e10vq
 
 
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 March 31, 2010.
     
o   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 o
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 o      No o
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 definition 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 o   Non-accelerated filer o (Do not check if a smaller reporting company)   Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o      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 April 30, 2010, there were approximately 115.0 million shares of common stock outstanding.
 
 

 


 

HCC INSURANCE HOLDINGS, INC.
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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. We have based these forward-looking statements on our current expectations and projections about future events. These forward-looking statements include information about possible or assumed future results of our operations. All statements, other than statements of historical facts, included or incorporated by reference in this report that address activities, events or developments that we expect or anticipate may occur in the future, including such things as 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. Also, when we use words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “plan,” “probably” or similar expressions, we are making forward-looking statements.
Many risks and uncertainties may 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 catastrophic 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 the credit market downturn and subprime market exposures,
 
    the effects of emerging claim and coverage issues,
 
    the effects of extensive governmental regulation of the insurance industry,
 
    potential credit risk with brokers,
 
    the effects of industry consolidations,
 
    our assessment of underwriting risk,
 
    our retention of risk, which could expose us to potential losses,
 
    the adequacy of reinsurance protection,
 
    the ability and willingness of reinsurers to pay balances due us,
 
    the occurrence of terrorist activities,
 
    our ability to maintain our competitive position,
 
    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,
 
    fluctuations in securities markets, which may reduce the value of our investment assets, reduce investment income or generate realized investment losses,
 
    our ability to successfully expand our business through the acquisition of insurance-related companies,
 
    impairment of goodwill,

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    the ability of our insurance company subsidiaries to pay dividends in needed amounts,
 
    fluctuations in foreign exchange rates,
 
    failures or constraints of our information technology systems,
 
    changes to the country’s health care delivery system,
 
    the effect, if any, of climate change, on the risks we insure,
 
    change of control, and
 
    difficulties with outsourcing relationships.
We describe 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, 2009.
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, also the forward-looking statements based on these assumptions, could themselves prove to be inaccurate. In light of the significant uncertainties inherent in the forward-looking statements 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.

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HCC Insurance Holdings, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
(unaudited, in thousands except per share data)
                 
    March 31,     December 31,  
    2010     2009  
ASSETS
               
 
               
Investments
               
Fixed income securities — available for sale, at fair value (amortized cost: 2010 — $4,638,702; 2009 — $4,381,762)
  $ 4,802,585     $ 4,538,073  
Fixed income securities — held to maturity, at amortized cost (fair value: 2010 — $137,607; 2009 — $104,008)
    135,619       102,792  
Short-term investments, at cost, which approximates fair value
    576,576       810,673  
Other investments
    4,535       4,691  
 
           
Total investments
    5,519,315       5,456,229  
 
           
Cash
    59,892       129,460  
Restricted cash and cash investments
    146,512       146,133  
Premium, claims and other receivables
    641,341       600,332  
Reinsurance recoverables
    1,028,948       1,016,411  
Ceded unearned premium
    261,256       270,436  
Ceded life and annuity benefits
    60,603       61,313  
Deferred policy acquisition costs
    209,083       208,463  
Goodwill
    821,698       822,006  
Other assets
    119,021       123,608  
 
           
 
Total assets
  $ 8,867,669     $ 8,834,391  
 
           
 
               
LIABILITIES
               
 
               
Loss and loss adjustment expense payable
  $ 3,495,705     $ 3,492,309  
Life and annuity policy benefits
    60,603       61,313  
Reinsurance balances payable
    157,735       182,661  
Unearned premium
    1,022,950       1,044,747  
Deferred ceding commissions
    67,876       71,595  
Premium and claims payable
    174,164       154,596  
Notes payable
    298,522       298,483  
Accounts payable and accrued liabilities
    496,286       497,504  
 
           
 
Total liabilities
    5,773,841       5,803,208  
 
           
 
               
SHAREHOLDERS’ EQUITY
               
 
               
Common stock, $1.00 par value; 250,000 shares authorized (shares issued: 2010 — 119,650 and 2009 — 118,724; outstanding: 2010 — 114,977 and 2009 — 114,051)
    119,650       118,724  
Additional paid-in capital
    923,666       914,339  
Retained earnings
    2,033,063       1,977,254  
Accumulated other comprehensive income
    116,248       119,665  
Treasury stock, at cost (shares: 2010 and 2009 — 4,673)
    (98,799 )     (98,799 )
 
           
 
Total shareholders’ equity
    3,093,828       3,031,183  
 
           
 
               
Total liabilities and shareholders’ equity
  $ 8,867,669     $ 8,834,391  
 
           
See Notes to Condensed Consolidated Financial Statements.

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HCC Insurance Holdings, Inc. and Subsidiaries
Condensed Consolidated Statements of Earnings
(unaudited, in thousands except per share data)
                 
    Three months ended March 31,  
    2010     2009  
REVENUE
               
 
               
Net earned premium
  $ 509,587     $ 502,388  
Fee and commission income
    20,993       30,294  
Net investment income
    49,249       45,218  
Other operating income
    9,906       22,896  
Net realized investment gain
    4,525       3,055  
Other-than-temporary impairment loss
               
Total loss
          (3,113 )
Portion recognized in other comprehensive income
           
 
           
Net loss recognized in earnings
          (3,113 )
 
           
 
               
Total revenue
    594,260       600,738  
 
           
 
               
EXPENSE
               
 
               
Loss and loss adjustment expense, net
    326,521       315,566  
Policy acquisition costs, net
    92,656       88,692  
Other operating expense
    66,668       68,998  
Interest expense
    5,390       4,639  
 
           
 
               
Total expense
    491,235       477,895  
 
           
 
               
Earnings before income tax expense
    103,025       122,843  
Income tax expense
    31,671       39,673  
 
           
 
               
Net earnings
  $ 71,354     $ 83,170  
 
           
 
               
Earnings per common share
               
 
               
Basic
  $ 0.62     $ 0.73  
 
           
 
               
Diluted
  $ 0.62     $ 0.73  
 
           
See Notes to Condensed Consolidated Financial Statements.

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HCC Insurance Holdings, Inc. and Subsidiaries
Condensed Consolidated Statement of Changes in Shareholders’ Equity
(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, 2009
  $ 118,724     $ 914,339     $ 1,977,254     $ 119,665     $ (98,799 )   $ 3,031,183  
 
                                               
Comprehensive income
                                               
 
                                               
Net earnings
                71,354                   71,354  
 
                                               
Other comprehensive income
                                               
Change in unrealized gain on investments, net of tax
                      4,579             4,579  
 
                                               
Other, net of tax
                      (7,996 )           (7,996 )
 
                                             
 
                                               
Total other comprehensive income
                                            (3,417 )
 
                                             
 
                                               
Comprehensive income
                                            67,937  
 
                                               
Issuance of 344 shares for exercise of options, including tax effect
    344       6,829                         7,173  
 
                                               
Stock-based compensation
    582       2,498                         3,080  
 
                                               
Cash dividends declared, $0.135 per share
                (15,545 )                 (15,545 )
 
                                   
 
                                               
Balance at March 31, 2010
  $ 119,650     $ 923,666     $ 2,033,063     $ 116,248     $ (98,799 )   $ 3,093,828  
 
                                   
See Notes to Condensed Consolidated Financial Statements.

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HCC Insurance Holdings, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(unaudited, in thousands)
                 
    Three months ended March 31,  
    2010     2009  
Operating activities
               
Net earnings
  $ 71,354     $ 83,170  
Adjustments to reconcile net earnings to net cash provided by operating activities
               
Change in premium, claims and other receivables
    (24,890 )     (28,719 )
Change in reinsurance recoverables
    (21,839 )     (29,973 )
Change in ceded unearned premium
    7,548       (217 )
Change in loss and loss adjustment expense payable
    28,921       67,544  
Change in reinsurance balances payable
    (23,913 )     11,481  
Change in unearned premium
    (17,600 )     (11,335 )
Change in premium and claims payable, net of restricted cash
    19,413       8,859  
Change in accounts payable and accrued liabilities
    (18,215 )     (7,556 )
Stock-based compensation expense
    3,080       4,783  
Depreciation and amortization expense
    3,971       3,579  
(Gain) loss on investments
    (5,011 )     1,020  
Other, net
    19,657       30,966  
 
           
Cash provided by operating activities
    42,476       133,602  
 
           
 
               
Investing activities
               
Sales of available for sale fixed income securities
    67,689       119,092  
Maturity or call of available for sale fixed income securities
    115,793       69,280  
Maturity or call of held to maturity fixed income securities
    8,260       85,821  
Cost of available for sale fixed income securities acquired
    (381,704 )     (210,093 )
Cost of held to maturity fixed income securities acquired
    (44,901 )     (59,515 )
Change in short-term investments
    223,947       (177,715 )
Proceeds from sales of strategic and other investments
          48,579  
Payments for purchase of businesses, net of cash received
    (36,348 )     (32,966 )
Proceeds from sale of subsidiary
    14,851        
Other, net
    (3,824 )     (3,482 )
 
           
Cash used by investing activities
    (36,237 )     (160,999 )
 
           
 
               
Financing activities
               
Advances on line of credit
          80,000  
Sale of common stock
    7,173       2,090  
Payments on convertible notes
    (64,472 )      
Purchase of common stock
          (35,464 )
Dividends paid
    (15,460 )     (14,182 )
Other, net
    (3,048 )     619  
 
           
Cash provided (used) by financing activities
    (75,807 )     33,063  
 
           
 
               
Net increase (decrease) in cash
    (69,568 )     5,666  
Cash at beginning of year
    129,460       27,347  
 
           
 
               
Cash at end of period
  $ 59,892     $ 33,013  
 
           
See Notes to Condensed Consolidated Financial Statements.

