 2002. The purchase agreement, as amended, includes a contingency for future earnout payments. The earnout is based on HCC Global’s pretax earnings on business written from the acquisition date through September 30, 2007, with no maximum amount due to the former owners. When conditions specified under the purchase agreement are met, we record a net amount owed to or due from the former owners based on our estimate, at that point in time, of how claims will ultimately be settled. This net amount will fluctuate in the future, and the ultimate total net earnout payments cannot be finally determined until all claims are settled or paid. In the third quarter of 2012, we increased goodwill by $11.8 million for additional earnout earned and accrued under the purchase agreement.

We conducted our 2012 goodwill impairment test as of June 30, 2012, which is consistent with the timeframe for our annual assessment in prior years. Based on our latest assessment, the fair value of each of our five reporting units exceeded its carrying amount.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

(6) Reinsurance

In the normal course of business, our insurance companies cede a portion of their premium to domestic and foreign reinsurers through treaty and facultative reinsurance agreements. Although reinsurance does not discharge the direct insurer from liability to its policyholder, our insurance companies participate in such agreements in order to limit their loss exposure, protect them against catastrophic losses and diversify their business. The following tables present the effect of such reinsurance transactions on our premium, loss and loss adjustment expense and policy acquisition costs.


	Nine months ended September 30,				Three months ended September 30,
	2012		2011		2012		2011
Direct written premium	$	1,826,610	$	1,724,869	$	603,844	$	555,427
Reinsurance assumed		313,395		295,268		61,919		73,420
Reinsurance ceded		(409,206)		(359,046)		(135,456)		(116,513)


Net written premium	$	1,730,799	$	1,661,091	$	530,307	$	512,334


Direct earned premium	$	1,795,109	$	1,728,082	$	601,572	$	574,571
Reinsurance assumed		259,870		255,293		90,988		96,799
Reinsurance ceded		(378,857)		(406,388)		(128,910)		(127,114)


Net earned premium	$	1,676,122	$	1,576,987	$	563,650	$	544,256


Direct loss and loss adjustment expense	$	1,029,227	$	1,197,225	$	301,306	$	410,573
Reinsurance assumed		96,143		186,805		35,108		44,600
Reinsurance ceded		(155,603)		(321,790)		(32,400)		(74,801)


Net loss and loss adjustment expense	$	969,767	$	1,062,240	$	304,014	$	380,372


Policy acquisition costs	$	299,854	$	292,645	$	101,698	$	100,975
Ceding commissions		(88,300)		(99,465)		(34,078)		(43,479)


Net policy acquisition costs	$	211,554	$	193,180	$	67,620	$	57,496

The table below shows the components of our reinsurance recoverables in our consolidated balance sheets.


	September 30,			December 31,
	2012			2011
Reinsurance recoverable on paid losses	$	58,220		$	83,109
Reinsurance recoverable on outstanding losses		479,378			477,760
Reinsurance recoverable on incurred but not reported losses		477,859			497,074
Reserve for uncollectible reinsurance		(1,500	)		(1,875	)


Total reinsurance recoverables	$	1,013,957		$	1,056,068

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

Reinsurers not authorized by the respective states of domicile of our U.S. domiciled insurance companies are required to collateralize reinsurance obligations due to us. The table below shows the amounts of letters of credit and cash available to us as collateral, plus other potential offsets at September 30, 2012 and December 31, 2011.


	September 30,		December 31,
	2012		2011
Payables to reinsurers	$	201,598	$	195,806
Letters of credit		97,357		120,589
Cash		112,105		83,731


Total credits	$	411,060	$	400,126

The tables below show the calculation of net reserves, net unearned premium and net deferred policy acquisition costs.


