Edgar Filing: HCC INSURANCE HOLDINGS INC/DE/

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, 2013.

¨	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 25, 2013, there were approximately 100.2 million shares of common stock outstanding.

HCC Insurance Holdings, Inc. and Subsidiaries

Table of Contents


	Page
Part I. FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

Consolidated Balance Sheets — September 30, 2013 and December 31, 2012		5

Consolidated Statements of Earnings — Nine and three months ended September 30, 2013 and 2012		6

Consolidated Statements of Comprehensive Income — Nine and three months ended September 30, 2013 and 2012		7

Consolidated Statement of Changes in Shareholders’ Equity — Nine months ended September 30, 2013		8

Consolidated Statements of Cash Flows — Nine months ended September 30, 2013 and 2012		9

Notes to Consolidated Financial Statements		10

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		27

Item 3. Quantitative and Qualitative Disclosures About Market Risk		48

Item 4. Controls and Procedures		48

Part II. OTHER INFORMATION

Item 1. Legal Proceedings		49

Item 1A. Risk Factors		49

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		49

Item 3. Defaults Upon Senior Securities		49

Item 4. Mine Safety Disclosures		49

Item 5. Other Information		49

Item 6. Exhibits		50

Signatures		51

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 economic or 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 of climate change on the risks we insure,

•

potential 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 described these risks and uncertainties in greater detail in Item 1A, Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2012.

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,			December 31,
	2013			2012

ASSETS

Investments
Fixed maturity securities – available for sale, at fair value (amortized cost: 2013 – $6,059,853 and 2012 – $5,856,432)	$	6,194,625		$	6,281,781
Equity securities – available for sale, at fair value (cost: 2013 – $395,018 and 2012 – $275,827)		433,345			284,639
Short-term investments, at cost (approximates fair value)		229,191			363,053
Other investments, at fair value (cost: 2012 – $18,391)		-			20,925

Total investments		6,857,161			6,950,398

Cash		55,037			71,390
Restricted cash and securities		121,231			101,480
Premium, claims and other receivables		600,311			549,725
Reinsurance recoverables		1,215,577			1,071,222
Ceded unearned premium		301,891			256,988
Ceded life and annuity benefits		57,137			58,641
Deferred policy acquisition costs		204,740			191,960
Goodwill		894,851			885,860
Other assets		140,843			130,143


Total assets	$	10,448,779		$	10,267,807


LIABILITIES

Loss and loss adjustment expense payable	$	4,021,847		$	3,767,850
Life and annuity policy benefits		57,137			58,641
Reinsurance, premium and claims payable		315,638			294,621
Unearned premium		1,165,580			1,069,956
Deferred ceding commissions		86,804			74,609
Notes payable		654,059			583,944
Accounts payable and accrued liabilities		559,635			875,574

Total liabilities		6,860,700			6,725,195


SHAREHOLDERS’ EQUITY

Common stock, $1.00 par value; 250,000 shares authorized (shares issued: 2013 – 125,423 and 2012 – 125,114; outstanding: 2013 – 100,182 and 2012 – 100,928)		125,423			125,114
Additional paid-in capital		1,068,338			1,052,253
Retained earnings		2,992,720			2,756,166
Accumulated other comprehensive income		130,002			295,271
Treasury stock, at cost (shares: 2013 – 25,241 and 2012 – 24,186)		(728,404	)		(686,192	)

Total shareholders’ equity		3,588,079			3,542,612


Total liabilities and shareholders’ equity	$	10,448,779		$	10,267,807

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,
	2013		2012			2013		2012

REVENUE

Net earned premium	$	1,679,210	$	1,676,122		$	556,668	$	563,650
Net investment income		165,641		166,642			54,208		56,342
Other operating income		24,308		23,229			7,679		10,840
Net realized investment gain		31,115		8,519			17,922		1,472
Other-than-temporary impairment credit losses		-		(1,028	)		-		(631	)


Total revenue		1,900,274		1,873,484			636,477		631,673


EXPENSE

Loss and loss adjustment expense, net		992,547		969,767			320,376		304,014
Policy acquisition costs, net		203,387		211,554			65,642		67,620
Other operating expense		268,357		268,164			103,785		100,458
Interest expense		19,656		19,101			6,574		5,962


Total expense		1,483,947		1,468,586			496,377		478,054


Earnings before income tax expense		416,327		404,898			140,100		153,619
Income tax expense		124,140		121,759			41,925		46,557


Net earnings	$	292,187	$	283,139		$	98,175	$	107,062


Earnings per common share

Basic	$	2.91	$	2.77		$	0.98	$	1.06


Diluted	$	2.90	$	2.76		$	0.98	$	1.05

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,
	2013			2012			2013			2012

Net earnings	$	292,187		$	283,139		$	98,175		$	107,062

Other comprehensive income (loss)

Investment gains (losses):
Investment gains (losses) during the period		(232,481	)		152,498			14,948			91,185
Income tax charge (benefit)		(82,526	)		54,078			4,917			32,274


Investment gains (losses), net of tax		(149,955	)		98,420			10,031			58,911


Less reclassification adjustments for:
Gains included in net earnings		31,115			7,491			17,922			832
Income tax charge		10,890			2,622			6,272			291


Gains included in net earnings, net of tax		20,225			4,869			11,650			541


Net unrealized investment gains (losses)		(170,180	)		93,551			(1,619	)		58,370


Foreign currency translation adjustment		4,265			(3,454	)		5,410			(141	)
Income tax benefit		(646	)		(483	)		(92	)		(234	)


Foreign currency translation adjustment, net of tax		4,911			(2,971	)		5,502			93


Other comprehensive income (loss)		(165,269	)		90,580			3,883			58,463


Comprehensive income	$	126,918		$	373,719		$	102,058		$	165,525

See Notes to Consolidated Financial Statements.

HCC Insurance Holdings, Inc. and Subsidiaries

Consolidated Statement of Changes in Shareholders’ Equity

Nine months ended September 30, 2013

(unaudited, in thousands except per share data)


								Accumulated
			Additional					other					Total
	Common		paid-in		Retained			comprehensive			Treasury		shareholders’
	stock		capital		earnings			income			stock		equity
Balance at December 31, 2012	$	125,114	$	1,052,253	$	2,756,166		$	295,271		$	(686,192)	$	3,542,612

Net earnings		-		-		292,187			-			-		292,187

Other comprehensive loss		-		-		-			(165,269	)		-		(165,269	)

Issuance of 291 shares for exercise of options, including tax effect		291		8,434		-			-			-		8,725

Purchase of 1,055 common shares		-		-		-			-			(42,212)		(42,212	)

Stock-based compensation		18		7,651		-			-			-		7,669

Cash dividends declared, $0.555 per share		-		-		(55,633	)		-			-		(55,633	)


Balance at September 30, 2013	$	125,423	$	1,068,338	$	2,992,720		$	130,002		$	(728,404)	$	3,588,079

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,

	2013			2012
Operating activities
Net earnings	$	292,187		$	283,139
Adjustments to reconcile net earnings to net cash provided by operating activities:
Change in premium, claims and other receivables		(52,395	)		6,623
Change in reinsurance recoverables		(138,103	)		47,149
Change in ceded unearned premium		(44,809	)		(39,918	)
Change in loss and loss adjustment expense payable		241,126			16,052
Change in unearned premium		95,395			87,177
Change in reinsurance, premium and claims payable, excluding restricted cash		21,516			(32,743	)
Change in accounts payable and accrued liabilities		(145,740	)		79,500
Stock-based compensation expense		10,100			10,361
Depreciation and amortization expense		13,962			13,919
Gain on investments		(31,115	)		(7,491	)
Other, net		9,288			32,267


Cash provided by operating activities		271,412			496,035


Investing activities
Sales of available for sale fixed maturity securities		337,895			293,969
Sales of equity securities		95,989			7,145
Sales of other investments		23,719			6,974
Maturity or call of available for sale fixed maturity securities		488,817			504,583
Maturity or call of held to maturity fixed maturity securities		-			28,511
Cost of available for sale fixed maturity securities acquired		(1,109,233	)		(1,056,909	)
Cost of equity securities acquired		(226,601	)		(205,092	)
Change in short-term investments		134,515			(5,401	)
Payments for purchase of businesses, net of cash received		(8,214	)		(32,590	)
Other, net		(5,248	)		(9,885	)


Cash used by investing activities		(268,361	)		(468,695	)


Financing activities
Advances on line of credit		130,000			140,000
Payments on line of credit		(60,000	)		(70,000	)
Sale of common stock		8,725			40,105
Purchase of common stock		(47,869	)		(135,151	)
Dividends paid		(49,773	)		(47,617	)
Other, net		(487	)		5,066


Cash used by financing activities		(19,404	)		(67,597	)


Net decrease in cash		(16,353	)		(40,257	)
Cash at beginning of year		71,390			104,550


Cash at end of period	$	55,037		$	64,293

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 largely non-correlated specialty insurance products, including property and casualty, accident and health, surety and credit product lines, in approximately 180 countries. We market our products through a network of independent agents and brokers, through managing general agents owned by the company, and directly to customers. In addition, we assume insurance written by other insurance companies.

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, 2012. The consolidated balance sheet at December 31, 2012 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.

(2) Investments

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



	Cost or		Gross		Gross
	amortized		unrealized		unrealized
	cost		gain		loss			Fair value
September 30, 2013

U.S. government and government agency securities	$	115,109	$	2,698	$	(302	)	$	117,505
Fixed maturity securities of states, municipalities and political subdivisions		965,526		55,813		(5,200	)		1,016,139
Special purpose revenue bonds of states, municipalities and political subdivisions		2,258,661		81,517		(43,340	)		2,296,838
Corporate securities		1,267,387		40,314		(9,997	)		1,297,704
Residential mortgage-backed securities		588,696		17,671		(13,410	)		592,957
Commercial mortgage-backed securities		524,706		18,519		(12,009	)		531,216
Asset-backed securities		141,594		282		(575	)		141,301
Foreign government securities		198,174		3,089		(298	)		200,965


Total fixed maturity securities	$	6,059,853	$	219,903	$	(85,131	)	$	6,194,625


Equity securities	$	395,018	$	43,023	$	(4,696	)	$	433,345

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)


	Cost or		Gross		Gross
	amortized		unrealized		unrealized
	cost		gain		loss			Fair value
December 31, 2012

U.S. government and government agency securities	$	195,049	$	4,560	$	(2	)	$	199,607
Fixed maturity securities of states, municipalities and political subdivisions		969,966		96,027		(182	)		1,065,811
Special purpose revenue bonds of states, municipalities and political subdivisions		2,033,947		168,772		(2,388	)		2,200,331
Corporate securities		1,247,282		69,243		(1,355	)		1,315,170
Residential mortgage-backed securities		632,665		32,560		(338	)		664,887
Commercial mortgage-backed securities		482,808		41,748		(267	)		524,289
Asset-backed securities		32,801		474		-			33,275
Foreign government securities		261,914		16,515		(18	)		278,411


Total fixed maturity securities	$	5,856,432	$	429,899	$	(4,550	)	$	6,281,781


Equity securities	$	275,827	$	13,768	$	(4,956	)	$	284,639

Substantially all of our fixed maturity securities are investment grade. 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

			Unrealized				Unrealized				Unrealized
	Fair value		losses		Fair value		losses		Fair value		losses
September 30, 2013

Fixed maturity securities
U.S. government and government agency securities	$	20,730	$	(302)	$	-	$	-	$	20,730	$	(302)
Fixed maturity securities of states, municipalities and political subdivisions		134,217		(5,200)		-		-		134,217		(5,200)
Special purpose revenue bonds of states, municipalities and political subdivisions		724,983		(43,322)		1,323		(18)		726,306		(43,340)
Corporate securities		307,327		(9,331)		14,821		(666)		322,148		(9,997)
Residential mortgage-backed securities		270,062		(13,410)		-		-		270,062		(13,410)
Commercial mortgage-backed securities		212,589		(11,414)		5,042		(595)		217,631		(12,009)
Asset-backed securities		49,647		(575)		-		-		49,647		(575)
Foreign government securities		74,354		(298)		-		-		74,354		(298)
Equity securities		95,697		(4,277)		5,711		(419)		101,408		(4,696)


Total	$	1,889,606	$	(88,129)	$	26,897	$	(1,698)	$	1,916,503	$	(89,827)

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)


	Less than 12 months					12 months or more					Total

			Unrealized					Unrealized					Unrealized
	Fair value		losses			Fair value		losses			Fair value		losses
December 31, 2012

Fixed maturity securities
U.S. government and government agency securities	$	55,034	$	(2	)	$	-	$	-		$	55,034	$	(2	)
Fixed maturity securities of states, municipalities and political subdivisions		14,162		(182	)		-		-			14,162		(182	)
Special purpose revenue bonds of states, municipalities and political subdivisions		155,902		(2,388	)		-		-			155,902		(2,388	)
Corporate securities		85,245		(1,220	)		2,616		(135	)		87,861		(1,355	)
Residential mortgage-backed securities		49,486		(338	)		-		-			49,486		(338	)
Commercial mortgage-backed securities		26,263		(267	)		-		-			26,263		(267	)
Foreign government securities		7,007		(18	)		-		-			7,007		(18	)
Equity securities		103,647		(4,956	)		-		-			103,647		(4,956	)


Total	$	496,746	$	(9,371	)	$	2,616	$	(135	)	$	499,362	$	(9,506	)

A security has an impairment loss when its fair value is less than its cost or amortized cost at the balance sheet date. We evaluate our securities for possible other-than-temporary impairment losses at each quarter end. Our reviews cover all impaired securities where the loss exceeds $0.5 million and the loss either exceeds 10% of cost or the security had been in a loss position for longer than twelve consecutive months. We recognized no other-than-temporary impairment losses in the first nine months of 2013. We recognized $1.0 million and $0.6 million of other-than-temporary impairment losses in the first nine months and third quarter of 2012, respectively.