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HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands except per share data)
(1) General Information
HCC Insurance Holdings, Inc. and its subsidiaries (collectively, we, us or our) include domestic and foreign property and casualty and life insurance companies and underwriting agencies. We provide specialized property and casualty, surety, and group life, accident and health insurance coverages and related agency services to commercial customers and individuals. We market our products both directly to customers and through a network of independent brokers, producers, agents and third party administrators. Our lines of business include diversified financial products (which includes directors’ and officers’ liability, errors and omissions liability (known as professional indemnity outside the U.S.), employment practices liability, surety, credit, and fidelity coverages); group life, accident and health (which includes medical stop-loss, short-term medical, occupational accident, and other coverages); aviation; our London market account (which includes energy, property, property treaty, marine, and accident and health coverages); and other specialty lines of insurance (which includes public entity, U.K. liability, event cancellation, contingency, and other coverages). We operate primarily in the United States, the United Kingdom, Spain and Ireland, although some of our operations have a broader international scope.
Basis of Presentation
Our unaudited condensed 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 Insurance Holdings, Inc. 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 condensed consolidated financial statements should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2009. The condensed consolidated balance sheet at December 31, 2009 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 condensed consolidated financial statements and in disclosures of contingent assets and liabilities. Ultimate results could differ from those estimates. We have reclassified certain amounts in our 2009 condensed consolidated financial statements to conform to the 2010 presentation. None of our reclassifications had an effect on our consolidated net earnings, shareholders’ equity or cash flows.
Accounting Guidance Adopted in 2010
A new accounting standard, originally issued as SFAS No. 167, Amendments to FASB Interpretation No. 46(R), became effective January 1, 2010. The guidance, which was incorporated into Accounting Standards Codification (ASC) Topic 810, Consolidation, changes various aspects of accounting for and disclosures of interests in variable interest entities. Our adoption of this guidance as of January 1, 2010 had no material impact on our condensed consolidated financial statements.
Effective January 1, 2010, we adopted Accounting Standards Update No. 2010-06, which incorporated changes in disclosure requirements into ASC Topic 820, Fair Value Measurements and Disclosures. When applicable, we have included the additional required disclosures in the notes to our condensed consolidated financial statements.
Derivative Financial Instruments
At December 31, 2009, we had interests in two long-term mortgage impairment insurance contracts that are denominated in British pound sterling. The exposure with respect to these two contracts is measured based on movement in a specified United Kingdom housing index. In the first quarter of 2010, we commuted our interest in one contract for $8.3 million cash. We recognized a gain of $8.0 million, which is included in other operating income in our condensed consolidated statements of earnings. The remaining contract qualifies as a derivative financial instrument, is unhedged and is reported at fair value in other assets in our condensed consolidated balance sheets. We record changes in fair value and any foreign exchange gain/loss on this contract as a component of other operating income.

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HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands except per share data)
Stock-based Compensation
In the first quarter of 2010, we granted the following shares of restricted stock, restricted stock units and stock options for the purchase of shares of our common stock. The fair value of the restricted stock, restricted stock units and stock options will be expensed over the vesting period.
                                 
            Weighted-average              
    Number of     grant date     Aggregate     Vesting
    shares     fair value     fair value     period
Restricted stock
    601       $28.24       $16,986     3-10 years
Restricted stock units
    22       28.30       636     4-10 years
Stock options
    130       6.78       882     5 years
Income Taxes
For the three months ended March 31, 2010 and 2009, the income tax provision was calculated based on an estimated effective tax rate for each fiscal year. Our effective tax rate differs from the United States Federal statutory rate primarily due to the effect of tax-exempt municipal bond interest.
Disposition
In 2010, we sold an inactive subsidiary, HCC Insurance Company, for $14.7 million cash.
(2) Fair Value Measurements
We value financial assets and financial liabilities at fair value. 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 are primarily U.S. Treasuries listed on stock exchanges. We use quoted prices for identical instruments to measure fair value.
Our Level 2 investments include most of our fixed income securities, which consist of U.S. government agency securities, municipal bonds, certain corporate debt securities, and certain mortgage-backed and asset-backed securities. Our Level 2 instruments also include our interest rate swap agreements, which were reflected as liabilities in our condensed consolidated balance sheets. We measure fair value for the majority of our Level 2 investments using quoted prices of securities with similar characteristics. The remaining investments are valued using pricing models or matrix pricing. The fair value measurements consider observable assumptions, including benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, default rates, loss severity and other economic measures.
We use independent pricing services to assist us in determining fair value for over 99% of our Level 1 and Level 2 investments. The pricing services provide a single price or quote per security. We use data provided by our third party investment manager to value the remaining Level 2 investments. To validate that these quoted and modeled prices are reasonable estimates of fair value, we perform various quantitative and qualitative procedures, including: 1) evaluation of the underlying methodologies, 2) analysis of recent sales activity, 3) analytical review of our fair values against current market prices, and 4) comparison of the pricing services’ fair value to other pricing services’ fair value for the same investment. Based on these procedures, we did not adjust the prices or quotes provided by our independent pricing services or third party investment managers as of March 31, 2010 or

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HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands except per share data)
December 31, 2009. In addition, we did not apply GAAP criteria for determining the fair value of securities in inactive markets since no markets for our investments were judged to be inactive as of March 31, 2010 or December 31, 2009.
Our Level 3 securities include certain fixed income securities and two insurance contracts that we account for as derivatives. We determine fair value based on internally developed models that use assumptions or other data that are not readily observable from objective sources. Because we use the lowest level significant input to determine our hierarchy classifications, a financial instrument may be classified in Level 3 even though there may be significant readily-observable inputs. We commuted our interest in one insurance contract in the first quarter of 2010. For the remaining insurance contract, we determine fair value based on our estimate of the present value of expected future cash flows, modified to reflect specific contract terms.
The following tables present our assets and interest rate swap liabilities that were measured at fair value.
                                 
    Level 1     Level 2     Level 3     Total  
March 31, 2010
                               
 
Fixed income securities
                               
U.S. government and government agency securities
  $ 175,950     $ 181,059     $     $ 357,009  
Fixed income securities of states, municipalities and political subdivisions
          1,110,823             1,110,823  
Special purpose revenue bonds of states, municipalities and political subdivisions
          1,262,201             1,262,201  
Corporate fixed income securities
          562,106       151       562,257  
Residential mortgage-backed securities
          1,014,909             1,014,909  
Commercial mortgage-backed securities
          146,816       2,758       149,574  
Asset-backed securities
          10,657       1,315       11,972  
Foreign government securities
          210,110             210,110  
Foreign non-government securities
          123,730             123,730  
 
                       
Total fixed income securities
    175,950       4,622,411       4,224       4,802,585  
Other investments
    13                   13  
Other assets
                291       291  
 
                       
 
                               
Total assets measured at fair value
  $ 175,963     $ 4,622,411     $ 4,515     $ 4,802,889  
 
                       
 
                               
Accounts payable and accrued liabilities
  $     $ (1,871 )   $     $ (1,871 )
 
                       
 
                               
Total liabilities measured at fair value
  $     $ (1,871 )   $     $ (1,871 )
 
                       

11


 

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands except per share data)
                                 
    Level 1     Level 2     Level 3     Total  
December 31, 2009
 
Fixed income securities
                               
U.S. government and government agency securities
  $ 178,927     $ 134,620     $     $ 313,547  
Fixed income securities of states, municipalities and political subdivisions
          1,059,426             1,059,426  
Special purpose revenue bonds of states, municipalities and political subdivisions
          1,146,334             1,146,334  
Corporate fixed income securities
          559,673       151       559,824  
Residential mortgage-backed securities
          944,182             944,182  
Commercial mortgage-backed securities
          143,412       2,805       146,217  
Asset-backed securities
          13,059       1,306       14,365  
Foreign government securities
          227,681             227,681  
Foreign non-government securities
          126,497             126,497  
 
                       
Total fixed income securities
    178,927       4,354,884       4,262       4,538,073  
Other investments
    14                   14  
Other assets
                432       432  
 
                       
 
                               
Total assets measured at fair value
  $ 178,941     $ 4,354,884     $ 4,694     $ 4,538,519  
 
                       
 
                               
Accounts payable and accrued liabilities
  $     $ (2,367 )   $     $ (2,367 )
 
                       
 
                               
Total liabilities measured at fair value
  $     $ (2,367 )   $     $ (2,367 )
 
                       
We excluded from our fair value disclosures our held to maturity investment portfolio measured at amortized cost and two other investments measured at cost. Our held to maturity portfolio had a fair value of $137.6 million at March 31, 2010 and $104.0 million at December 31, 2009. The two other investments collectively were valued at $4.1 million at both balance sheet dates.
The following table presents the changes in fair value of our Level 3 assets.
                                                 
    2010     2009  
    Fixed                     Fixed              
    income     Other             income     Other        
    securities     assets     Total     securities     assets     Total  
Balance at beginning of year
  $ 4,262     $ 432     $ 4,694     $ 6,515     $ 16,100     $ 22,615  
Net redemptions
    (100 )     (8,342 )     (8,442 )     (281 )           (281 )
Gains and (losses) — unrealized
    62       (141 )     (79 )     567       363       930  
Gains — realized
          8,342       8,342       30             30  
Transfers out of Level 3
                      (1,746 )           (1,746 )
 
                                   
 
                                               
Balance at March 31
  $ 4,224     $ 291     $ 4,515     $ 5,085     $ 16,463     $ 21,548  
 
                                   
Unrealized gains and losses on our Level 3 fixed income securities are reported in other comprehensive income within shareholders’ equity, and unrealized gains and losses on our Level 3 other assets are reported in other operating income. We transferred investments from Level 3 to Level 2 in the first quarter of 2009 because we were able to determine their fair value using inputs based on observable market data at March 31, 2009. There were no investments transferred between Level 1 and Level 2 for either period.