	September 30,			December 31,
	2012			2011
Loss and loss adjustment expense payable	$	3,692,250		$	3,658,317
Reinsurance recoverable on outstanding losses		(479,378	)		(477,760	)
Reinsurance recoverable on incurred but not reported losses		(477,859	)		(497,074	)


Net reserves	$	2,735,013		$	2,683,483


Unearned premium	$	1,118,094		$	1,031,034
Ceded unearned premium		(262,168	)		(222,300	)


Net unearned premium	$	855,926		$	808,734


Deferred policy acquisition costs	$	199,401		$	189,633
Deferred ceding commissions		(74,441	)		(62,364	)


Net deferred policy acquisition costs	$	124,960		$	127,269

(7) Notes Payable

Notes payable were as follows:


	September 30,		December 31,
	2012		2011
6.30% Senior Notes	$	298,906	$	298,790
$600.0 million Revolving Loan Facility		250,000		180,000


Total notes payable	$	548,906	$	478,790

We have a $90.0 million Standby Letter of Credit Facility that is used to guarantee our performance in our Lloyd’s of London Syndicate 4141. There have been no changes to the terms and conditions related to our 6.30% Senior Notes, the $600.0 million Revolving Loan Facility (the Facility) or the Standby Letter of Credit Facility from those described in Note 7, “Notes Payable” to the Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2011.

The weighted-average interest rate on borrowings under the Facility at September 30, 2012 was 1.60%. The borrowings and letters of credit issued under the Facility reduced our available borrowing capacity on the Facility to $340.1 million at September 30, 2012.

We were in compliance with debt covenants related to our 6.30% Senior Notes, the Facility and the Standby Letter of Credit Facility at September 30, 2012.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

(8) Earnings Per Share

The following table details the numerator and denominator used in our earnings per share calculations.


	Nine months ended September 30,						Three months ended September 30,
	2012			2011			2012			2011
Net earnings	$	283,139		$	176,905		$	107,062		$	60,437
Less: net earnings attributable to unvested restricted stock		(5,150	)		(2,551	)		(1,912	)		(950	)


Net earnings available to common stock	$	277,989		$	174,354		$	105,150		$	59,487

Weighted-average common shares outstanding		100,340			110,665			99,424			106,919
Dilutive effect of outstanding options (determined using treasury stock method)		261			245			276			129


Weighted-average common shares and potential common shares outstanding		100,601			110,910			99,700			107,048


Anti-dilutive stock options not included in treasury stock method computation		717			2,279			461			2,744

(9) Stock-Based Compensation

In 2012, we granted the following shares of common stock, restricted stock awards, restricted stock units and stock options for the purchase of shares of our common stock. For all grants except stock options, we measure fair value based on the closing stock price of our common stock on the grant date. For stock options, we use the Black-Scholes single option pricing model to determine the fair value of an option on its grant date. The fair value of the common stock was expensed on the grant date. The fair value of the restricted stock awards, restricted stock units and stock options is being expensed over the vesting period.


	Number of shares		Weighted-average grant date fair value		Aggregate fair value		Vesting period

Common stock		29	$	31.49	$	920		None
Restricted stock awards		313		31.20		9,758		2-4 years
Restricted stock units		13		30.60		403		4 years
Stock options		218		8.00		1,741		1-5 years

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

(10) Segments

We report HCC’s results in six operating segments, including the following five insurance segments:


• U.S. Property & Casualty		• U.S. Surety & Credit
• Professional Liability		• International
• Accident & Health

The Investing segment includes our consolidated investment portfolio, as well as all investment income, investment related expenses, realized investment gains and losses, and other-than-temporary impairment credit losses on investments. All investment activity is reported as revenue, consistent with our consolidated presentation.

In addition to our segments, we include a Corporate & Other category to reconcile segment results to consolidated totals. The Corporate & Other category includes corporate operating expenses not allocable to the segments, interest expense on long-term debt, foreign currency expense (benefit), and underwriting results of our Exited Lines.

Our Exited Lines include product lines that we no longer write and do not expect to write in the future. In the third quarter of 2012, we exited the HMO and medical excess reinsurance businesses that had previously been included in our Accident & Health segment. We have recast all prior financial data to report these two lines of business in Exited Lines for all periods presented.

The following tables present information by business segment.