We do not consider the $89.8 million of gross unrealized losses on fixed maturity and equity securities in our portfolio at September 30, 2013 to be other-than-temporary impairments because: 1) as of September 30, 2013, we have received all contractual interest and principal payments on the fixed maturity securities, 2) we do not intend to sell the 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 primarily relates to non-credit factors, particularly the significant interest rate increases that occurred in mid-2013.

The amortized cost and fair value of our fixed maturity securities at September 30, 2013, 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 5.9 years at September 30, 2013.


	Cost or amortized cost		Fair value
Due in 1 year or less	$	216,068	$	219,092
Due after 1 year through 5 years		1,098,887		1,139,408
Due after 5 years through 10 years		1,470,040		1,533,694
Due after 10 years through 15 years		1,016,530		1,036,012
Due after 15 years		1,003,332		1,000,945

Securities with contractual maturities		4,804,857		4,929,151
Mortgage-backed and asset-backed securities		1,254,996		1,265,474


Total fixed maturity securities	$	6,059,853	$	6,194,625

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

The sources of net investment income were as follows:


	Nine months ended September 30,				Three months ended September 30,
	2013		2012		2013		2012
Fixed maturity securities
Taxable	$	75,407	$	86,548	$	24,385	$	28,330
Exempt from U.S. income taxes		85,063		80,163		28,988		27,291

Total fixed maturity securities		160,470		166,711		53,373		55,621
Equity securities		10,758		2,339		2,950		1,346
Short-term investments		122		397		42		295
Other investment income		350		1,699		31		831

Total investment income		171,700		171,146		56,396		58,093
Investment expense		(6,059)		(4,504)		(2,188)		(1,751)


Net investment income	$	165,641	$	166,642	$	54,208	$	56,342

(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.

In 2012, we entered into a forward contract to sell 45.0 million Euros for U.S. dollars in September 2013. Through June 30, 2013, this transaction was designated and qualified as a hedge of a portion of our net investment in a subsidiary that has the Euro as its functional currency. Changes in the fair value of the forward contract, net of the related deferred income tax effect, totaled $1.5 million through June 30, 2013. We recognized this amount in our foreign currency translation adjustment, which is a component of accumulated other comprehensive income. This amount 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.

In July 2013, we entered into a forward contract to buy 45.0 million Euros for U.S. dollars in September 2013, effectively offsetting the contract entered into in 2012. Beginning in July 2013, we discontinued hedge accounting and subsequent changes in the fair value of the two forward contracts were recognized in our consolidated statements of earnings. Because the contracts offset, the combined net change in fair value and the impact on pretax earnings was immaterial in the third quarter of 2013. No forward contracts remain at September 30, 2013.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

(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 (including those held as restricted securities), corporate debt securities, bank loans, mortgage-backed and asset-backed securities (including collateralized loan obligations), and deposits supporting our Lloyd’s syndicate business. Level 2 also includes certificates of deposit and other interest-bearing deposits at banks, which we report as short-term investments, and, prior to September 30, 2013, a forward contract that hedged 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 matrix pricing. The fair value measurements consider observable assumptions, including benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, default rates, loss severity and other economic measures.

We are responsible for the prices used in our fair value measurements. 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 and Lloyd’s of London to value the remaining Level 2 investments. To validate that these quoted 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, third party investment managers or Lloyd’s of London as of September 30, 2013 or December 31, 2012.

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. This category also includes a liability for future earnout payments due to former owners of a business we acquired, which is classified within accounts payable and accrued liabilities. Fixed maturity securities classified as Level 3 are primarily special purpose revenue bond auction rate securities. The interest rates on these securities are reset through auctions at periodic intervals. These securities are thinly traded and observable market data is not readily available. We determine the fair value of these securities using prices quoted by a broker. We determine fair value of our other Level 3 assets and liabilities based on internally developed models that use assumptions or other data that are not readily observable from objective sources.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

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, 2013

Fixed maturity securities
U.S. government and government agency securities	$	97,279	$	20,226	$	-	$	117,505
Fixed maturity securities of states, municipalities and political subdivisions		-		1,016,139		-		1,016,139
Special purpose revenue bonds of states, municipalities and political subdivisions		-		2,287,625		9,213		2,296,838
Corporate securities		-		1,297,554		150		1,297,704
Residential mortgage-backed securities		-		592,957		-		592,957
Commercial mortgage-backed securities		-		531,216		-		531,216
Asset-backed securities		-		141,301		-		141,301
Foreign government securities		-		200,965		-		200,965

Total fixed maturity securities		97,279		6,087,983		9,363		6,194,625
Equity securities		433,345		-		-		433,345
Short-term investments*		107,350		121,841		-		229,191
Restricted cash and securities		-		1,846		-		1,846
Premium, claims and other receivables		-		65,490		-		65,490
Other assets		17		-		831		848


Total assets measured at fair value	$	637,991	$	6,277,160	$	10,194	$	6,925,345


Notes payable*	$	-	$	701,881	$	-	$	701,881
Accounts payable and accrued liabilities - earnout liability		-		1,846		7,195		9,041


Total liabilities measured at fair value	$	-	$	703,727	$	7,195	$	710,922

* 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, 2012

Fixed maturity securities
U.S. government and government agency securities	$	174,520	$	25,087	$	-	$	199,607
Fixed maturity securities of states, municipalities and political subdivisions		-		1,065,811		-		1,065,811
Special purpose revenue bonds of states, municipalities and political subdivisions		-		2,200,331		-		2,200,331
Corporate securities		-		1,315,006		164		1,315,170
Residential mortgage-backed securities		-		664,887		-		664,887
Commercial mortgage-backed securities		-		524,289		-		524,289
Asset-backed securities		-		33,275		-		33,275
Foreign government securities		-		278,411		-		278,411

Total fixed maturity securities		174,520		6,107,097		164		6,281,781
Equity securities		284,639		-		-		284,639
Short-term investments*		251,988		111,065		-		363,053
Other investments		20,925		-		-		20,925
Restricted cash and securities		-		2,043		-		2,043
Premium, claims and other receivables		-		68,207		-		68,207
Other assets		-		-		349		349


Total assets measured at fair value	$	732,072	$	6,288,412	$	513	$	7,020,997


Notes payable*	$	-	$	636,363	$	-	$	636,363
Accounts payable and accrued liabilities - forward contract		-		3,194		-		3,194
Accounts payable and accrued liabilities - earnout liability		-		2,043		7,009		9,052


Total liabilities measured at fair value	$	-	$	641,600	$	7,009	$	648,609

*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)

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


	2013											2012
Nine months ended September 30	Fixed maturity securities			Other assets		Total assets			Accounts payable and accrued liabilities			Fixed maturity securities			Other assets			Total assets

Balance at beginning of year	$	164		$	349	$	513		$	7,009		$	1,170		$	1,516		$	2,686
Purchases		9,430			-		9,430			-			-			-			-
Settlements		-			-		-			-			-			(1,863	)		(1,863	)
Gains (losses) reported in:
Net earnings		37			482		519			(186	)		(1	)		553			552
Other comprehensive income (loss)		(268	)		-		(268	)		-			8			-			8
Transfers out of Level 3		-			-		-			-			(1,015	)		-			(1,015	)


Balance at September 30	$	9,363		$	831	$	10,194		$	7,195		$	162		$	206		$	368


Three months ended September 30

Balance at beginning of quarter	$	9,446		$	589	$	10,035		$	7,133		$	159		$	1,847		$	2,006
Settlements		-			-		-			-			-			(1,863	)		(1,863	)
Gains (losses) reported in:
Net earnings		16			242		258			(62	)		-			222			222
Other comprehensive income (loss)		(99	)		-		(99	)		-			3			-			3


Balance at September 30	$	9,363		$	831	$	10,194		$	7,195		$	162		$	206		$	368

There were no transfers between Level 1, Level 2 or Level 3 in 2013. We transferred an investment from Level 3 to Level 2 in 2012 because we were able to determine its fair value using inputs based on observable market data in the period transferred.

(5) Goodwill

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


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

Balance at beginning of year	$	223,000	$	314,089	$	144,113	$	79,700	$	124,958	$	885,860
Earnout and other		-		9,010		-		-		(19)		8,991


Balance at September 30, 2013	$	223,000	$	323,099	$	144,113	$	79,700	$	124,939	$	894,851

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 2013, we increased goodwill by $9.0 million for additional earnout earned under the purchase agreement.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

We conducted our 2013 goodwill impairment test as of June 30, 2013, which is consistent with the timeframe for our annual assessment in prior years. Based on our latest assessment, the fair value of each reporting unit exceeded its carrying amount.

(6) Reinsurance

In the normal course of business, our insurance companies cede a portion of their premium to 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,
	2013		2012		2013		2012
Direct written premium	$	1,911,619	$	1,826,610	$	616,938	$	603,844
Reinsurance assumed		296,942		313,395		61,975		61,919
Reinsurance ceded		(478,609)		(409,206)		(157,179)		(135,456)


Net written premium	$	1,729,952	$	1,730,799	$	521,734	$	530,307


Direct earned premium	$	1,860,093	$	1,795,109	$	622,464	$	601,572
Reinsurance assumed		252,902		259,870		81,594		90,988
Reinsurance ceded		(433,785)		(378,857)		(147,390)		(128,910)


Net earned premium	$	1,679,210	$	1,676,122	$	556,668	$	563,650


Direct loss and loss adjustment expense	$	1,210,862	$	1,029,227	$	517,382	$	301,306
Reinsurance assumed		119,315		96,143		8,607		35,108
Reinsurance ceded		(337,630)		(155,603)		(205,613)		(32,400)


Net loss and loss adjustment expense	$	992,547	$	969,767	$	320,376	$	304,014


Policy acquisition costs	$	309,285	$	299,854	$	105,254	$	101,698
Ceding commissions		(105,898)		(88,300)		(39,612)		(34,078)


Net policy acquisition costs	$	203,387	$	211,554	$	65,642	$	67,620

The table below shows the components of our reinsurance recoverables in our consolidated balance sheets.
					September 30,		December 31,
					2013		2012
Reinsurance recoverable on paid losses					$	51,262	$	54,675
Reinsurance recoverable on outstanding losses						456,364		479,026
Reinsurance recoverable on incurred but not reported losses						709,451		539,021
Reserve for uncollectible reinsurance						(1,500)		(1,500)


Total reinsurance recoverables					$	1,215,577	$	1,071,222

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, 2013 and December 31, 2012.