12


 

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands except per share data)
(3) Investments
Substantially all of our fixed income securities are investment grade and 97% are rated “A” or better. The cost or amortized cost, gross unrealized gain or loss, and fair value of investments in fixed income securities that are classified as available for sale were as follows:
                                 
    Cost or     Gross     Gross        
    amortized     unrealized     unrealized     Fair  
    cost     gain     loss     value  
March 31, 2010
                               
 
                               
U.S. government and government agency securities
  $ 351,461     $ 6,419     $ (871 )   $ 357,009  
Fixed income securities of states, municipalities and political subdivisions
    1,067,684       45,344       (2,205 )     1,110,823  
Special purpose revenue bonds of states, municipalities and political subdivisions
    1,223,431       41,097       (2,327 )     1,262,201  
Corporate fixed income securities
    538,805       23,593       (141 )     562,257  
Residential mortgage-backed securities
    980,331       39,161       (4,583 )     1,014,909  
Commercial mortgage-backed securities
    147,001       3,725       (1,152 )     149,574  
Asset-backed securities
    12,513       500       (1,041 )     11,972  
Foreign government securities
    200,183       9,961       (34 )     210,110  
Foreign non-government securities
    117,293       6,437             123,730  
 
                       
 
                               
Total available for sale fixed income securities
  $ 4,638,702     $ 176,237     $ (12,354 )   $ 4,802,585  
 
                       
 
                               
December 31, 2009
                               
 
                               
U.S. government and government agency securities
  $ 308,618     $ 6,255     $ (1,326 )   $ 313,547  
Fixed income securities of states, municipalities and political subdivisions
    1,012,262       49,491       (2,327 )     1,059,426  
Special purpose revenue bonds of states, municipalities and political subdivisions
    1,101,566       46,551       (1,783 )     1,146,334  
Corporate fixed income securities
    537,347       22,594       (117 )     559,824  
Residential mortgage-backed securities
    915,203       35,130       (6,151 )     944,182  
Commercial mortgage-backed securities
    151,357       630       (5,770 )     146,217  
Asset-backed securities
    15,118       445       (1,198 )     14,365  
Foreign government securities
    219,985       7,914       (218 )     227,681  
Foreign non-government securities
    120,306       6,191             126,497  
 
                       
 
                               
Total available for sale fixed income securities
  $ 4,381,762     $ 175,201     $ (18,890 )   $ 4,538,073  
 
                       

13


 

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands except per share data)
The amortized cost and fair value of investments in fixed income securities that are classified as held to maturity were as follows:
                                 
    March 31, 2010     December 31, 2009  
    Amortized             Amortized        
    cost     Fair value     cost     Fair value  
U.S. government securities
  $ 12,986     $ 13,296     $ 14,988     $ 15,257  
Foreign government securities
    79,194       80,274       80,210       81,066  
Foreign non-government securities
    43,439       44,037       7,594       7,685  
 
                       
 
                               
Total held to maturity fixed income securities
  $ 135,619     $ 137,607     $ 102,792     $ 104,008  
 
                       
All fixed income securities were income producing in 2010. The following table displays the gross unrealized losses and fair value of all available for sale fixed income 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  
March 31, 2010
                                               
 
                                               
U.S. government and government agency securities
  $ 79,931     $ (871 )   $     $     $ 79,931     $ (871 )
Fixed income securities of states, municipalities and political subdivisions
    113,823       (1,122 )     17,787       (1,083 )     131,610       (2,205 )
Special purpose revenue bonds of states, municipalities and political subdivisions
    194,288       (1,802 )     22,171       (525 )     216,459       (2,327 )
Corporate fixed income securities
    31,350       (141 )                 31,350       (141 )
Residential mortgage-backed securities
    151,297       (1,100 )     37,997       (3,483 )     189,294       (4,583 )
Commercial mortgage-backed securities
    25             21,942       (1,152 )     21,967       (1,152 )
Asset-backed securities
                6,278       (1,041 )     6,278       (1,041 )
Foreign government securities
                3,984       (34 )     3,984       (34 )
 
                                   
 
                                               
Total
  $ 570,714     $ (5,036 )   $ 110,159     $ (7,318 )   $ 680,873     $ (12,354 )
 
                                   

14


 

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, 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, 2009
                                               
 
                                               
U.S. government and government agency securities
  $ 101,542     $ (1,326 )   $     $     $ 101,542     $ (1,326 )
Fixed income securities of states, municipalities and political subdivisions
    48,836       (985 )     19,816       (1,342 )     68,652       (2,327 )
Special purpose revenue bonds of states, municipalities and political subdivisions
    76,305       (1,305 )     25,261       (478 )     101,566       (1,783 )
Corporate fixed income securities
    13,773       (117 )                 13,773       (117 )
Residential mortgage-backed securities
    147,621       (2,018 )     40,568       (4,133 )     188,189       (6,151 )
Commercial mortgage-backed securities
    30,209       (418 )     73,451       (5,352 )     103,660       (5,770 )
Asset-backed securities
    2,476       (246 )     7,532       (952 )     10,008       (1,198 )
Foreign government securities
    4,153       (130 )     8,593       (88 )     12,746       (218 )
 
                                   
 
                                               
Total
  $ 424,915     $ (6,545 )   $ 175,221     $ (12,345 )   $ 600,136     $ (18,890 )
 
                                   
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 the securities in our fixed income securities portfolio for possible other-than-temporary impairment losses at each quarter end. During 2010 and 2009, our reviews covered all impaired securities where the loss exceeded $0.5 million and the loss either exceeded 10% of cost or the security had been in a loss position for longer than twelve consecutive months.
For other-than-temporary impairment losses, we recognize an other-than-temporary impairment loss in earnings in the period that we determine: 1) we intend to sell the security, 2) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis or 3) the security has a credit loss. We recognized no other-than-temporary impairment losses in the first quarter of 2010, compared to $3.1 million of other-than-temporary impairment credit losses in the first quarter of 2009.
At March 31, 2010, we had $5.0 million after-tax of other-than-temporary impairments, primarily related to mortgage-backed and asset-backed securities, included in accumulated other comprehensive income within shareholders’ equity. The credit-related portion of our pretax other-than-temporary impairment loss recognized in earnings, for which a portion of the other-than-temporary loss was recognized in other comprehensive income, did not change in the first quarter of 2010 and was $3.8 million at March 31, 2010.
We do not consider the $12.4 million of gross unrealized losses in our fixed income securities portfolio at March 31, 2010 to be other-than-temporary impairments as of that date because: 1) we received all contractual interest and principal payments on these securities as of March 31, 2010, 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 bases and 4) the unrealized loss relates to non-credit factors, such as interest rate changes and market conditions.

15


 

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands except per share data)
The amortized cost and fair value of our fixed income securities at March 31, 2010, 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 at March 31, 2010 was 3.7 years.
                                 
    Available for sale     Held to maturity  
    Cost or amortized             Amortized        
    cost     Fair value     cost     Fair value  
Due in 1 year or less
  $ 309,014     $ 313,966     $ 38,205     $ 38,404  
Due after 1 year through 5 years
    1,104,920       1,156,837       87,012       88,515  
Due after 5 years through 10 years
    803,390       838,882       10,402       10,688  
Due after 10 years through 15 years
    687,406       706,459              
Due after 15 years
    594,127       609,986              
 
                       
Securities with fixed maturities
    3,498,857       3,626,130       135,619       137,607  
Asset-backed and mortgage-backed securities
    1,139,845       1,176,455              
 
                       
 
                               
Total fixed income securities
  $ 4,638,702     $ 4,802,585     $ 135,619     $ 137,607  
 
                       
The sources of net investment income were as follows:
                 
    Three months ended March 31,  
    2010     2009  
Fixed income securities
  $ 48,599     $ 45,438  
Short-term investments
    190       884  
Other
    1,508       (52 )
 
           
Total investment income
    50,297       46,270  
Investment expense
    (1,048 )     (1,052 )
 
           
 
               
Net investment income
  $ 49,249     $ 45,218  
 
           
Realized pretax gains (losses) on the sale of investments, which exclude other-than-temporary impairment losses, were as follows:
                                                 
    Three months ended March 31,  
    2010     2009  
    Gains     Losses     Net     Gains     Losses     Net  
Fixed income securities
  $ 4,901     $ (223 )   $ 4,678     $ 2,970     $ (451 )   $ 2,519  
Other
    2       (155 )     (153 )     683       (147 )     536  
 
                                   
 
                                               
Realized gain (loss)
  $ 4,903     $ (378 )   $ 4,525     $ 3,653     $ (598 )   $ 3,055  
 
                                   

16


 

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands except per share data)
(4) Earnings Per Share
The following table details the numerator and denominator used in our earnings per share calculations.
                 
    Three months ended March 31,  
    2010     2009  
Net earnings
  $ 71,354     $ 83,170  
Less: net earnings attributable to unvested restricted stock and restricted stock units
    (752 )     (396 )
 
           
 
               
Net earnings available to common stock
  $ 70,602     $ 82,774  
 
           
 
               
Weighted-average common shares outstanding
    113,668       112,799  
Dilutive effect of outstanding options (determined using treasury stock method)
    456       235  
Dilutive effect of convertible debt (determined using treasury stock method)
          255  
 
           
 
               
Weighted-average common shares and potential common shares outstanding
    114,124       113,289  
 
           
 
               
Anti-dilutive stock options not included in treasury stock method computation
    3,413       6,509  
 
           
(5) Segment and Geographic Data
The performance of each segment is evaluated by our management based on net earnings. Net earnings is calculated on an after-tax basis and after corporate expense allocations, interest expense on debt incurred for acquired companies and intercompany eliminations have been charged or credited to our individual segments. All stock-based compensation is included in the corporate segment because it is not included in management’s evaluation of the other segments. All contractual and discretionary bonuses are expensed in the respective employee’s segment in the year the bonuses are earned. Any such bonuses that will be paid by restricted stock awards, which will be granted by the Compensation Committee in the following year, are reversed on the corporate segment, which will record the appropriate stock-based compensation expense as the awards vest in future years.