	U.S. Property & Casualty		Professional Liability		Accident & Health		U.S. Surety & Credit		International		Investing		Corporate & Other		Consolidated
Nine months ended September 30, 2012

Net earned premium	$	265,593	$	298,454	$	624,077	$	154,232	$	302,303	$	-	$	31,463	$	1,676,122
Other revenue		15,300		799		3,589		659		2,766		174,133		116		197,362


Segment revenue		280,893		299,253		627,666		154,891		305,069		174,133		31,579		1,873,484


Loss and LAE		154,156		170,506		447,262		42,444		126,547		-		28,852		969,767
Other expense		89,348		49,621		93,127		83,402		108,018		-		75,303		498,819


Segment expense		243,504		220,127		540,389		125,846		234,565		-		104,155		1,468,586


Segment pretax earnings (loss)	$	37,389	$	79,126	$	87,277	$	29,045	$	70,504	$	174,133	$	(72,576)	$	404,898

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)


	U.S. Property & Casualty		Professional Liability			Accident & Health		U.S. Surety & Credit		International			Investing		Corporate & Other			Consolidated
Nine months ended September 30, 2011

Net earned premium	$	245,121	$	307,240		$	568,318	$	153,309	$	267,458		$	-	$	35,541		$	1,576,987
Other revenue		16,556		358			3,468		955		2,791			158,472		(503	)		182,097


Segment revenue		261,677		307,598			571,786		154,264		270,249			158,472		35,038			1,759,084


Loss and LAE		148,783		257,632			411,851		42,351		175,635			-		25,988			1,062,240
Other expense		82,202		40,055			89,228		82,909		99,754			-		60,120			454,268


Segment expense		230,985		297,687			501,079		125,260		275,389			-		86,108			1,516,508


Segment pretax earnings (loss)	$	30,692	$	9,911		$	70,707	$	29,004	$	(5,140	)	$	158,472	$	(51,070	)	$	242,576


Three months ended September 30, 2012

Net earned premium	$	87,741	$	97,549		$	209,049	$	53,388	$	105,831		$	-	$	10,092		$	563,650
Other revenue		8,415		532			1,095		244		631			57,183		(77	)		68,023


Segment revenue		96,156		98,081			210,144		53,632		106,462			57,183		10,015			631,673


Loss and LAE		53,229		36,183			140,344		15,721		46,924			-		11,613			304,014
Other expense		29,581		13,414			32,025		27,879		39,253			-		31,888			174,040


Segment expense		82,810		49,597			172,369		43,600		86,177			-		43,501			478,054


Segment pretax earnings (loss)	$	13,346	$	48,484		$	37,775	$	10,032	$	20,285		$	57,183	$	(33,486	)	$	153,619


Three months ended September 30, 2011

Net earned premium	$	85,946	$	104,066		$	191,715	$	51,906	$	99,294		$	-	$	11,329		$	544,256
Other revenue		6,890		109			1,275		254		889			57,439		(588	)		66,268


Segment revenue		92,836		104,175			192,990		52,160		100,183			57,439		10,741			610,524


Loss and LAE		56,355		119,617			138,566		12,664		45,242			-		7,928			380,372
Other expense		26,627		6,023			29,897		27,657		35,734			-		21,422			147,360


Segment expense		82,982		125,640			168,463		40,321		80,976			-		29,350			527,732


Segment pretax earnings (loss)	$	9,854	$	(21,465	)	$	24,527	$	11,839	$	19,207		$	57,439	$	(18,609	)	$	82,792

Catastrophe losses reduced the International segment’s pretax earnings by $15.9 million and $101.7 million in the first nine months of 2012 and 2011, respectively, and $7.6 million and $29.4 million in the third quarter of 2012 and 2011, respectively. The Professional Liability segment’s pretax earnings were reduced by $75.4 million in the first nine months and $58.5 million in the third quarter of 2011 due to net adverse loss development and an increase in the 2011 accident year loss ratio for the diversified financial products line of business.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

(11) Commitments and Contingencies

Catastrophe and Large Loss Exposure

We have exposure to catastrophic losses caused by natural perils (such as hurricanes, earthquakes, floods, tsunamis and tornados), as well as from man-made events (such as terrorist attacks). The incidence, timing and severity of catastrophe losses are unpredictable. We assess our exposures in areas most vulnerable to natural catastrophes and apply procedures to ascertain our probable maximum loss from a single event. We maintain reinsurance protection that we believe is sufficient to limit our exposure to a foreseeable event. Following a catastrophic loss, we often incur additional costs for reinstatement premium to continue our reinsurance coverage for future loss events. Our pretax catastrophe losses were $22.7 million gross and $20.3 million net (after reinsurance and reinstatement premium) in the first nine months of 2012 and $168.0 million gross and $107.9 million net in the same period of 2011.