					September 30,		December 31,
					2013		2012
Payables to reinsurers					$	194,857	$	190,228
Letters of credit						82,115		89,832
Funds held in trust						89,050		116,597


Total credits					$	366,022	$	396,657

The tables below show the calculation of net reserves, net unearned premium and net deferred policy acquisition costs.
					September 30,		December 31,
					2013		2012
Loss and loss adjustment expense payable					$	4,021,847	$	3,767,850
Reinsurance recoverable on outstanding losses						(456,364)		(479,026)
Reinsurance recoverable on incurred but not reported losses						(709,451)		(539,021)


Net reserves					$	2,856,032	$	2,749,803


Unearned premium					$	1,165,580	$	1,069,956
Ceded unearned premium						(301,891)		(256,988)


Net unearned premium					$	863,689	$	812,968


Deferred policy acquisition costs					$	204,740	$	191,960
Deferred ceding commissions						(86,804)		(74,609)


Net deferred policy acquisition costs					$	117,936	$	117,351

(7) Liability for Unpaid Loss and Loss Adjustment Expense The table below provides a reconciliation of our consolidated liability for loss and loss adjustment expense payable (referred to as reserves), net of reinsurance ceded.
	Nine months ended September 30,				Three months ended September 30,
	2013		2012		2013		2012
Net reserves for loss and loss adjustment expense payable at beginning of period	$	2,749,803	$	2,683,483	$	2,811,021	$	2,748,995
Net reserve additions from acquired businesses		-		14,705		-		-
Foreign currency adjustment		(2,296)		11,261		22,331		15,717
Net loss and loss adjustment expense		992,547		969,767		320,376		304,014
Net loss and loss adjustment expense payments		(884,022)		(944,203)		(297,696)		(333,713)


Net reserves for loss and loss adjustment expense payable at end of period	$	2,856,032	$	2,735,013	$	2,856,032	$	2,735,013

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

The table below details our net loss and loss adjustment expense on a consolidated basis and for our segments.


	Nine months ended September 30,				Three months ended September 30,
	2013		2012		2013		2012
Net (favorable) adverse loss development:
U.S. Property & Casualty	$	(40,754)	$	2,138	$	(40,754)	$	2,138
Professional Liability		(26,284)		(26,186)		(26,284)		(26,186)
Accident & Health		-		(10,695)		-		(10,695)
U.S. Surety & Credit		(9,492)		-		-		-
International		36,896		-		39,196		-
Exited Lines		-		111		-		111

Total net favorable loss development		(39,634)		(34,632)		(27,842)		(34,632)
Catastrophe losses		48,055		21,406		18,134		8,738
All other net loss and loss adjustment expense		984,126		982,993		330,084		329,908


Net loss and loss adjustment expense	$	992,547	$	969,767	$	320,376	$	304,014

In the third quarter of 2013, we conducted our annual review of the reserves in our U.S. Property & Casualty, Professional Liability and International segments. Based on this review, we recognized net favorable loss development of $27.8 million, which is described by segment below:

U.S. Property & Casualty

Net favorable development of $40.8 million was due to better than expected actual experience, primarily in underwriting years 2011 and prior, compared to the same review conducted in the third quarter of 2012. The majority of the net favorable development related to a run-off assumed quota share contract, where experience continues to develop favorably. While some lines of business experienced adverse loss development, which partially offset favorable development, such adverse development was immaterial.

Professional Liability

Net favorable development of $26.3 million was due to better than expected experience in the U.S. D&O and International D&O lines of business, compared to the same review conducted in the third quarter of 2012. The favorable development primarily related to underwriting years prior to 2007, as well as 2009 and 2010 (totaling $64.2 million), partially offset by reserve strengthening in underwriting years 2007 and 2008 (totaling $37.9 million) that were impacted by the worldwide financial crisis. Reserves for the diversified financial products (DFP) line of business within U.S. D&O performed slightly better than expected in the past year, but no changes were made to the estimated ultimate losses given the continued evaluation and re-underwriting of this line of business.

International

Net adverse development of $39.2 million was due to reserve strengthening of $70.3 million in the surety & credit line of business, partially offset by net favorable development in several other lines of business, primarily energy and liability. For surety & credit, we increased our reserves on a specific class of Spanish surety bonds, the majority of which were written prior to 2006. The increase was made to reflect our revised estimates of our liability under these bonds in light of an adverse Spanish Supreme Court ruling reported in September 2013 against an unaffiliated insurance company with respect to a surety bond similar to ours. The net favorable development in energy ($13.1 million) and liability ($13.3 million) primarily related to better than expected experience in underwriting years 2011 and prior, as well as $3.0 million related to the release of 2012 energy catastrophe reserves for Hurricane Sandy, due to lower than expected losses.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

In the second quarter of 2013, we recognized favorable development of $9.5 million in our U.S. Surety & Credit segment and $2.3 million in our International segment. Our review of reserves at that time indicated that continued lower than expected claims activity related to older underwriting years was contributing to a growing redundancy in our U.S. Surety & Credit segment. As a result, we recognized favorable development of $3.7 million and $5.8 million for our surety and credit lines of business, respectively, related to the 2010 and prior underwriting years. In the International segment, we released $2.3 million of prior year catastrophe reserves related to the 2010 New Zealand earthquake, due to settlement of these claims in 2013.

In the first nine months and third quarter of 2012, our Professional Liability and Accident & Health segments reported net favorable loss development of $26.2 million and $10.7 million, respectively, resulting from our scheduled annual reviews of these reserves. The net favorable development in our Professional Liability segment consisted of $9.3 million in U.S. D&O and $16.9 million in International D&O related to lower than expected reported loss development in underwriting years 2003 – 2006, partially offset by higher expected losses in underwriting year 2008. The favorable development in our Accident & Health segment related to favorable claims activity in the medical stop-loss product line for the 2011 underwriting year.

(8) Notes Payable

Our notes payable consisted of the following:


	September 30,		December 31,
	2013		2012
6.30% Senior Notes	$	299,059	$	298,944
$600.0 million Revolving Loan Facility		355,000		285,000


Total notes payable	$	654,059	$	583,944

On April 26, 2013, we entered into an agreement to modify our $600.0 million Revolving Loan Facility (the Facility). Under the amended agreement, the Facility expires on April 26, 2017. The new borrowing rate is LIBOR plus 125 basis points with a commitment fee of 15 basis points. The weighted-average interest rate on borrowings under the Facility at September 30, 2013 was 1.43%. The borrowings and letters of credit issued under the Facility reduced our available borrowing capacity on the Facility to $239.1 million at September 30, 2013.

There have been no changes to the terms and conditions related to our Senior Notes or the Standby Letter of Credit Facility (Standby 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, 2012.

We were in compliance with debt covenants related to our 6.30% Senior Notes, the Facility and the Standby Facility at September 30, 2013.

(9) Income Taxes

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. We provide a deferred tax liability for un-repatriated earnings of our foreign subsidiaries at prevailing statutory rates when required. The deferred tax liability of our foreign subsidiaries at September 30, 2013 was based on the assumption that we will merge certain subsidiaries in our International segment.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

(10) Accumulated Other Comprehensive Income

The components of accumulated other comprehensive income in our consolidated balance sheets were as follows:


				Net			Foreign			Accumulated
				unrealized			currency			other
				investment			translation			comprehensive
Nine months ended September 30, 2013				gains (losses)			adjustment			income

Balance at December 31, 2012				$	282,503		$	12,768		$	295,271
Other comprehensive income (loss)					(170,180	)		4,911			(165,269	)


Balance at September 30, 2013				$	112,323		$	17,679		$	130,002


Three months ended September 30, 2013

Balance at June 30, 2013				$	113,942		$	12,177		$	126,119
Other comprehensive income (loss)					(1,619	)		5,502			3,883


Balance at September 30, 2013				$	112,323		$	17,679		$	130,002

The reductions in net unrealized investment gains (losses) during 2013, shown in the table above, included reclassifications of amounts into net earnings. The reclassifications recorded in our consolidated statements of earnings were as follows:
							Nine months			Three months
							ended			ended
							September 30, 2013			September 30, 2013

Net realized investment gain							$	31,115		$	17,922
Income tax expense								10,890			6,272


Total reclassifications							$	20,225		$	11,650


(11) 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,
	2013			2012			2013			2012
Net earnings	$	292,187		$	283,139		$	98,175		$	107,062
Less: net earnings attributable to unvested restricted stock		(4,754	)		(5,150	)		(1,527	)		(1,912	)


Net earnings available to common stock	$	287,433		$	277,989		$	96,648		$	105,150


Weighted-average common shares outstanding		98,881			100,340			98,723			99,424
Dilutive effect of outstanding securities (determined using treasury stock method)		254			261			270			276

Weighted-average common shares and potential common shares outstanding		99,135			100,601			98,993			99,700

Anti-dilutive securities not included in treasury stock method computation		89			717			131			461

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

(12) Stock-Based Compensation

In 2013, we granted the following shares of common stock, shares of restricted stock, restricted stock units and stock options for the purchase of shares of our common stock.


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

Common stock		22	$	42.46	$	918		None
Restricted stock		191		41.30		7,893		1 - 4 years
Restricted stock units		16		40.66		661		4 years
Stock options		154		7.37		1,131		1 - 5 years

For common stock grants, we measure fair value based on the closing stock price of our common stock on the grant date and expense it on the grant date.

Certain awards of restricted stock and restricted stock units contain a performance condition based on the ultimate results for the 2012 underwriting year. The number of such shares that vest could differ from the number initially granted. We measure fair value for these awards based on the closing price of our common stock on the grant date, and we recognize expense on a straight-line basis over the vesting period for those awards expected to vest. These awards earn dividends or dividend equivalents during the vesting period.

In 2013, we granted a new form of restricted stock to certain of our executive officers. This restricted stock vests after three years and can vest from 0% to 200% of the initial shares granted. Vesting is determined equally based on an operating return on equity performance factor (ROE factor) and a total shareholder return performance factor (TSR factor). The ROE factor is calculated by comparing our actual results over the three-year period to an internal target, whereas the TSR factor is calculated by comparing our TSR over the three-year period to that of nine peer companies. The ROE factor qualifies as a performance condition and those awards are accounted for in the same manner as the other restricted stock grants described above. The TSR factor qualifies as a market condition and we determine the fair value at grant date using a Monte Carlo simulation model that takes into account the probabilities of numerous outcomes of our TSR as well as that of the peer companies. This fair value is expensed on a straight-line basis over the vesting period and is not adjusted for the ultimate number of shares to vest. No dividends are earned during the vesting period on these shares.

For stock options, we use the Black-Scholes option pricing model to determine the fair value of an option on its grant date. The fair value is expensed over the vesting period.

Employee Stock Purchase Plan

In the second quarter of 2013, our stockholders authorized the issuance of up to 2.0 million shares of our common stock under the 2013 Employee Stock Purchase Plan (ESPP). The ESPP encourages share ownership by providing employees the opportunity to purchase our common stock at 85% of the closing price of the stock on either the first day or the last day of each six-month offering period (whichever is lower). Employees can invest between 1% and 15% of their base salary, subject to a maximum of the lesser of 1,500 shares in each offering period or $25,000 in each calendar year. The first offering period began on September 16, 2013 and ends on March 14, 2014. We recognize expense related to the ESPP over each offering period. The expense includes the 15% discount and the fair value of the “look-back” option calculated using the Black-Scholes option pricing model.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

(13) Segments

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

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, 2013

Net earned premium	$	276,647	$	277,662	$	657,995	$	144,673	$	311,261		$	-	$	10,972		$	1,679,210
Other revenue		16,198		304		3,736		1,027		2,790			196,756		253			221,064

Segment revenue		292,845		277,966		661,731		145,700		314,051			196,756		11,225			1,900,274

Loss and LAE		121,060		141,921		483,709		32,287		204,137			-		9,433			992,547
Other expense		84,801		46,781		97,414		80,182		114,534			-		67,688			491,400

Segment expense		205,861		188,702		581,123		112,469		318,671			-		77,121			1,483,947


Segment pretax earnings (loss)	$	86,984	$	89,264	$	80,608	$	33,231	$	(4,620	)	$	196,756	$	(65,896	)	$	416,327


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
Three months ended September 30, 2013

Net earned premium	$	91,684	$	92,439		$	223,048	$	47,442	$	100,849		$	-	$	1,206		$	556,668
Other revenue		4,769		(21	)		1,406		406		888			72,130		231			79,809

Segment revenue		96,453		92,418			224,454		47,848		101,737			72,130		1,437			636,477

Loss and LAE		13,666		30,100			163,143		13,436		99,221			-		810			320,376
Other expense		32,044		10,909			33,705		26,501		42,613			-		30,229			176,001

Segment expense		45,710		41,009			196,848		39,937		141,834			-		31,039			496,377


Segment pretax earnings (loss)	$	50,743	$	51,409		$	27,606	$	7,911	$	(40,097	)	$	72,130	$	(29,602	)	$	140,100


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

In the first nine months and third quarter of 2013, the U.S. Property & Casualty segment pretax earnings included net favorable loss development of $40.8 million and the International segment pretax loss included reserve strengthening of $70.3 million related to Spanish surety bonds.