17


 

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands except per share data)
The following tables show information by business segment and geographic location. Geographic location is determined by physical location of our offices and does not represent the location of insureds or reinsureds from whom the business was generated.
                                         
    Insurance             Other              
    Company     Agency     Operations     Corporate     Total  
Three months ended March 31, 2010
                                       
 
Revenue:
                                       
Domestic
  $ 460,478     $ 10,926     $ 1,919     $ 683     $ 474,006  
Foreign
    116,963       3,291                   120,254  
Inter-segment
          14,707       185             14,892  
 
                             
 
                                       
Total segment revenue
  $ 577,441     $ 28,924     $ 2,104     $ 683       609,152  
 
                               
 
                                       
Inter-segment eliminations
                                    (14,892 )
 
                                     
 
                                       
Consolidated total revenue
                                  $ 594,260  
 
                                     
 
                                       
Net earnings (loss):
                                       
Domestic
  $ 70,694     $ (3,326 )   $ 815     $ (5,451 )   $ 62,732  
Foreign
    5,990       (1,089 )                 4,901  
 
                             
 
                                       
Total segment net earnings (loss)
  $ 76,684     $ (4,415 )   $ 815     $ (5,451 )     67,633  
 
                               
 
                                       
Inter-segment eliminations
                                    3,721  
 
                                     
 
                                       
Consolidated net earnings
                                  $ 71,354  
 
                                     
 
                                       
Other items:
                                       
Net investment income
  $ 48,498     $ 59     $ 1     $ 691     $ 49,249  
Depreciation and amortization
    1,170       1,855       22       924       3,971  
Interest expense
    260       4,246             884       5,390  
Capital expenditures
    807       889       1       2,127       3,824  
 
                                       
Tax expense:
                                       
Income tax expense (benefit)
  $ 32,532     $ (2,794 )   $ 256     $ (725 )   $ 29,269  
Inter-segment eliminations
                                    2,402  
 
                                     
 
                                       
Consolidated income tax expense
                                  $ 31,671  
 
                                     

18


 

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands except per share data)
                                         
    Insurance             Other              
    Company     Agency     Operations     Corporate     Total  
Three months ended March 31, 2009
                                       
 
Revenue:
                                       
Domestic
  $ 470,386     $ 18,010     $ 2,278     $ 652     $ 491,326  
Foreign
    103,103       6,309                   109,412  
Inter-segment
          23,747       254             24,001  
 
                             
 
                                       
Total segment revenue
  $ 573,489     $ 48,066     $ 2,532     $ 652       624,739  
 
                               
 
                                       
Inter-segment eliminations
                                    (24,001 )
 
                                     
 
                                       
Consolidated total revenue
                                  $ 600,738  
 
                                     
 
                                       
Net earnings (loss):
                                       
Domestic
  $ 69,913     $ 3,161     $ 1,013     $ (7,606 )   $ 66,481  
Foreign
    16,002       215                   16,217  
 
                             
 
                                       
Total segment net earnings (loss)
  $ 85,915     $ 3,376     $ 1,013     $ (7,606 )     82,698  
 
                               
 
                                       
Inter-segment eliminations
                                    472  
 
                                     
 
                                       
Consolidated net earnings
                                  $ 83,170  
 
                                     
 
                                       
Other items:
                                       
Net investment income
  $ 44,220     $ 210     $ 4     $ 784     $ 45,218  
Depreciation and amortization
    1,126       1,747       22       684       3,579  
Interest expense (benefit)
    279       3,734       (7 )     633       4,639  
Capital expenditures
    496       2,088       10       888       3,482  
 
                                       
Tax expense:
                                       
Income tax expense (benefit)
  $ 38,236     $ 3,376     $ 589     $ (2,479 )   $ 39,722  
Inter-segment eliminations
                                    (49 )
 
                                     
 
                                       
Consolidated income tax expense
                                  $ 39,673  
 
                                     

19


 

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands except per share data)
The following tables present selected revenue items by line of business and major product lines.
                 
    Three months ended March 31,  
    2010     2009  
Diversified financial products
               
Directors’ and officers’
  $ 92,918     $ 82,802  
Errors and omissions
    53,893       59,405  
Other
    11,826       10,976  
U.S. surety and credit
    46,749       44,492  
International surety and credit.
    18,189       16,409  
 
           
 
    223,575       214,084  
 
           
 
               
Group life, accident and health
               
Medical stop-loss
    161,766       159,483  
Other medical
    25,021       33,053  
Other
    6,855       8,552  
 
           
 
    193,642       201,088  
 
           
 
               
Aviation
    28,943       32,814  
 
           
 
               
London market account
               
Energy
    16,187       9,235  
Property treaty
    6,754        
Other
    13,227       14,439  
 
           
 
    36,168       23,674  
 
           
 
               
Other specialty lines
               
Public risk
    11,490       8,620  
HCC Lloyd’s
    10,185       10,790  
Other
    5,542       11,314  
 
           
 
    27,217       30,724  
 
           
 
               
Discontinued lines
    42       4  
 
           
Total net earned premium
  $ 509,587     $ 502,388  
 
           
 
               
Property and casualty
  $ 17,680     $ 24,418  
Accident and health
    3,313       5,876  
 
           
Fee and commission income
  $ 20,993     $ 30,294  
 
           

20


 

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands except per share data)
(6)   Reinsurance
 
    In the normal course of business, our insurance companies cede a portion of their premium to domestic and foreign reinsurers through treaty and facultative reinsurance agreements. Although ceding for reinsurance purposes 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 loss and diversify their business. The following table presents the effect of such reinsurance transactions on our premium and loss and loss adjustment expense.
                         
    Written     Earned     Loss and loss
adjustment
 
    premium     premium     expense  
Three months ended March 31, 2010
                       
 
Direct business
  $ 509,192     $ 571,962     $ 360,951  
Reinsurance assumed
    113,304       69,240       52,835  
Reinsurance ceded
    (124,245 )     (131,615 )     (87,265 )
 
                 
 
                       
Net amounts
  $ 498,251     $ 509,587     $ 326,521  
 
                 
 
                       
Three months ended March 31, 2009
                       
 
                       
Direct business
  $ 532,032     $ 549,037     $ 362,270  
Reinsurance assumed
    70,355       64,140       36,665  
Reinsurance ceded
    (111,137 )     (110,789 )     (83,369 )
 
                 
 
                       
Net amounts
  $ 491,250     $ 502,388     $ 315,566  
 
                 
 
Ceding commissions that are netted against policy acquisition costs in the condensed consolidated statements of earnings were $16.4 million and $12.5 million in the first quarter of 2010 and 2009, respectively,
 
The table below shows the components of reinsurance recoverables in our condensed consolidated balance sheets.
 
            March 31,     December 31,  
            2010     2009  
Reinsurance recoverable on paid losses
          $ 91,858     $ 82,887  
Reinsurance recoverable on outstanding losses
            472,538       495,964  
Reinsurance recoverable on incurred but not reported losses
            467,497       440,505  
Reserve for uncollectible reinsurance
            (2,945 )     (2,945 )
 
                   
 
                       
Total reinsurance recoverables
          $ 1,028,948     $   1,016,411  
 
                   

21


 

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands except per share data)
    The tables below present the calculation of net reserves, net unearned premium and net deferred policy acquisition costs.
                 
    March 31,     December 31,  
    2010     2009  
Loss and loss adjustment expense payable
  $ 3,495,705     $ 3,492,309  
Reinsurance recoverable on outstanding losses
    (472,538 )     (495,964 )
Reinsurance recoverable on incurred but not reported losses
    (467,497 )     (440,505 )
 
           
 
               
Net reserves
  $ 2,555,670     $ 2,555,840  
 
           
 
Unearned premium
  $ 1,022,950     $ 1,044,747  
Ceded unearned premium
    (261,256 )     (270,436 )
 
           
 
               
Net unearned premium
  $ 761,694     $ 774,311  
 
           
 
               
Deferred policy acquisition costs
  $ 209,083     $ 208,463  
Deferred ceding commissions
    (67,876 )     (71,595 )
 
           
 
               
Net deferred policy acquisition costs
  $ 141,207     $ 136,868  
 
           
(7)   Supplemental Information
    Supplemental information was as follows:
                 
    Three months ended March 31,  
    2010     2009  
Income taxes paid
  $ 12,850     $ 20,214  
Interest paid
    222       3,442  
Comprehensive income
    67,937       107,536  

22


 

HCC Insurance Holdings, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(unaudited, in thousands except per share data)
(8)   Commitments and Contingencies
 
    Catastrophe Exposure and Loss
    We have exposure to catastrophic losses caused by natural perils (such as hurricanes and earthquakes), as well as from man-made events (such as terrorist attacks). The incidence and severity of catastrophic losses is 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 quarter of 2010, we recognized gross losses from catastrophic events, primarily the Chilean earthquake, of $31.9 million. After reinsurance, our pretax loss was $20.6 million.
 