Litigation

We are a party to lawsuits, arbitrations and other proceedings that arise in the normal course of our business. Many of such lawsuits, arbitrations 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, arbitrations and other proceedings that relate to disputes with third parties, or that involve alleged errors and omissions on the part of our subsidiaries. We have provided accruals for these items to the extent we deem the losses probable and reasonably estimable. Although the ultimate outcome of these matters cannot be determined at this time, based on present information, the availability of insurance coverage and advice received from our outside legal counsel, we believe the resolution of any such matters will not, individually or in the aggregate, have a material adverse effect on our consolidated financial position, results of operations or cash flows.

Indemnifications

In conjunction with the sales of business assets and subsidiaries, we have provided indemnifications to the buyers. Certain indemnifications cover typical representations and warranties related to our responsibilities to perform under the sales contracts. Under other indemnifications, we agree to reimburse the purchasers for taxes or ERISA-related amounts, if any, assessed after the sale date but related to pre-sale activities. We cannot quantify the maximum potential exposure covered by all of our indemnifications because the indemnifications cover a variety of matters, operations and scenarios. Certain of these indemnifications have no time limit. For those with a time limit, the longest such indemnification expires in 2025. We accrue a loss when a valid claim is made by a purchaser and we believe we have potential exposure. At September 30, 2012, we have an accrued liability of $11.2 million, as well as $6.1 million in escrow and $3.2 million of letters of credit, to cover our obligations or anticipated payments under these indemnifications.

(12) Supplemental Information

Supplemental cash flow information was as follows:


	Nine months ended September 30,				Three months ended September 30,
	2012		2011		2012		2011
Income taxes paid	$	83,979	$	88,973	$	44,531	$	31,366
Interest paid		13,321		12,937		1,321		785
Proceeds from sales of available for sale fixed maturity securities		293,969		494,532		75,397		248,201
Proceeds from sales of equity securities		7,145		-		5,406		-
Dividends declared but not paid at end of period		16,728		16,535

(13) Subsequent Event

On October 29, 2012, Hurricane Sandy made landfall in the United States. We have begun assessing our exposures but are unable to reasonably quantify the extent of our losses with respect to this event at this time.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following Management’s Discussion and Analysis should be read in conjunction with the Consolidated Financial Statements and the related Notes as of September 30, 2012 and December 31, 2011.

Overview

We are a specialty insurance group with offices in the United States, the United Kingdom, Spain and Ireland, transacting business in approximately 180 countries. Our shares trade on the New York Stock Exchange and closed at $35.08 on October 26, 2012, resulting in market capitalization of $3.6 billion.

We underwrite a variety of relatively non–correlated specialty insurance products, including property and casualty, accident and health, surety and credit product lines. We market our insurance products through a network of independent agents and brokers, managing general agents and directly to consumers. In addition, we assume insurance written by other insurance companies. We manage our businesses through five insurance underwriting segments and our Investing segment. Our insurance underwriting segments are U.S. Property & Casualty, Professional Liability, Accident & Health, U.S. Surety & Credit and International.

Our business philosophy is to maximize underwriting profit while managing risk. We concentrate our insurance writings in selected specialty lines of business in which we believe we can achieve meaningful underwriting profit. We also rely on our experienced underwriting personnel and our access to and expertise in the reinsurance marketplace to limit or reduce our risk. Our business plan is shaped by our underlying business philosophy. As a result, our primary objective is to maximize net earnings and grow book value per share, rather than to grow gross written premium or market share.