(14) Commitments and Contingencies

Catastrophe Exposure

We have exposure to catastrophic losses caused by natural perils (such as hurricanes, earthquakes, floods, tsunamis, hail storms and tornados), as well as from man-made events (such as terrorist attacks). The incidence, timing and severity of catastrophic 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. In the first nine months of 2013, we recognized accident year net catastrophe losses, after reinsurance and reinstatement premium, of $44.5 million, primarily due to European floods, German hail storms and various small catastrophes. We recognized $20.3 million in the first nine months of 2012, primarily due to United States spring storms and various small catastrophes.

HCC Insurance Holdings, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(unaudited, tables in thousands except per share data)

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. We currently have claims under one indemnification that covers development on losses that were incurred prior to our sale of a subsidiary. At September 30, 2013, we have an accrued liability of $7.6 million to cover our obligations or anticipated payments under these indemnifications.

(15) Supplemental Information

Supplemental cash flow information was as follows:


	Nine months ended September 30,				Three months ended September 30,
	2013		2012		2013		2012
Income taxes paid	$	126,295	$	83,979	$	26,354	$	44,531
Interest paid		14,808		13,321		1,486		1,321
Proceeds from sales of available for sale fixed maturity securities		337,895		293,969		166,094		75,397
Proceeds from sales of equity securities		95,989		7,145		51,681		5,406
Dividends declared but not paid at end of period		22,540		16,728
Purchases of common stock not paid at end of period		-		6,400

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 our Consolidated Financial Statements and the related Notes as of September 30, 2013 and December 31, 2012.

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 $45.11 on October 25, 2013, resulting in market capitalization of $4.5 billion.

We underwrite and manage a variety of largely non-correlated specialty insurance products 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. We market our insurance products through a network of independent agents and brokers, through managing general agents owned by the company, and directly to consumers. In addition, we assume insurance written by other insurance companies.

Our organization is focused on generating consistent, industry-leading combined ratios. We concentrate our insurance writings in selected specialty lines of business in which we believe we can achieve meaningful underwriting profit. We rely on experienced underwriting personnel and our access to and expertise in the reinsurance marketplace to limit or reduce risk. By focusing on underwriting profitability, we are able to accomplish our primary objectives of maximizing net earnings and growing book value per share.

Our major 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, 2013 are as follows:

•

We had consolidated shareholders’ equity of $3.6 billion, with book value per share of $35.82.

•

We generated year-to-date net earnings of $292.2 million, or $2.90 per diluted share. Our third quarter earnings were $98.2 million, or $0.98 per diluted share.

•

We produced total revenue of $1.9 billion and $636.5 million in the first nine months and third quarter, respectively.

•

Our year-to-date net loss ratio was 59.1% and our combined ratio was 84.1%.

•

Our debt to capital ratio was 15.4%.

•

We purchased $42.2 million of our common stock at an average cost of $40.02 per share in the first nine months of 2013. At September 30, 2013, we had $207.6 million remaining under our current $300.0 million share buyback authorization.

•

We increased our regular cash dividend to $0.225 per share, marking the 17^th consecutive year of increases and the largest increase in the quarterly cash dividend in our history. In the first nine months of 2013, we declared dividends of $0.555 per share and paid $49.8 million of dividends.

Comparisons in the following sections refer to the first nine months of 2013 compared to the same period of 2012. Amounts in tables are in thousands, except for earnings per share, percentages, ratios and number of employees.

Results of Operations

Our results and key metrics for the first nine months and third quarter of 2013 and 2012 were as follows:


	Nine months ended September 30,						Three months ended September 30,
	2013			2012			2013			2012

Net earnings	$	292,187		$	283,139		$	98,175		$	107,062

Earnings per diluted share	$	2.90		$	2.76		$	0.98		$	1.05


Net loss ratio		59.1	%		57.9	%		57.6	%		53.9	%
Expense ratio		25.0			25.4			25.9			25.2


Combined ratio		84.1	%		83.3	%		83.5	%		79.1	%


In 2013, we recognized $28.0 million of pretax net catastrophe losses, including inward reinstatement premium, related to German hail storms ($13.0 million in the third quarter) and European floods ($15.0 million in the second quarter). In 2012, we recognized $3.4 million of pretax catastrophe losses from United States spring storms. The 2013 losses were in the property treaty line of business within our International segment, and the 2012 losses were primarily in the public risk line of business within our U.S. Property & Casualty segment. Various other catastrophes that were not individually significant events to us or the industry (which we refer to as “small catastrophes”) and that primarily impacted our property treaty line of business totaled $16.5 million in the first nine months of 2013 ($4.9 million in the third quarter) and $16.9 million ($8.6 million) in the comparable periods of 2012. The following table summarizes our catastrophe losses, as well as the impact on our net earnings and key metrics in 2013 and 2012:
	Nine months ended September 30,						Three months ended September 30,
	2013			2012			2013			2012

Net losses, after reinsurance	$	48,055		$	21,406		$	18,134		$	8,738
Reinstatement premium, net		(3,508	)		(1,123	)		(217	)		(712	)


Total net catastrophe losses	$	44,547		$	20,283		$	17,917		$	8,026


Impact of net catastrophe losses on:
Net earnings per diluted share	$	(0.29	)	$	(0.13	)	$	(0.12	)	$	(0.05	)
Net loss ratio (percentage points)		2.7	%		1.3	%		3.3	%		1.4	%
Combined ratio (percentage points)		2.6	%		1.3	%		3.3	%		1.4	%

We recognized net favorable loss development of $39.6 million and $34.6 million in the first nine months of 2013 and 2012, respectively, which included, in the respective periods, $7.3 million and $2.5 million of net favorable development related to prior year catastrophes. Net favorable loss development was $27.8 million in the third quarter of 2013 and $34.6 million in the third quarter of 2012. See the “Loss and Loss Adjustment Expense” and “Segment Operations” sections below for discussion of our 2013 and 2012 loss activity and the “Critical Accounting Policies” section below for discussion of our policies and procedures related to establishing and reviewing loss reserves.

Revenue

Total revenue increased $26.8 million in the first nine months of 2013, compared to 2012, primarily due to higher net earned premium and net realized investment gains.

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,
	2013		2012		2013		2012

U.S. Property & Casualty	$	534,509	$	481,024	$	176,121	$	162,411
Professional Liability		371,184		377,876		124,791		132,126
Accident & Health		652,782		622,613		222,312		209,738
U.S. Surety & Credit		169,805		166,678		58,367		55,976
International		469,324		460,111		96,131		95,200
Exited Lines		10,957		31,703		1,191		10,312


Total gross written premium	$	2,208,561	$	2,140,005	$	678,913	$	665,763


U.S. Property & Casualty	$	307,893	$	297,866	$	99,024	$	99,972
Professional Liability		247,183		264,398		83,422		93,261
Accident & Health		651,860		622,018		221,992		209,647
U.S. Surety & Credit		147,976		146,865		49,848		50,769
International		364,068		368,189		66,242		66,566
Exited Lines		10,972		31,463		1,206		10,092


Total net written premium	$	1,729,952	$	1,730,799	$	521,734	$	530,307


U.S. Property & Casualty	$	276,647	$	265,593	$	91,684	$	87,741
Professional Liability		277,662		298,454		92,439		97,549
Accident & Health		657,995		624,077		223,048		209,049
U.S. Surety & Credit		144,673		154,232		47,442		53,388
International		311,261		302,303		100,849		105,831
Exited Lines		10,972		31,463		1,206		10,092


Total net earned premium	$	1,679,210	$	1,676,122	$	556,668	$	563,650

Growth in gross written premium from our insurance underwriting segments occurred primarily in: 1) the U.S. Property & Casualty segment, from new business lines started in 2011 and increased writings of our disability product and 2) the Accident & Health segment, from the growth of our medical stop-loss product. This growth was partially offset by lower premium in Exited Lines related to two products exited in the third quarter of 2012. Our net written premium was flat year-over-year due to increased quota share reinsurance in 2013. See the “Segment Operations” section below for further discussion of the relationship and changes in premium revenue within each insurance segment.

Net investment income, which is included in our Investing segment, decreased 1% year-over-year and 4% quarter-over-quarter primarily due to reduced reinvestment yields. The cost basis of our fixed maturity and equity securities portfolio increased 7% from $6.0 billion at September 30, 2012 to $6.5 billion at September 30, 2013. The growth resulted primarily from cash flow from operations.

Loss and Loss Adjustment Expense

The tables below detail our net loss and loss adjustment expense and our net loss ratios on a consolidated basis and for our segments.


	Nine months ended September 30,						Three months ended September 30,
	2013			2012			2013			2012

U.S. Property & Casualty	$	121,060		$	154,156		$	13,666		$	53,229
Professional Liability		141,921			170,506			30,100			36,183
Accident & Health		483,709			447,262			163,143			140,344
U.S. Surety & Credit		32,287			42,444			13,436			15,721
International		204,137			126,547			99,221			46,924
Exited Lines		9,433			28,852			810			11,613


Net loss and loss adjustment expense	$	992,547		$	969,767		$	320,376		$	304,014


Net (favorable) adverse loss development:
U.S. Property & Casualty	$	(40,754	)	$	2,138		$	(40,754	)	$	2,138
Professional Liability		(26,284	)		(26,186	)		(26,284	)		(26,186	)
Accident & Health		-			(10,695	)		-			(10,695	)
U.S. Surety & Credit		(9,492	)		-			-			-
International		36,896			-			39,196			-
Exited Lines		-			111			-			111

Total net favorable loss development		(39,634	)		(34,632	)		(27,842	)		(34,632	)
Catastrophe losses		48,055			21,406			18,134			8,738
All other net loss and loss adjustment expense		984,126			982,993			330,084			329,908


Net loss and loss adjustment expense	$	992,547		$	969,767		$	320,376		$	304,014


U.S. Property & Casualty		43.8	%		58.0	%		14.9	%		60.7	%
Professional Liability		51.1			57.1			32.6			37.1
Accident & Health		73.5			71.7			73.1			67.1
U.S. Surety & Credit		22.3			27.5			28.3			29.4
International		65.6			41.9			98.4			44.3
Exited Lines		86.0			91.7			67.2			115.1


Consolidated net loss ratio		59.1	%		57.9	%		57.6	%		53.9	%


Consolidated accident year net loss ratio		61.5	%		59.9	%		62.6	%		60.1	%

Net loss and loss adjustment expense (referred to as loss expense) increased $22.8 million and $16.4 million in the first nine months and third quarter of 2013, respectively, compared to the same periods in 2012. The loss expense increased primarily due to: 1) our Accident & Health segment, from growth of our medical stop-loss product writings and 2) our International segment, from a $70.3 million reserve increase on Spanish surety bonds and higher catastrophe losses. Partially offsetting these increases were reductions from: 1) higher favorable loss development in 2013 and 2) lower losses in our diversified financial products (DFP) line of business. See the “Segment Operations” section below for additional discussion of the changes in our loss expense, as well as discussion of the net loss ratios for each segment for 2013 and 2012.