    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 have a material adverse effect on our consolidated financial position, results of operations or cash flows.
    Indemnifications
    In conjunction with the sales of business assets and subsidiaries, we have provided indemnifications to the buyers. Certain indemnifications cover typical representations and warranties related to our responsibilities to perform under the sales contracts. Under other indemnifications, we agree to reimburse the purchasers for taxes or ERISA-related amounts, if any, assessed after the sale date but related to pre-sale activities. We cannot quantify the maximum potential exposure covered by all of our indemnifications because the indemnifications cover a variety of matters, operations and scenarios. Certain of these indemnifications have no time limit. For those with a time limit, the longest such indemnification expires in 2025. We accrue a loss when a valid claim is made by a purchaser and we believe we have potential exposure. At March 31, 2010, we have recorded a liability of $13.0 million and have provided a $3.0 million escrow account and $9.7 million of letters of credit to cover our obligations or anticipated payments under these indemnifications.

23


 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following Management’s Discussion and Analysis should be read in conjunction with the Condensed Consolidated Financial Statements and the related Notes thereto.
Overview
We are a specialty insurance group with offices in the United States, the United Kingdom, Spain and Ireland, transacting business in approximately 150 countries. Our group consists of insurance companies, underwriting agencies and participation in an active Lloyd’s of London syndicate that we manage. Our shares trade on the New York Stock Exchange and closed at $27.60 on March 31, 2010. We had a market capitalization of $3.1 billion at April 30, 2010.
We underwrite a variety of relatively non-correlated specialty lines of business identified as diversified financial products; group life, accident and health; aviation; London market account; and other specialty lines of business. Products in each line are marketed by our insurance companies, agencies and the syndicate, through a network of independent agents and brokers, directly to customers or through third party administrators. The majority of our business is low limit or small premium business that has less intense price competition, as well as lower catastrophe and volatility risk. We reinsure a significant portion of our catastrophic exposure to hurricanes and earthquakes to minimize the impact on our net earnings and shareholders’ equity.
Our major domestic and international insurance companies have a financial strength rating of “AA (Very Strong)” from Standard & Poor’s Corporation. Our major domestic insurance companies have a financial strength rating of “AA (Very Strong)” from Fitch Ratings, “A1 (Good Security)” from Moody’s Investors Service, Inc., and “A+ (Superior)” from A.M. Best Company, Inc.
Key facts about our consolidated group as of and for the quarter ended March 31, 2010 are as follows:
    We had consolidated shareholders’ equity of $3.1 billion. Our book value per share increased to $26.91.
    We had net earnings of $71.4 million, or $0.62 per diluted share.
    We produced $594.3 million of total revenue.
    We recognized $20.6 million of net catastrophic losses, primarily related to the Chilean earthquake. This loss increased our first quarter loss ratio by 4.0 percentage points.
    Our loss ratio, including the catastrophic losses, was 64.1% and our combined ratio was 90.3%.
    We declared dividends of $0.135 per share and paid $15.5 million of dividends.
    We hold a $4.9 billion portfolio of fixed income securities with an average rating of AA+ and a total investment portfolio of $5.5 billion.
Comparisons in the following sections refer to the first three months of 2010 compared to the same period of 2009, unless otherwise noted. Amounts in tables are in thousands, except for earnings per share, percentages, ratios and number of employees.

24


 

Results of Operations
Net earnings were $71.4 million ($0.62 per diluted share) in the first three months of 2010, compared to $83.2 million ($0.73 per diluted share) in the same period of 2009. The 2010 net earnings included $20.6 million (pretax) of net catastrophic losses, primarily from the Chilean earthquake, partially offset by a $5.0 million pretax gain, net of related expenses, that we realized from commuting a derivative contract. The 2009 net earnings included a $15.6 million pretax gain, net of related expenses, from the commutation of the MGIC reinsurance contract.
These items are described more fully below:
  In 2010, we incurred a gross loss of $31.9 million and a net loss of $20.6 million after reinsurance related to several catastrophic events that occurred in the first quarter, including the Chilean and Haitian earthquakes and the European windstorm Xynthia. The net catastrophic losses increased our first quarter 2010 loss ratio and combined ratio by 4.0 percentage points and decreased net earnings by $0.12 per diluted share.
 
  In 2010, we commuted our interest in a long-term mortgage impairment insurance contract that had been accounted for as a derivative financial instrument. The contract was denominated in British pound sterling. We received £5.6 million ($8.3 million) of cash and recognized a gain of $8.0 million, which was included in other operating income, and incurred related expenses of $3.0 million, which were included in other operating expense in the condensed consolidated statements of earnings.
 
  In 2009, we commuted, loss-free, all liability under a contract with Mortgage Guarantee Insurance Corporation (MGIC) to provide reinsurance coverage for certain residential mortgage guaranty contracts. We had been recording revenue under this contract using the deposit method of accounting because we determined the contract did not transfer significant underwriting risk. We received a cash termination payment of $25.0 million in the first quarter. As a result of the termination, other operating income increased $20.5 million, and fee and commission income increased $5.0 million. This additional revenue was partially offset by $9.9 million of expenses for reinsurance and other direct costs, which were recorded in other operating expense.
The following table sets forth the relationships of statement of earnings line items as a percent of total revenue.
                 
    Three months ended March 31,  
    2010     2009  
Net earned premium
    85.8 %     83.6 %
Fee and commission income
    3.5       5.0  
Net investment income
    8.3       7.5  
Other operating income
    1.6       3.9  
Net realized investment gain
    0.8       0.5  
Other-than-temporary impairment loss
          (0.5 )
 
           
Total revenue
    100.0       100.0  
Loss and loss adjustment expense, net
    55.0       52.5  
Policy acquisition costs, net
    15.6       14.8  
Other operating expense
    11.2       11.5  
Interest expense
    0.9       0.8  
 
           
Earnings before income tax expense
    17.3       20.4  
Income tax expense
    5.3       6.6  
 
           
Net earnings
    12.0 %     13.8 %
 
           
Revenue
Total revenue decreased $6.5 million in 2010 due to: 1) the $25.0 million from the 2009 commutation of the MGIC reinsurance contract, partially offset by 2) higher net earned premium in 2010 and 3) $8.0 million of revenue in 2010 related to the gain on the commutation of a derivative contract.
Gross written premium, net written premium and net earned premium are detailed below. Growth in written premium occurred primarily in our London market account line of business, directly related to property treaty business that we began to write in late 2009. The increase in net earned premium was due to growth in our directors’ and officers’ liability business in 2009 and 2010. See the “Insurance Company Segment” section below for further discussion of the relationship and changes in premium revenue.

25


 

                 
    Three months ended March 31,  
    2010     2009  
Gross written premium
  $ 622,496     $ 602,387  
Net written premium
    498,251       491,250  
Net earned premium
    509,587       502,388  
The table below shows the source of our fee and commission income, which decreased 31% in 2010. The decrease primarily related to the sale of our U.K. reinsurance broker and the sale of the operations of our commercial marine agency business, both in 2009, and a $5.0 million termination payment from the 2009 commutation of the MGIC reinsurance contract.
                 
    Three months ended March 31,  
    2010     2009  
Agencies
  $ 15,061     $ 24,576  
Insurance companies
    5,932       5,718  
 
           
Fee and commission income
  $ 20,993     $ 30,294  
 
           
The sources of net investment income are detailed below.
                 
    Three months ended March 31,  
    2010     2009  
Fixed income securities
               
Taxable
  $ 26,868     $ 25,105  
Exempt from U.S. income taxes
    21,731       20,333  
 
           
Total fixed income securities
    48,599       45,438  
Short-term investments
    190       884  
Other
    1,508       (52 )
 
           
Total investment income
    50,297       46,270  
Investment expense
    (1,048 )     (1,052 )
 
           
Net investment income
  $ 49,249     $ 45,218  
 
           
Net investment income increased 9% in 2010, primarily due to higher income from fixed income securities, generated from an increased amount of investments. Our fixed income securities portfolio increased 14% from $4.3 billion at March 31, 2009 to $4.9 billion at March 31, 2010. The growth in fixed income securities resulted primarily from cash flow from operations and reinvestment of funds that were held in short-term investments at December 31, 2009. Short-term investment income declined in the first quarter of 2010, due to lower short-term market interest rates. Other interest income in 2010 included $0.6 million of interest related to a tax refund, and in 2009 included a $1.0 million loss on hedge fund investments, which were liquidated in late 2008.
Other operating income was $9.9 million in 2010 compared to $22.9 million in 2009. The 2010 amount included an $8.0 million gain related to commuting a derivative contract. The 2009 income included $20.5 million from the commutation of the MGIC reinsurance contract. Period to period comparisons of our other operating income may vary substantially, depending on earnings generated by new transactions or investments, income or loss related to changes in the fair value of certain investments, and gains or losses related to dispositions. The following table details the components of our other operating income.
                 