Our major domestic and international insurance companies have financial strength ratings of AA (Very Strong) from Standard & Poor’s Corporation, A+ (Superior) from A.M. Best Company, Inc., AA (Very Strong) from Fitch Ratings and A1 (Good Security) from Moody’s Investors Service, Inc.

Key facts about our consolidated group as of and for the nine months and quarter ended September 30, 2012 were as follows:

•

We had consolidated shareholders’ equity of $3.5 billion, with a book value per share of $34.60.

•

We generated year-to-date net earnings of $283.1 million, or $2.76 per diluted share. Our third quarter earnings were $107.1 million, or $1.05 per diluted share.

•

We produced total revenue of $1.9 billion and $631.7 million in the first nine months and third quarter, respectively. In the first nine months, 89% related to net earned premium and 9% related to net investment income.

•

In the first nine months, we recognized $20.3 million of pretax net catastrophe losses — $4.4 million in our U.S. Property & Casualty segment from storms in the United States and $15.9 million in our International segment from other small catastrophes. The third quarter included pretax net catastrophe losses of $8.0 million.

•

We recorded net favorable loss development of $34.6 million in the first nine months and third quarter of 2012.

•

Our year-to-date net loss ratio was 57.9% and our combined ratio was 83.3%.

•

Our debt to capital ratio was 13.5%.

•

We purchased $141.5 million, or 4.5 million shares, of our common stock at an average cost of $31.15 per share in the first nine months of 2012.

•

We increased our regular cash dividend to $0.165 per share, marking the 16^th consecutive year of increases in our dividend. In the first nine months of 2012, we declared dividends of $0.475 per share and paid $47.6 million of dividends.

Comparisons in the following sections refer to the first nine months of 2012 compared to the same period of 2011, unless otherwise noted. Amounts in tables are in thousands, except for earnings per share, percentages, ratios and number of employees. We adjusted certain 2011 amounts to reflect our adoption of a new accounting standard in 2012 (see Note 1, “General Information” to the Consolidated Financial Statements). We also recast all prior segment data to reflect our exit from two lines of business previously included in our Accident & Health segment (see Note 10, “Segments”).

Results of Operations

Our results and key metrics for the first nine months and third quarter of 2012 and 2011 were as follows:


	Nine months ended September 30,						Three months ended September 30,
	2012			2011			2012			2011

Net earnings	$	283,139		$	176,905		$	107,062		$	60,437

Earnings per diluted share	$	2.76		$	1.57		$	1.05		$	0.56


Net loss ratio		57.9	%		67.4	%		53.9	%		69.9	%
Expense ratio *		25.4			25.2			25.2			23.2


Combined ratio *		83.3	%		92.6	%		79.1	%		93.1	%

* 2011 adjusted to reflect 2012 change in Exited Lines. In 2012, we recognized catastrophe losses from United States storms, primarily in our aviation and public risk lines of business within our U.S. Property and Casualty segment, and from other small catastrophes in our property treaty line of business within our International segment. In 2011, we recognized losses from catastrophic events in Japan, New Zealand, Australia, the United States and Denmark. Our third quarter 2011 catastrophe losses, which primarily related to Hurricane Irene in the United States, impacted our U.S. Property and Casualty and International segments. We reinsure a portion of our exposure to catastrophic events, although we incur some additional cost for reinstatement premium to continue our reinsurance coverage for future loss events. The following table summarizes our catastrophe losses, as well as the impact on our net earnings and key metrics in 2012 and 2011:
	Nine months ended September 30,						Three months ended September 30,
	2012			2011			2012			2011
Net losses, after reinsurance and reinstatement premium	$	20,283		$	107,915		$	8,026		$	34,587
Impact of net catastrophe losses on:
Net earnings per diluted share	$	(0.13	)	$	(0.63	)	$	(0.05	)	$	(0.21	)
Net loss ratio (percentage points)		1.3	%		6.5	%		1.4	%		6.2	%
Combined ratio (percentage points)		1.3	%		6.7	%		1.4	%		6.3	%

We recognized net favorable loss development of $34.6 million in the first nine months of 2012, compared to net adverse loss development of $21.6 million in the same period of 2011. See the “Loss and Loss Adjustment Expense” and “Segment Operations” sections below for discussion of our 2012 and 2011 loss activity.