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,
	2013			2012			2013			2012
Net reserves for loss and loss adjustment expense payable at beginning of period	$	2,749,803		$	2,683,483		$	2,811,021		$	2,748,995
Net reserve additions from acquired businesses		-			14,705			-			-
Foreign currency adjustment		(2,296	)		11,261			22,331			15,717
Net loss and loss adjustment expense		992,547			969,767			320,376			304,014
Net loss and loss adjustment expense payments		(884,022	)		(944,203	)		(297,696	)		(333,713	)

Net reserves for loss and loss adjustment expense payable at end of period	$	2,856,032		$	2,735,013		$	2,856,032		$	2,735,013


Net paid loss ratio		52.6	%		56.3	%		53.5	%		59.2	%

The amount of claims paid fluctuates year-over-year due to the timing of claims settlement, the occurrence of catastrophic events and commutations, and the mix of our business. In the first quarter of 2012, we commuted certain loss reserves on a large contract included in our Exited Lines for $27.5 million. The commutation had no material effect on net earnings but increased our net paid loss ratio by 1.6 percentage points in the first nine months of 2012. Excluding the commutation, our year-to-date net paid loss ratio decreased 2.1 percentage points compared to 2012.

Policy Acquisition Costs

The percentage of policy acquisition costs to net earned premium was 12.1% and 12.6% for the first nine months of 2013 and 2012, respectively, and 11.8% and 12.0% for the third quarter of 2013 and 2012, respectively. The difference between periods primarily related to changes in the mix of business and reinsurance programs.

Other Operating Expense

Other operating expense was flat year-over-year and increased 3% quarter-over-quarter. In the first nine months of 2013, higher employee compensation and benefit costs were offset by lower foreign currency expense compared to 2012. The increase in other operating expense in the third quarter of 2013 primarily related to higher foreign currency expense. We recognized foreign currency expense of $0.1 million and $9.2 million in the first nine months and third quarter of 2013, respectively, compared to $5.3 million and $6.8 million in the same periods of 2012. The foreign currency expense related to changes in the value of the British pound sterling and the Euro relative to the U.S. dollar.

Excluding the effect of foreign currency expense, other operating expense increased 2% year-over-year and 1% quarter-over-quarter, mainly due to increased compensation and benefit costs in 2013 for our 1,900 employees. Approximately 64% and 61% of our other operating expense in 2013 and 2012, respectively, related to compensation and benefits. Other operating expense included stock-based compensation expense of $10.4 million in 2013 and $10.6 million in 2012. At September 30, 2013, there was approximately $24.1 million of total unrecognized compensation expense related to unvested options, shares of restricted stock and restricted stock units that is expected to be recognized over a weighted-average period of 2.6 years.

Interest Expense

Interest expense was $19.7 million and $19.1 million in the first nine months of 2013 and 2012, and $6.6 million and $6.0 million in the third quarter of 2013 and 2012, respectively. The year-to-date interest expense for 2013 and 2012 included $14.5 million for our Senior Notes.

Income Tax Expense

Our effective income tax rate was 29.8% for the first nine months of 2013, compared to 30.1% for the same period of 2012.

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. Certain 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 catastrophic 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 underwriting 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,
	2013			2012			2013			2012

Net earned premium	$	276,647		$	265,593		$	91,684		$	87,741
Other revenue		16,198			15,300			4,769			8,415


Segment revenue		292,845			280,893			96,453			96,156

Loss and loss adjustment expense, net		121,060			154,156			13,666			53,229
Other expense		84,801			89,348			32,044			29,581


Segment expense		205,861			243,504			45,710			82,810


Segment pretax earnings	$	86,984		$	37,389		$	50,743		$	13,346


Net loss ratio		43.8	%		58.0	%		14.9	%		60.7	%
Expense ratio		29.0			31.8			33.2			30.8


Combined ratio		72.8	%		89.8	%		48.1	%		91.5	%


Aviation	$	84,191		$	87,890		$	27,905		$	29,670
E&O		39,494			47,177			13,061			15,198
Public Risk		48,530			48,363			15,775			16,571
Other		104,432			82,163			34,943			26,302


Total net earned premium	$	276,647		$	265,593		$	91,684		$	87,741


Aviation		52.7	%		56.9	%		31.8	%		58.9	%
E&O		42.2			74.1			4.0			102.1
Public Risk		73.2			95.9			66.0			130.8
Other		23.5			27.8			(17.6	)		(5.5	)


Total net loss ratio		43.8	%		58.0	%		14.9	%		60.7	%


	Nine months ended September 30,				Three months ended September 30,
	2013		2012		2013		2012

Aviation	$	115,001	$	117,300	$	39,819	$	34,430
E&O		41,909		46,483		13,581		14,990
Public Risk		57,757		67,066		20,652		23,821
Other		319,842		250,175		102,069		89,170


Total gross written premium	$	534,509	$	481,024	$	176,121	$	162,411


Aviation	$	91,540	$	92,043	$	31,406	$	28,638
E&O		36,969		44,335		12,278		14,100
Public Risk		47,110		54,185		17,230		18,618
Other		132,274		107,303		38,110		38,616


Total net written premium	$	307,893	$	297,866	$	99,024	$	99,972

Our U.S. Property & Casualty segment pretax earnings increased $49.6 million year-over-year and $37.4 million quarter-over-quarter primarily due to the following: 1) net favorable loss development of $40.8 million in 2013, compared to net adverse development of $2.1 million in 2012, 2) no catastrophe losses in 2013, compared to $4.4 million in 2012 and 3) higher ceding commissions in 2013. Net earned premium increased in 2013, compared to 2012, due to higher writings by our new underwriting teams for the technical property, primary casualty and excess casualty lines of business, as well as for disability, residual value and title reinsurance (all grouped in Other).

The net (favorable) adverse loss development recognized by line of business was as follows:


	Nine months ended September 30,						Three months ended September 30,
	2013			2012			2013			2012

Aviation	$	(8,402	)	$	(924	)	$	(8,402	)	$	(924	)
E&O		(7,302	)		6,742			(7,302	)		6,742
Public Risk		(567	)		10,418			(567	)		10,418
Other		(24,483	)		(14,098	)		(24,483	)		(14,098	)


Total net (favorable) adverse loss development	$	(40,754	)	$	2,138		$	(40,754	)	$	2,138

The net development resulted from our annual review of reserves for this segment, which we conduct in the third quarter of each year. The majority of the lines of business in this segment provide primary coverage, and claims are reported and settled on a short to medium-term basis. Accordingly, changes to our ultimate losses for a given underwriting year typically result from revised expectations, as compared to the prior year reserve review, with respect to the settlement value of known claims. The reserve changes made in conjunction with our 2013 reserve review related to the 2011 and prior underwriting years, unless noted below.

Our aviation line of business had a lower net loss ratio in the first nine months and the third quarter of 2013, compared to the same periods in 2012, due to more favorable loss development in 2013 and no catastrophe losses in 2013 compared to $1.2 million year-to-date in 2012.

We experienced substantially lower losses and loss ratios in our E&O line of business in 2013, due to favorable development in 2013 (primarily related to underwriting years 2010 and 2011), compared to adverse loss development in 2012 (primarily related to underwriting years 2005 – 2010).

The year-to-date and quarter-to-date loss ratios for our public risk line of business decreased primarily due to adverse loss development recognized in 2012 and $3.2 million of catastrophe losses from United States spring storms incurred in the first quarter of 2012. The adverse loss development was primarily due to deteriorating results compared to expectations, particularly from large property losses, related to the 2009 and 2010 underwriting years. The adverse development was partially offset by favorable development from the release of $2.5 million of 2011 catastrophe reserves related to Hurricane Irene.

The various lines of business included in Other recognized $10.4 million more net favorable development in 2013 than in 2012. One product line, which is an assumed quota share contract for 2003 – 2009 business that is in runoff, recognized $17.0 million of favorable development in 2013, compared to $5.6 million in 2012, due to continued better than expected results since the prior annual review. This product line is no longer earning premium, resulting in negative loss ratios in total for the Other line of business in both years. The remaining favorable development in Other was not material for any one product line in either year.

Other expense and the expense ratio were lower year-to-date in 2013 primarily due to higher ceding commissions (that offset policy acquisition costs) from increased writings of our highly-ceded sports and entertainment disability product. In addition, a $2.5 million recovery of an indemnification liability in the second quarter of 2013 reduced the segment’s year-to-date expense ratio by 0.8 percentage points. The higher quarter-to-date expense ratio related to higher compensation and benefits expense in 2013.

Professional Liability Segment

The following tables summarize the operations of the Professional Liability segment.


	Nine months ended September 30,						Three months ended September 30,
	2013			2012			2013			2012

Net earned premium	$	277,662		$	298,454		$	92,439		$	97,549
Other revenue		304			799			(21	)		532


Segment revenue		277,966			299,253			92,418			98,081

Loss and loss adjustment expense, net		141,921			170,506			30,100			36,183
Other expense		46,781			49,621			10,909			13,414


Segment expense		188,702			220,127			41,009			49,597


Segment pretax earnings	$	89,264		$	79,126		$	51,409		$	48,484


Net loss ratio		51.1	%		57.1	%		32.6	%		37.1	%
Expense ratio		16.8			16.6			11.8			13.7


Combined ratio		67.9	%		73.7	%		44.4	%		50.8	%


U.S. D&O	$	229,501		$	252,622		$	75,780		$	81,955
International D&O		48,161			45,832			16,659			15,594


Total net earned premium	$	277,662		$	298,454		$	92,439		$	97,549


U.S. D&O		55.7	%		64.9	%		41.3	%		54.9	%
International D&O		29.3			14.5			(7.2	)		(56.3	)


Total net loss ratio		51.1	%		57.1	%		32.6	%		37.1	%


U.S. D&O	$	284,769		$	297,933		$	97,924		$	111,749
International D&O		86,415			79,943			26,867			20,377


Total gross written premium	$	371,184		$	377,876		$	124,791		$	132,126


U.S. D&O	$	198,452		$	218,794		$	68,874		$	81,968
International D&O		48,731			45,604			14,548			11,293


Total net written premium	$	247,183		$	264,398		$	83,422		$	93,261

Our Professional Liability segment pretax earnings increased 13% year-over-year and 6% quarter-over-quarter, compared to 2012, due to an improved net loss ratio, primarily related to re-underwriting of our diversified financial products (DFP) line of business in U.S. D&O beginning in 2012. The U.S. D&O gross written premium decreased in 2013 due to lower writings of our directors’ and officers’ liability and DFP products. Net written premium decreased 7% year-over-year primarily due to reduced retention under our reinsurance program. Net earned premium decreased in 2013 primarily due to our re-underwriting of the DFP book of business in 2012 and the additional reinsurance.

The segment had net favorable loss development of $26.3 million in the first nine months and third quarter of 2013, compared to $26.2 million in the same periods of 2012. The development in each period resulted from our annual review of reserves for this segment, which we conduct in the third quarter of each year. The majority of the insurance coverage in this segment is provided through “claims made” policies, and the final settlement value of these claims is not expected to be determined for several years due to the underlying complex nature of the claims. Accordingly, changes to our ultimate losses for a given underwriting year typically result from revised expectations, as compared to the prior year reserve review, with respect to the settlement value of known claims.

The 2013 net favorable development consisted of $15.8 million in U.S. D&O and $10.5 million in International D&O. Our 2013 review indicated better than expected experience for underwriting years prior to 2007, as well as 2009 and 2010 (totaling $64.2 million), partially offset by reserve strengthening in underwriting years 2007 and 2008 (totaling $37.9 million) that were impacted by the worldwide financial crisis. Reserves for the diversified financial products (DFP) line of business within U.S. D&O performed slightly better than expected in the past year, but no changes were made to the estimated ultimate losses given the continued evaluation and re-underwriting of this line of business.

The 2012 net favorable development consisted of $9.3 million in U.S. D&O and $16.9 million in International D&O. Our 2012 review indicated that incurred loss development, primarily for underwriting years 2005 and 2006, was lower than expected as compared to our review in 2011, primarily due to favorable actual outcomes on reported claims. This favorable outcome was partially offset by higher estimates of ultimate losses in the 2008 underwriting year, driven by our revised expectations with regard to the expected outcomes on outstanding claims, based upon loss development and other information available since the 2011 review.