    Three months ended March 31,  
    2010     2009  
Contract using deposit accounting
  $     $ 20,532  
Strategic investments
    410       750  
Financial instruments
    8,200       363  
Other
    1,296       1,251  
 
           
Other operating income
  $ 9,906     $ 22,896  
 
           

26


 

Expenses
Loss and loss adjustment expense increased year-over-year primarily due to the $20.6 million of net catastrophic losses incurred in 2010. Excluding the catastrophic losses, the 2010 loss and loss adjustment expense was 3% lower than in 2009. Our loss ratio was 64.1% for 2010 (which included 4.0 percentage points for the catastrophes), compared to 62.8% in 2009. Policy acquisition costs increased in 2010 due to: 1) our 2009 policy acquisition costs being lower due to the effect of a $3.8 million premium deficiency reserve recorded at December 31, 2008, which reduced the amount of policy acquisition costs recognized throughout 2009 and 2) the higher amount of premium earned in 2010. See the “Insurance Company Segment” section below for further discussion of the changes in our loss and loss adjustment expense and policy acquisition costs.
Other operating expense, which includes compensation expense, decreased 3% in 2010. We had 1,874 employees at March 31, 2010 compared to 1,937 a year earlier. In 2009, we sold our U.K. reinsurance broker and the operations of our commercial marine agency business, which primarily accounts for the reduction in other operating expense and the number of employees in 2010. In addition, other operating expense for 2010 and 2009 included $3.0 million and $9.9 million of expense for costs directly related to the commutations of a derivative contract and the MGIC reinsurance contract, respectively. Currency conversion expense was $1.5 million in 2010, compared to a $0.1 million benefit in 2009.
Other operating expense includes $3.2 million and $3.7 million in 2010 and 2009, respectively, of stock-based compensation expense, after the effect of the deferral and amortization of policy acquisition costs related to stock-based compensation for our underwriters. In the first quarter of 2010, we granted $17.6 million of restricted stock awards and units, with a weighted-average life of 6.2 years. At March 31, 2010, there was approximately $28.8 million of total unrecognized compensation expense related to unvested options and restricted stock awards and units that is expected to be recognized over a weighted-average period of 4.1 years.
Our effective income tax rate was 30.7% for 2010, compared to 32.3% for 2009. The lower effective rate in 2010 related to the increased benefit from tax-exempt investment income relative to a lower pretax income base.
At March 31, 2010, total assets were $8.9 billion and shareholders’ equity was $3.1 billion, compared to $8.8 billion and $3.0 billion, respectively, at December 31, 2009. Our book value per share was $26.91, which increased from $26.58 at December 31, 2009.
Segments
Insurance Company Segment
Net earnings of our insurance company segment decreased $9.2 million, or 11%, in the first quarter of 2010. We recognized catastrophe losses in 2010 of $20.6 million (pretax and net of reinsurance). In addition, the commutation of the MGIC reinsurance contract generated $20.5 million in insurance company revenue in 2009. These two items more than offset the effect of higher net earned premium and greater investment income recognized in 2010, as well as the gain in 2010 from the commutation of a derivative contract.
Premium
Gross written premium was 3% higher in 2010 due to the addition of our property treaty business, which we began writing in late 2009, partially offset by reductions in other lines of business due to the soft insurance market. The overall percentage of retained premium, as measured by the percent of net written premium to gross written premium, was 80% and 82% in the first quarter of 2010 and 2009, respectively.

27


 

The following tables provide premium information by line of business.
                                 
    Gross             NWP        
    Written     Net Written     as% of     Net Earned  
    Premium     Premium     GWP     Premium  
Three months ended March 31, 2010
                               
 
Diversified financial products
                               
Directors’ and officers’
  $ 84,168     $ 55,956       66 %   $ 92,918  
Errors and omissions
    56,348       47,963       85       53,893  
Other
    16,412       12,921       79       11,826  
U.S. surety and credit
    54,021       47,419       88       46,749  
International surety and credit
    21,305       19,636       92       18,189  
 
                       
 
    232,254       183,895       79       223,575  
 
                       
 
                               
Group life, accident and health
                               
Medical stop-loss
    161,766       161,766       100       161,766  
Other medical
    22,318       22,318       100       25,021  
Other
    22,298       5,148       23       6,855  
 
                       
 
    206,382       189,232       92       193,642  
 
                       
 
                               
Aviation
    37,521       26,021       69       28,943  
 
                       
 
                               
London market account
                               
Energy
    16,582       9,842       59       16,187  
Property treaty
    37,630       35,257       94       6,754  
Other
    39,750       23,451       59       13,227  
 
                       
 
    93,962       68,550       73       36,168  
 
                       
 
                               
Other specialty lines
                               
Public risk
    16,712       9,205       55       11,490  
HCC Lloyd’s
    17,602       16,273       92       10,185  
Other
    18,021       5,033       28       5,542  
 
                       
 
    52,335       30,511       58       27,217  
 
                       
 
                               
Discontinued lines
    42       42     nm     42  
 
                       
 
                               
Totals
  $ 622,496     $ 498,251       80 %   $ 509,587  
 
                       

28


 

                                 
    Gross             NWP        
    Written     Net Written     as% of     Net Earned  
    Premium     Premium     GWP     Premium  
Three months ended March 31, 2009
                               
 
Diversified financial products
                               
Directors’ and officers’
  $ 94,284     $ 67,467       72 %   $ 82,802  
Errors and omissions
    62,359       54,652       88       59,405  
Other
    25,774       21,832       85       10,976  
U.S. surety and credit
    44,133       42,402       96       44,492  
International surety and credit
    18,562       17,010       92       16,409  
 
                       
 
    245,112       203,363       83       214,084  
 
                       
 
                               
Group life, accident and health
                               
Medical stop-loss
    159,486       159,484       100       159,483  
Other medical
    31,606       31,606       100       33,053  
Other
    25,901       7,966       31       8,552  
 
                       
 
    216,993       199,056       92       201,088  
 
                       
 
                               
Aviation
    41,952       30,611       73       32,814  
 
                       
 
                               
London market account
                               
Energy
    14,814       6,177       42       9,235  
Property treaty
                       
Other
    29,935       20,217       68       14,439  
 
                       
 
    44,749       26,394       59       23,674  
 
                       
 
                               
Other specialty lines
                               
Public risk
    19,934       15,116       76       8,620  
HCC Lloyd’s
    11,222       9,681       86       10,790  
Other
    22,421       7,025       31       11,314  
 
                       
 
    53,577       31,822       59       30,724  
 
                       
 
                               
Discontinued lines
    4       4     nm     4  
 
                       
 
                               
Totals
  $ 602,387     $ 491,250       82 %   $ 502,388  
 
                       
 
    nm — Not meaningful
The changes in premium volume and retention levels between quarters resulted principally from the following factors:
    Diversified financial products — Gross written premium was higher in 2009 because we wrote more directors’ and officers’ liability and errors and omissions business due to the perception of some of our competitors in the market place at that time. The pricing for credit insurance improved in 2010, and our premium has increased accordingly. Our retention rate was lower in 2010 due to lower quota share retention on our international directors’ and officers’ liability business and higher excess of loss premium. Net earned premium increased in 2010 primarily due to the high volume of directors’ and officers’ liability business written in 2009, primarily in the second half of the year.
    Group life, accident and health — The decrease in premium was due to our discontinuance of the provider excess business in late 2009.

29


 

    Aviation — We wrote less aviation premium in 2010 due to continuing competition for U.S. business and lack of growth in the aviation industry. Our international writings were stable due to improved pricing in the international market.
    London market account — Premium increased primarily due to our new property treaty business, which we started writing in late 2009. On a full year basis, our retained premium on the property treaty business is expected to approximate 80%.
    Other specialty lines — Although premium and retention ratios by product changed quarter-over-quarter, due to changes in the mix of business, total premium and the overall retention rate were essentially flat for our other specialty lines.
Losses and Loss Adjustment Expenses
Our gross loss ratio was 64.5% and 65.1% in 2010 and 2009, respectively. The 2010 gross loss ratio included 5.0 percentage points related to the catastrophes in 2010.
The table below shows the composition of net incurred loss and loss adjustment expense.
                                 
    Three months ended March 31,  
    2010     2009  
            Loss             Loss  
    Amount     ratio     Amount     ratio  
2010 catastrophes
  $ 20,588       4.0 %   $       %
Adverse reserve development
    5,010       1.0       4,727       0.9  
All other net incurred loss and loss adjustment expense
    300,923       59.1       310,839       61.9  
 
                       
 
                               
Net incurred loss and loss adjustment expense
  $ 326,521       64.1 %   $ 315,566       62.8 %
 
                       
The adverse reserve development relating to prior year losses was approximately the same amount in both the first quarter of 2010 and 2009. The development in each year primarily resulted from the re-estimation of our net claim exposure for products primarily in the life, accident and health line of business. Deficiencies and redundancies in reserves occur as we review our loss reserves with our actuaries, increasing or reducing loss reserves as a result of such reviews and as losses are finally settled or claims exposures change.
We write directors’ and officers’ liability, errors and omissions liability and fiduciary liability coverage for public and private companies and not-for-profit organizations and continue to closely monitor our exposure to subprime lending issues. We provide coverage for certain financial institutions, which have potential exposure to shareholders’ lawsuits. At March 31, 2010, we had 17 “Side A only” and 77 “non-Side A only” directors’ and officers’ liability, errors and omissions liability and fiduciary liability claims related to subprime issues, compared to 17 and 75 claims, respectively, at December 31, 2009. Based on our present knowledge, we believe our ultimate losses from these coverages will be contained within our current overall loss reserves for these lines of business.
We have no material exposure to environmental or asbestos losses.
We believe we have provided for all material net incurred losses as of March 31, 2010. In addition, we have no material exposure to the Transocean event in April 2010, due to our facultative reinsurance coverage for this large loss.

30


 

The following table provides comparative net loss ratios by line of business and major product lines.
                                 