Revenue

Total revenue increased $114.4 million in the first nine months of 2012, primarily due to higher net earned premium.

Gross written premium, net written premium and net earned premium are detailed below by segment.


	Nine months ended September 30,				Three months ended September 30,
	2012		2011		2012		2011
U.S. Property & Casualty	$	481,024	$	409,733	$	162,411	$	144,222
Professional Liability		377,876		392,903		132,126		130,631
Accident & Health		622,613		565,235		209,738		191,472
U.S. Surety & Credit		166,678		169,368		55,976		55,415
International		460,111		447,355		95,200		95,774
Exited Lines		31,703		35,543		10,312		11,333


Total gross written premium	$	2,140,005	$	2,020,137	$	665,763	$	628,847


U.S. Property & Casualty	$	297,866	$	273,212	$	99,972	$	92,776
Professional Liability		264,398		287,494		93,261		96,846
Accident & Health		622,018		564,805		209,647		191,359
U.S. Surety & Credit		146,865		155,761		50,769		50,660
International		368,189		344,286		66,566		69,364
Exited Lines		31,463		35,533		10,092		11,329


Total net written premium	$	1,730,799	$	1,661,091	$	530,307	$	512,334


U.S. Property & Casualty	$	265,593	$	245,121	$	87,741	$	85,946
Professional Liability		298,454		307,240		97,549		104,066
Accident & Health		624,077		568,318		209,049		191,715
U.S. Surety & Credit		154,232		153,309		53,388		51,906
International		302,303		267,458		105,831		99,294
Exited Lines		31,463		35,541		10,092		11,329


Total net earned premium	$	1,676,122	$	1,576,987	$	563,650	$	544,256

Growth in premium occurred in the U.S. Property & Casualty segment from our new business lines started in 2011 and increased public risk and residual value premium; in the Accident & Health segment from higher writings of our medical stop-loss product; and in the International segment from new business and pricing increases in our energy and property treaty lines of business. In 2011, we recorded $14.0 million ($15.9 million ceded, net of $1.9 million assumed) of catastrophe-related reinstatement premium, which reduced the International segment’s 2011 net written and net earned premium. See the “Segment Operations” section below for further discussion of the relationship and changes in premium revenue within each segment.

Net investment income, which is included in our Investing segment, increased 5% year-over-year and 3% quarter-over-quarter primarily due to higher income from fixed maturity securities, generated from an increased amount of investments. Our fixed maturity portfolio increased 9% from $5.8 billion at September 30, 2011 to $6.3 billion at September 30, 2012. In addition, at September 30, 2012, we had $202.9 million of publicly traded equity securities, which is an asset class we added to our portfolio during 2012. The growth in investments resulted primarily from cash flow from operations and an increase of $185.2 million in the net unrealized gain on available for sale securities since September 30, 2011.

The following table details the components of our other operating income. The fee and commission income relates to third party agency and broker commissions.


	Nine months ended September 30,						Three months ended September 30,
	2012			2011			2012			2011
Fee and commission income	$	20,682		$	21,708		$	10,140		$	8,487
Financial instruments		552			516			222			131
Other		1,995			1,401			478			211


Other operating income	$	23,229		$	23,625		$	10,840		$	8,829

*Loss and Loss Adjustment Expense* The tables below detail, by segment, our net loss and loss adjustment expense and our net loss ratios.
	Nine months ended September 30,						Three months ended September 30,
	2012			2011			2012			2011
U.S. Property & Casualty	$	154,156		$	148,783		$	53,229		$	56,355
Professional Liability		170,506			257,632			36,183			119,617
Accident & Health		447,262			411,851			140,344			138,566
U.S. Surety & Credit		42,444			42,351			15,721			12,664
International		126,547			175,635			46,924			45,242
Exited Lines		28,852			25,988			11,613			7,928


Net loss and loss adjustment expense	$	969,767		$	1,062,240		$	304,014		$	380,372