Accident & Health Segment

The following tables summarize the operations of the Accident & Health segment.


	Nine months ended September 30,						Three months ended September 30,
	2013			2012			2013			2012

Net earned premium	$	657,995		$	624,077		$	223,048		$	209,049
Other revenue		3,736			3,589			1,406			1,095


Segment revenue		661,731			627,666			224,454			210,144

Loss and loss adjustment expense, net		483,709			447,262			163,143			140,344
Other expense		97,414			93,127			33,705			32,025


Segment expense		581,123			540,389			196,848			172,369


Segment pretax earnings	$	80,608		$	87,277		$	27,606		$	37,775


Net loss ratio		73.5	%		71.7	%		73.1	%		67.1	%
Expense ratio		14.7			14.8			15.0			15.2


Combined ratio		88.2	%		86.5	%		88.1	%		82.3	%


Medical Stop-loss	$	609,693		$	583,344		$	205,089		$	195,671
Other		48,302			40,733			17,959			13,378


Total net earned premium	$	657,995		$	624,077		$	223,048		$	209,049


Medical Stop-loss		75.2	%		73.1	%		75.2	%		68.5	%
Other		52.5			50.5			50.0			46.6


Total net loss ratio		73.5	%		71.7	%		73.1	%		67.1	%


Medical Stop-loss	$	610,366		$	583,639		$	205,327		$	195,665
Other		42,416			38,974			16,985			14,073


Total gross written premium	$	652,782		$	622,613		$	222,312		$	209,738


Medical Stop-loss	$	609,693		$	583,344		$	205,089		$	195,671
Other		42,167			38,674			16,903			13,976


Total net written premium	$	651,860		$	622,018		$	221,992		$	209,647

The Accident & Health segment generated higher net earned premium in 2013 related to its medical stop-loss product line, due to writing new business and rate increases on renewal business. The impact of this growth was offset by the recognition of $10.7 million of favorable loss development in the third quarter of 2012, compared to none in 2013.

The majority of our stop-loss business provides annual coverage for groups of employees, and claims are reported and settled quickly in the following year. Our 2012 reserve review indicated lower than expected claims activity related to the 2011 underwriting year. We generally conduct our annual comprehensive review of this segment’s reserves in the fourth quarter. However, in the third quarter of 2012, we exited the HMO and medical excess reinsurance business that had previously been included in this segment. As a result, we conducted our 2012 annual reserve review of this segment’s reserves in the third quarter. We will conduct the 2013 annual review in the fourth quarter.

U.S. Surety & Credit Segment

The following tables summarize the operations of the U.S. Surety & Credit segment.


	Nine months ended September 30,						Three months ended September 30,
	2013			2012			2013			2012

Net earned premium	$	144,673		$	154,232		$	47,442		$	53,388
Other revenue		1,027			659			406			244


Segment revenue		145,700			154,891			47,848			53,632

Loss and loss adjustment expense, net		32,287			42,444			13,436			15,721
Other expense		80,182			83,402			26,501			27,879


Segment expense		112,469			125,846			39,937			43,600


Segment pretax earnings	$	33,231		$	29,045		$	7,911		$	10,032


Net loss ratio		22.3	%		27.5	%		28.3	%		29.4	%
Expense ratio		55.0			53.8			55.4			52.0


Combined ratio		77.3	%		81.3	%		83.7	%		81.4	%


Surety	$	109,370		$	118,944		$	36,645		$	39,336
Credit		35,303			35,288			10,797			14,052


Total net earned premium	$	144,673		$	154,232		$	47,442		$	53,388


Surety		21.5	%		24.7	%		24.9	%		24.6	%
Credit		24.8			37.0			40.1			43.0


Total net loss ratio		22.3	%		27.5	%		28.3	%		29.4	%


Surety	$	125,235		$	121,087		$	44,908		$	40,325
Credit		44,570			45,591			13,459			15,651


Total gross written premium	$	169,805		$	166,678		$	58,367		$	55,976


Surety	$	111,746		$	110,074		$	39,600		$	36,689
Credit		36,230			36,791			10,248			14,080


Total net written premium	$	147,976		$	146,865		$	49,848		$	50,769

Our U.S. Surety & Credit segment pretax earnings increased 14% year-over-year and decreased 21% quarter-over-quarter, compared to 2012, primarily due to favorable loss development in the second quarter of 2013. Net earned premium for our surety line of business decreased in 2013, primarily due to ongoing competition and market conditions.

The segment had favorable loss development of $9.5 million in 2013 and none in 2012. In the first half of 2013, we settled a large 2010 claim on favorable terms, which generated $5.8 million of reserve redundancy, and we noted continued lower than expected claims activity related to older underwriting years. As a result, we conducted a limited review of the segment’s reserves during the second quarter. This review indicated that actual loss experience for the 2010 and prior underwriting years was significantly better in 2013 than the actuarial expectations in our 2012 comprehensive review. In view of the growing redundancy in the segment’s reserves, we recognized favorable development of $3.7 million for surety and $5.8 million for credit related to the 2010 and prior underwriting years in the second quarter of 2013.

International Segment

The following tables summarize the operations of the International segment.


	Nine months ended September 30,						Three months ended September 30,
	2013			2012			2013			2012

Net earned premium	$	311,261		$	302,303		$	100,849		$	105,831
Other revenue		2,790			2,766			888			631


Segment revenue		314,051			305,069			101,737			106,462

Loss and loss adjustment expense, net		204,137			126,547			99,221			46,924
Other expense		114,534			108,018			42,613			39,253


Segment expense		318,671			234,565			141,834			86,177


Segment pretax earnings (loss)	$	(4,620	)	$	70,504		$	(40,097	)	$	20,285


Net loss ratio		65.6	%		41.9	%		98.4	%		44.3	%
Expense ratio		36.5			35.4			41.9			36.9


Combined ratio		102.1	%		77.3	%		140.3	%		81.2	%


Energy	$	62,271		$	61,377		$	18,814		$	20,488
Property Treaty		85,067			77,422			26,569			28,415
Liability		54,671			57,603			19,088			18,472
Surety & Credit		54,186			53,701			18,120			18,756
Other		55,066			52,200			18,258			19,700


Total net earned premium	$	311,261		$	302,303		$	100,849		$	105,831


Energy		26.7	%		42.5	%		(16.6	) %		44.2	%
Property Treaty		54.6			22.0			62.3			29.3
Liability		29.2			49.5			(8.5	)		49.6
Surety & Credit		189.4			57.7			441.0			56.6
Other		40.8			45.9			41.1			49.5


Total net loss ratios		65.6	%		41.9	%		98.4	%		44.3	%


Energy	$	127,162		$	125,578		$	15,303		$	14,864
Property Treaty		133,578			134,527			19,583			20,672
Liability		59,992			58,293			19,782			18,051
Surety & Credit		68,186			61,759			21,990			18,308
Other		80,406			79,954			19,473			23,305


Total gross written premium	$	469,324		$	460,111		$	96,131		$	95,200


	Nine months ended September 30,						Three months ended September 30,
	2013			2012			2013			2012

Energy	$	72,949		$	83,353		$	1,829		$	2,340
Property Treaty		113,169			113,302			11,903			13,483
Liability		56,259			53,954			18,682			16,638
Surety & Credit		59,326			55,887			19,036			16,074
Other		62,365			61,693			14,792			18,031


Total net written premium	$	364,068		$	368,189		$	66,242		$	66,566


Our International segment pretax earnings decreased $75.1 million in the first nine months and $60.4 million in the third quarter of 2013, compared to the same periods of 2012, primarily due to the impact of higher net catastrophe losses and net adverse loss development in 2013.

In the third quarter of 2013, the International segment recognized $13.0 million of pretax catastrophe losses related to German hail storms. In the second quarter of 2013, the segment recognized $15.0 million of pretax catastrophe losses related to European floods, including $2.0 million of inward reinstatement premium. There were no large catastrophe losses in the first nine months of 2012. The remaining net catastrophe losses in 2013 and 2012 related to small catastrophes. The following table summarizes the segment’s net catastrophe losses, as well as the impact on key metrics:

	Nine months ended September 30,						Three months ended September 30,
	2013			2012			2013			2012

Loss and loss adjustment expense, after reinsurance	$	48,055		$	17,006		$	18,134		$	8,338
Reinstatement premium, net		(3,508	)		(1,123	)		(217	)		(712	)


Total net catastrophe losses	$	44,547		$	15,883		$	17,917		$	7,626


Impact of net catastrophe losses (percentage points):

Net loss ratio		14.9	%		5.5	%		17.8	%		7.6	%
Expense ratio		(0.4	)		(0.1	)		(0.1	)		(0.2	)


Combined ratio		14.5	%		5.4	%		17.7	%		7.4	%


The International segment recognized $36.9 million and $39.2 million of net adverse loss development in the first nine months and third quarter of 2013, respectively, and none in the same periods of 2012. The net (favorable) adverse loss development recognized by line of business was as follows:
	Nine months ended September 30,						Three months ended September 30,
	2013			2012			2013			2012
Energy	$	(13,055	)	$	-		$	(13,055	)	$	-
Property Treaty		(3,291	)		-			(3,291	)		-
Liability		(13,335	)		-			(13,335	)		-
Surety & Credit		70,321			-			70,321			-
Other		(3,744	)		-			(1,444	)		-


Total (favorable) adverse loss development	$	36,896		$	-		$	39,196		$	-

We generally conduct our annual review of this segment’s reserves in the fourth quarter, as we did in 2012. However, we accelerated our 2013 comprehensive review to the third quarter due to a growing indicated redundancy in several lines of business and issues related to certain Spanish surety bonds.

The adverse development in the International surety & credit line of business related to our increase in reserves on a specific class of Spanish surety bonds, the majority of which were written prior to 2006. The reserve increase reflected our revised estimates of our liability under these bonds in light of an adverse Spanish Supreme Court ruling reported in September 2013 against an unaffiliated insurance company with respect to a surety bond similar to ours. This resulted in $70.3 million of net adverse loss development in the quarter.

The favorable development in energy related to the 2012 and prior underwriting years and included $3.0 million related to the release of 2012 catastrophe reserves for Hurricane Sandy, due to lower than expected losses. The net favorable development in liability included $16.1 million of favorable development on our U.K. professional liability product related to the 2011 and prior underwriting years, partially offset by net adverse development on other liability products. Our actual loss experience for energy and U.K. professional liability was significantly better than the actuarial expectations in our 2012 reserve review. In the second quarter of 2013, we recognized favorable development of $2.3 million in the property line of business (included in Other) related to our 2010 New Zealand earthquake catastrophe losses, due to settlement of these claims in 2013.

The previously-discussed adverse and favorable loss development caused the significant variances in the segment and line of business net loss ratios for the nine months and third quarter of 2013, compared to 2012.

The increase in net earned premium in the first nine months of 2013 primarily related to increased writings of our property treaty line of business during 2012. The decrease in net written premium primarily related to additional reinsurance on our energy line of business in 2013. The higher expense ratio year-over-year and quarter-over-quarter related to higher compensation and benefits expense in 2013.

Investing Segment

We invest the majority of our funds in highly-rated fixed maturity securities, which are designated as available for sale securities. We held $6.2 billion of fixed maturity securities at September 30, 2013. Substantially all of our fixed maturity securities were investment grade and 71% were rated AAA or AA.

The following tables summarize the results and key metrics of our Investing segment.


	Nine months ended September 30,						Three months ended September 30,
	2013			2012			2013			2012

Fixed maturity securities	$	160,470		$	166,711		$	53,373		$	55,621
Equity securities		10,758			2,339			2,950			1,346
Short-term investments		122			397			42			295
Other investments and deposits		350			1,699			31			831
Net realized investment gain		31,115			8,519			17,922			1,472
Other-than-temporary impairment credit losses		-			(1,028	)		-			(631	)
Investment expenses		(6,059	)		(4,504	)		(2,188	)		(1,751	)


Segment pretax earnings	$	196,756		$	174,133		$	72,130		$	57,183


Fixed maturity securities:
Average yield*		3.6	%		3.9	%		3.6	%		3.9	%
Average tax equivalent yield*		4.5	%		4.8	%		4.4	%		4.7	%
Weighted-average life		8.2 years			8.0 years
Weighted-average duration		5.5 years			4.6 years
Weighted-average rating		AA			AA

* Excluding realized and unrealized gains and losses.