    Three months ended March 31,  
    2010     2009  
    Net     Net     Net     Net  
    earned     loss     earned     loss  
    premium     ratio     premium     ratio  
Diversified financial products
                               
Directors’ and officers’
  $ 92,918       63.1 %   $ 82,802       60.7 %
Errors and omissions
    53,893       57.1       59,405       55.2  
Other
    11,826       34.2       10,976       50.0  
U.S. surety and credit
    46,749       26.5       44,492       30.5  
International surety and credit
    18,189       44.0       16,409       53.0  
 
                       
 
    223,575       50.9       214,084       51.8  
 
                       
 
                               
Group life, accident and health
                               
Medical stop-loss
    161,766       73.9       159,483       72.6  
Other medical
    25,021       76.9       33,053       88.7  
Other
    6,855       54.2       8,552       57.1  
 
                       
 
    193,642       73.6       201,088       74.6  
 
                       
 
                               
Aviation
    28,943       56.6       32,814       61.3  
 
                       
 
                               
London market account
                               
Energy
    16,187       77.8       9,235       29.5  
Property treaty
    6,754       177.0              
Other
    13,227       80.7       14,439       48.8  
 
                       
 
    36,168       97.4       23,674       41.3  
 
                       
Other specialty lines
                               
Public risk
    11,490       70.0       8,620       68.8  
HCC Lloyd’s
    10,185       61.2       10,790       67.4  
Other
    5,542       78.7       11,314       103.4  
 
                       
 
    27,217       68.5       30,724       81.0  
 
                       
 
                               
Discontinued lines
    42     nm       4     nm  
 
                       
 
                               
Totals
  $ 509,587       64.1 %   $ 502,388       62.8 %
 
                           
 
                               
Expense ratio
            26.2               24.5  
 
                           
 
                               
Combined ratio
            90.3 %             87.3 %
 
                           
 
nm   —  Not meaningful comparison
The changes in net loss ratios between periods resulted principally from the following factors:
    London market account — The 2010 net loss ratios for all major product lines included the effect of the first quarter catastrophe losses, which increased the total London market account loss ratio by 56.9 percentage points. The 2009 net loss ratios included redundant reserve development on prior year hurricanes, which reduced the total London market account loss ratio by 4.2 percentage points.
 
    Other specialty lines — We incurred large losses on our film completion and film production businesses in 2009, which increased the total other specialty lines net loss ratio by 19.7 percentage points.

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The table below provides a reconciliation of our reserves for loss and loss adjustment expense payable, net of reinsurance ceded, the amount of our paid claims and our net paid loss ratios.
                 
    Three months ended March 31,  
    2010     2009  
Net reserves for loss and loss adjustment expense payable at beginning of period
  $ 2,555,840     $ 2,416,271  
Net reserve additions from reinsurance to close of our Lloyd’s syndicate business
    8,110       30,209  
Foreign currency adjustment
    (27,113 )     (18,272 )
Incurred loss and loss adjustment expense
    326,521       315,566  
Loss and loss adjustment expense payments
    (307,688 )     (271,299 )
 
           
 
               
Net reserves for loss and loss adjustment expense payable at end of period
  $ 2,555,670     $ 2,472,475  
 
           
 
               
Net paid loss ratio
    60.4 %     54.0 %
 
           
The net paid loss ratio is the percentage of losses paid, net of reinsurance, divided by net earned premium for the period. The net paid loss ratio was higher in 2010, primarily due to a higher amount of claims payments for our directors’ and officers’ liability, credit and medical stop-loss businesses than in the prior year quarter.
Policy Acquisition Costs
Policy acquisition costs, which are reported net of the related portion of commissions on reinsurance ceded, as a percentage of net earned premium increased to 18.2% in 2010 from 17.7% in the first quarter of 2009, principally due to the effect of a $3.8 million premium deficiency reserve recorded at December 31, 2008, which reduced the amount of policy acquisition costs recognized throughout 2009. The GAAP expense ratio of 26.2% in 2010 exceeded the expense ratio of 24.5% in the first quarter of 2009 primarily due to higher expenses related to our international business and higher currency conversion expense. In addition, the 2009 expense ratio included a benefit from reversing a provision for uncollectible reinsurance.
Agency Segment
Revenue from our agency segment was $28.9 million in 2010, compared to $48.1 million in 2009. The reduction was expected due to the sale of our U.K. reinsurance broker and the sale of the operations of our commercial marine agency business in 2009. In addition, we had $5.0 million of revenue in 2009 from a termination payment from the commutation of the MGIC reinsurance contract. As a result of this lower revenue, the segment had a net loss of $4.4 million in 2010 compared to net earnings of $3.4 million in 2009. We expect the agency segment will generate net earnings for full year 2010 due to the seasonality of business written by our largest agency.
Other Operations Segment
Revenue and net earnings from our other operations segment were $2.1 million and $0.8 million, respectively, in 2010 compared to $2.5 million and $1.0 million, respectively, in 2009. Results of this segment may vary substantially period to period depending on our investment in or disposition of strategic investments.
Liquidity and Capital Resources
Credit market disruptions in recent years have resulted in a tightening of available sources of credit and significant liquidity concerns for many companies. We believe we have sufficient sources of liquidity at a reasonable cost at the present time, based on the following:
    We held $636.5 million of cash and liquid short-term investments at March 31, 2010, compared to $940.1 million at December 31, 2009. We reinvested $234.1 million of short-term investments in higher yielding fixed income securities in the first quarter of 2010.

32


 

    Our insurance companies have sufficient resources to pay potential claims in 2010. As of December 31, 2009, we projected they will pay $1.2 billion of claims and collect approximately $314.7 million of reinsurance recoveries in 2010. At December 31, 2009, our insurance companies had approximately $1.2 billion of cash, short-term investments, maturing bonds, and principal payments from asset-backed and mortgage-backed securities that will be available to pay these expected claims in 2010. There has been no significant change in our expectations of our subsidiaries’ ability to pay claims as of March 31, 2010.
 
    Our available for sale bond portfolio had a fair value of $4.8 billion at March 31, 2010, compared to $4.5 billion at December 31, 2009, and has an average rating of AA+. We intend to hold these securities until their maturity, but we would be able to sell securities to generate cash if the need arises. Should we sell certain securities in the portfolio before their maturity, we cannot be assured that we would recoup the full reported fair value of the securities sold at the time of sale.
 
    Our debt consists of $300.0 million principal amount of unsecured 6.30% Senior Notes due November 15, 2019. Our debt to total capital ratio was 8.8% at March 31, 2010 and 9.0% at December 31, 2009.
 
    We have a committed $575.0 million Revolving Loan Facility at a rate of 30-day LIBOR plus 25 basis points that matures December 19, 2011. At March 31, 2010, we had $553.4 million of unused capacity, which we can draw against at any time at our request. If we do, we believe that the banks will be able and willing to perform on their commitments to us. The facility agreement contains two restrictive financial covenants, with which we were in compliance at March 31, 2010.
 
    In the first quarter of 2010, we transferred $22.2 million of outstanding letters of credit, which had been issued in 2009 on behalf of certain of our subsidiaries, to our Revolving Loan Facility. This transfer released $26.4 million of fixed income securities that had previously been held as collateral for these letters of credit. The letters of credit now reduce available borrowing capacity under our Revolving Loan Facility.
 
    During 2010, there was no significant change in our Standby Letter of Credit Facility used to guarantee our performance in our Lloyd’s of London syndicates.
 
    Our domestic insurance subsidiaries have the ability to pay $217.8 million in dividends in 2010 to our holding company without obtaining special permission from state regulatory authorities. Our underwriting agencies have no restrictions on the amount of dividends that can be paid to our holding company. The holding company can utilize these dividends for any purpose, including to pay down debt, pay dividends to shareholders, fund acquisitions, repurchase common stock and pay operating expenses. Cash flow available to the holding company in 2010 is expected to be more than ample to cover the holding company’s required cash disbursements.
 
    We have a “Universal Shelf” registration statement that provides for the issuance of an aggregate of $1.0 billion of securities, of which we have $700.0 million of remaining capacity. These securities may be debt securities, equity securities, trust preferred securities, or a combination thereof. The shelf registration statement provides us the means to access the debt and equity markets relatively quickly, if we are satisfied with the current pricing in the financial market.
Cash Flow
We receive substantial cash from premiums, reinsurance recoverables, outward commutations, fee and commission income, proceeds from sales and redemptions of investments and investment income. Our principal cash outflows are for the payment of claims and loss adjustment expenses, premium payments to reinsurers, inward commutations, purchases of investments, debt service, policy acquisition costs, operating expenses, taxes and dividends. Cash provided by operating activities can fluctuate due to timing differences in the collection of premiums and reinsurance recoverables and the payment of losses and premium and reinsurance balances payable and the completion of commutations.

33


 

We generated cash from operations of $42.5 million and $133.6 million in the first three months of 2010 and 2009, respectively. The components of our net operating cash flows are summarized in the following table.
                 
    Three months ended March 31,  
    2010     2009  
Net earnings
  $ 71,354     $ 83,170  
Change in premium, claims and other receivables, net of reinsurance, other payables and restricted cash
    (29,390 )     (8,379 )
Change in unearned premium, net
    (10,052 )     (11,552 )
Change in loss and loss adjustment expense payable, net of reinsurance recoverables
    7,082       37,571  
(Gain) loss on investments
    (5,011 )     1,020  
Other, net
    8,493       31,772  
 
           
 
               
Cash provided by operating activities
  $ 42,476     $ 133,602  
 
           
We had $36.4 million of higher claims payments in 2010, compared to 2009, which was the largest contributor to the reduction in cash provided by operating activities. Timing differences in the payment of reinsurance balances payable reduced our 2010 cash provided by operating activities by $35.4 million compared to the first quarter of 2009. In 2010, we received $8.3 million of cash to commute a derivative contract and, in 2009, we received $25.0 million to commute the MGIC reinsurance contract. Cash provided by operating activities can fluctuate due to timing differences in the collection of premium and reinsurance recoverables and the payment of claims and premium and reinsurance balances payable.
We maintain a substantial level of cash and liquid short-term investments to meet anticipated payment obligations. During January 2010, we paid the final $64.5 million due to previous holders of our 1.3% Convertible Notes that were submitted for conversion in December 2009, using cash held as of December 31, 2009. Our combined cash and short-term investments totaled $636.5 million at March 31, 2010.
Investments
At March 31, 2010, we had $5.5 billion of total investments, an increase of $63.1 million from December 31, 2009. This table summarizes our investments by type, substantially all of which are reported at fair value, at March 31, 2010 and December 31, 2009.
                                 