(Favorable) adverse loss development:
U.S. Property & Casualty	$	2,138		$	(4,613)		$	2,138		$	(7,163)
Professional Liability		(26,186)			48,137			(26,186)			31,153
Accident & Health		(10,695)			1,956			(10,695)			60
U.S. Surety & Credit		-			(2,767)			-			(2,786)
International		-			(20,623)			-			(21,287)
Exited Lines		111			(467)			111			(620)

Total (favorable) adverse loss development		(34,632)			21,623			(34,632)			(643)
Catastrophe losses		21,406			93,907			8,738			32,187
All other net loss and loss adjustment expense		982,993			946,710			329,908			348,828


Net loss and loss adjustment expense	$	969,767		$	1,062,240		$	304,014		$	380,372


U.S. Property & Casualty		58.0	%		60.7	%		60.7	%		65.6	%
Professional Liability		57.1			83.9			37.1			114.9
Accident & Health		71.7			72.5			67.1			72.3
U.S. Surety & Credit		27.5			27.6			29.4			24.4
International		41.9			65.7			44.3			45.6
Exited Lines		91.7			73.1			115.1			70.0


Consolidated net loss ratio		57.9	%		67.4	%		53.9	%		69.9	%


Consolidated accident year net loss ratio		59.9	%		66.0	%		60.1	%		70.0	%

Loss development represents an increase or decrease in estimates of ultimate losses related to prior accident years. Deficiencies and redundancies in ultimate loss estimates occur as we review our loss exposure with our actuaries, increasing or reducing estimates of our ultimate losses as a result of such reviews and as losses are finally settled or claims exposures change. The excess of total recorded net reserves over the actuarial point estimate approximated 6.1% of our recorded net reserves at September 30, 2012, compared to 4.2% at December 31, 2011. We recognized (favorable) adverse loss development of $(34.6) million and $21.6 million in the first nine months of 2012 and 2011, respectively, and $(34.6) million and $(0.6) million in the third quarter of 2012 and 2011, respectively. Our consolidated accident year net loss ratio was lower in 2012 due to higher catastrophe losses and higher losses on our diversified financial products line of business in 2011. See the “Segment Operations” section below for additional discussion of the changes in our net loss and loss adjustment expense and net loss ratios for each segment.

The table below provides a reconciliation of our consolidated reserves for loss and loss adjustment expense payable, net of reinsurance ceded, the amount of our paid claims, and our net paid loss ratio.


	Nine months ended September 30,						Three months ended September 30,
	2012			2011			2012			2011
Net reserves for loss and loss adjustment expense payable at beginning of period	$	2,683,483		$	2,537,772		$	2,748,995		$	2,612,945
Net reserve additions from acquired businesses		14,705			645			-			-
Foreign currency adjustment		11,261			5,364			15,717			(22,622)
Net loss and loss adjustment expense		969,767			1,062,240			304,014			380,372
Net loss and loss adjustment expense payments		(944,203)			(937,171)			(333,713)			(301,845)

Net reserves for loss and loss adjustment expense payable at end of period	$	2,735,013		$	2,668,850		$	2,735,013		$	2,668,850


Net paid loss ratio		56.3	%		59.4	%		59.2	%		55.5	%

The amount of claims paid fluctuates period to period due to our mix of business and the timing of claims settlement and catastrophic events. Our year-to-date net loss and loss adjustment expense payments include $27.5 million and $26.7 million that we paid in 2012 and 2011, respectively, to commute large contracts included in our Exited Lines. These commutations had no material effect on net earnings but increased our year-to-date net paid loss ratios by 1.6 percentage points in 2012 and 1.7 percentage points in 2011.