In the past several years, the average yield on our fixed maturity securities has continued to decline due to persistently lower interest rates on new investments. We have addressed this issue by investing longer-term, especially in tax-exempt municipal bonds, in anticipation of a prolonged low interest rate environment and, since 2012, by investing in new classes of securities with attractive yields and low/no duration. These new classes of investments include bank loans (classified as corporate securities), collateralized loan obligations (classified as asset-backed securities) and global publicly-traded equity securities. At September 30, 2013, our investments included $157.4 million of bank loans, $73.8 million of collateralized loan obligations and $433.3 million of equity securities, compared to $103.8 million, none and $202.9 million, respectively, at September 30, 2012.

Our duration has increased from 4.7 years at December 31, 2012 to 5.5 years at September 30, 2013. The higher duration directly relates to increased prevailing interest rates and spreads, primarily in the second quarter of 2013, due to investor concerns that the U.S. Federal government would tighten its fiscal policies. In 2013, rates on 10-year U.S. Treasury notes rose 86 basis points to their highest level in two years.

These rising interest rates impacted the fair value of our fixed maturity securities portfolio at September 30, 2013, as described below. Conversely, the higher interest rates will result in higher anticipated yields as we invest our future cash flows.

This table summarizes our investments by type, all of which were reported at fair value, at September 30, 2013 and December 31, 2012. The methodologies used to determine the fair value of our investments are described in Note 4, “Fair Value Measurements” to the Consolidated Financial Statements.


	September 30, 2013					December 31, 2012
	Amount		%			Amount		%
Fixed maturity securities
U.S. government and government agency securities	$	117,505		2	%	$	199,607		3	%
Fixed maturity securities of states, municipalities and political subdivisions		1,016,139		15			1,065,811		15
Special purpose revenue bonds of states, municipalities and political subdivisions		2,296,838		33			2,200,331		32
Corporate securities		1,297,704		19			1,315,170		19
Residential mortgage-backed securities		592,957		9			664,887		10
Commercial mortgage-backed securities		531,216		8			524,289		8
Asset-backed securities		141,301		2			33,275		-
Foreign government securities		200,965		3			278,411		4
Equity securities		433,345		6			284,639		4
Short-term investments		229,191		3			363,053		5
Other investments		-		-			20,925		-


Total investments	$	6,857,161		100	%	$	6,950,398		100	%

Our total investments decreased $93.2 million in 2013, principally from a $263.6 million decrease in the pretax net unrealized gain and return of $127.9 million of collateral held for our U.S. surety business, partially offset by investment of newly generated cash flow. At September 30, 2013, the net unrealized gain on our investment portfolio was $173.1 million, compared to $436.7 million at December 31, 2012. The significant decline in the net unrealized gain was due to the rise in interest rates in 2013 discussed previously.

The ratings of our individual securities within our fixed maturity securities portfolio at September 30, 2013 were as follows:


	Amount		%
AAA	$	897,756		14	%
AA		3,526,181		57
A		1,325,501		21
BBB		278,791		5
BB and below		166,396		3


Total fixed maturity securities	$	6,194,625		100	%

At September 30, 2013, we held $2.3 billion of special purpose revenue bonds, as well as $1.0 billion of general obligation bonds, which are issued by states, municipalities and political subdivisions and collectively referred to as municipal bonds in the investment market. The overall rating of our municipal bonds was AA at September 30, 2013. Within our municipal bond portfolio, we held $425.9 million of pre-refunded bonds, which are supported by U.S. government debt obligations. Our special purpose revenue bonds are secured by revenue sources specific to each security. At September 30, 2013, the percentages of our special purpose revenue bond portfolio supported by these major revenue sources were as follows: 1) education – 24%, 2) transportation – 23%, 3) water and sewer – 18% and 4) electric – 14%.

Many of our special purpose revenue bonds are insured by mono-line insurance companies or supported by credit enhancement programs of various states and municipalities. We view bond insurance as credit enhancement and not credit substitution. We base our investment decision on the strength of the issuer. A credit review is performed on each issuer and on the sustainability of the revenue source before we acquire a special purpose revenue bond and periodically thereafter. The underlying average credit rating of our special purpose revenue bond issuers, excluding any bond insurance, was AA at September 30, 2013. Although recent economic

conditions in the United States may reduce the source of revenue to support certain of these securities, the majority are supported by revenue from essential sources, as indicated above, which we believe generate a stable source of revenue.

At September 30, 2013, we held corporate fixed maturity securities issued by foreign corporations with an aggregate fair value of $559.6 million. In addition, we held securities issued by foreign governments, agencies or supranational entities with an aggregate fair value of $201.0 million.

Some of our fixed maturity securities have call or prepayment options. In addition, mortgage-backed and certain asset-backed securities have prepayment, extension or other market-related credit risk. Calls and prepayments subject us to reinvestment risk should interest rates fall and issuers call their securities and we reinvest the proceeds at lower interest rates. Prepayment risk exists if cash flows from the repayment of principal occur earlier than anticipated because of declining interest rates. Extension risk exists if cash flows from the repayment of principal occur later than anticipated because of rising interest rates. Credit risk exists if mortgagees default on the underlying mortgages. Net investment income and/or cash flows from investments that have call or prepayment options and prepayment, extension or credit risk may differ from what was anticipated at the time of investment. We mitigate these risks by investing in investment grade securities with varied maturity dates so that only a portion of our portfolio will mature at any point in time. Through December 31, 2014, we expect approximately 9% of our fixed maturity securities portfolio to mature, call or prepay. Assuming prevailing interest rates remain constant for the next fifteen months, reinvestment of these funds will be at book yields and tax-equivalent yields that are approximately 80 basis points lower than the current yields for these securities.

Corporate & Other

The following table summarizes activity in the Corporate & Other category.


	Nine months ended September 30,						Three months ended September 30,
	2013			2012			2013			2012

Net earned premium	$	10,972		$	31,463		$	1,206		$	10,092
Other revenue		253			116			231			(77	)


Total revenue		11,225			31,579			1,437			10,015


Loss and loss adjustment expense, net		9,433			28,852			810			11,613
Other expense - Exited Lines		3,575			6,152			1,052			2,147
Other expense - Corporate		44,641			45,082			13,503			17,076
Interest expense		19,337			18,721			6,494			5,877
Foreign currency expense		135			5,348			9,180			6,788


Total expense		77,121			104,155			31,039			43,501


Pretax loss	$	(65,896	)	$	(72,576	)	$	(29,602	)	$	(33,486	)

Net earned premium decreased year-over-year as we wrote less business related to our exited HMO and medical excess reinsurance products. Premium related to the other products included in Exited Lines was insignificant in all periods. The majority of the loss and loss adjustment expense relates to the HMO and medical excess reinsurance products.

Our Corporate expenses not allocable to the segments were flat year-over-year, and decreased $3.6 million quarter-over-quarter primarily due to lower compensation and benefit costs. The impact of foreign currency expense fluctuated period-over-period principally due to changes in the value of the British pound sterling and the Euro relative to the U.S. dollar. We hold available for sale securities denominated in non-functional currencies to economically hedge the currency exchange risk on our loss reserves denominated in non-functional currencies. The foreign currency benefit/expense related to loss reserves is recorded through the income statement, while the foreign currency benefit/expense related to available for sale securities is recorded through other comprehensive income within shareholders’ equity. This accounting mismatch may cause fluctuations in our reported foreign currency benefit/expense in future periods.

Liquidity and Capital Management

We believe we have sufficient sources of liquidity at both a consolidated and insurance company legal entity level at a reasonable cost to pay claims and meet our other contractual obligations and liabilities as they become due in the short-term and long-term. Our current sources of liquidity include: 1) significant operating cash flow generated by our insurance companies, 2) a $6.9 billion investment portfolio, most of which is held by our insurance companies, 3) our revolving loan and standby letter of credit facilities and 4) a $1.0 billion shelf registration. Our insurance companies have sufficient resources to pay potential claims. Based on historical payment patterns and claims history, at year-end 2012, we projected that our insurance companies will pay approximately $1.4 billion of claims in 2013. We also projected that they will collect approximately $0.4 billion of reinsurance recoveries in 2013. In addition to expected cash flow from their 2013 operations, these companies had $6.4 billion of investments available to fund claims payments, if needed. Our sources of liquidity are discussed below.

Cash Flow

We manage the liquidity of our insurance companies such that each subsidiary’s anticipated claims payments will be met by its own current operating cash flows, cash, short-term investments or investment maturities. Our insurance companies receive substantial cash from premiums, reinsurance recoverables, surety collateral, outward commutations, proceeds from sales and redemptions of investments, and investment income. Their principal cash outflows are for the payment of claims and loss adjustment expenses, premium payments to reinsurers, return of surety collateral, inward commutations, purchases of investments, policy acquisition costs, operating expenses, taxes and dividends paid to the parent company. We report all of the insurance companies’ investing activity in our Investing segment for segment reporting purposes. Our parent company’s principal cash inflows relate to its investment portfolio and dividends paid by the insurance companies, and its principal cash outflows relate to debt service, operating expenses, dividends paid to shareholders and common stock purchases. Cash provided by operating activities can fluctuate due to timing differences in the collection of premium receivables, reinsurance recoverables and surety collateral; the payment of losses, premium payables and return of surety collateral; and the completion of commutations.

The components of our net operating cash flows are summarized in the following table.


	Nine months ended September 30,
	2013			2012

Net earnings	$	292,187		$	283,139
Change in premium, claims and other receivables, net of reinsurance, premium and claims payables and excluding restricted cash		(30,879	)		(26,120	)
Change in unearned premium, net		50,586			47,259
Change in loss and loss adjustment expense payable, net of reinsurance recoverables		103,023			63,201
Change in accounts payable and accrued liabilities		(145,740	)		79,500
Gain on investments		(31,115	)		(7,491	)
Other, net		33,350			56,547


Cash provided by operating activities	$	271,412		$	496,035

Our cash provided by operating activities was $271.4 million in the first nine months of 2013, compared to $496.0 million in the same period of 2012. Cash provided by operating activities includes collateral funds we receive or refund for our U.S. surety business, as well as funds we pay to commute large contracts. We refunded U.S. surety collateral of $127.9 million in 2013, compared to a net receipt of $81.0 million in 2012. We paid $27.5 million in 2012 to commute a large contract in our Exited Lines. The remaining $43.2 million reduction in our cash provided by operating activities primarily resulted from $42.3 million of higher income tax payments in 2013, compared to 2012, as well as the timing of the collection and the payment of insurance-related receivables and payables.

The net impact of payment of claims and collection of recoverables related to the Spanish surety bonds is expected to reduce our cash provided by operating activities in future periods, although the amount and timing of such payments and receipts are not determinable at this time.

Investments

At September 30, 2013, we held a $6.9 billion investment portfolio, which included $229.2 million of liquid short-term investments. Our fixed maturity and equity securities portfolio is classified as available for sale. We expect to hold our fixed maturity securities until maturity, but we would be able to sell these securities, as well as our equity securities and other investments, to generate cash if needed. See the “Investing Segment” section above for additional information about our investment portfolio. The parent company held $400.8 million of cash and investments at September 30, 2013, which are available to cover the holding company’s required cash disbursements.

Revolving Loan and Standby Letter of Credit Facilities

We maintain a $600.0 million Revolving Loan Facility (Facility), of which $239.1 million of available capacity remained at September 30, 2013. During the past several years, we used the Facility to fund purchases of our common stock, which we expect to continue to do as we opportunistically repurchase stock in future periods. On April 26, 2013, we entered into an agreement to modify the Facility. Under the amended agreement, the Facility expires on April 26, 2017. We also have a $90.0 million Standby Letter of Credit Facility (Standby Facility) that is used to guarantee our performance in our Lloyd’s of London syndicate. The Standby Facility expires in 2016. See Note 8, “Notes Payable” to the Consolidated Financial Statements for additional information related to the Facility and Standby Facility and our long-term indebtedness.