    March 31, 2010     December 31, 2009  
    Amount     %     Amount     %  
Short-term investments
  $ 576,576       11 %   $ 810,673       15 %
U.S. government and government agency securities
    369,995       7       328,535       6  
Fixed income securities of states, municipalities and political subdivisions
    1,110,823       20       1,059,426       19  
Special purpose revenue bonds of states, municipalities and political subdivisions
    1,262,201       23       1,146,334       21  
Corporate fixed income securities
    562,257       10       559,824       10  
Residential mortgage-backed securities
    1,014,909       18       944,182       17  
Commercial mortgage-backed securities
    149,574       3       146,217       3  
Asset-backed securities
    11,972             14,365        
Foreign government securities
    289,304       5       307,891       6  
Foreign non-government securities
    167,169       3       134,091       3  
Other investments
    4,535             4,691        
 
                       
 
                               
Total investments
  $ 5,519,315       100 %   $ 5,456,229       100 %
 
                       

34


 

This table shows the average amount of investments, net income earned, related yields and duration, and average rating of our fixed income securities.
                 
    Three months ended March 31,  
    2010     2009  
Average investments, at cost
  $ 5,327,676     $ 4,874,738  
Net investment income *
    49,249       45,218  
Average short-term yield *
    0.1 %     1.2 %
Average long-term yield *
    4.2 %     4.3 %
Average long-term tax equivalent yield *
    5.0 %     5.2 %
Average combined tax equivalent yield *
    4.4 %     4.7 %
Weighted-average life of fixed income securities
  6.6 years   6.1 years
Weighted-average duration of fixed income securities
  5.0 years   4.8 years
Weighted-average combined duration
  4.5 years   4.2 years
Average rating of fixed income securities
  AA+     AA+  
 
*   Excluding realized and unrealized gains and losses.
This table summarizes our investments in fixed income securities by their rating category at March 31, 2010.
                                 
    Available for sale     Held to maturity  
    at fair value     at amortized cost  
    Amount     %     Amount     %  
AAA
  $ 2,267,486       47 %   $ 135,619       100 %
AA
    1,697,665       35              
A
    691,650       15              
BBB
    112,549       2              
BB and below
    33,235       1              
 
                       
 
                               
Total fixed income securities
  $ 4,802,585       100 %   $ 135,619       100 %
 
                       
The overall rating of our municipal bonds (consisting of our fixed income securities of states, municipalities and political subdivisions and our special purpose revenue bonds of states, municipalities and political subdivisions) was AA at March 31, 2010. Our portfolio of special purpose revenue bonds at March 31, 2010 and December 31, 2009 included $112.5 million and $138.7 million, respectively, of pre-refunded bonds that are supported by U.S. government debt obligations. The remaining special purpose bonds are secured by revenue sources specific to each security, such as water, sewer and utility fees; highway tolls; airport usage fees; property, sales and fuel taxes; college tuition and services fees; electric utilities and lease income. The table below summarizes our percentage holdings of special purpose revenue bonds by revenue source:
                 
    March 31,     December 31,  
    2010     2009  
Water and sewer
    27 %     27 %
Education
    16       14  
Transportation
    13       13  
Special tax
    10       11  
Pre-refunded
    9       13  
Leasing
    8       8  
Electric
    7       7  
Other
    10       7  
 
           
 
               
Total
    100 %     100 %
 
           
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, on an ongoing basis, thereafter. The underlying average credit rating of our special purpose revenue bond issuers, excluding any bond insurance, was AA at March 31, 2010. Although recent

35


 

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, such as water and sewer, education and transportation fees, which we believe generate a stable source of revenue.
At March 31, 2010, we held a corporate bond portfolio with a fair value of $562.3 million, an overall rating of A, and a weighted-average life of approximately 3.1 years.
At March 31, 2010, we also held a portfolio of residential mortgage-backed securities (MBSs) and collateralized mortgage-obligations (CMOs) with a fair value of $1.0 billion. Within our residential MBS/CMO portfolio, $950.6 million of securities, or 95%, were issued by the Federal National Mortgage Association (Fannie Mae), the Government National Mortgage Association (GNMA) and the Federal Home Loan Mortgage Corporation (Freddie Mac), which are backed by the U.S. government. Of the remaining $64.3 million of residential mortgage-backed securities, 92% were collateralized by prime mortgages.
At March 31, 2010, we held a commercial MBS securities portfolio with a fair value of $149.6 million, an average rating of AA+, an average loan-to-value ratio of 70%, and a weighted-average life of approximately 4.7 years. We owned no collateralized debt obligations (CDOs) or collateralized loan obligations (CLOs), and we have never been counterparty to any credit default swap transactions.
This table indicates the expected maturity distribution of our fixed income securities at March 31, 2010.
                                                                 
                    Asset-backed and              
    Available for sale at     mortgage-backed at     Held to maturity at     Total fixed income  
    amortized cost     amortized cost     amortized cost     securities  
    Amount     %     Amount     %     Amount     %     Amount     %  
One year or less
  $ 309,014       9 %   $ 305,647       27 %   $ 38,205       28 %   $ 652,866       14 %
One year to five years
    1,104,920       31     834,198       73     87,012       64     2,026,130       42
Five years to ten years
    803,390       23                 10,402       8     813,792       17
Ten years to fifteen years
    687,406       20                             687,406       14
More than fifteen years
    594,127       17                             594,127       13
 
                                               
 
                                                               
Total fixed income securities
  $ 3,498,857       100 %   $ 1,139,845       100 %   $ 135,619       100 %   $ 4,774,321       100 %
 
                                               
A security has an impairment loss when its fair value is less than its cost or amortized cost at the balance sheet date. The gross unrealized losses of the individual securities within our available for sale fixed income securities portfolios were $12.4 million at March 31, 2010, compared to $18.9 million at December 31, 2009. We evaluate the securities in our fixed income securities portfolio for possible other-than-temporary impairment losses at each quarter end. For a description of the accounting polices and procedures that we use to determine our other-than-temporary impairment losses, see Footnote 3, “Investments,” in the notes to these condensed consolidated financial statements and “Critical Accounting Policies — Other-than-temporary Impairments in Investments” in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2009. We recognized no other-than-temporary impairment losses in the first quarter of 2010 and $3.1 million of other-than-temporary impairment credit losses in the first quarter of 2009.
At March 31, 2010, the net unrealized gain on our available for sale fixed income securities portfolio was $163.9 million, compared to $156.3 million at December 31, 2009. The change in the net unrealized gain, net of the related income tax effect, is recorded in other comprehensive income and fluctuates with changes in market interest rates. Our general policy has been to hold our fixed income securities, most of which are primarily classified as available for sale, through periods of fluctuating interest rates and to not realize significant gains or losses from their sale. We recognized $4.5 million and $3.1 million of net realized investment gains in 2010 and 2009, respectively.

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Accounting Guidance Adopted in 2010
A new accounting standard, originally issued as SFAS No. 167, Amendments to FASB Interpretation No. 46(R), became effective January 1, 2010. The guidance, which was incorporated into Accounting Standards Codification Topic 810, Consolidation, changes various aspects of accounting for and disclosures of interests in variable interest entities. Our adoption of this guidance as of January 1, 2010 had no material impact on our condensed consolidated financial statements.
Effective January 1, 2010, we adopted Accounting Standards Update No. 2010-06, which incorporated changes in disclosure requirements into ASC Topic 820, Fair Value Measurements and Disclosures. When applicable, we have included the additional required disclosures in the notes to our condensed consolidated financial statements.
Critical Accounting Policies
We have made no changes in the identification or methods of application of our critical accounting policies from the information provided 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, 2009.
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, 2009.
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 March 31, 2010. Based on this evaluation, our CEO and CFO concluded that our disclosure controls and procedures were effective as of March 31, 2010.
(b) Changes in Internal Control over Financial Reporting
During the first quarter of 2010, there were no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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Part II — Other Information
Item 1. Legal Proceedings
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 have a material adverse effect on our consolidated financial position, results of operations or cash flows.
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, 2009.
Item 6. Exhibits
a. Exhibits
3.1   Restated Certificate of Incorporation and Certificate of Amendment of Certificate of Incorporation of HCC Insurance Holdings, Inc., filed with the Delaware Secretary of State on July 23, 1996 and May 21, 1998, respectively (incorporated by reference to Exhibit 4.1 to our Registration Statement of Form S-8 (Registration No. 333-61687) filed August 17, 1998).
 
3.2   Amended and Restated Bylaws of HCC Insurance Holdings, Inc., as amended, (incorporated by reference to Exhibit 3.1 to our Form 8-K filed April 3, 2008).
 
10.1   First Amendment to Employment Agreement effective April 19, 2010, between HCC Insurance Holdings, Inc. and William T. Whamond (incorporated by reference to Exhibit 10.01 to our Form 8-K filed on April 19, 2010).
 
12   Statement of Ratio of Earnings to Fixed Charges.
 
31.1   Certification by Chief Executive Officer.
 
31.2   Certification by Chief Financial Officer.
 
32   Certification with Respect to Quarterly Report.

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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)    
 
           
May 7, 2010
      /s/ John N. Molbeck, Jr.    
 
     
 
   
(Date)
      John N. Molbeck, Jr., President    
 
      and Chief Executive Officer    
 
           
May 7, 2010
      /s/ Pamela J. Penny    
 
     
 
   
(Date)
      Pamela J. Penny, Executive Vice President    
 
      and Chief Accounting Officer    

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