Policy Acquisition Costs

Our policy acquisition cost percentage was 12.6% and 12.2% for the first nine months of 2012 and 2011, respectively, and 12.0% and 10.6% for the third quarter of 2012 and 2011, respectively. We record profit commissions due from reinsurers as an offset to policy acquisition costs, which impacted our policy acquisition cost percentages as follows:


	Nine months ended September 30,						Three months ended September 30,
	2012			2011			2012			2011

Profit commissions	$	10,013		$	16,494		$	7,403		$	15,684
Impact of profit commissions (percentage points)		0.6	%		1.1	%		1.3	%		2.8	%

Other Operating Expense

For the first nine months of 2012, 61% of our other operating expense related to compensation and benefits for our 1,875 employees. Other operating expense increased 10% year-over-year and 19% quarter-over-quarter, primarily due to increased compensation expense, including higher bonus expense directly related to higher pretax earnings in 2012, and the fluctuation in foreign currency gain and loss. We recognized foreign currency loss of $5.3 million and $6.8 million in the first nine months and third quarter of 2012, respectively, primarily related to the fluctuations in the British pound sterling. Conversely, we recognized foreign currency benefit of $2.5 million and $0.5 million in the first nine months and third quarter of 2011, respectively. Other operating expense included stock-based compensation expense of $10.6 million in 2012 and $10.4 million in 2011. At September 30, 2012, there was approximately $27.2 million of total unrecognized compensation expense related to unvested options and restricted stock awards and units that is expected to be recognized over a weighted-average period of 3.0 years.

Interest Expense

Interest expense on debt and short-term borrowings was $19.1 million and $16.6 million in the first nine months of 2012 and 2011, respectively, and $6.0 million and $5.6 million in the third quarter of 2012 and 2011, respectively. Our interest expense increased in 2012 due to a higher amount of outstanding borrowings on our $600.0 million Revolving Loan Facility, primarily to fund purchases of our common stock. Our year-to-date interest expense for 2012 and 2011 included $14.5 million for our Senior Notes.

Income Tax Expense

Our effective income tax rate was 30.1% for the first nine months of 2012, compared to 27.1% for the same period of 2011. The higher effective rate in 2012 is due to the relationship of pretax income and tax-exempt investment income in the two periods. Our pretax income was substantially higher in 2012 from larger underwriting profit than in 2011, whereas our tax-exempt investment income was essentially flat in 2012 and 2011.

Segment Operations

Each of our insurance segments bears risk for insurance coverage written within its portfolio of insurance products. Each segment generates income from premium written by our underwriting agencies, through third party agents and brokers, or on a direct basis. The insurance segments also write facultative or individual account reinsurance, as well as treaty reinsurance business. In some cases, we purchase reinsurance to limit the segments’ net losses from both individual policy losses and multiple policy losses from catastrophe occurrences. Our segments maintain disciplined expense management and a streamlined management structure, which results in favorable expense ratios. The following provides operational information about our five insurance segments and our Investing segment.

U.S. Property & Casualty Segment

The following tables summarize the operations of the U.S. Property & Casualty segment.


	Nine months ended September 30,						Three months ended September 30,
	2012			2011			2012			2011

Net earned premium	$	265,593		$	245,121		$	87,741		$	85,946
Other revenue		15,300			16,556			8,415			6,890

Segment revenue		280,893			261,677			96,156			92,836


Loss and loss adjustment expense, net		154,156			148,783			53,229			56,355
Other expense		89,348			82,202			29,581			26,627

Segment expense		243,504			230,985			82,810			82,982


Segment pretax earnings	$	37,389		$	30,692		$	13,346		$	9,854


Net loss ratio		58.0	%		60.7	%		60.7	%		65.6	%
Expense ratio		31.8			31.4			30.8			28.7


Combined ratio		89.8	%		92.1	%		91.5	%		94.3	%


Aviation	$	87,890		$	83,879		$	29,670		$	29,279
E&O		47,177			56,354			15,198			17,997
Public Risk		48,363			36,523			16,571			13,344
Other		82,163			68,365			26,302			25,326


Total net earned premium	$	265,593		$	245,121		$	87,741		$	85,946


Aviation		56.9	%		64.9	%		58.9	%		67.1	%
E&O		74.1			73.7			102.1			108.6
Public Risk		95.9			84.5			130.8			115.1
Other		27.8			32.1			(5.5)			7.1


Total net loss ratio		58.0	%		60.7	%		60.7	%		65.6	%


	Nine months ended September 30,				Three months ended September 30,
	2012		2011		2012		2011

Aviation	$	117,300	$	116,933	$	34,430	$	37,877
E&O		46,483		52,961		14,990