Share Purchases

On August 23, 2012, the Board approved the purchase of up to $300.0 million of our common stock (the Plan). Purchases under the Plan may be made in the open market or in privately negotiated transactions from time-to-time in compliance with applicable laws, rules and regulations, including Rule 10b-18 under the Securities Exchange Act of 1934, as amended. Purchases under the Plan will be made subject to market and business conditions, the level of cash generated from our operations, cash required for acquisitions, our debt covenant compliance, and other relevant factors. The Plan does not obligate us to purchase any particular number of shares, has no expiration date, and may be suspended or discontinued at any time at the Board’s discretion.

In the third quarter of 2013, we purchased $1.3 million, or 30,538 shares, at an average cost of $42.00 per share. We purchased $42.2 million, or 1.1 million shares, at an average cost of $40.02 per share in the first nine months of 2013. As of October 25, 2013, $207.6 million of repurchase authority remains under the Plan.

Shelf Registration

We have a “Universal Shelf” registration statement that expires in March 2015. The Universal Shelf provides for the issuance of $1.0 billion of securities, which may be debt securities, equity securities, or a combination thereof. The Universal Shelf provides us the means to access the debt and equity markets relatively quickly, if we are satisfied with the current pricing in the financial markets.

Critical Accounting Policies

We provided information about our critical accounting policies in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies”, in our Annual Report on Form 10-K for the year ended December 31, 2012. We have made no changes in the identification or methods of application of these policies; however, the following information supplements the “Reserves” disclosures on page 55 of our Annual Report on Form 10-K for the year ended December 31, 2012.

Our recorded reserves represent management’s best estimate of unpaid losses and loss adjustment expenses as of each quarter end, based on information, facts and circumstances known at that time. The process of establishing reserves is complex, imprecise and inherently uncertain and, as such, involves a considerable degree of judgment involving our management review and actuarial processes. We must consider many variables that are subject to the outcome of future events. As a result, an integral component of our loss reserving process is the use of informed subjective estimates and judgments about our ultimate exposure to losses. Therefore, it is possible that management’s estimate of the ultimate liability for losses may change.

Management considers many factors in determining the ultimate losses and reserves for the various products in our five insurance underwriting segments. These factors include: 1) actuarial point estimates and the estimated ranges around these estimates, 2) information used to price the applicable policies, 3) historical loss information, where available, 4) public industry data for the product or similar products, 5) an assessment of current market conditions, 6) information on individual claims, 7) an assessment of current or potential litigation involving claims and 8) information from underwriting and claims personnel. The estimate of our reserves is increased or decreased as more information becomes known about the frequency and severity of losses for prior and current years. We believe our review process is effective, such that any required changes in reserves are recognized in the period of change as soon as the need for the change is evident.

Our actuaries monitor the adequacy and reasonableness of our recorded reserves for over 100 specialty insurance products by accident year or underwriting year, as applicable. The table on page 57 of our Annual Report on Form 10-K for the year ended December 31, 2012 details the characteristics for our major products in each segment. Although the duration (the time period between the occurrence of a loss and the settlement of a claim) is either short-term or medium-term for the majority of these products, approximately 50% of our total gross reserves at December 31, 2012 related to long-tail products in our Professional Liability and International segments and our Exited Lines. These long-tail products include directors’ and officers’ liability, large account E&O liability, International accident and health, and assumed accident and health reinsurance business that we no longer write. We write many of these contracts as excess insurance, where losses in lower layers must develop first before our excess coverage attaches. Significant periods of time, ranging up to several years or more, may elapse between occurrence of the loss, reporting of the loss to us, and settlement of the claim. In addition, many of these claims are susceptible to litigation and can be affected by escalating legal defense costs, contract interpretations and the changing economic and legal environment. As a result, our long-tail products are subject to greater levels of reserve volatility, creating favorable or adverse loss development over a longer period of time.

Our actuaries perform a comprehensive review of loss reserves for each major product at least once each year. The reviews take into consideration the variety of trends that impact the ultimate settlement of claims for each product type. These reviews follow a pre-set schedule, which covers the product lines in each segment, as follows: 1) second quarter – Exited Lines, 2) third quarter – U.S. Property & Casualty and Professional Liability and 3) fourth quarter – Accident & Health, U.S. Surety & Credit, and International. Management determines if additional or earlier comprehensive reviews are warranted based on significant unusual issues identified during the year. In addition to these comprehensive reviews, each quarter the actuaries review the emergence of paid and reported losses relative to expectations (established during the annual reviews) for all product lines and, if considered necessary, perform a more detailed review of the particular reserves.

Our actuaries’ loss review process relies on the basic assumption that past experience, adjusted for the effects of current developments and likely trends, is a reasonable basis for predicting future outcomes. As part of their process, our actuaries use a variety of actuarial methods that analyze experience, trends and other relevant factors. The principal standard actuarial methods used by our actuaries for their comprehensive reviews include:

•

Loss ratio method – This method uses loss ratios for prior accident years, adjusted for current trends, to determine an appropriate expected loss ratio for a given accident year.

•

Loss development methods – Loss development methods assume that the losses yet to emerge for an accident year are proportional to the paid or reported loss amounts observed to-date. The paid loss development method uses losses paid to-date, while the reported loss development method uses losses reported to-date.

•

Bornheutter-Ferguson method – This method is a combination of the loss ratio and loss development methods, where the loss development factor is given more weight as an accident year matures.

•

Frequency/severity method – This method projects claim counts and average cost per claim on a paid or reported basis for high frequency, low severity products.

Our actuaries calculate an actuarial point estimate, as well as a high and low end of the actuarial range, for the products that they review. The actuarial point estimates represent our actuaries’ estimate of the most likely amount that will ultimately be paid to settle the net reserves we have recorded at a particular point in time. While standard actuarial techniques are utilized in making these actuarial point estimates, these techniques require a high degree of judgment, and changing conditions can cause fluctuations in the reserve estimates. While, from an actuarial standpoint, a point estimate is considered the most likely amount to be paid, there is inherent uncertainty in the point estimate, and it can be thought of as the expected value in a distribution of possible reserve estimates. The actuarial ranges represent our actuaries’ estimate of a likely lowest amount and highest amount that will ultimately be paid to settle the net reserves. There is still a possibility of ultimately paying an amount below the range or above the range. The range determinations are based on estimates and actuarial judgments and are intended to encompass reasonably likely changes in one or more of the variables that were used to determine the point estimates.

Management evaluates the adequacy of our recorded consolidated reserves at each reporting period and approves increases or decreases in reserves, as considered necessary, based on a consideration of all material facts and circumstances known at that time. The Reserve Review Committee (which includes our Chief Executive Officer, President, Chief Financial Officer, executive management, chief actuary, segment management, and key actuarial, claims and accounting personnel) meets each quarter to review our actuaries’ comprehensive review of loss reserves and assessment of the emergence of paid and reported losses relative to expectations. The Reserve Review Committee discusses factors impacting the reserves in that quarter, including the most recent actuarial point and range estimates for each insurance segment, to monitor the adequacy and reasonableness of the recorded reserves. If the recorded reserves vary significantly from the actuarial point estimate, management discusses the reasons for the variances. Based on the discussions during this meeting, and any additional subsequent meetings, the Reserve Review Committee determines whether any recorded reserves should be increased or decreased during the quarter to an amount that, in management’s judgment, is adequate based on all of the facts and circumstances considered, including the actuarial point estimates. Historically, our consolidated net reserves at each quarter-end, which reflect management’s best estimate of unpaid losses and loss adjustment expenses, have been above the total actuarial point estimate and within the actuarial range.

Any increase or decrease in prior years’ reserves approved by the Reserve Review Committee generates favorable or adverse loss development related to our ultimate losses, which is reflected in our incurred but not reported (IBNR) reserves in the period of the reserve change. In addition, we may have loss development due to the normal claims settlement process. For our most recent accident years, recorded loss reserves are generally based on management’s establishment of ultimate loss ratios for each product line, based on historical loss trends and current market considerations. We do not recognize favorable or adverse development for these recent accident years until loss trends emerge. The time required for credible loss trends to emerge differs based on the characteristics of the product, and with long-tail products this can take several years. Over time, our recorded reserves align closer to the actuarial indications as we place additional weight on the credibility of assumptions relating to actual experience and claims outstanding.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

There have been no material changes in market risk from the information provided in Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” in our Annual Report on Form 10-K for the year ended December 31, 2012.

Item 4. Controls and Procedures

(a) Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Act)) that are designed to ensure that required information is recorded, processed, summarized and reported within the required timeframe, as specified in rules set forth by the Securities and Exchange Commission. Our disclosure controls and procedures are also designed to ensure that information required to be disclosed is accumulated and communicated to management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO), to allow timely decisions regarding required disclosures.

Our management, with the participation of our CEO and CFO, evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2013 using criteria established in the Internal Control – Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective in providing reasonable assurance of achieving the purposes described in Rule 13a-15(e) under the Act as of September 30, 2013.

(b) Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Part II — Other Information

Item 1. Legal Proceedings

Item 1A. Risk Factors

There have been no material changes in the risk factors described in our Annual Report on Form 10-K for the year ended December 31, 2012.

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

On August 23, 2012, the Board approved the purchase of up to $300.0 million of our common stock (the Plan). Purchases under the Plan may be made in the open market or in privately negotiated transactions from time-to-time in compliance with applicable laws, rules and regulations, including Rule 10b-18 under the Securities Exchange Act of 1934, as amended. Purchases under the Plan will be made, subject to market and business conditions, the level of cash generated from our operations, cash required for acquisitions, our debt covenant compliance, and other relevant factors. The Plan does not obligate us to purchase any particular number of shares, has no expiration date, and may be suspended or discontinued at any time at the Board’s discretion. Our purchases in the third quarter of 2013 were as follows:


Period	Total number of shares purchased		Average price paid per share		Total number of shares purchased as part of publicly announced plans or programs		Approximate dollar value of shares that may yet be purchased under the plans or programs

July		-		-		-		$208,855,025
August		-		-		-		$208,855,025
September		30,538		$42.00		30,538		$207,572,469

Item 3. Defaults Upon Senior Securities

None.

Item 4. Mine Safety Disclosures

None.

Item 5. Other Information

None.

Item 6. Exhibits


Exhibit Number

3.1		Restated Certificate of Incorporation and Amendment of Certificate of Incorporation of HCC Insurance Holdings, Inc., filed with Delaware Secretary of State on July 23, 1996 and May 21, 1998, respectively (incorporated by reference to Exhibit 4.1 to Registration Statement on Form S-8 (Registration No. 333-61687) filed on August 17, 1998).

3.2		Fourth Amended and Restated Bylaws of HCC Insurance Holdings, Inc. (incorporated by reference to Exhibit 3.1 to Current Report on Form 8-K filed on August 22, 2013).

4.1		Indenture, dated August 23, 2001, between HCC Insurance Holdings, Inc. and First Union National Bank related to Debt Securities (Senior Debt) (incorporated by reference to Exhibit 4.1 to Current Report on Form 8-K filed on August 24, 2001).

4.2		Form of Fourth Supplemental Indenture, dated November 16, 2009, between HCC Insurance Holdings, Inc. and U.S. Bank National Association related to 6.30% Senior Notes due 2019 (incorporated by reference to Exhibit 4.2 to Current Report on Form 8-K filed on November 13, 2009).

12	†	Statement of Ratios.

31.1	†	Certification by Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2	†	Certification by Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1	†	Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

101	†	The following financial statements from the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2013 formatted in XBRL: 1) Consolidated Balance Sheets, 2) Consolidated Statements of Earnings, 3) Consolidated Statements of Comprehensive Income, 4) Consolidated Statement of Changes in Shareholders’ Equity, 5) Consolidated Statements of Cash Flows and 6) Notes to Consolidated Financial Statements.

†	Filed herewith.

SIGNATURES

Pursuant to the requirements 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)
November 1, 2013		/s/ Christopher J.B. Williams
(Date)		Christopher J.B. Williams,
		Chief Executive Officer
November 1, 2013		/s/ Pamela J. Penny
(Date)		Pamela J. Penny, Executive Vice President
		and Chief Accounting Officer